**SECURITIESAND EXCHANGE COMMISSION**WASHINGTON, D. C. 20459

**FORM 10-Q**

**QUARTERLYREPORT UNDER SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

**FOR THE QUARTER ENDED September 30, 2006**

**COMMISSION FILE NUMBER 0-20970**

**VISION-SCIENCES,INC.**(Exact name of registrant asspecified in its charter)

| **Delaware**                              | ** ** | **13-3430173**          |
|-------------------------------------------|------------|-------------------------|
| (State or other  jurisdiction of          |       | (IRS Employer           |
| incorporation or  organization)           |       | Identification  Number) |
|                                      |       |                    |
| **9  Strathmore Road, Natick, MA**        | ** ** | **01760**               |
| (Address of  principal executive offices) |       | (Zip Code)              |

 

**(508) 650-9971**(Registrant’s telephonenumber, including area code)

**None**(Former name, formeraddress, and former fiscal year if changed since last report)

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirement for the past 90 days.

Yes  x      No  o

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  o      Acceleratedfiler  o      Non-acceleratedfiler  x

Indicate by check mark whether the registrant is a shell company (asdefined by Rule 12b-2 of the Exchange Act).

Yes  o      No  x

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of October 31, 2006.

| **Common Stock, par value of $.01** | ** ** | **35,166,278**      |
|-------------------------------------|------------|---------------------|
| (Title of Class)                    |       | (Number of  Shares) |

 

 

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**VISION-SCIENCES, INC.TABLE OF CONTENTS**
|           | ** ** | ** **             | ** ** | ** **                                                                                  | ** ** | ** ** | ** ** |   |
|-----------|------------|------------------------|------------|---------------------------------------------------------------------------------------------|------------|------------|------------|--------|
| Part I.   |       | Financial  Information |       |                                                                                        |       |
|      |       |                   |       |                                                                                        |       |       |       |
|      |       | Item 1.                |       | Financial  Statements                                                                       |       |       |       |
|      |       |                   |       |                                                                                        |       |       |       |
|      |       |                   |       | Consolidated  Balance Sheets                                                                |       |       |       |
|      |       |                   |       |                                                                                        |       |       |       |
|      |       |                   |       | Consolidated  Statements of Operations                                                      |       |       |       |
|      |       |                   |       |                                                                                        |       |       |       |
|      |       |                   |       | Consolidated  Statement of Stockholders’ Equity and Comprehensive Loss                 |       |       |       |
|      |       |                   |       |                                                                                        |       |       |       |
|      |       |                   |       | Consolidated  Statements of Cash Flows                                                      |       |       |       |
|      |       |                   |       |                                                                                        |       |       |       |
|      |       |                   |       | Notes to Consolidated Financial Statements                                                  |       |       |       |
|      |       |                   |       |                                                                                        |       |       |       |
|      |       | Item 2.                |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |       |       |       |
|      |       |                   |       |                                                                                        |       |       |       |
|      |       | Item 3.                |       | Quantitative and Qualitative Disclosures about Market  Risk                                 |       |       |       |
|      |       |                   |       |                                                                                        |       |       |       |
|      |       | Item 4.                |       | Controls and Procedures                                                                     |       |       |       |
|      |       |                   |       |                                                                                        |       |       |       |
| Part  II. |       | Other  Information     |       |                                                                                        |       |
|      |       |                   |       |                                                                                        |       |       |       |
|      |       | Item  1A.              |       | Risk  Factors                                                                               |       |       |       |
|      |       |                   |       |                                                                                        |       |       |       |
|      |       | Item 4.                |       | Submission of Matters to a Vote of Stockholders                                             |       |       |       |
|      |       |                   |       |                                                                                        |       |       |       |
|      |       | Item 6.                |       | Exhibits                                                                                    |       |       |       |
|      |       |                   |       |                                                                                        |       |       |       |
|      |       | Signatures             |       |                                                                                        |       |
|      |       |                   |       |                                                                                        |       |       |       |
|      |       | Exhibits               |       |                                                                                        |       |
|           |            |                        |            |                                                                                             |            |            |            |        |  |

 

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**PART I - FINANCIALINFORMATION**

**Item 1: FINANCIALSTATEMENTS**

**VISION-SCIENCES,INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                    | ** ** | **September 30,** | ** ** | **March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|--------------------|------------|
| ** **                                                                                                    | ** ** | **2006**               | ** ** | **2006**           | ** ** |
| ** **                                                                                                    | ** ** | **(Unaudited)**        | ** ** | ** **         | ** ** |
| ASSETS                                                                                                        |       |                   |       |               |       |
| Current Assets:                                                                                               |       |                   |       |               |       |
| Cash and cash  equivalents                                                                                    |       | $                      | 4,038,235  |               | $          | 6,138,148 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $124,343 and $145,402,  respectively          |       | 1,055,663              |       | 1,767,913          |       |
| Inventories                                                                                                   |       | 2,586,674              |       | 2,384,993          |       |
| Prepaid expenses  and deposits                                                                                |       | 32,966                 |       | 59,532             |       |
| Total current  assets                                                                                         |       | 7,713,538              |       | 10,350,586         |       |
|                                                                                                          |       |                   |       |               |       |
| Property and Equipment,  at cost:                                                                             |       |                   |       |               |       |
| Machinery and  equipment                                                                                      |       | 5,059,319              |       | 4,747,964          |       |
| Furniture and  fixtures                                                                                       |       | 262,278                |       | 250,865            |       |
| Leasehold  improvements                                                                                       |       | 588,796                |       | 582,631            |       |
|                                                                                                          |       | 5,910,393              |       | 5,581,460          |       |
| Less-Accumulated  depreciation and amortization                                                               |       | 4,698,243              |       | 4,489,529          |       |
|                                                                                                          |       | 1,212,150              |       | 1,091,931          |       |
|                                                                                                          |       |                   |       |               |       |
| Other assets, net of  accumulated amortization of $63,270 and $60,127, respectively                           |       | 65,362                 |       | 68,505             |       |
| Total assets                                                                                                  |       | $                      | 8,991,050  |               | $          | 11,511,022 |   |
|                                                                                                          |       |                   |       |               |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                    |       |                   |       |               |       |
| Current Liabilities:                                                                                          |       |                   |       |               |       |
| Acceptances  payable to a bank                                                                                |       | $                      | 28,642     |               | $          | 61,536 |   |
| Current portion  of note payable                                                                              |       | 17,452                 |       | 26,431             |       |
| Accounts payable                                                                                              |       | 588,168                |       | 892,398            |       |
| Accrued expenses                                                                                              |       | 1,103,091              |       | 1,028,146          |       |
| Total current  liabilities                                                                                    |       | 1,737,353              |       | 2,008,511          |       |
|                                                                                                          |       |                   |       |               |       |
| Long-term portion of  note payable                                                                            |       | —                 |       | 4,193              |       |
|                                                                                                          |       |                   |       |               |       |
| Stockholders’ Equity:                                                                                    |       |                   |       |               |       |
| Common stock,  $.01 par value—                                                                           |       |                   |       |               |       |
| Authorized—50,000,000  shares                                                                            |       |                   |       |               |       |
| Issued and  outstanding—35,166,278 shares at September 30, 2006 and 35,148,427 shares at  March 31, 2006 |       | 351,662                |       | 351,483            |       |
| Additional  paid-in capital                                                                                   |       | 75,941,682             |       | 75,678,615         |       |
| Accumulated  deficit                                                                                          |       | (69,039,647            | )          | (66,531,780        | )          |
| Total  stockholders’ equity                                                                              |       | 7,253,697              |       | 9,498,318          |       |
| Total liabilities and  stockholders’ equity                                                              |       | $                      | 8,991,050  |               | $          | 11,511,022 |   |

 

See accompanying notes toconsolidated financial statements.

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**VISION-SCIENCES,INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)**
| ** **                                                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                           | ** ** | **September 30,**           | ** ** | **September 30,**         | ** ** |
| ** **                                                           | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales                                                            |       | $                                | 2,291,305  |                           | $          | 2,301,552 |   | $ | 4,298,378 |   | $ | 4,834,510 |   |
| Cost of sales                                                        |       | 1,894,783                        |       | 1,807,204                      |       | 3,413,854 |   | 3,730,022 |   |
|                                                                 |       |                             |       |                           |       |   |   |   |   |
| Gross profit                                                         |       | 396,522                          |       | 494,348                        |       | 884,524 |   | 1,104,488 |   |
|                                                                 |       |                             |       |                           |       |   |   |   |   |
| Selling, general and  administrative expenses                        |       | 1,181,660                        |       | 1,169,392                      |       | 2,263,469 |   | 2,164,336 |   |
| Research and  development expenses                                   |       | 600,820                          |       | 442,484                        |       | 1,211,024 |   | 939,658 |   |
| Loss from  operations                                                |       | (1,385,958                       | )          | (1,117,528                     | )          | (2,589,969 | ) | (1,999,506 | ) |
|                                                                 |       |                             |       |                           |       |   |   |   |   |
| Interest income                                                      |       | 41,447                           |       | 41,093                         |       | 89,838 |   | 86,880 |   |
| Interest expense                                                     |       | (371                             | )          | (851                           | )          | (856 | ) | (1,817 | ) |
| Other income (expense),  net                                         |       | (2,600                           | )          | (1,260                         | )          | (6,880 | ) | 4,800 |   |
|                                                                 |       |                             |       |                           |       |   |   |   |   |
| Net loss                                                             |       | $                                | (1,347,482 | )                              | $          | (1,078,546 | ) | $ | (2,507,867 | ) | $ | (1,909,643 | ) |
|                                                                 |       |                             |       |                           |       |   |   |   |   |
| Basic and diluted net  loss per common share                         |       | $                                | (0.04      | )                              | $          | (0.03 | ) | $ | (0.07 | ) | $ | (0.05 | ) |
|                                                                 |       |                             |       |                           |       |   |   |   |   |
| Shares used in computing basic and diluted net loss per common share |       | 35,166,278                       |       | 35,092,438                     |       | 35,159,392 |   | 35,070,300 |   |

 

See accompanying notes toconsolidated financial statements.

