**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D. C. 20459**

 

**FORM 10-Q**

 

**QUARTERLY REPORT UNDER SECTION 13 OR 15(d)**

**OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THEQUARTER ENDED****December 31, 2004**

 

**COMMISSIONFILE NUMBER 0-20970**

 

**VISION-SCIENCES, INC.**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                                                                         | ** ** | **13-3430173**                        |
|--------------------------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization)                     |       | (IRS Employer  Identification Number) |
|                                                                                 |       |                                  |
| **9  Strathmore Road, Natick, MA**                                                   | ** ** | **01760**                             |
| (Address of  principal executive offices)                                            |       | (Zip Code)                            |
|                                                                                 |       |                                  |
| **(508)  650-9971**                                                                  |
| (Registrant’s  telephone number, including area code)                           |
| ** **                                                                           |       |                                  |
| **None**                                                                             |
| (Former name,  former address, and  former fiscal year if changed since last report) |

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirement for the past90 days.

 

Yes  ý                   No  o

 

Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act).

 

Yes  o                   No  ý

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of January31, 2005.

 
| **Common  Stock, par value of $.01** |   | **31,163,412**      |
|--------------------------------------|--------|---------------------|
| (Title of Class)                     |   | (Number of  Shares) |

 

 

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**VISION-SCIENCES,INC.**

**TABLE OFCONTENTS**

 
| Part I.  | Financial Information |                                                                                        |
|----------|-----------------------|---------------------------------------------------------------------------------------------|
|     |                  |                                                                                        |
|     | Item 1.               | Financial Statements                                                                        |   |
|     |                  |                                                                                        |   |
|     |                  | Consolidated Balance Sheets                                                                 |   |
|     |                  |                                                                                        |   |
|     |                  | Consolidated  Statements of Operations                                                      |   |
|     |                  |                                                                                        |   |
|     |                  | Consolidated  Statement of Stockholders’ Equity                                        |   |
|     |                  |                                                                                        |   |
|     |                  | 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 6.               | Exhibits and Reports on Form 8-K                                                            |   |
|     |                  |                                                                                        |
|     | Signatures            |                                                                                        |
|     |                  |                                                                                        |
|     | Exhibits              |                                                                                        |
|          |                       |                                                                                             |  |  |

 

2

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**PART I****- FINANCIAL INFORMATION**

 

**Item 1****: FINANCIALSTATEMENTS**

 

**VISION-SCIENCES,INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

**(Unaudited)**

 
| ** **                                                                                                                                                                        | ** ** | **December 31,  2004** | ** ** | **March 31,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|---------------------|------------|
| ASSETS                                                                                                                                                                            |       |                   |       |                |       |
| Current Assets:                                                                                                                                                                   |       |                   |       |                |       |
| Cash and cash  equivalents                                                                                                                                                        |       | $                      | 689,794    |                | $          | 2,714,941 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $67,666 and $52,800,  respectively                                                                                |       | 1,621,260              |       | 1,683,459           |       |
| Inventories                                                                                                                                                                       |       | 1,751,296              |       | 1,352,716           |       |
| Prepaid expenses  and deposits                                                                                                                                                    |       | 41,951                 |       | 62,182              |       |
| Total current  assets                                                                                                                                                             |       | 4,104,301              |       | 5,813,298           |       |
|                                                                                                                                                                              |       |                   |       |                |       |
| Property and  Equipment, at cost:                                                                                                                                                 |       |                   |       |                |       |
| Machinery and  equipment                                                                                                                                                          |       | 4,291,415              |       | 3,623,854           |       |
| Furniture and  fixtures                                                                                                                                                           |       | 242,227                |       | 212,002             |       |
| Leasehold  improvements                                                                                                                                                           |       | 573,780                |       | 473,411             |       |
|                                                                                                                                                                              |       | 5,107,422              |       | 4,309,267           |       |
| Less-Accumulated  depreciation and amortization                                                                                                                                   |       | 3,940,355              |       | 3,728,242           |       |
|                                                                                                                                                                              |       | 1,167,067              |       | 581,025             |       |
|                                                                                                                                                                              |       |                   |       |                |       |
| Advance to Three  BY Ltd                                                                                                                                                          |       | —                 |       | 267,500             |       |
|                                                                                                                                                                              |       |                   |       |                |       |
| Other assets,  net of accumulated amortization of $52,214 and $47,428, respectively                                                                                               |       | 76,417                 |       | 66,751              |       |
| Total assets                                                                                                                                                                      |       | $                      | 5,347,785  |                | $          | 6,728,574 |   |
|                                                                                                                                                                              |       |                   |       |                |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                         |       |                   |       |                |       |
| Current  Liabilities:                                                                                                                                                             |       |                   |       |                |       |
| Acceptances  payable to a bank                                                                                                                                                    |       | $                      | 59,884     |                | $          | 51,766 |   |
| Current portion  of note payable                                                                                                                                                  |       | 18,837                 |       | 17,495              |       |
| Accounts payable                                                                                                                                                                  |       | 620,480                |       | 681,998             |       |
| Accrued expenses                                                                                                                                                                  |       | 1,145,548              |       | 970,755             |       |
| Total current  liabilities                                                                                                                                                        |       | 1,844,749              |       | 1,722,014           |       |
|                                                                                                                                                                              |       |                   |       |                |       |
| Long term  portion of note payable                                                                                                                                                |       | 26,313                 |       | 40,614              |       |
|                                                                                                                                                                              |       |                   |       |                |       |
| Stockholders’  Equity:                                                                                                                                                       |       |                   |       |                |       |
| Common stock,  $.01 par value— Authorized—50,000,000 shares Issued and outstanding—31,007,563  shares at December 31, 2004 and 30,687,963 shares at March 31, 2004 |       | 310,075                |       | 306,879             |       |
| Additional  paid-in capital                                                                                                                                                       |       | 65,150,176             |       | 64,649,956          |       |
| Accumulated  deficit                                                                                                                                                              |       | (61,983,528            | )          | (59,990,889         | )          |
| Total  stockholders’ equity                                                                                                                                                  |       | 3,476,723              |       | 4,965,946           |       |
| Total  liabilities and stockholders’ equity                                                                                                                                  |       | $                      | 5,347,785  |                | $          | 6,728,574 |   |

 

See accompanyingnotes to consolidated financial statements.