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**VISION-SCIENCES,INC. AND SUBSIDIARIESCONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITYand COMPREHENSIVE LOSS(Unaudited)**
| ** **                                     | ** ** | **Common Stock**      | ** ** | ** **               | ** ** | ** **                      | ** ** | ** **               | ** ** | ** **                            | ** **  |
|------------------------------------------------|------------|----------------------------|------------|--------------------------|------------|---------------------------------|------------|--------------------------|------------|---------------------------------------|-------------|
| ** **                                     | ** ** | **Number  of Shares** | ** ** | **$.01  Par Value** | ** ** | **Additional  Paid-in-Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Total  Stockholders’  Equity** | ** **  | **Total  Comprehensive  Loss** | ** ** |
|                                           |       |                       |       |                     |       |                            |       |                     |       |                                  |        |   |   |
| Balance, March 31, 2006                        |       | 35,148,427                 |       | $                        | 351,483    |                            | $          | 75,678,615               |       | $                                     | (66,531,780 | ) | $ | 9,498,318 |   |   |   |
| Exercise of stock  options, net                |       | 17,851                     |       | 179                      |       | 19,219                          |       |                     |       | 19,398                                |        |   |   |
| Compensation expense  related to stock options |       |                       |       |                     |       | 243,848                         |       |                     |       | 243,848                               |        |   |   |
| Net loss                                       |       |                       |       |                     |       |                            |       | (2,507,867               | )          | (2,507,867                            | )           | $ | (2,507,867 | ) |
| Total comprehensive loss                       |       |                       |       |                     |       |                            |       |                     |       |                                  |        | $ | (2,507,867 | ) |
| Balance September 30, 2006                     |       | 35,166,278                 |       | $                        | 351,662    |                            | $          | 75,941,682               |       | $                                     | (69,039,647 | ) | $ | 7,253,697 |   |   |   |

 

See accompanying notes toconsolidated financial statements.

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**VISION-SCIENCES,INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)**
| ** **                                                                    | ** ** | **Six Months Ended**   | ** ** | **Six Months Ended**   | ** ** |
|-------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                    | ** ** | **September 30, 2006** | ** ** | **September 30, 2005** | ** ** |
| Cash flows from  operating activities:                                        |       |                             |       |                             |       |
| Net loss                                                                      |       | $                                | (2,507,867 | )                                | $          | (1,909,643 | ) |
| Adjustments to  reconcile net loss to net cash used for operating activities: |       |                             |       |                             |       |
| Depreciation and  amortization                                                |       | 211,857                          |       | 206,073                          |       |
| Stock-based  compensation                                                     |       | 243,848                          |       | 99,369                           |       |
| Changes in  assets and liabilities:                                           |       |                             |       |                             |       |
| Accounts  receivable                                                          |       | 712,250                          |       | 326,361                          |       |
| Inventories                                                                   |       | (201,681                         | )          | (696,827                         | )          |
| Prepaid expenses  and deposits                                                |       | 26,566                           |       | 10,357                           |       |
| Accounts payable                                                              |       | (304,230                         | )          | 58,298                           |       |
| Accrued expenses                                                              |       | 74,945                           |       | (203,366                         | )          |
| Net cash used  for operating activities                                       |       | (1,744,312                       | )          | (2,109,378                       | )          |
|                                                                          |       |                             |       |                             |       |
| Cash flows used for  investing activities:                                    |       |                             |       |                             |       |
| Purchase of  property and equipment, net                                      |       | (328,933                         | )          | (198,885                         | )          |
|                                                                          |       |                             |       |                             |       |
| Net cash used  for investing activities                                       |       | (328,933                         | )          | (198,885                         | )          |
|                                                                          |       |                             |       |                             |       |
| Cash flows provided by  (used for) financing activities:                      |       |                             |       |                             |       |
| Payments on note  payable for computer equipment                              |       | (13,172                          | )          | (12,211                          | )          |
| Payments of  acceptances payable to a bank, net                               |       | (32,894                          | )          | —                           |       |
| Proceeds from  the sale of common stock, net                                  |       | —                           |       | 55,869                           |       |
| Exercise of  stock options, net                                               |       | 19,398                           |       | 120,430                          |       |
| Net cash (used  for) provided by financing activities                         |       | (26,668                          | )          | 164,088                          |       |
| Net decrease in cash  and cash equivalents                                    |       | (2,099,913                       | )          | (2,144,175                       | )          |
| Cash and cash  equivalents, beginning of period                               |       | 6,138,148                        |       | 9,868,586                        |       |
| Cash and cash  equivalents, end of period                                     |       | $                                | 4,038,235  |                             | $          | 7,724,411 |   |
|                                                                          |       |                             |       |                             |       |
| Supplemental Disclosure  of Cash Flow Information:                            |       |                             |       |                             |       |
| Cash paid during the  period for interest                                     |       | $                                | 856        |                             | $          | 1,817 |   |
|                                                                          |       |                             |       |                             |       |
| Supplemental Disclosure of Non-cash Items from Financing Activities:          |       |                             |       |                             |       |

 

See accompanying notes to consolidated financial statements.

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**VISION-SCIENCES, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

**1**.                                      **Basis of Presentation**

The consolidated financial statementsincluded herein have been prepared by Vision-Sciences, Inc. and subsidiaries(the “Company”) in accordance with generally accepted accounting principles inthe United States of America (“GAAP”), without audit, pursuant to the rules andregulations of the Securities and Exchange Commission and include, in theopinion of management, all adjustments (consisting only of normal and recurringadjustments) that the Company considers necessary for a fair presentation ofsuch information.  Certain informationand footnote disclosures normally included in financial statements have beencondensed or omitted pursuant to such rules and regulations.  The Company believes, however, that itsdisclosures are adequate to make the information presented not misleading.  These consolidated financial statementsshould be read in conjunction with the audited consolidated financialstatements and notes thereto included in the Company’s latest annual report tostockholders.  The results for theinterim periods presented are not necessarily indicative of results to beexpected for the full fiscal year.

**2**.                                      **Summary of Significant AccountingPolicies**

The accompanying consolidated financialstatements reflect the application of certain accounting policies describedbelow:

a.                                       *Principles of Consolidation*: The accompanying consolidated financialstatements include the accounts of the Company and its wholly-ownedsubsidiaries.  All material intercompanyaccounts and transactions have been eliminated in consolidation.

b**.****                                     ***Cash Equivalents*: The Company classifies investments withoriginal maturities of ninety days or less, consisting of commercial paper anda money market account at a bank, as cash equivalents.  Cash equivalents are stated at amortizedcost, which approximates market value*.*

c.                                       *Inventories*: Inventories are stated at the lower of cost or market using thefirst-in, first-out (FIFO) method and consist of the following:
| ** **      | ** ** | **September 30,** | ** ** | **March 31,** | ** ** |
|-----------------|------------|------------------------|------------|--------------------|------------|
| ** **      | ** ** | **2006**               | ** ** | **2006**           | ** ** |
| ** **      | ** ** | **(unaudited)**        | ** ** | **(audited)**      | ** ** |
| Raw materials   |       | $                      | 1,465,627  |               | $          | 1,600,652 |   |
| Work-in-process |       | 427,144                |       | 143,803            |       |
| Finished goods  |       | 693,903                |       | 640,538            |       |
|            |       | $                      | 2,586,674  |               | $          | 2,384,993 |   |

 

Work-in-process and finishedgoods inventories consist of material, labor, and manufacturing overhead.

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d.                                      *Depreciation and Amortization*: The Company provides for depreciation andamortization using the straight-line method in amounts that allocate the cost ofthe assets to operations over their estimated useful lives as follows:
| **Asset Classification** | ** ** | **Estimated Useful Life** | ** ** |
|-------------------------------|------------|-------------------------------------|------------|
| Machinery and  Equipment      |       | 3-5 Years                           |       |
| Furniture and Fixtures        |       | 5 Years                             |       |

 

Leasehold improvements are amortized over theshorter of their estimated useful lives or the lives of the leases.

e.                                       *Basic and Diluted Net Loss PerCommon Share*: Basic anddiluted net loss per common share is based on the weighted average number ofcommon shares outstanding.  Shares ofcommon stock issuable pursuant to outstanding stock options have not beenconsidered, as their effect would be antidilutive.

f.                                         *RevenueRecognition*: The following must occur before the Companyrecognizes revenue: (1) persuasive evidence of an arrangement exists, (2)delivery has occurred or services have been rendered, (3) the price is fixed ordeterminable, (4) collectibility is reasonably assured and (5) the fair valueof undelivered elements, if any, exists. To date the Company has not entered into any multiple elementarrangements.  The Company recognizesrevenue when title passes to the customer, generally upon shipment of productsF.O.B. its plants.  Since September 2003,the Company’s medical segment has distributed all of its products for theEar-Nose-Throat (“ENT”) market in the United States and Canada through anagreement (the “Medtronic Agreement”) with Medtronic ENT, Inc. (“MENT”).  The initial term of the Medtronic Agreementwas three years, but is automatically renewed thereafter for successiveone-year periods, unless terminated by either party upon advance writtennotice.  Neither party provided suchnotice, so the Medtronic Agreement has been renewed for one year.  The Medtronic Agreement does not provide forany contingencies, nor provide any terms related to product acceptance orwarranty that are different from the normal terms provided by the Company toits other customers.

From December 2004 to May 1, 2006, theCompany’s medical segment distributed all of its products for the urologymarket in the United States and Canada through Medtronic USA, Inc. (theMedtronic Gastroenterology/Urology business, or “MGU”) as part of a separateexclusive agreement (the “MGU Agreement”). The MGU Agreement continued in full force and effect until March 31,2006, renewable thereafter annually, unless terminated by either party.  In May 2006, the Company and MGU terminatedthe MGU Agreement.  Subsequent to May 1,2006, the Company has been developing its own worldwide independent salesrepresentative organization to distribute its products to the urology market.

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The Company’s medical segment distributes itsproducts for the pulmonary and gastro-intestinal (“GI”) markets through anetwork of independent domestic sales representatives. The Company’s medicalsegment distributes all its products outside the United States and Canadathrough a network of independent international distributors.

The Company’s industrial segment distributesall its products using direct sales personnel and a network of independentsales representatives.

g.                                      *Foreign Currency Transactions*: In accordance with Statement of FinancialAccounting Standard (“SFAS”) No. 52, *Foreign CurrencyTranslation,* the Company charges foreign currency exchange gains orlosses, in connection with its purchases of products from vendors in Japan, tooperations.

h.                                      *Income Taxes*: The Company accounts for income taxes underthe liability method in accordance with SFAS No. 109, *Accountingfor Income Taxes*(“SFAS 109”). Under SFAS 109, deferred tax assets or liabilities are computed basedupon the differences between the financial statement and income tax bases ofassets and liabilities as measured by the enacted tax rates.  The Company has recorded a valuationallowance equal to its net deferred tax asset due to the uncertainty ofrealizing the benefit of this asset.

i.                                          *Stock-based Compensation:*Effective April 1, 2006 the Company beganaccounting for compensation expense related to stock options granted toemployees and directors in accordance with SFAS No. 123 (Revised 2004) *Share-Based Payment*(“SFAS 123R”).  Prior to April 1, 2006, the Company accountedfor stock options according to Accounting Principles Board (“APB”) Opinion 25, *Accounting for Stock Issued to Employees.*

The Company has adopted the modifiedprospective transition method provided for under SFAS 123R, and consequentlyhas not retroactively adjusted results from prior periods.  Under this transition method, compensationcost associated with stock options now includes: (i) amortization related tothe remaining unvested portion of all stock options outstanding at March 31,2006, based on the fair value determined on the grant date in accordance withthe original provisions of SFAS 123, and (ii) amortization related to all stockoption awards granted subsequent to March 31, 2006, based upon the fair valueestimated in accordance with SFAS 123R. The compensation expense for stock-based compensation awards under SFAS123R is recognized over the vesting period of the options, and includes anestimate for forfeitures.

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The Company continues to account forcompensation expense related to stock options granted to non-employees inaccordance with EITF 96-18, *Accounting for EquityInstruments That Are Issued to Other Than Employees for Acquiring, or inConjunction with Selling, Goods and Services*(“EITF 96-18”).  According to the provisions of EITF 96-18,the Company determines the fair value of options granted to non-employees usingthe Black-Scholes option-pricing model on the measurement date which is eitherthe date a commitment for performance is reached, or when performance has beencompleted, depending upon the facts and circumstances of the option.  The fair value of the options valued at themeasurement date is expensed over the vesting period of the options.  This method approximates the same periods theexpense would be recognized had the Company paid cash for the services.  The Company does not account for the fairvalue of options granted, in which the quantity and terms are known up front,prior to the measurement date, as the services are not rendered prior to thosedates.  The Company accounts for the fairvalue of options granted, in which the quantity and terms are not known upfront, when the services are performed.

In accordance withSFAS 123R and EITF 96-18, the Company recorded $131,378 and $243,848 ofstock-based compensation expense in the statement of operations for the threeand six months ended September 30, 2006, respectively in the following expensecategories:
| ** **          | ** ** | **Three Months  Ended**     | ** ** | **Six Months  Ended** | ** ** |
|---------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **          | ** ** | **September 30, 2006** | ** ** |
| Cost of Goods  Sold |       | $                                | 15,583     |                       | $          | 30,035 |   |
| SG&A            |       | 105,014                          |       | 191,454                    |       |
| R&D             |       | 10,781                           |       | 22,359                     |       |
| Total               |       | $                                | 131,378    |                       | $          | 243,848 |   |

 

At September 30, 2006,the total unamortized stock-based compensation is approximately $866,000.  The Company will expense that amount overperiods ending March 31, 2011.  TheCompany does not expect to realize any tax benefits from future disqualifyingdispositions, if any, due to its policy of recording valuation allowances equalto its deferred tax asset.

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Inthe three and six months ended September 30, 2005, the Company recordedcompensation expense of $49,684 and $99,369 for non-qualified stock options inthe statement of operations in the following expense categories:
| ** **          | ** ** | **Three Months  Ended**     | ** ** | **Six Months  Ended** | ** ** |
|---------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **          | ** ** | **September 30, 2005** | ** ** |
| Cost of Goods  Sold |       | $                                | —     |                       | $          | — |   |
| SG&A            |       | 49,575                           |       | 99,150                     |       |
| R&D             |       | 109                              |       | 219                        |       |
| Total               |       | $                                | 49,684     |                       | $          | 99,369 |   |

 

In the six monthsended September 30, 2006 (“6M 07”), the Company granted options to purchase265,000 shares of the Company’s common stock to employees.  The fair value of these options measured atthe option grant dates was approximately $240,000, determined using theBlack-Scholes option-pricing model, and is being recorded as an expense overthe vesting period.  The assumptions usedin the Black-Scholes option-pricing model in the period by the Company were asfollows:
| ** **                              | ** ** | **Six Months Ended  September 30, 2006** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------|------------|
| Risk-free  interest rate                |       | 4.51%-4.96                                                   | %          |
| Expected  dividend yield                |       | —                                                       |       |
| Expected life                           |       | 6.25 years                                                   |       |
| Expected  volatility                    |       | 67%-69                                                       | %          |
| Weighted average value grant  per share |       | $                                                            | 1.36       |   |
|                                         |            |                                                              |            |  |

 

11

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In 6M 07, the Companygranted options to purchase 100,000 shares of the Company’s common stock to anon-employee.  The fair value of theseoptions measured at the option grant dates was approximately $107,000,determined using the Black-Scholes option-pricing model, and is being recordedas an expense over the vesting period. The assumptions used in the Black-Scholes option-pricing model in theperiod by the Company were as follows:
| ** **                              | ** ** | **Six Months Ended  September 30, 2006** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------|------------|
| Risk-free  interest rate                |       | 4.91                                                         | %          |
| Expected  dividend yield                |       | —                                                       |       |
| Expected life                           |       | 10.0 years                                                   |       |
| Expected  volatility                    |       | 69                                                           | %          |
| Weighted average value  grant per share |       | $                                                            | 1.60       |   |
|                                         |            |                                                              |            |  |

 

In 6M 07, the Companygranted options to purchase 16,000 shares of the Company’s common stock tooutside members of the board of directors. The fair value of these options measured at the option grant dates wasapproximately $15,160, determined using the Black-Scholes option-pricing model,and was recorded as an expense in the three months ended September 30, 2006, asthe options were 100% vested upon grant. The assumptions used in the Black-Scholes option-pricing model in theperiod by the Company were as follows:
| ** **                              | ** ** | **Six Months Ended  September 30, 2006** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------|------------|
| Risk-free  interest rate                |       | 4.91                                                         | %          |
| Expected dividend  yield                |       | —                                                       |       |
| Expected life                           |       | 5.50 years                                                   |       |
| Expected  volatility                    |       | 69                                                           | %          |
| Weighted average value  grant per share |       | $                                                            | 1.49       |   |
|                                         |            |                                                              |            |  |

 

12

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Weaccount for options issued in accordance with the provisions of SFAS 123R.  We grant options with vesting periods rangingfrom immediate to four years.  For thequarters ended June 30, 2006 (“Q1 07”) and September 30, 2006 (“Q2 07”), foroptions granted to employees, we have chosen to employ the simplified method ofcalculating the expected option term, which averages an award’s weightedaverage vesting period and its contractual term.  For the option granted to the non-employee,we used the full contractual term for the expected option term.  The contractual term of our options is tenyears.  The options granted in Q1 07 andQ2 07 to employees and the non-employee vest at a rate of 25% per year for thefirst four years.  The options granted inQ2 07 to members of the board are 100% vested upon grant. The risk-free rate isbased upon the daily Treasury yield curve for a period approximately equal tothe expected option term.  We usedhistorical data to estimate the expected price volatility and forfeiturerate.  The expected dividend yield is 0%,based on our history of not paying dividends and on the fact that we areprohibited from paying dividends under our bank agreement.

SFAS 123R requires the presentation of proforma information for the comparative period prior to the adoption, as if theCompany had accounted for all its employee stock options under the fair valuemethod of the original SFAS 123.  Thefollowing table illustrates the effect on net loss and loss per share if theCompany had applied the fair value recognition provisions of SFAS 123 tostock-based employee compensation in the prior year.
| ** **                                            | ** ** | **Three Months  Ended  September 30, 2005** | ** ** | **Six Months  Ended  September 30, 2005** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| Net loss — as  reported                          |       | $                                                          | (1,078,546 | )                                                        | $          | (1,909,643 | ) |
| Stock-based  employee compensation — as reported |       | 3,297                                                      |       | 6,594                                                    |       |
| Pro forma  stock-based employee compensation          |       | (146,493                                                   | )          | (265,662                                                 | )          |
| Net loss — pro  forma                            |       | $                                                          | (1,221,742 | )                                                        | $          | (2,168,711 | ) |
|                                                  |       |                                                       |       |                                                     |       |
| Net loss per  share — as reported                |       | $                                                          | (.03       | )                                                        | $          | (.05 | ) |
| Stock-based  employee compensation — as reported |       | —                                                     |       | —                                                   |       |
| Pro forma  stock-based employee compensation          |       | —                                                     |       | (.01                                                     | )          |
| Net loss per share —  pro forma                  |       | $                                                          | (.03       | )                                                        | $          | (.06 | ) |

 

13

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In the six monthsended September 30, 2005, the Company granted options to purchase 241,500shares of the Company’s common stock. The fair value of these options measured at the option grant date wereapproximately $308,853, determined using the Black-Scholes option-pricingmodel, and were not recorded as an expense over the vesting period, as theCompany was not accounting for options under SFAS 123R.

Theassumptions used in the Black-Scholes option-pricing model in the period by theCompany were as follows:
| ** **                              | ** ** | **Six Months Ended  September 30, 2005** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------|------------|
| Risk-free  interest rate                |       | 3.33                                                         | %          |
| Expected  dividend yield                |       | —                                                       |       |
| Expected life                           |       | 5 years                                                      |       |
| Expected  volatility                    |       | 69%-72                                                       | %          |
| Weighted average value  grant per share |       | $                                                            | 2.13       |   |
|                                         |            |                                                              |            |  |

 

j.                                                *Recently Issued Accounting Standards*

In July 2006, the Financial AccountingStandards Board (“FASB”) issued FIN 48, *Accounting for Uncertaintyin Income Taxes-an**Interpretation of FASBStatement No. 109*, which seeks to reduce the significant diversityin practice associated with certain aspects of measurement and recognition inaccounting for income taxes. FIN 48 prescribes a recognition threshold andmeasurement attribute for financial statement recognition and measurement of atax position taken or expected to be taken in a tax return, and also providesguidance on de-recognition, classification, interest and penalties, accountingin interim periods, disclosure and transition. The provisions of FIN 48 areeffective for fiscal years beginning after December 15, 2006. Upon adoption, thecumulative effect of any changes in net assets resulting from the applicationof FIN 48 will be recorded as an adjustment to retained earnings. The Companyis currently evaluating the impact, if any, that FIN 48 will have on itsfinancial position and results of operations.

14

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In February 2006, the FASBissued SFAS 155, *Accounting for CertainHybrid Financial Instruments* which amends SFAS 133, *Accounting for Derivative Instruments and Hedging Activities*and SFAS 140, *Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities*.  SFAS 155 simplifies the accounting forcertain derivatives embedded in other financial instruments by allowing them tobe accounted for as a whole if the holder elects to account for the whole instrumenton a fair value basis.  SFAS 155also clarifies and amends certain other provisions of SFAS 133 andSFAS 140.  SFAS 155 iseffective for all financial instruments acquired, issued or subject to are-measurement event occurring in fiscal years beginning afterSeptember 15, 2006 and is therefore required to be adopted by the Companyin the first quarter of its fiscal year ended March 31, 2008. The Companyis currently evaluating the effect that the adoption of SFAS 155 will haveon its consolidated financial statements but does not expect that it will havea material impact.