 

3

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**VISION-SCIENCES,INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

** **
| ** **                                                                     | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                     | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                           |       |                                 |       |                                |       |   |   |   |   |
| Net sales                                                                      |       | $                                    | 2,826,949  |                                | $          | 2,717,775 |   | $ | 7,635,167 |   | $ | 6,785,012 |   |
| Cost of sales                                                                  |       | 2,040,079                            |       | 1,826,106                           |       | 5,514,894 |   | 4,333,773 |   |
|                                                                           |       |                                 |       |                                |       |   |   |   |   |
| Gross profit                                                                   |       | 786,870                              |       | 891,669                             |       | 2,120,273 |   | 2,451,239 |   |
|                                                                           |       |                                 |       |                                |       |   |   |   |   |
| Selling, general  and administrative expenses (1)                              |       | 1,103,583                            |       | 847,537                             |       | 2,944,640 |   | 2,655,289 |   |
| Research and  development expenses (1)                                         |       | 412,111                              |       | 159,452                             |       | 1,060,854 |   | 454,785 |   |
| Stock-based  compensation                                                      |       | 65,843                               |       | (132,531                            | )          | 132,895 |   | 502,457 |   |
| Income (Loss)  from operations                                                 |       | (794,667                             | )          | 17,211                              |       | (2,018,116 | ) | (1,161,292 | ) |
|                                                                           |       |                                 |       |                                |       |   |   |   |   |
| Interest income                                                                |       | 3,862                                |       | 6,681                               |       | 19,936 |   | 21,393 |   |
| Interest expense                                                               |       | (1,190                               | )          | —                              |       | (3,891 | ) | — |   |
| Other income,  net                                                             |       | 5,773                                |       | 3,862                               |       | 9,432 |   | 11,099 |   |
|                                                                           |       |                                 |       |                                |       |   |   |   |   |
| Net income (loss)                                                              |       | $                                    | (786,222   | )                                   | $          | 27,754 |   | $ | (1,992,639 | ) | $ | (1,128,800 | ) |
|                                                                           |       |                                 |       |                                |       |   |   |   |   |
| Basic and  diluted net income (loss) per common share                          |       | $                                    | (0.03      | )                                   | $          | 0.00 |   | $ | (0.06 | ) | $ | (0.04 | ) |
|                                                                           |       |                                 |       |                                |       |   |   |   |   |
| Shares used in  computing basic and diluted net income (loss) per common share |       | 30,976,505                           |       | 30,228,794                          |       | 30,912,528 |   | 30,118,564 |   |
|                                                                                |            |                                      |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)          Excludes non-cashstock-based compensation, as follows:

 
| Research and  development expenses            |   | $      | 109    |    | $ | (121,114 | )      | $       | 328     |   | $ | 398,449 |   |
|-----------------------------------------------|--------|--------|--------|---------|---|----------|--------|---------|---------|--------|---|---------|--------|
| Selling, general  and administrative expenses |   | 65,734 |   | (11,417 | ) | 132,567  |   | 104,008 |    |
| Total                                         |   | $      | 65,843 |    | $ | (132,531 | )      | $       | 132,895 |   | $ | 502,457 |   |

 

See accompanyingnotes to consolidated financial statements.

 

4

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**VISION-SCIENCES,INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENT OF STOCKHOLDERS’ EQUITY**

**(Unaudited)**

 
| ** **                                                                | ** ** | **Common Stock** | ** ** | **Additional  Paid-in-Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Total  Stockholders’  Equity** | ** ** | **Total  Comprehensive  Loss** | ** **  |
|---------------------------------------------------------------------------|------------|------------------|------------|---------------------------------|------------|--------------------------|------------|---------------------------------------|------------|--------------------------------|-------------|
| **Number**                                                                | ** ** | **$.01**         |
| **of Shares**                                                             | ** ** | **Par Value**    |
| ** **                                                                | ** ** | ** **       | ** ** | ** **                      | ** ** | ** **               | ** ** | ** **                            | ** ** | ** **                     | ** **  | ** ** | ** ** |
| Balance, March  31, 2004                                                  |       | 30,687,963       |       | $                               | 306,879    |                     | $          | 64,649,956                            |       | $                              | (59,990,889 | ) | $ | 4,965,946 |   |   |   |
| Exercise of  stock options, net                                           |       | 319,600          |       | 3,196                           |       | 367,325                  |       | —                                |       | 370,521                        |        |   |   |
| Compensation  expense related to non-employee non-qualified stock options |       |             |       |                            |       | 123,004                  |       | —                                |       | 123,004                        |        |   |   |
| Compensation  expense related to employee non-qualified stock options     |       |             |       |                            |       | 9,891                    |       |                                  |       | 9,891                          |        |   |   |
| Net loss                                                                  |       | —           |       | —                          |       | —                   |       | (1,992,639                            | )          | (1,992,639                     | )           | $ | (1,992,639 | ) |
|                                                                      |       |             |       |                            |       |                     |       |                                  |       |                           |        |   |   |
| Total  comprehensive loss                                                 |       |             |       |                            |       |                     |       |                                  |       |                           |        | $ | (1,992,639 | ) |
|                                                                      |       |             |       |                            |       |                     |       |                                  |       |                           |        |   |   |
| Balance December  31, 2004                                                |       | 31,007,563       |       | $                               | 310,075    |                     | $          | 65,150,176                            |       | $                              | (61,983,528 | ) | $ | 3,476,723 |   |   |   |

 

See accompanyingnotes to consolidated financial statements.