In September 2006, the FASB issuedSFAS 158, *Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans*. This statement requirespublic entities with defined benefit pension plans and other postretirementplans to fully recognize, as an asset or a liability, the overfunded orunderfunded status of its benefit plans in its 2006 balance sheet. The Companydoes not expect SFAS 158 to have an impact on its consolidated financialstatements as it has no defined benefit pension or other postretirement plans.

In September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No.108, *Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements* to provide guidance on the consideration of the effectsof prior year misstatements in quantifying current year misstatements for thepurpose of a materiality assessment. Under SAB No. 108, companies shouldevaluate a misstatement based on its impact on the current year incomestatement, as well as the cumulative effect of correcting such misstatementsthat existed in prior years existing in the current year’s ending balancesheet. SAB No. 108 is effective for fiscal years ending after November 15,2006.  The Company has not determined the effect the adoption of SAB No.108 will have on its financial position and results of operations.

15

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In September 2006, the FASB issued SFAS 157 *Fair Value Measurements*. SFAS 157establishes a framework for measuring fair value in generally acceptedaccounting principles, and expands disclosures about fair valuemeasurements.  The standard applies whenever other standards require (orpermit) assets or liabilities to be measured at fair value.  The standarddoes not expand the use of fair value in any new circumstances.  SFAS 157is effective for financial statements issued for fiscal years beginning afterNovember 15, 2007, and interim periods within those fiscal years.  Earlierapplication is encouraged. The Company has not yet determined the effect theadoption of SFAS 157 will have on its financial position and results ofoperations.

In June 2006, the FASB ratified the consensuson EITF Issue No. 06-03, *How Taxes Collectedfrom Customers and Remitted to Governmental Authorities Should Be Presented inthe Income Statement.* The scope of EITF Issue No. 06-03includes any tax assessed by a governmental authority that is directly imposedon a revenue-producing transaction between a seller and a customer and mayinclude, but is not limited to, sales, use, value added, Universal Service Fund(“USF”) contributions and some excise taxes. The Task Force affirmed itsconclusion that entities should present these taxes in the income statement oneither a gross or a net basis, based on their accounting policy, which shouldbe disclosed pursuant to APB Opinion No. 22, *Disclosure of Accounting Policies.* If such taxes aresignificant, and are presented on a gross basis, the amounts of those taxesshould be disclosed. The consensus on Issue No. 06-03 will be effectivefor interim and annual reporting periods beginning after December 15,2006. The Company is currently evaluating the impact of EITF No. 06-03. Should the Company need to change the manner in which it records grossreceipts, it is not expected that the change will have a material impact ontotal operating revenue and expenses and operating income and net income wouldnot be affected.

 

16

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**3.             Stock Option Plans**

The Company had a stock option plan (the “1990Plan”) under which it could grant employees and non-employees stock options atthe fair value of the stock on the date of grant.  The Board of Directors had authorized theissuance of options for the purchase of up to 4,375,000 shares of common stockunder the 1990 Plan, of which 872,087 were retired as of the expiration of the1990 Plan.  Options for the purchase of1,495,750 shares of common stock under the 1990 Plan remain outstanding atSeptember 30, 2006.

The Company has a stock option plan (the “2000Plan”) under which it grants key employees and consultants stock options at thefair value of the stock on the date of grant. Options become exercisable at varying dates ranging up to five yearsfrom the date of grant.  The Board ofDirectors and shareholders have authorized the issuance of options for thepurchase of up to 4,500,000 shares of common stock under the 2000 Plan, ofwhich 808,358 shares remain available for future grant.  Options for the purchase of 3,039,500 sharesof common stock under the 2000 Plan remain outstanding at September 30,2006.  The Company grants options to bothemployees and non-employee consultants.

A summary of the stockoption activity for 6M 07 is as follows:
| ** **                      | ** ** | **Number of Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Weighted Average Remaining  Contractual Term** | ** ** |
|---------------------------------|------------|--------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| Outstanding March 31,  2006     |       | 4,367,351                      |       | $                                              | 1.52       |                                                            | 6.08       |   |
| Granted                         |       | 365,000                        |       | 1.43                                           |       |                                                            |       |
| Exercised                       |       | (17,851                        | )          | 1.09                                           |       |                                                            |       |
| Canceled                        |       | (179,250                       | )          | 2.30                                           |       |                                                            |       |
| Outstanding September  30, 2006 |       | 4,535,250                      |       | $                                              | 1.49       |                                                            | 5.85       |   |
| Exercisable September 30, 2006  |       | 3,315,375                      |       | $                                              | 1.47       |                                                            |       |   |

 

The total intrinsic value ofoptions exercised in 6M 07 was $11,722.00.

The following table summarizes information about stock optionsoutstanding and exercisable at September 30, 2006:
| ** **                              | ** ** | **Outstanding**            | ** ** | **Exercisable**                                                      | ** ** |
|-----------------------------------------|------------|----------------------------|------------|----------------------------------------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted Average  Exercise  Price** | ** ** | **Number  of Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|                                    |       |                       |       |                                                                 |       |   |   |   |   |   |   |
| $.79 - 1.05                             |       | 1,151,250                  |       | 6.46                                                                 |       | $ | 1.02 |   | 1,103,750 |   | $ | 1.02 |   |
| 1.06 - 1.31                             |       | 1,202,750                  |       | 5.24                                                                 |       | 1.14 |   | 710,875 |   | 1.17 |   |
| 1.34 - 1.67                             |       | 1,502,750                  |       | 4.88                                                                 |       | 1.57 |   | 1,138,000 |   | 1.61 |   |
| 1.73 - 2.25                             |       | 312,500                    |       | 8.50                                                                 |       | 1.90 |   | 79,375 |   | 1.93 |   |
| 2.28 - 2.90                             |       | 136,000                    |       | 7.80                                                                 |       | 2.50 |   | 118,375 |   | 2.46 |   |
| 3.25 - 4.30                             |       | 230,000                    |       | 7.59                                                                 |       | 3.95 |   | 165,000 |   | 3.87 |   |
|                                    |       | 4,535,250                  |       | 5.85                                                                 |       | $ | 1.49 |   | 3,315,375 |   | $ | 1.47 |   |

 

17

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The aggregate intrinsicvalue of all outstanding and exercisable options at September 30, 2006 isnegative, as the closing price of the Company’s common stock on September 30,2006 is less than the weighted average price of the outstanding and exercisableoptions.

The Company has a 2003Director Option Plan (the “2003 Plan”) under which it may grant up to 200,000non-statutory stock options to non-employee directors of the Company at thefair value of the stock on the grant date. The terms of the 2003 Plan include automatic grants of 4,000 shares toeach outside director on each date on which an annual meeting of thestockholders of the Company is held, provided that such outside director doesnot hold on such date any outstanding options to purchase common stock of theCompany’s 1993 Plan, which options are not fully exercisable.  Options granted under the 2003 Plan are 100%vested on the date of grant.  The Companygranted options to purchase 16,000 shares to the outside directors on August 3,2006.  The Company expects to makesimilar grants at the annual meetings in each of 2007, 2008 and 2009.

A summary of the 2003 Plan activity is asfollows:
| ** **                      | ** ** | **Number  of Shares** | ** ** | **Exercise  Price Range** | ** **   | **Weighted  Average  Exercise Price** | ** ** |
|---------------------------------|------------|----------------------------|------------|--------------------------------|--------------|--------------------------------------------|------------|
| Outstanding  March 31, 2006     |       | 72,000                     |       | $                              | 1.00 - $2.10 |                                       | $          | 1.39 |   |
| Granted                         |       | 16,000                     |       | 1.49                           |         | 1.49                                       |       |
| Exercised                       |       | —                     |       | —                         |         | —                                     |       |
| Canceled                        |       | —                     |       | —                         |         | —                                     |       |
| Outstanding  September 30, 2006 |       | 88,000                     |       | $                              | 1.00 - $2.10 |                                       | $          | 1.41 |   |
| Exercisable September  30, 2006 |       | 88,000                     |       | $                              | 1.00 - $2.10 |                                       | $          | 1.41 |   |

 

The following table summarizes information aboutdirector stock options outstanding and exercisable at September 30, 2006:
| ** **                              | ** ** | **Outstanding**            | ** ** | **Exercisable**                                                  | ** ** |
|-----------------------------------------|------------|----------------------------|------------|------------------------------------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  of Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                                    |       |                       |       |                                                             |       |   |   |   |   |   |   |
| $1.00 - 1.30                            |       | 40,000                     |       | 4.69                                                             |       | $ | 1.15 |   | 40,000 |   | $ | 1.15 |   |
| 1.49 - 1.92                             |       | 40,000                     |       | 5.26                                                             |       | 1.54 |   | 40,000 |   | 1.54 |   |
| 2.06 - 2.10                             |       | 8,000                      |       | 8.91                                                             |       | 2.08 |   | 8,000 |   | 2.08 |   |
|                                    |       | 88,000                     |       | 5.33                                                             |       | $ | 1.41 |   | 88,000 |   | $ | 1.41 |   |

 

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**4.**               Segment Information

The Company has three reportable segments — medical,industrial and corporate.  The medicalsegment designs, manufactures and sells disposable Slide-On® EndoSheaths® (“EndoSheaths”)and sells endoscopes to users in the healthcare industry.  The industrial segment designs, manufacturesand sells borescopes to a variety of users, primarily in the aircraft enginemanufacturing and aircraft engine maintenance industries.  In addition, the industrial segmentmanufactures and repairs endoscopes for the medical segment.  The corporate segment consists of certainadministrative and business development activities applicable to the Company asa whole.

All segments follow the accounting policies describedin the summary of significant accounting policies.  The Company evaluates segment performancebased upon operating income.  Identifiableassets are those used directly in the operations of each segment.  Corporate assets include cash, marketablesecurities and the assets of Vision-Sciences, Ltd.  Data regarding management’s view of theCompany’s segments are provided in the following tables.

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| **Three months ended September 30,** | ** ** | **Medical** | ** ** | **Industrial** | ** ** | **Corporate** | ** ** | **Adjustments** | ** ** | **Total**  | ** ** |
|----------------------------------------------------------|------------|-------------|------------|----------------|------------|---------------|------------|-----------------|------------|------------|------------|
| **2006**                                                 |       |        |       |           |       |          |       |            |       |       |       |
| Sales to  external customers                             |       | $           | 1,589,019  |           | $          | 702,286       |       | $               | —     |       | $          | — |   | $ | 2,291,305 |   |
| Intersegment  sales                                      |       | —      |       | 424,829        |       | —        |       | (424,829        | )          | —     |       |
| Operating income  (loss)                                 |       | (781,788    | )          | (114,206       | )          | (489,964      | )          | —          |       | (1,385,958 | )          |
| Interest income  (expense), net                          |       | —      |       | —         |       | 41,076        |       | —          |       | 41,076     |       |
| Depreciation and  amortization                           |       | 103,008     |       | 6,544          |       | —        |       | —          |       | 109,552    |       |
| Other  significant non-cash items:                       |       |        |       |           |       |          |       |            |       |       |       |
| Stock-based compensation                                 |       | 28,924      |       | 25,679         |       | 76,775        |       | —          |       | 131,378    |       |
| Expenditures for  fixed assets                           |       | 145,569     |       | 39,005         |       | —        |       | —          |       | 184,574    |       |
| ** **                                               |       |        |       |           |       |          |       |            |       |       |       |
| **2005**                                                 |       |        |       |           |       |          |       |            |       |       |       |
| Sales to  external customers                             |       | $           | 1,706,980  |           | $          | 594,572       |       | $               | —     |       | $          | — |   | $ | 2,301,552 |   |
| Intersegment  sales                                      |       | —      |       | 587,102        |       | —        |       | (587,102        | )          | —     |       |
| Operating income  (loss)                                 |       | (735,852    | )          | (13,474        | )          | (368,202      | )          | —          |       | (1,117,528 | )          |
| Interest income  (expense), net                          |       | —      |       | —         |       | 40,242        |       | —          |       | 40,242     |       |
| Depreciation and  amortization                           |       | 92,960      |       | 8,862          |       | —        |       | —          |       | 101,822    |       |
| Other  significant non-cash items:                       |       |        |       |           |       |          |       |            |       |       |       |
| Stock-based compensation                                 |       | 46,575      |       | 62             |       | 3,047         |       | —          |       | 49,684     |       |
| Expenditures for  fixed assets                           |       | 80,789      |       | 8,044          |       | —        |       | —          |       | 88,833     |       |
| ** **                                               |       |        |       |           |       |          |       |            |       |       |       |
| Six months ended  September 30,                          |       |        |       |           |       |          |       |            |       |       |       |
| **2006**                                                 |       |        |       |           |       |          |       |            |       |       |       |
| Sales to  external customers                             |       | $           | 2,940,608  |           | $          | 1,357,770     |       | $               | —     |       | $          | — |   | $ | 4,298,378 |   |
| Intersegment  sales                                      |       | —      |       | 907,470        |       | —        |       | (907,470        | )          | —     |       |
| Operating income  (loss)                                 |       | (1,541,531  | )          | (257,290       | )          | (791,148      | )          | —          |       | (2,589,969 | )          |
| Interest income  (expense), net                          |       | —      |       | —         |       | 88,982        |       | —          |       | 88,982     |       |
| Depreciation and  amortization                           |       | 199,263     |       | 12,594         |       | —        |       | —          |       | 211,857    |       |
| Other  significant non-cash items:                       |       |        |       |           |       |          |       |            |       |       |       |
| Stock-based compensation                                 |       | 66,747      |       | 43,941         |       | 133,160       |       | —          |       | 243,848    |       |
| Expenditures for  fixed assets                           |       | 278,316     |       | 50,617         |       | —        |       | —          |       | 328,933    |       |
| Total assets                                             |       | 2,989,903   |       | 1,990,419      |       | 5,003,557     |       | (992,829        | )          | 8,991,050  |       |
|                                                     |       |        |       |           |       |          |       |            |       |       |       |
| **2005**                                                 |       |        |       |           |       |          |       |            |       |       |       |
| Sales to  external customers                             |       | $           | 3,616,309  |           | $          | 1,218,201     |       | $               | —     |       | $          | — |   | $ | 4,834,510 |   |
| Intersegment  sales                                      |       | —      |       | 1,415,893      |       | —        |       | (1,415,893      | )          | —     |       |
| Operating income  (loss)                                 |       | (1,348,375  | )          | (27,516        | )          | (623,615      | )          | —          |       | (1,999,506 | )          |
| Interest income  (expense), net                          |       | —      |       | —         |       | 85,063        |       | —          |       | 85,063     |       |
| Depreciation and  amortization                           |       | 182,403     |       | 23,670         |       | —        |       | —          |       | 206,073    |       |
| Other  significant non-cash items:                       |       |        |       |           |       |          |       |            |       |       |       |
| Stock-based compensation                                 |       | 93,150      |       | 125            |       | 6,094         |       | —          |       | 99,369     |       |
| Expenditures for  fixed assets                           |       | 183,015     |       | 15,870         |       | —        |       | —          |       | 198,885    |       |
| Total assets                                             |       | 3,741,647   |       | 1,842,183      |       | 7,810,366     |       | (437,601        | )          | 12,956,595 |       |

 

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**Item 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

**Executive Summary**

ThisQuarterly Report on Form 10-Q contains forward-looking statements within themeaning of The Private Securities Litigation Reform Act of 1995.  Examples of forward-looking statementsinclude statements about expectations about future financial results, futureproducts and future sales of new and existing products, future expenditures, andcapital resources to meet anticipated requirements.  Without limiting the foregoing, the words “believes”,“anticipates”, “plans”, “expects”, and similar expressions are intended toidentify forward-looking statements. These forward-looking statements involve risks and uncertainties, andour actual results may differ significantly from those discussed in theforward-looking statements. Factors that might cause such a difference include,but are not limited to, the availability of capital resources, the availabilityof third-party reimbursement, government regulation, the availability ofsupplies, competition, technological difficulties, the continuation of ourcontract with MENT, general economic conditions and other risks detailed in ourmost recent Annual Report on Form 10-K and any subsequent periodic filings madewith the Securities and Exchange Commission. We do not undertake an obligation to update our forward-lookingstatements to reflect future events or circumstances.

Wedevelop, manufacture and sell flexible endoscope products for the medicaldevice and industrial device markets.  Weoperate in three reporting segments, medical, industrial and corporate.

*Medical Segment*

Themedical segment supplies flexible endoscopes and disposable Slide-On®EndoSheath® Systems (“EndoSheaths”) to the ENT, urology, GI and pulmonarymarkets.  Health-care providers useEndoSheaths to cover the insertion tube of flexible endoscopes, such as ENTendoscopes, Trans-Nasal Esophagoscopes (“TNE”), cystoscopes, sigmoidoscopes andbronchoscopes.  We have designed theEndoSheaths to allow the health-care providers to process patients economicallyby permitting the providers to minimize reprocessing the endoscopes betweenprocedures.  In addition, the EndoSheathsensure a sterile insertion tube for each patient procedure.

Ourstrategy in the medical segment is comprised of three components: a) improvesales distribution, b) lower manufacturing costs and c) increase the number ofnew product offerings.

#### *SalesDistribution*

Since September 19, 2003, we have been distributing all of our productsfor the ENT market in the United States and Canada through MENT, as part of theMedtronic Agreement. The initial term of the Medtronic Agreement was threeyears, but is automatically renewed thereafter for successive one-year periods,unless terminated by either party upon advance written notice.  Neither party provided such notice, so theMedtronic Agreement has been renewed for one year.  Under the Medtronic Agreement, we havegranted MENT exclusive distribution rights in the United States and Canada tomarket and sell our ENT and TNE EndoSheaths and endoscopes to ENTpractitioners.  MENT fulfilled certainminimum purchase requirements for the initial twelve-month period of the term.

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We believe the marketing and sales capabilities ofMENT have facilitated and will continue to facilitate the introduction of newproducts to the ENT market by allowing quicker market acceptance of theseproducts than if we marketed them ourselves. As a result of this agreement, the success of our ENT product line issubstantially dependent upon the success of the marketing and sales activitiesof MENT, over which we have limited control.

In December 2004, we signed the MGU Agreement with MGU, granting MGUthe exclusive right to distribute our new cystoscope with Slide-On EndoSheathSystem to urologists in the United States and Canada.  The term of the MGU Agreement was throughMarch 31, 2006, renewable for successive one-year periods unless either partynotified the other party in writing at least 90 days prior to the end of anyterm that it did not want to renew.  InMay 2006, we and MGU mutually terminated the MGU Agreement, due to lower salesthan we expected, and a change in strategy by MGU.  MGU decided to put greater focus on therapiesand narrow its overall uro-diagnostics product offerings, which included ourproducts.  We then decided to exploreother forms of distribution for our flexible cystoscope and Slide-On EndoSheathSystem, including through a network of independent sales representatives. Weare in the process of establishing a network of independent salesrepresentatives for the domestic urology market, and we are also increasing ourinternational network of independent distributors.  We expect developing this network will takebetween nine and twelve months.  We willcontinually assess our progress in this area, and could abandon our efforts ifthey do not prove to be successful during that time frame.

We have retained our domestic network of independent salesrepresentatives for the GI and pulmonary product lines.  Also, we have retained our own internationalnetwork of distributors for all our medical product lines.

#### *CostReduction*

During the fiscal year ending March 31, 2007 (“FY 07”), we plan tocontinue the efforts begun in the fiscal year ended March 31, 2006 (“FY 06”) toreduce the cost of materials and labor across our endoscope and EndoSheathproduct lines.  We also plan to continuea development project that we expect will result in automating many of theprocesses performed in the manufacture of EndoSheaths.

#### *NewProducts*

In May 2005, we received clearance from the U.S. Food and DrugAdministration to market our new ENT-3000 portable endoscope with batterypowered LED light source.  During FY 07,our product development plans include the design of a new family of videoscopeswith a miniature digital camera mounted on the distal end of the insertiontube, and design and cost improvements to our EndoSheaths for TNE and urologyendoscopes.

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#### *Industrial Segment*

Theindustrial segment designs, manufactures and sells flexible endoscopes, termedborescopes, for industrial users, and manufactures and repairs flexibleendoscopes for the medical segment.  Theindustrial segment users consist primarily of companies in the aircraft enginemanufacturing and maintenance markets, the defense market and a variety ofspecialized industrial markets.

#### *Corporate Segment*

Thecorporate segment consists of certain administrative and business developmentactivities applicable to the Company as a whole.