 

5

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**VISION-SCIENCES,INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                                         | ** ** | **Nine Months Ended  December 31, 2004** | ** ** | **Nine Months Ended  December 31, 2003** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| Cash flows from  operating activities:                                                             |       |                                     |       |                                     |       |
| Net loss                                                                                           |       | $                                        | (1,992,639 | )                                        | $          | (1,128,800 | ) |
| Adjustments to  reconcile net loss to net cash used for operating activities:                      |       |                                     |       |                                     |       |
| Depreciation and  amortization                                                                     |       | 216,899                                  |       | 156,311                                  |       |
| Stock  compensation for non-qualified options                                                      |       | 132,895                                  |       | 502,457                                  |       |
| Changes in  assets and liabilities:                                                                |       |                                     |       |                                     |       |
| Accounts  receivable                                                                               |       | 62,199                                   |       | (513,048                                 | )          |
| Inventories                                                                                        |       | (398,580                                 | )          | (134,040                                 | )          |
| Prepaid expenses  and deposits                                                                     |       | 20,231                                   |       | (35,031                                  | )          |
| Accounts payable                                                                                   |       | (61,518                                  | )          | 391,286                                  |       |
| Accrued expenses                                                                                   |       | 174,793                                  |       | 65,186                                   |       |
|                                                                                               |       |                                     |       |                                     |       |
| Net cash used  for operating activities                                                            |       | (1,845,720                               | )          | (695,679                                 | )          |
|                                                                                               |       |                                     |       |                                     |       |
| Cash flows used  for investing activities                                                          |       |                                     |       |                                     |       |
| Increase in  marketable securities                                                                 |       | —                                   |       | (299                                     | )          |
| Purchase of  property and equipment, net of conversion of Advance to 3BY Ltd                       |       | (530,655                                 | )          | (120,106                                 | )          |
| Advance to Three  BY Ltd                                                                           |       | —                                   |       | (267,500                                 | )          |
| (Increase)  decrease in other assets                                                               |       | (14,452                                  | )          | 16,666                                   |       |
|                                                                                               |       |                                     |       |                                     |       |
| Net cash used  for investing activities                                                            |       | (545,107                                 | )          | (371,239                                 | )          |
|                                                                                               |       |                                     |       |                                     |       |
| Cash flows  provided by (used for) financing activities:                                           |       |                                     |       |                                     |       |
| Payments on note  payable for computer equipment                                                   |       | (12,959                                  | )          | —                                   |       |
| Proceeds from  acceptances payable to a bank                                                       |       | 8,118                                    |       | 79,021                                   |       |
| Proceeds from  the sale of common stock, net                                                       |       | —                                   |       | 329,012                                  |       |
| Exercise of  stock options, net                                                                    |       | 370,521                                  |       | 151,707                                  |       |
| Net cash  provided by financing activities                                                         |       | 365,680                                  |       | 559,740                                  |       |
|                                                                                               |       |                                     |       |                                     |       |
| Net decrease in  cash and cash equivalents                                                         |       | (2,025,147                               | )          | (507,178                                 | )          |
| Cash and cash  equivalents, beginning of period                                                    |       | 2,714,941                                |       | 2,744,143                                |       |
| Cash and cash  equivalents, end of period                                                          |       | $                                        | 689,794    |                                     | $          | 2,236,965 |   |
|                                                                                               |       |                                     |       |                                     |       |
| Supplemental  Disclosure of Cash Flow Information:                                                 |       |                                     |       |                                     |       |
| Cash paid during  the period for interest                                                          |       | $                                        | 3,891      |                                     | $          | — |   |
|                                                                                               |       |                                     |       |                                     |       |
| Supplemental  Disclosure of Non-cash Items from Financing Activities:                              |       |                                     |       |                                     |       |
|                                                                                               |       |                                     |       |                                     |       |
| Fair market  value of non-qualified options granted in the period                                  |       | $                                        | 371,101    |                                     | $          | 1,411,550 |   |
|                                                                                               |       |                                     |       |                                     |       |
| Change in the  fair market value of non-qualified options existing at the beginning of the  period |       | $                                        | —     |                                     | $          | 489,269 |   |

 

See accompanyingnotes to consolidated financial statements.

 

6

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**VISION-SCIENCES,INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

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

 

The consolidatedfinancial statements included herein have been prepared by the Company inaccordance with accounting principles generally accepted in the United Statesof America, without audit, pursuant to the rules and regulations of theSecurities and Exchange Commission and include, in the opinion of management,all adjustments (consisting only of normal and recurring adjustments) that theCompany considers necessary for a fair presentation of such information.  Certain information and footnote disclosuresnormally included in financial statements have been condensed or omittedpursuant to such rules and regulations. The Company believes, however, that its disclosures are adequate to makethe information presented not misleading. These consolidated financial statements should be read in conjunctionwith the audited consolidated financial statements and notes thereto includedin the Company’s latest annual report to stockholders.  The results for the interim periods presentedare not necessarily indicative of results to be expected for the full fiscalyear.

 

**2**.             **Summary of Significant Accounting Policies**

 

The accompanyingconsolidated financial statements reflect the application of certain accountingpolicies described below:

 

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

 

b**.****                                     ***Cash Equivalents*: Cash equivalents are carried at marketvalue, which includes accrued interest*.** *Cash equivalents areshort-term, highly liquid investments with original maturities of less thanthree months.

 

c.                                       *Marketable Securities*: Marketable securities are carried atmarket value, which includes accrued interest. The Company has classified its investments in marketable securities asavailable-for-sale securities.  At December31, 2004, the Company had no marketable securities.

 

d.                                      *Inventories*: Inventories are stated at the lower of cost or market using thefirst-in, first-out (FIFO) method and consist of the following:

 
| ** **      | ** ** | **December 31,  2004** | ** ** | **March 31,  2004** | ** ** |
|-----------------|------------|------------------------|------------|---------------------|------------|
| ** **      | ** ** | ** **             | ** ** | **(audited)**       | ** ** |
| Raw materials   |       | $                      | 1,156,704  |                | $          | 726,221 |   |
| Work-in-process |       | 132,124                |       | 297,220             |       |
| Finished goods  |       | 462,468                |       | 329,275             |       |
|            |       | $                      | 1,751,296  |                | $          | 1,352,716 |   |

 

Work-in-process andfinished goods inventories consist of material, labor, and manufacturingoverhead.

 

7

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e.                                       *Depreciation and Amortization*: The Company provides fordepreciation and amortization using the straight-line method in amounts thatallocate the cost of the assets to operations over their estimated useful livesas follows:

 
| **Asset Classification** | ** ** | **Estimated  Useful Life** | ** ** |
|--------------------------|------------|----------------------------|------------|
| Machinery and  Equipment |       | 3-5 Years                  |       |
| Furniture and  Fixtures  |       | 5 Years                    |       |

 

Leasehold improvementsare amortized over the shorter of their estimated useful lives or the lives ofthe leases.