**CriticalAccounting Policies and Estimates**

This discussion and analysis of our financialcondition and results of operations is based upon our Consolidated FinancialStatements, which have been prepared in accordance with generally acceptedaccounting principles in the United States of America.  See the Notes to the Consolidated FinancialStatements included elsewhere herein. Certain of our accounting policies require the application of judgmentin selecting the appropriate assumptions for calculating financial estimates.  By their nature these judgments are subjectto an inherent degree of uncertainty.  Weperiodically evaluate the judgments and estimates used for our criticalaccounting policies to ensure that such judgments and estimates are reasonablefor our interim and year-end reporting requirements.  These judgments and estimates are based uponour historical experience, current trends and information available from othersources, as appropriate.  If differentconditions result from those assumptions used in our judgment, the resultscould be materially different from our estimates.  Our critical accounting policies include thefollowing:

### *Revenue Recognition*

Werecognize revenue in accordance with SEC Staff Accounting Bulletin No. 104, *Revenue Recognition in Financial Statements*and EITF 00-21, *Revenue Arrangements with Multiple Deliverables.* Thesepronouncements require that five basic criteria must be met before revenue canbe recognized: (1) persuasive evidence that an arrangement exists; (2) deliveryhas occurred or services rendered; (3) the fee is fixed and determinable; (4)collectibility is reasonably assured and (5) the fair value of undeliveredelements, if any, exists.  Determinationof criterion (4) is based on management’s judgment regarding the collectibilityof invoices for products and services delivered to customers.  Should changes in conditions cause managementto determine these criteria are not met for certain future transactions,revenue recognized for any reporting period could be adversely affected.

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*OptionsIssued*

Weaccount for options issued to non-employees and employees in accordance withthe provisions of SFAS 123R.  We use theBlack-Scholes option-pricing model for determining the value of options issued,and we expense that value over the vesting period of the options.  We grant options with vesting periods rangingfrom immediate to four years.  For Q1 07and Q2 07 we have chosen to employ the simplified method of calculating theexpected option term, which averages an award’s weighted average vesting periodand its contractual term.  Thecontractual term of our options is ten years. The options granted in Q1 07 and Q2 07 to employees and consultants vestat a rate of 25% per year for the first four years.  The options granted to members of the boardof directors are 100% vested upon grant. The risk-free rate is based upon the daily Treasury yield curve for aperiod approximately equal to the expected option term.  We used historical data to estimate theexpected price volatility and forfeiture rate. The expected dividend yield is 0%, based on our history of not payingdividends and on the fact we are prohibited from paying dividends under ourbank agreement.

*IncomeTaxes*

Underour income tax policy, we record the estimated future tax effects of temporarydifferences between the tax bases of assets and liabilities and amountsrecorded in the accompanying consolidated balance sheets, as well as operatingloss and tax credit carryforwards.  The evaluationof the recoverability of any tax assets recorded on the balance sheet issubject to significant judgment.  We haveprovided valuation allowances for all our deferred tax assets to date.

**Resultsof Operations**

NetSales

*Q2 07Compared to the Three-month Period Ended September 30, 2005 (“Q2 06”)*

Netsales for Q2 07 were $2,291,305, a decrease of $10,247, or less than 1%,compared to Q2 06.  During Q2 07, netsales of the medical segment decreased by $117,961, or 7%, to $1,589,019, andnet sales of the industrial segment increased by $107,714, or 18%, to $702,286,compared to Q2 06.  In the medicalsegment, we track sales of endoscopes and EndoSheaths by market.  We also track sales of peripheral items thatcan be sold to more than one market. Sales of other products include sales to the GI and pulmonary marketsand sales of repairs and accessories.  Sales by segment and category in Q2 07 and Q2 06 were as follows ($000’s):

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| **Category**     | ** ** | **Q2 07** | ** ** | **Q2 06** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|------------------|------------|----------------|------------|----------------|------------|--------------------------|------------|-------------|------------|
| ENT              |       | $              | 1,264      |           | $          | 1,253                    |       | $           | 11         |   | 1 | % |
| Urology          |       | 142            |       | 155            |       | (13                      | )          | (8          | )%         |
| Peripherals      |       | 22             |       | 78             |       | (56                      | )          | (72         | )%         |
| Other            |       | 161            |       | 221            |       | (60                      | )          | (27         | )%         |
| Total medical    |       | $              | 1,589      |           | $          | 1,707                    |       | $           | (118       | ) | (7 | )% |
| Total industrial |       | 702            |       | 594            |       | 108                      |       | 18          | %          |
| Total Company    |       | $              | 2,291      |           | $          | 2,301                    |       | $           | (10        | ) | 0 | % |

 

*Medical Sales — ENT Market*

Netsales to the ENT market include products for domestic and internationalcustomers as follows ($000’s):
| **ENT Market** | ** ** | **Q2 07** | ** ** | **Q2 06** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|---------------------|------------|----------------|------------|----------------|------------|--------------------------|------------|-------------|------------|
| Domestic            |       | $              | 752        |           | $          | 638                      |       | $           | 114        |   | 18 | % |
| International       |       | 512            |       | 615            |       | (103                     | )          | (17         | )%         |
| Total ENT           |       | $              | 1,264      |           | $          | 1,253                    |       | $           | 11         |   | 1 | % |

 

Wefurther delineate products sold to the domestic ENT market as follows ($000’s):
| **Products**          | ** ** | **Q2 07** | ** ** | **Q2 06** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|-----------------------|------------|----------------|------------|----------------|------------|--------------------------|------------|-------------|------------|
| Slide-On  EndoSheaths |       | $              | 447        |           | $          | 258                      |       | $           | 189        |   | 73 | % |
| Endoscopes            |       | 305            |       | 380            |       | (75                      | )          | (20         | )%         |
| Total Domestic  ENT   |       | $              | 752        |           | $          | 638                      |       | $           | 114        |   | 18 | % |

 

The primary reason for the increase in sales of products to thedomestic ENT market was higher demand for our basic ENT Slide-On EndoSheaths (“ENTSOS”) from MENT.  This increase waspartially offset by lower demand for our ENT endoscopes.  Sales of our ENT SOS increased in Q2 07,compared to Q2 06, when MENT was in the process of starting to replenish theirinventory after their initial purchases under the Medtronic Agreement.  In Q2 07, we sold 59,080 units of our basicENT SOS to MENT, an increase of 24,250 units compared to Q2 06.  This quantity is approximately 8% higher thanwe expected to sell in Q2 07.  For all ofFY 07, we are on a run rate to sell approximately 225,000 units of theseEndoSheaths to MENT.

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We experienced initial demand for EndoSheaths for ourTNE therapeutic (“TNE Bx”) endoscopes. However, we did not sell any TNE Bx endoscopes in Q2 07.  We manufacture TNE diagnostic (“TNE D”) andTNE Bx endoscopes, both of which allow ENT physicians to perform alternative proceduresin their offices to those currently performed by GI physicians.  Educating this market on the advantages ofthese procedures has proven more difficult than we or MENT had anticipated.  We expect these procedures will be morepopular among ENT physicians in the future to diagnose and treatgastroenterology reflux disease (“GERD”), especially as the populationages.  A TNE procedure allows patients toreceive topical anesthetics in a physician’s office, as opposed to the morecommon Trans Oral Esophagoscopy procedure that requires a patient to beconsciously sedated.   A patient whoundergoes a TNE procedure can recover more quickly than one who is consciouslysedated.  In addition, physicians canreceive higher reimbursement rates and treat more patients in a given day byperforming these procedures in their offices. It is our view that these procedures will increase in the future becausethe inconvenience to the patient is less and the total cost is less when theyare done in an office.  However, it willtake time to educate and train the physicians and educate the patientpopulation on these advantages.

As a result of the Medtronic Agreement, the success of our ENT productlines is substantially dependent upon the success of the marketing and salesactivities of MENT over which we have limited control.

Wefurther delineate products sold to the international ENT market as follows($000’s):
| **Products**             | ** ** | **Q2 07** | ** ** | **Q2 06** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|--------------------------|------------|----------------|------------|----------------|------------|--------------------------|------------|-------------|------------|
| Slide-On  EndoSheaths    |       | $              | 374        |           | $          | 509                      |       | $           | (135       | ) | (27 | )% |
| Endoscopes               |       | 138            |       | 106            |       | 32                       |       | 30          | %          |
| Total  International ENT |       | $              | 512        |           | $          | 615                      |       | $           | (103       | ) | (17 | )% |

 

Thedecrease in net sales to international distributors is primarily due to lowerdemand for ENT SOS primarily from distributors in the United Kingdom countriesand the Middle East, offset partially by higher demand from distributors in theEuropean Union.  We believe demand fromthe United Kingdom countries was lower due to seasonal factors.  The demand from distributors in the MiddleEast that we experienced in FY 06 did not repeat in FY 07.  In addition, during Q2 07 we lost theservices of our director of international sales and have replaced our VicePresident of Sales and Marketing.  It willtake time for the new Vice President of Sales and Marketing to assess the statusof our international distributors and recommend any appropriate changes.  Unit sales of ENT SOS to the internationaldistributors were 59,880 in Q2 07, a decrease of 19,580 units, compared to unitsales in Q2 06.

Theincrease in sales from international distributors for endoscopes in Q2 07,compared to Q2 06, was due primarily to higher demand for the ENT-1000, oursmall diameter endoscope, and the ENT-3000, our portable endoscope withbattery-powered LED light source.  Unitsales of ENT endoscopes in Q2 07 to international distributors were 41,compared to 25 in Q2 06.  This increasewas partially offset by lower demand for our TNE endoscopes from theinternational market.  Sales ofendoscopes are dependent upon a variety of factors, including the timingrequirements of end users, foreign exchange rates, sales promotions ofinternational competitors and other factors. We are in the early stages of selling TNE endoscopes to ourdistributors, and we plan to increase our sales of this product by increasingthe number of distributors in countries where we do not haverepresentation.  However, there can be noassurance we will be able to consummate these agreements on terms that arebeneficial to us.

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*Medical Sales — Urology*

Thedecrease in sales of urology products reflects primarily the cancellation ofthe MGU Agreement, offset partially by higher demand from our internationaldistributors in Europe and Israel.  InMay 2006, we and MGU mutually terminated the MGU Agreement, due to lower salesthan we expected, and a change in strategy by MGU.  MGU decided to put greater focus on therapiesand narrow its overall uro-diagnostics product offerings, which included ourproducts.  We then decided to exploreother forms of distribution for our flexible cystoscope and Slide-On EndoSheathSystem.  We are in the process ofestablishing a network of independent sales representatives for the domesticurology market, and we are also increasing our network of independentdistributors for the international urology market.  We expect developing these networks will takebetween nine and twelve months.  We willcontinually assess our progress in this area, and could abandon our efforts ifthey do not prove to be successful during that time frame.

Wehave begun to see the results of the efforts of our international distributorsto sell urology products, as we sold fifteen cystoscopes to this channel in Q207, compared to two in Q2 06.  Also, wesold approximately 2,200 EndoSheaths for our cystoscopes in Q2 07, compared to230 in Q2 06.