 

f.                                         *Basic and Diluted Net Income (Loss) Per Common Share*: Basicand diluted net income (loss) per common share is based on the weighted averagenumber of common shares outstanding. Shares of common stock issuable pursuant to outstanding stock optionshave not been considered, as their effect would be antidilutive.

 

g.                                      *Revenue Recognition*: 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 follows EmergingIssues Task Force (“EITF”) 01-9 to record the effect on sales of any rebatesoffered to customers.  The Companyrecognizes revenue upon the passage of title that normally occurs upon shipmentfrom our plants.

 

h.                                      *Foreign Currency Transactions*: In accordance with Statementof Financial Accounting Standard (“SFAS”) No. 52, *ForeignCurrency Translation,* the Company charges foreign currency exchangegains or losses, in connection with its purchases of products from vendors inJapan, to operations, and charges foreign exchange translation gains and lossesto retained earnings.

 

i.                                          *Income Taxes*: The Company accounts for income taxes underthe liability method in accordance with SFAS No. 109, *Accountingfor Income Taxes*.  Under SFASNo. 109, deferred tax assets or liabilities are computed based upon thedifferences between the financial statement and income tax bases of assets andliabilities as measured by the enacted tax rates.

 

The Company has recordeda valuation allowance equal to its net deferred tax asset due to theuncertainty of realizing the benefit of this asset.

 

8

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j.                                          *Accounting for Options Issued to Non-employees:*The Companyaccounts for non-qualified stock option agreements issued to non-employees asequity instruments, in accordance with the provisions of EITF 96-18.  In the nine months ended December 31, 2004,the Company granted non-qualified options to purchase 100,000 and 50,000 sharesof the Company’s Common Stock to a consultant, with a value of approximately $241,832and $129,269, respectively.  This valuewas determined using the Black-Scholes option-pricing model.  The assumptions used during the nine monthsended December 31, 2004 were as follows.

 
| Risk-free  interest rate |   | .93% - 1.36% |   |
|--------------------------|--------|--------------|--------|
| Expected  dividend yield |   | —       |   |
| Expected levis           |   | 5 years      |   |
| Expected volatility      |   | 79% - 83%    |   |

 

The Company isrecognizing these amounts in its operations ratably over a two-year period,according to the vesting schedules of the options.  In the three and nine months ended December31, 2004, the Company recognized $62,546 and $123,004, respectively of expense relatedto these two options as stock-based compensation in the consolidated statementsof operations.

 

k.                                       *Employee Stock-based Compensation Arrangements:*The Companyaccounts for its employee stock-based compensation arrangements using theintrinsic value method under the provisions of Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for Stock Issued to Employees*,and Financial Interpretation No. (“FIN”) 44. The Company does not recognize stock-based employee compensation costwhen the options granted have an exercise price equal to, or greater than, themarket value of the underlying common stock on the date of the grant.  The Company does recognize stock-basedemployee compensation cost when the options granted have an exercise price lessthan the market value of the underlying common stock on the date of the grant.

 

In June 2003, theCompany granted options to purchase 1,295,000 shares of common stock to itsemployees at an exercise price of $1.04 per share.  The fair market value of the common stock onthe date of grant was $1.09 per share. As a result, the Company has recognized compensation expense for thedifference between the fair market value and the option price over the life ofthe options.  In the three and nine monthsended December 31, 2004, the Company recognized $3,297 and $9,891, respectivelyof expense related to these options as stock-based compensation in theconsolidated statements of operations.

 

9

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In accordance with theFinancial Accounting Standards Board (FASB) Statement No. 148, *Accounting for Stock-Based Compensation – Transition and Disclosure*,beginning in the quarter ending March 31, 2003, the Company adopted thedisclosure requirements of FASB No. 148. Had compensation expense for all stock option grants to employees beendetermined under the fair value method at the grant dates, consistent with themethod prescribed by SFAS No. 123, the Company’s net loss would have beenincreased to the pro forma amounts indicated as follows:

 

*l.*                                         *New Accounting Standards:* In November 2004 the FASB issued SFAS No. 151, *InventoryCosts*, an amendment of ARB No. 43, Chapter 4.  SFAS No. 151 amends the guidance in ARB No.43, Chapter 4, *Inventory Pricing*, to clarify theaccounting for abnormal amounts of idle facility expense, freight, handlingcosts and spoilage.  This statementrequires that those items be recognized as current period charges regardless ofwhether they meet the criterion of “so abnormal” which was the criterionspecified in ARB No. 43.  In addition, thisStatement requires that allocation of fixed production overheads to the cost ofproduction be based on normal capacity of the production facilities.  This pronouncement is effective for theCompany beginning October 1, 2005.  TheCompany has not yet assessed the impact of adopting this new standard.

 

In December 2004, theFASB issued SFAS No. 123 (revised 2004), *Share Based Payment,*whichis a revision of SFAS No. 123, *Accounting for Stock-BasedCompensation*.  SFAS No. 123(R)supercedes APB Opinion No. 25, *Accounting for StockIssued to Employees*, and amends SFAS No. 95, S*tatement ofCash Flows*.  Generally, theapproach in SFAS No. 123(R) is similar to the approach described in SFAS No.123.  However, SFAS No. 123(R) requiresall share-based payments to employees, including grants of employee stockoptions, to be recognized in the income statement based on their fairvalues.  Pro forma disclosure is nolonger an alternative.  The new standardwill be effective for the Company in the first interim or annual reportingperiod beginning after June 15, 2005. The Company has not yet assessed the impact of adopting this newstandard.