Webelieve the CST-2000 and EndoSheath can significantly enhance the practiceefficiency of urologists by allowing them to avoid the tedious andtime-consuming reprocessing of conventional cystoscopes, and presents thesignificant benefit of a sterile insertion tube for each patient.  In addition, the use of our CST-2000 withEndoSheath avoids the need to reprocess endoscopes with harsh chemicals, one ofwhich has been contraindicated for use on patients with bladder cancer.

*Medical Sales — Peripherals and Other*

Salesof peripheral and other products declined in Q2 07, compared to Q2 06, dueprimarily to lower demand for our GI and pulmonary EndoSheaths.  We have a small installed base of users ofthese products, and we plan to continue to supply them with EndoSheaths in FY07.  However, we do not plan to promotethese products.  As a result, we expectsale of these products will continue to decline during FY 07, compared to FY06.  In addition, we experienced lowerdemand for light sources and other accessories.

*Industrial Segment*

Theincrease in net sales of the industrial segment was due to higher demand in themarket for new fiberscopes.

*6 M 07 Compared to the Six Months Ended September 30, 2005 (“6M 06”)*

*Medical Sales — ENT Market*

Netsales for 6M 07 were $4,298,378, a decrease of $536,132, or 11%, compared tonet sales in 6M 06.  In 6M 07, sales ofthe medical segment were $2,940,608, a decrease of $675,701, or 19%, comparedto net sales of $3,616,309 in 6M 06.  In6M 07, sales of the industrial segment were $1,357,770, an increase of$139,569, or 11%, compared to net sales of $1,218,201 in 6M 06.  Net sales by category were as follows ($000’s):

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| **Category**     | ** ** | **6M 07** | ** ** | **6M 06** | ** ** | **Increase (Decrease)** | ** ** | **Percent** | ** ** |
|------------------|------------|----------------|------------|----------------|------------|------------------------------|------------|-------------|------------|
| ENT              |       | $              | 2,296      |           | $          | 2,443                        |       | $           | (147       | ) | (6 | )% |
| Urology          |       | 216            |       | 503            |       | (287                         | )          | (57         | )%         |
| Peripherals      |       | 91             |       | 200            |       | (109                         | )          | (55         | )%         |
| Other            |       | 337            |       | 470            |       | (133                         | )          | (28         | )%         |
| Total medical    |       | $              | 2,940      |           | $          | 3,616                        |       | $           | (676       | ) | (19 | )% |
| Total industrial |       | 1,358          |       | 1,218          |       | 140                          |       | 11          | %          |
| Total Company    |       | $              | 4,298      |           | $          | 4,834                        |       | $           | (536       | ) | (11 | )% |

 

Salesto the ENT market include products for the domestic and international customersas follows:
| **ENT Market** | ** ** | **6M 07** | ** ** | **6M 06** | ** ** | **Increase (Decrease)** | ** ** | **Percent** | ** ** |
|---------------------|------------|----------------|------------|----------------|------------|------------------------------|------------|-------------|------------|
| Domestic            |       | $              | 1,283      |           | $          | 1,194                        |       | $           | 89         |   | 7 | % |
| International       |       | 1,013          |       | 1,249          |       | (236                         | )          | (19         | )%         |
| Total ENT           |       | $              | 2,296      |           | $          | 2,443                        |       | $           | (147       | ) | (6 | )% |

 

Wefurther delineate products sold to the domestic ENT market as follows ($000’s):
| **Products**          | ** ** | **6M 07** | ** ** | **6M 06** | ** ** | **Increase (Decrease)** | ** ** | **Percent** | ** ** |
|-----------------------|------------|----------------|------------|----------------|------------|------------------------------|------------|-------------|------------|
| Slide-On  EndoSheaths |       | $              | 850        |           | $          | 429                          |       | $           | 421        |   | 98 | % |
| Endoscopes            |       | 433            |       | 765            |       | (332                         | )          | (43         | )%         |
| Total Domestic  ENT   |       | $              | 1,283      |           | $          | 1,194                        |       | $           | 89         |   | 7 | % |

 

Theprimary reason for the increase in sales of ENT EndoSheaths to the domesticmarket was higher demand from MENT, offset partially by lower demand for ENTand TNE endoscopes.  The lower demand forendoscopes was due in approximately equal measure to lower demand for ENT andTNE endoscopes.

Wefurther delineate products sold to the international ENT market as follows($000’s):
| **Products**             | ** ** | **6M 07** | ** ** | **6M 06** | ** ** | **Increase (Decrease)** | ** ** | **Percent** | ** ** |
|--------------------------|------------|----------------|------------|----------------|------------|------------------------------|------------|-------------|------------|
| Slide-On  EndoSheaths    |       | $              | 856        |           | $          | 942                          |       | $           | (86        | ) | (9 | )% |
| Endoscopes               |       | 157            |       | 307            |       | (150                         | )          | (49         | )%         |
| Total  International ENT |       | $              | 1,013      |           | $          | 1,249                        |       | $           | (236       | ) | (19 | )% |

 

The primary cause for thelower sales of  EndoSheaths in the 6M 07,compared to 6M 06 was lower demand from distributors in the Middle East.  The primary cause for the lower sales ofendoscopes to international distributors was the lower demand in the threemonths ended June 30, 2006 for ENT endoscopes. Demand recovered partially in Q2 07, but due to the more unpredictablenature of the sales cycle of endoscopes we cannot expect demand will recoverfully in FY 07 to where it was in FY 06.

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*MedicalSales — Urology Market*

Thelower sales to the urology market are due primarily to the termination of theMGU Agreement and the resulting time required to establish a network ofdomestic sales representatives.  Sales ofcystoscopes and EndoSheath Systems to the international market increased toapproximately $163,000 in the 6M 07, compared to approximately $43,000 in the6M 06.  We believe we will continue toshow progress in international markets from the distributors who are sellingthe urology line and from additional distributors with whom we intend toestablish agreements.  However, there canbe no assurance that we will be able to establish these agreements on termssatisfactory to us.

*Industrial Segment*

Theincrease in sales to the industrial market in 6M 07 was due primarily to higherdemand for new borescopes.  However, thiswill continue to be a difficult market for us until we are able to provide acompetitive videoscope to this market.

GrossProfit

*Q2 07Compared to Q2 06*

Grossprofit was $396,522 in Q2 07, a decrease of $97,826, compared to gross profitin Q2 06.  Gross profit increased byapproximately $88,000 in the medical segment, and decreased by approximately$186,000 in the industrial segment. Gross profit in the medical segment increased due to lower fixed costs,and lower charges for inventory that reflect an excess of cost over marketvalue of our EndoSheaths for our cystoscope. In the industrial segment, the decrease in gross profit was dueprimarily to an increase in overhead costs associated with improving ourmanufacturing and quality control of endoscopes.

*6M 07Compared to 6M 06*

Grossprofit was $884,524 in 6M 07, a decrease of $219,964, compared to gross profitin 6M 06.  Gross profit increased byapproximately $90,000 in the medical segment and decreased by approximately$310,000 in the industrial segment.  Thecauses of the changes were the same as noted above.

OperatingExpenses

*Selling, General and Administrative Expenses*

*Q2 07Compared to Q2 06*

Theincrease in selling, general and administrative (“SG&A”) expenses in Q2 07was due primarily to higher spending for professional fees of approximately$57,000, and higher spending for travel of approximately $18,000.  These increases were partially offset bylower charges to the reserve for bad debts of approximately $73,000.

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*6M 07Compared to 6M 06*

Theincrease in SG&A expenses in 6M 07 was due primarily to higher spending forprofessional fees of approximately $83,000; higher spending for outsideservices for translation of marketing materials of approximately $25,000;higher spending for personnel, including stock-based compensation, ofapproximately $35,000.  These increaseswere partially offset by lower charges to the reserve for bad debts ofapproximately $73,000.

*Research and Development Expenses*

Theincrease in research and development (“R&D”) expenses in Q2 07, compared toQ2 06 and for 6M 07, compared to 6M 06 was due primarily to additional spendingfor materials and personnel hired to work on developing our new videoscope.  We expect R&D expenses will continue tobe higher in FY 07, compared to FY 06, as we accelerate our efforts to developthis new family of videoscopes.

OperatingIncome (Loss)

Operatingloss by segment was as follows ($000’s):
| **Segment** | ** ** | **Q2 07** | ** ** | **Q2 06** | ** ** | **Change** | ** ** | **6M 07** | ** ** | **6M 06** | ** ** | **Change** | ** ** |
|-------------|------------|----------------|------------|----------------|------------|------------|------------|----------------|------------|----------------|------------|------------|------------|
| Medical     |       | $              | (782       | )              | $          | (736       | )          | $              | (46        | )              | $          | (1,542     | )          | $ | (1,348 | ) | $ | (194 | ) |
| Industrial  |       | (114           | )          | (13            | )          | (101       | )          | (257           | )          | (28            | )          | (229       | )          |
| Corporate   |       | (490           | )          | (368           | )          | (122       | )          | (791           | )          | (624           | )          | (167       | )          |
| Total       |       | $              | (1,386     | )              | $          | (1,117     | )          | $              | (269       | )              | $          | (2,590     | )          | $ | (2,000 | ) | $ | (590 | ) |

 

Inthe medical segment, higher spending for SG&A and R&D, offset partiallyby higher gross profit, resulted in an increase to the operating loss for Q2 07and 6M 07.  In the industrial segment,the lower gross profit more than offset the lower spending for SG&A,causing an increase in the operating loss in Q2 07 and 6M 07.  In the corporate segment, higher charges forprofessional fees and stock-based compensation resulted in an increased loss inQ2 07 and 6M 07.

Liquidityand Capital Resources

AtSeptember 30, 2006, our principal source of liquidity was working capital ofapproximately $6.0 million, including $4.0 million in cash and cashequivalents.  At September 30, 2006, wehad acceptances payable to a bank totaling approximately $29,000.  We have pledged $125,000 to support theseacceptances.

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In July 2006, we renewed our bank agreement, which is subject torenewal again in July 2007.  This bankagreement includes a revolving line of credit under which we may borrow up to$250,000, including any outstanding letters of credit and banker’sacceptances.  Borrowings under these loanarrangements would bear interest at the prime rate, and would be collateralizedby our assets.  In addition, we have anequipment line with the bank, providing for us to borrow up to $750,000 for thepurchase of new equipment until July 31, 2007. At that time, any borrowings under the equipment line would becomepayable as a note, over a three-year period, at the bank’s prime rate.  Alternatively, we could arrange for otherfinancing of the equipment at that time, and repay any amounts drawn down underthat line.  The agreement also stipulatesthat we have the greater of $2.0 million, or one-half of our cash and cash equivalents,on deposit or invested at the bank.  In6M 07, we did not utilize the equipment line.