 

In December 2004 the FASBissued SFAS No. 153, *Exchanges of NonmonetaryAssets*, an amendment of APB Opinion No. 29, *Accounting forNonmonetary Transactions*.  Theamendments made by SFAS No. 153 are based on the principle that exchanges ofnonmonetary assets should be measured based on the fair value of assetsexchanged.  Further, the amendmentseliminate the narrow exception for nonmonetary exchanges of similar productiveassets and replace it with a broader exception for exchanges of nonmonetaryassets that do not have commercial substance. Previously, Opinion No. 29 required that the accounting for an exchangeof a productive asset for a similar productive asset or an equivalent interestin the same or similar productive asset should be based on the recorded amountof the asset relinquished.  The newstandard will be effective for nonmonetary asset exchanges occurring in fiscalperiods beginning after June 15, 2005. The Company has not yet assessed the impact of adopting this newstandard.

 
| ** **                                            | ** ** | **Three Months Ended   December 31,** | ** ** | **Nine Months Ended   December 31,** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                            | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income (loss)  – as reported                 |       | $                                     | (786,222   | )                                    | $          | 27,754 |   | $ | (1,992,639 | ) | $ | (1,128,800 | ) |
| Stock-based  employee compensation – as reported |       | 3,297                                 |       | 5,652                                |       | 9,891 |   | 13,188 |   |
| Pro forma  stock-based employee compensation          |       | (103,900                              | )          | (69,000                              | )          | (301,900 | ) | (207,000 | ) |
| Net loss – pro  forma                            |       | $                                     | (886,825   | )                                    | $          | (35,594 | ) | $ | (2,284,648 | ) | $ | (1,322,612 | ) |
|                                                  |       |                                  |       |                                 |       |   |   |   |   |
| Net income (loss)  per share – as reported       |       | $                                     | (.03       | )                                    | $          | — |   | $ | (.06 | ) | $ | (.04 | ) |
| Stock-based  employee compensation – as reported |       | —                                |       | —                               |       | — |   | — |   |
| Pro forma  stock-based employee compensation          |       | —                                |       | —                               |       | (.01 | ) | — |   |
| Net income (loss)  per share – pro forma         |       | $                                     | (.03       | )                                    | $          | — |   | $ | (.07 | ) | $ | (.04 | ) |

 

**3.**             **Three BY Ltd.**

 

In June 2003, theCompany entered into a Contract Manufacturing Agreement, a Loan Agreement and aPledge Agreement (collectively, the “3BY Agreements”) with Three BY Ltd., anIsraeli company (“3BY”).  The 3BYAgreements provide for, among other things, the manufacture of certain of theCompany’s products by 3BY, and a loan of up to $267,500 by the Company to 3BYfor the purchase and installation of certain manufacturing equipment by 3BY, at3BY’s facility, to be used to manufacture certain of the Company’sproducts.  As of December 31, 2003, theCompany had advanced the complete loan.  3BYhas completed the purchase and installation of the manufacturing equipment, andthe Company began receiving commercial production from 3BY in the three monthsending September 30, 2004.  On October 1,2004, according to terms in the Loan Agreement, 3BY and the Company agreed thatthe Company would take title to the manufacturing equipment, in lieu of 3BYretaining title and paying back the advance.

 

10

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**4.****                                     ****Segment Information**

 

The Company hasthree reportable segments – medical, industrial and corporate.  The medical segment designs, manufactures andsells EndoSheaths and sells endoscopes to users in the health careindustry.  The industrial segmentdesigns, manufactures and sells borescopes to a variety of users, primarily inthe aircraft engine manufacturing and aircraft engine maintenanceindustries.  In addition, the industrialsegment manufactures and repairs endoscopes for the medical segment.  The corporate segment consists of certainadministrative expenses applicable to the Company as a whole and the managementoversight of the Company’s investment in Vision-Sciences Ltd. (the Company’sIsraeli subsidiary).

 

All segments follow theaccounting policies described in the summary of significant accountingpolicies.  The Company evaluates segmentperformance based upon operating income. Identifiable assets are those used directly in the operations of eachsegment.  Corporate assets include cash,marketable securities and the assets of Vision-Sciences, Ltd.  Data regarding management’s view of theCompany’s segments are provided in the following tables.

 

11

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| **Three months ended December 31,**   | ** ** | **Medical** | ** ** | **Industrial** | ** ** | **Corporate** | ** ** | **Adjustments** | ** ** | **Total**  | ** ** |
|---------------------------------------|------------|-------------|------------|----------------|------------|---------------|------------|-----------------|------------|------------|------------|
| **2004**                              | ** ** | ** **  | ** ** | ** **     | ** ** | ** **    | ** ** | ** **      | ** ** | ** ** | ** ** |
| Sales to  external customers          |       | $           | 2,158,084  |           | $          | 668,865       |       | $               | —     |       | $          | — |   | $ | 2,826,949 |   |
| Intersegment  sales                   |       | —      |       | 838,159        |       | —        |       | (838,159        | )          | —     |       |
| Operating income  (loss)              |       | (275,890    | )          | (26,833        | )          | (491,944      | )          | —          |       | (794,667   | )          |
| Interest income  (expense), net       |       | —      |       | —         |       | 2,672         |       | —          |       | 2,672      |       |
| Depreciation and  amortization        |       | 76,379      |       | 14,664         |       | 1,506         |       | —          |       | 92,549     |       |
| Advance to 3BY  Ltd.                  |       | —      |       | —         |       | —        |       | —          |       | —     |       |
| Other  significant non-cash items:    |       |        |       |           |       |          |       |            |       |       |       |
| Stock-based  compensation             |       | 62,734      |       | 62             |       | 3,047         |       | —          |       | 65,843     |       |
| Conversion of  advance to fixed asset |       | 267,500     |       | —         |       | —        |       | —          |       | 267,500    |       |
| Expenditures for  fixed assets        |       | 131,694     |       | —         |       | —        |       | —          |       | 131,694    |       |
|                                  |       |        |       |           |       |          |       |            |       |       |       |
| **2003**                              |       |        |       |           |       |          |       |            |       |       |       |
| Sales to  external customers          |       | $           | 1,767,982  |           | $          | 949,793       |       | $               | —     |       | $          | — |   | $ | 2,717,775 |   |
| Intersegment  sales                   |       | —      |       | 612,914        |       | —        |       | (612,914        | )          | —     |       |
| Operating income  (loss)              |       | 66,906      |       | 102,102        |       | (151,797      | )          | —          |       | 17,211     |       |
| Interest income  (expense), net       |       | —      |       | —         |       | 6,681         |       | —          |       | 6,681      |       |
| Depreciation and  amortization        |       | 38,401      |       | 10,083         |       | —        |       | —          |       | 48,484     |       |
| Advance to 3BY  Ltd.                  |       | 51,000      |       | —         |       | —        |       | —          |       | 51,000     |       |
| Other  significant non-cash items:    |       |        |       |           |       |          |       |            |       |       |       |
| Stock-based  compensation             |       | 321         |       | 107            |       | (132,959      | )          | —          |       | (132,531   | )          |
| Expenditures for  fixed assets        |       | 69,474      |       | —         |       | —        |       | —          |       | 69,474     |       |

 
| **Nine months ended December 31,**    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **2004**                              |       |       |       |       |       |       |       |       |       |       |       |
| Sales to  external customers          |       | $          | 5,265,728  |       | $          | 2,369,439  |       | $          | —     |       | $          | — |   | $ | 7,635,167 |   |
| Intersegment  sales                   |       | —     |       | 1,815,373  |       | —     |       | (1,815,373 | )          | —     |       |
| Operating income  (loss)              |       | (1,008,495 | )          | (58,463    | )          | (951,158   | )          | —     |       | (2,018,116 | )          |
| Interest income  (expense)            |       | —     |       | —     |       | 16,045     |       | —     |       | 16,045     |       |
| Depreciation and  amortization        |       | 175,148    |       | 37,233     |       | 4,518      |       | —     |       | 216,899    |       |
| Advance to 3BY  Ltd.                  |       | —     |       | —     |       | —     |       | —     |       | —     |       |
| Other  significant non-cash items:    |       | —     |       | —     |       | —     |       | —     |       | —     |       |
| Stock-based  compensation             |       | 123,567    |       | 187        |       | 9,141      |       | —     |       | 132,895    |       |
| Conversion of  advance to fixed asset |       | 267,500    |       | —     |       | —     |       | —     |       | 267,500    |       |
| Expenditures for  fixed assets        |       | 508,505    |       | 22,150     |       | —     |       | —     |       | 530,655    |       |
| Total assets                          |       | 3,394,262  |       | 1,456,707  |       | 777,249    |       | (280,433   | )          | 5,347,785  |       |
|                                  |       |       |       |       |       |       |       |       |       |       |       |
| **2003**                              |       |       |       |       |       |       |       |       |       |       |       |
| Sales to  external customers          |       | $          | 4,438,597  |       | $          | 2,346,415  |       | $          | —     |       | $          | — |   | $ | 6,785,012 |   |
| Intersegment  sales                   |       | —     |       | 1,169,131  |       | —     |       | (1,169,131 | )          | —     |       |
| Operating income  (loss)              |       | 107,581    |       | 81,332     |       | (1,350,205 | )          | —     |       | (1,161,292 | )          |
| Interest income  (expense)            |       | —     |       | —     |       | 21,393     |       | —     |       | 21,393     |       |
| Depreciation and  amortization        |       | 126,209    |       | 30,102     |       | —     |       | —     |       | 156,311    |       |
| Advance to 3BY  Ltd.                  |       | 267,500    |       | —     |       | —     |       | —     |       | 267,500    |       |
| Other  significant non-cash items:    |       |       |       |       |       |       |       |       |       |       |       |
| Stock-based  compensation             |       | 750        |       | 250        |       | 501,457    |       | —     |       | 502,457    |       |
| Expenditures for  fixed assets        |       | 118,594    |       | 1,512      |       | —     |       | —     |       | 120,106    |       |
| Total assets                          |       | 2,207,624  |       | 1,263,363  |       | 2,454,310  |       | (88,582    | )          | 5,836,715  |       |

 

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## **Item 2**. MANAGEMENT’S DISCUSSION AND ANALYSIS OF

## **FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

## ** **

**Executive Summary**

 

This Quarterly Report onForm 10-Q contains forward-looking statements within the meaning of The PrivateSecurities Litigation Reform Act of 1995. Examples of forward-looking statements include statements about expectationsabout future financial results, future products and future sales of new andexisting products, future expenditures, and capital resources to meetanticipated requirements.  Withoutlimiting the foregoing, the words “believes”, “anticipates”, “plans”, “expects”,and similar expressions are intended to identify forward-lookingstatements.  These forward-lookingstatements involve risks and uncertainties, and our actual results may differsignificantly from those discussed in the forward-looking statements. Factorsthat might cause such a difference include, but are not limited to, theavailability of capital resources, the availability of third-partyreimbursement, government regulation, the availability of supplies,competition, technological difficulties, the continuation of our contracts withMedtronic Xomed, Inc. and Medtronic USA, Inc., general economic conditions andother risks detailed in our most recent Annual Report on Form 10-K and anysubsequent periodic filings made with the Securities and ExchangeCommission.  We do not undertake anobligation to update our forward-looking statements to reflect future events orcircumstances.

 

We develop, manufactureand sell flexible endoscope products for the medical device and industrialdevice markets.  We operate in threereporting segments, medical, industrial and corporate.

 

#### *MedicalSegment*

#### * *

The medical segmentsupplies flexible endoscopes and disposable Slide-OnTM EndoSheath® Systems (“EndoSheaths”)to the Ear-Nose-Throat (“ENT”), gastrointestinal (“GI”), urology and pulmonarymarkets.  Health-care providers useEndoSheaths to cover the insertion tube of flexible endoscopes, such as ENTendoscopes, Trans-Nasal Esophagoscopes (“TNE”), sigmoidoscopes, cystoscopes andbronchoscopes.  We have designed theEndoSheaths to allow the health-care providers to process patients economicallyby permitting the providers to minimize reprocessing the endoscopes between procedures.  In addition, the EndoSheaths ensure a sterileinsertion tube for each patient procedure.

 

Our strategy in themedical segment is comprised of three components: a) improve salesdistribution, b) lower manufacturing costs and c) increase the number of newproduct offerings.