Ourcash and cash equivalents decreased by approximately $2.1 million in the sixmonths ended September 30, 2006, due primarily to cash used for operations ofapproximately $1.74 million, cash used for investing activities ofapproximately $0.33 million, and cash used for financing of approximately$0.03.  We expect that our currentbalance of cash and cash equivalents will be sufficient to fund our operationsfor the next twelve months.

Wehave incurred losses since our inception, and losses are expected to continueat least during FY 07.  We have fundedthe losses principally with the proceeds from public and private equityfinancings.

Weexpected total spending for property and equipment to be approximately$1,500,000 for FY 07.  Approximately 45%of this spending is dependent upon the purchase of unique machinery to allow usto reduce the cost of our production of EndoSheaths.  We continue to work on this project, thetiming of which will determine the timing of the spending for property andequipment.

**ContractualObligations**

Weconduct our operations in certain leased facilities.  These leases expire on various dates throughAugust 31, 2010.  In addition, we haveoperating leases for certain office equipment. These leases expire on various dates through June 2007.  The following chart summarizes ourcontractual obligations as of September 30, 2006.
| **Contractual Obligation** | ** ** | **Total** | ** ** | **Due within 1 Year** | ** ** | **Due in 1-3 years** | ** ** | **Due in 3-5 Years** | ** ** |
|---------------------------------|------------|-----------|------------|--------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
| Operating leases                |       | $         | 962,624    |                                 | $          | 365,461                             |       | $                                   | 446,366    |   | $ | 150,797 |   |
| Capital lease                   |       | 17,452    |       | 17,452                               |       | —                              |       | —                              |       |
|                                 |            |           |            |                                      |            |                                     |            |                                     |            |  |  |  |  |

 

**Off-BalanceSheet Arrangements**

Wehave no off-balance sheet arrangements that have, or are reasonably likely tohave, a current or future effect on our financial condition, changes infinancial condition, revenues or expenses, results of operations, liquidity,capital expenditures or capital resources.

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**RecentlyIssued Accounting Standards**

In July 2006, the FASBissued FIN 48, *Accounting for Uncertainty in IncomeTaxes-an Interpretation of FASB Statement No. 109*, which seeks toreduce the significant diversity in practice associated with certain aspects ofmeasurement and recognition in accounting for income taxes. FIN 48 prescribes arecognition threshold and measurement attribute for financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return, and also provides guidance on de-recognition, classification,interest and penalties, accounting in interim periods, disclosure andtransition. The provisions of FIN 48 are effective for fiscal years beginningafter December 15, 2006. Upon adoption, the cumulative effect of any changes innet assets resulting from the application of FIN 48 will be recorded as anadjustment to retained earnings. The Company is currently evaluating theimpact, if any, that FIN 48 will have on its financial position and results ofoperations.

InFebruary 2006, the FASB issued SFAS 155, *Accountingfor Certain Hybrid Financial Instruments* which amends SFAS 133,*Accounting for Derivative Instruments and HedgingActivities* and SFAS 140, *Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities*.  SFAS 155 simplifies the accounting forcertain derivatives embedded in other financial instruments by allowing them tobe accounted for as a whole if the holder elects to account for the wholeinstrument on a fair value basis. SFAS 155 also clarifies and amends certain other provisions ofSFAS 133 and SFAS 140. SFAS 155 is effective for all financial instruments acquired,issued or subject to a re-measurement event occurring in fiscal years beginningafter September 15, 2006 and is therefore required to be adopted by theCompany in the first quarter of its fiscal year ended March 31, 2008. TheCompany is currently evaluating the effect that the adoption of SFAS 155will have on its consolidated financial statements but does not expect that itwill have a material impact.

InSeptember 2006, the FASB issued SFAS 158, *Employers’Accounting for Defined Benefit Pension and Other Postretirement Plans*.This statement requires public entities with defined benefit pension plans andother postretirement plans to fully recognize, as an asset or a liability, theoverfunded or underfunded status of its benefit plans in its 2006 balancesheet. The Company does not expect SFAS 158 to have an impact on itsconsolidated financial statements as it has no defined benefit pension or otherpostretirement plans.

In September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No.108, *Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements* to provide guidance on the consideration of the effectsof prior year misstatements in quantifying current year misstatements for thepurpose of a materiality assessment. Under SAB No. 108, companies shouldevaluate a misstatement based on its impact on the current year incomestatement, as well as the cumulative effect of correcting such misstatements thatexisted in prior years existing in the current year’s ending balance sheet. SABNo. 108 is effective for fiscal years ending after November 15, 2006.  TheCompany has not determined the effect the adoption of SAB No. 108 will have onits financial position and results of operations.

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InSeptember 2006, the FASB issued SFAS 157 *FairValue Measurements*. SFAS 157 establishes a framework for measuringfair value in generally accepted accounting principles, and expands disclosuresabout fair value measurements.  The standard applies whenever otherstandards require (or permit) assets or liabilities to be measured at fairvalue.  The standard does not expand the use of fair value in any newcircumstances.  SFAS 157 is effective for financial statements issued forfiscal years beginning after November 15, 2007, and interim periods withinthose fiscal years.  Earlier application is encouraged. The Company hasnot yet determined the effect the adoption of SFAS 157 will have on itsfinancial position and results of operations.

InJune 2006, the FASB ratified the consensus on EITF Issue No. 06-03, *How Taxes Collected from Customers and Remitted toGovernmental Authorities Should Be Presented in the Income Statement.* Thescope of EITF Issue No. 06-03 includes any tax assessed by a governmentalauthority that is directly imposed on a revenue-producing transaction between aseller and a customer and may include, but is not limited to, sales, use, valueadded, Universal Service Fund (“USF”) contributions and some excise taxes.The Task Force affirmed its conclusion that entities should present these taxesin the income statement on either a gross or a net basis, based on theiraccounting policy, which should be disclosed pursuant to APB OpinionNo. 22, *Disclosure of AccountingPolicies.* If such taxes are significant, and are presented on agross basis, the amounts of those taxes should be disclosed. The consensus onIssue No. 06-03 will be effective for interim and annual reporting periodsbeginning after December 15, 2006. The Company is currently evaluating theimpact of EITF No. 06-03.  Should the Company need to change the manner inwhich it records gross receipts, it is not expected that the change will have amaterial impact on total operating revenue and expenses and operating incomeand net income would not be affected.

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**Item 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

Inthe normal course of business, we are subject to the risks associated withfluctuations in interest rates and changes in foreign currency exchange rates.

#### **Interestand Market Risk**

Wecurrently invest our excess cash in commercial paper and in a money marketaccount at our bank.  We have not usedderivative financial instruments in our investment portfolio.  We attempt to limit our exposure to interestrate and credit risk by placing our investments with high-quality financialinstitutions and have established investment guidelines relative todiversification and maturities designed to maintain safety and liquidity.

Investmentsin both fixed-rate and floating-rate interest earning instruments carry adegree of interest rate risk.  Fixed-ratesecurities may have their fair market value adversely impacted due to a rise ininterest rates, while floating-rate securities may produce less income thanexpected if interest rates decline.  Duein part to these factors, our future investment income may fall short ofexpectations due to changes in interest rates, or we may suffer losses inprincipal if forced to sell securities which have seen a decline in marketvalue due to changes in interest rates.

#### **ForeignCurrency Exchange**

Weface exposure, due to purchases of raw materials from Japanese suppliers, toadverse movements in the value of the Japanese Yen.  This exposure may change over time, and couldhave a materially adverse effect on our financial results.  We may attempt to limit this exposure bypurchasing forward contracts, as required. Most of our Japanese Yen liabilities are settled within 90 days ofreceipt of materials.  At September 30, 2006,our liabilities relating to Japanese Yen were approximately $50,000.

**Item 4.  CONTROLS AND PROCEDURES**

*a)**           **Evaluation of Disclosure Controlsand Procedures.*

Basedon an evaluation of our disclosure controls and procedures (as defined in Rules13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934), the chiefexecutive officer and chief financial officer have concluded that ourdisclosure controls and procedures as of the end of the quarter ended September30, 2006, are effective.

*b)**           **Changes in Internal Controls OverFinancial Reporting.*

There were no changes in our internal controls over financial reportingthat occurred during the fiscal quarter ended September 30, 2006 that havematerially affected, or are reasonable likely to materially affect, ourinternal controls over financial reporting.

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**PART II - OTHERINFORMATION**

**Item 1A. RISKFACTORS**

The risk factors included in the Company’s AnnualReport on Form 10-K for the fiscal year ended March 31, 2006 have notmaterially changed.

**Item 4.  SUBMISSION OF MATTERS TO A VOTE OFSTOCKHOLDERS**

We held the 2006Annual General Meeting of Shareholders (the “Annual Meeting”) on August 3,2006.  At the Annual Meeting, thefollowing actions were taken:

1.                                       Thestockholders elected Messrs. David W. Anderson, Kenneth W. Anstey and WarrenBielke as Class III Directors to serve for a three-year term.  Holders of 28,864,160 shares of common stockvoted for and holders of 5,941 shares of common stock withheld votes for Mr.Anderson.  Holders of 28,854,789 sharesof common stock voted for and holders of 15,312 shares of common stock withheldvotes for Mr. Anstey.  Holders of28,864,160 shares of common stock voted for and holders of 5,941 shares ofcommon stock withheld votes for Mr. Bielke. In addition to Messrs. Anderson, Anstey and Bielke, Messrs. Lewis C.Pell, Katsumi Oneda, Ron Hadani and John J. Wallace continue to serve on theBoard of Directors.

2.                                       Thestockholders ratified the selection of BDO Seidman, LLP as the Company’sindependent auditors for the current fiscal year.  Holders of 28,842,425 shares of common stockvoted for; holders of 22,326 shares of common stock voted against; and holdersof 5,350 shares of common stock withheld votes for BDO Seidman, LLP.

**Item 6.  EXHIBITS**

Exhibits

31.1                           Certificationof Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a), promulgatedunder the Securities Exchange Act of 1934, as amended.

31.2                           Certificationof Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a), promulgatedunder the Securities Exchange Act of 1934, as amended.

32                                    Certificationof Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C.§1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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**SIGNATURES**

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

VISION-SCIENCES, INC.
|  Date: November 14, 2006 | /s/ Ron Hadani                                                                                                                        |
|-------------------------------|---------------------------------------------------------------------------------------------------------------------------------------|
|                          | Ron Hadani                                                                                                                            |
|                          | President, CEO (Duly Authorized Officer)                                                                                              |
|                          |                                                                                                                                  |
|  Date: November 14, 2006 | /s/ James A. Tracy                                                                                                                    |
|                          | James A. Tracy                                                                                                                        |
|                          | Vice President Finance, Chief Financial Officer and  Controller (Principal Financial Officer and Principal  Accounting  Officer) |

 

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