 

#### *Sales Distribution*

#### * *

Since September 19, 2003we have been distributing all of our products for the ENT markets in the U.S.A.and Canada through Medtronic Xomed, Inc. (“Medtronic Xomed”) as part of ourexclusive distribution agreement (the “Medtronic Agreement”) with them. Theinitial term of the Medtronic Agreement is three years.  Thereafter, the Medtronic Agreement will beautomatically renewed for successive one-year periods, unless terminated byeither party upon advance written notice. Under the Medtronic Agreement, we have granted Medtronic Xomed exclusivedistribution rights in the United States and Canada to market and sell our ENTEndoSheaths, ENT endoscopes, TNE endoscopes and TNE EndoSheaths to ENTpractitioners.  As of July 2004 MedtronicXomed completed the minimum purchase requirements for the initial twelve-monthperiod of the term, ending in August 2004 (“Year 1”).

 

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Underthe Medtronic Agreement, in order to maintain its exclusive distributionrights, Medtronic Xomed is required to purchase at least 110% of the Year 1unit volume of ENT EndoSheaths in Year 2. Due to higher than expected inventory levels of ENT EndoSheaths atMedtronic Xomed at the end of Year 1, we currently expect Medtronic Xomed topurchase approximately 6,300 units of ENT EndoSheaths during the remaining threemonths of our fiscal year ending March 31, 2005 (“FY 05”), compared toapproximately 140,240 units purchased by Medtronic Xomed in the first ninemonths of FY 05.  If Medtronic Xomedcontinues to sell units to end users at their current rate, they would purchasesignificantly less ENT EndoSheaths from us than required under the Agreement tomaintain exclusivity.  There can be noassurance that Medtronic Xomed will purchase the required units to maintainexclusivity.  We have made nodetermination, as of December 31, 2004, as to whether we will terminate theexclusive distribution rights of Medtronic Xomed if Medtronic Xomed does not purchase theunit volume required in Year 2.  As aresult of the Medtronic Agreement, the success of our ENT product linesin the domestic market is substantially dependent upon the success of themarketing and sales activities of Medtronic Xomed over which we have limitedcontrol.

 

The Medtronic Agreementdoes not contain any provisions for Medtronic Xomed to return unsold products,nor are there any terms related to product acceptance and warranty that aredifferent from the normal terms we offer our other customers.  The Medtronic Agreement does provide for adiscount to Medtronic Xomed for payment within 10 days of invoice date.

 

In December 2004 weconcluded an agreement (the “MDT USA Agreement”) with the Urology division ofMedtronic, Inc. (“MDT USA”) that provides for MDT USA to be the exclusivedistributor in the United States and Canada of our flexible Cystoscope withSlide-On EndoSheath System and ancillary products to the urology market,including urogynecology.  The MDT USAAgreement runs until March 31, 2006, the “Initial Term”, and thereafter willautomatically renew for successive one-year periods, unless either partynotifies the other party in writing, at least ninety days prior to the end ofany term, of its intent not to renew.

 

During the Initial Term,MDT USA is required to purchase $1,965,000 of our flexible Cystoscope and ourSlide-On Cystoscope EndoSheath System, of which $353,500 will be purchased in FY05 and $1,611,500 will be purchased in our fiscal year ending March 31, 2006 (“FY06”). In the 12-month periods following the Initial Term, the MDT USA Agreementrequires us and MDT USA to negotiate minimum sales values. If MDT USA fails topurchase such minimums, or if we cannot agree on such minimums, we have theright and option to terminate MDT USA’s exclusivity, or terminate the MDT USAAgreement.

 

The MDT USA Agreementdoes not contain any provisions for MDT USA to return unsold products, nor arethere any terms related to product acceptance and warranty that are differentfrom the normal terms we offer our other customers.  The MDT USA Agreement does provide for adiscount to MDT USA for payment within 10 days of invoice date.

 

We continue to market andsell our GI product line directly to that market, and we have retained our owninternational network of distributors for all our medical product lines.

 

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#### *Cost Reduction*

#### * *

During FY 04 we decidedwe could reduce manufacturing costs by sub-contracting the manufacture of ourEndoSheaths for the GI and ENT markets to 3BY, Ltd. (“3BY”), a company inIsrael.  We realized a benefit ofapproximately $60,000 in the six months ended December 31, 2004 as we sold thefirst commercial lots of sigmoidoscope EndoSheaths and ENT EndoSheaths thatwere manufactured by 3BY.  This costreduction is net of depreciation expense recognized in the three months endedDecember 31, 2004 for the ENT equipment we took title to from 3BY effectiveOctober 1, 2004.

 

#### *New Products*

#### * *

In FY 04 we receivedclearance from the U.S. Food and Drug Administration, (“FDA”) to market anumber of new products to the ENT market. In general, we designed these products to allow the ENT physician toperform procedures in their offices, using their standard laryngoscopes, asopposed to the current practice of traveling to hospitals to use special ENTendoscopes to perform the procedures. Under the current reimbursement procedures of the Centers for Medicare& Medicaid Services (“CMS”), a governmental agency under the U.S.Department of Health and Human Services, the ENT physician will receive ahigher reimbursement by performing the procedures in their offices than theyreceive when they perform them in a hospital.

 

In April 2004 we receivedclearance from the Food & Drug Administration to market our FlexibleCystoscope with Slide-On EndoSheath System. We plan to continue to introduceproducts during FY 05 that enhance the practice efficiency of physicians andalso ensure a sterile insertion tube for each patient procedure.

 

#### *IndustrialSegment*

#### * *

The industrial segmentdesigns, manufactures and sells flexible endoscopes, termed borescopes, forindustrial users, and manufactures and repairs flexible endoscopes for themedical segment.  The industrial segmentusers consist primarily of companies in the aircraft engine manufacturing andmaintenance markets and the defense market.

 

#### *CorporateSegment*

#### * *

The corporate segmentconsists of certain administrative and business development activitiesapplicable to the company as a whole.

 

15

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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 accounting principlesgenerally accepted in the United States. See the Notes to the Consolidated Financial Statements includedelsewhere herein.  Certain of ouraccounting policies require the application of judgment in selecting theappropriate 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*

### * *

We recognize revenue inaccordance with SEC Staff Accounting Bulletin No. 104, *RevenueRecognition in Financial Statements*(SAB 104) 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.

 

We account for the rebatewe granted to Medtronic Xomed in accordance with EITF 01-9, *Accounting for Consideration Given by a Vendor to a Customer (Includinga Reseller of the Vendor’s Products)*.  This pronouncement requires that a vendorrecognize rebates as a reduction of revenue based on a systematic and rationalallocation of the cost of honoring rebates earned and claimed to each of theunderlying revenue transactions that result in progress by the customer towardearning the rebate.  Accordingly, as ofSeptember 30, 2004, we recognized an allowance of $39,000 for the estimatedrebate that would accrue to Medtronic Xomed for sales of ENT EndoSheaths thatwere in Medtronic Xomed’s inventory at that date that would be sold to newcustomers under the rebate program. Subsequent to September 30, 2004, we recognize revenue on sales of ENTEndoSheaths to Medtronic Xomed, net of an estimated sales allowance related to thatrebate program.  Measurement of the totalrebate is based on the estimatednumber of customers that will ultimately earn rebates under the offer.  Determination of the number of customers thatwill earn rebates and the amount of those rebates is based on management’sjudgment.  We review our estimates of thenumber of customers that will earn benefits under the rebate program eachfiscal quarter.  If different conditionsresult from those assumptions used in our judgment, the results could bematerially different from our estimates.

 

16

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*OptionsIssued to Non-employees*

 

We account fornon-qualified options issued to non-employees as equity instruments, inaccordance with the provisions of EITF 96-18.  Fair values for these non-qualified optionsare derived from pricing models that consider current market and contractualprices for the underlying financial instruments, as well as time value, yieldcurve and volatility factors underlying the positions.  Pricing models and their underlyingassumptions impact the amount and timing of the value of these non-qualifiedoptions, and the use of different pricing models or assumptions could producedifferent financial results.  We use theBlack-Scholes option-pricing model for determining the value of non-qualifiedoptions issued to non-employees, and we expense that value over the vestingperiod of the non-qualified options.

 

We account for certainnon-qualified options granted to employees to purchase our common stock inaccordance with Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for**Stock Issued to Employees.*  If the fair market value of the underlyingstock at the date of grant is greater than the option price, we recognizecompensation expense for the difference between the market price and the optionprice over the vesting period of the options.

 

*Income Taxes*

 

Under our income taxpolicy, we record the estimated future tax effects of temporary differencesbetween the tax bases of assets and liabilities and amounts recorded in theaccompanying consolidated balance sheets, as well as operating loss and taxcredit carryforwards.  The evaluation ofthe recoverability of any tax assets recorded on the balance sheet is subjectto significant judgment.  We haveprovided valuation allowances for all our deferred tax assets to date.

 

**Results of Operations**

 

Net Sales

*Q3 05 Compared to Q3 04*

Net sales for the threemonths ended December 31, 2004 (“Q3 05”) were $2,826,949, an increase of $109,174,or 4%, compared to the three-month period ended December 31, 2003 (“Q3 04”).  During Q3 05, net sales of the medicalsegment increased by $390,102, or 22%, to $2,158,084, and net sales of theindustrial segment decreased by $280,928, or 30%, to $668,865, compared to Q3 04.  In the medical segment, the net sales andchanges in net sales by market were as follows ($000’s):

 
| **Market** | ** ** | **Q3 05** | ** ** | **Q3 04** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| ENT        |       | $         | 1,646      |      | $          | 1,572                    |       | $           | 74         |   | 5 | % |
| GI         |       | 78        |       | 120       |       | (42                      | )          | (36         | )%         |
| Urology    |       | 263       |       | —    |       | 263                      |       | 100         | %          |
| Pulmonary  |       | 28        |       | 21        |       | 7                        |       | 33          | %          |
| Other      |       | 143       |       | 55        |       | 88                       |       | 159         | %          |
| Total      |       | $         | 2,158      |      | $          | 1,768                    |       | $           | 390        |   | 22 | % |

 

17

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*MedicalSales – ENT Market*

 

Net sales to the ENTmarket include products for domestic and international customers as follows:

 
| **ENT Market** | ** ** | **Q3 05** | ** ** | **Q3 04** | ** ** | **Increase   (Decrease)** | ** ** | **Percent** | ** ** |
|----------------|------------|-----------|------------|-----------|------------|---------------------------|------------|-------------|------------|
| Domestic       |       | $         | 1,080      |      | $          | 1,208                     |       | $           | (128       | ) | (11 | )% |
| International  |       | 566       |       | 364       |       | 202                       |       | 55          | %          |
| Total ENT      |       | $         | 1,646      |      | $          | 1,572                     |       | $           | 74         |   | 5 | % |

 

We further delineateproducts sold to the domestic ENT market as follows:

 
| **ENT Products**      | ** ** | **Q3 05** | ** ** | **Q3 04** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|-----------------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| Slide-On  EndoSheaths |       | $         | 151        |      | $          | 453                      |       | $           | (302       | ) | (67 | )% |
| Endoscopes            |       | 911       |       | 657       |       | 254                      |       | 39          | %          |
| Other products        |       | 18        |       | 98        |       | (80                      | )          | (82         | )%         |
| Total Domestic        |       | $         | 1,080      |      | $          | 1,208                    |       | $           | (128       | ) | (11 | )% |

 

The primary reason forthe decrease in net sales of ENT products to the domestic market was the completionin July 2004 by Medtronic Xomed of its minimum purchase requirements for Year 1of the Medtronic Agreement.  As a result,Medtronic Xomed had higher than expected levels of inventory of ENT endoscopesand ENT Slide-On EndoSheaths (“ENT SOS”) and has not purchased as much of thoseproducts since that time.  MedtronicXomed did resume purchases of those products in Q3 05, but at a significantlyslower rate than Q3 04.  We expect salesof ENT SOS to Medtronic Xomed in the remainder of FY 05 to continue to be slow,as Medtronic Xomed has sufficient inventory to support their average monthlysales for approximately six months.  Thelower sales of these products were partially offset by the purchase byMedtronic Xomed of new products, including our TNE Bx endoscope and ourENT-1000 small diameter flexible endoscope and companion EndoSheaths for theseendoscopes.

 

To attempt to increasethe sales of our ENT SOS, Medtronic Xomed has initiated three programs.  Two of these programs were generatedinternally at Medtronic Xomed and we do not participate in them at all.  We have assumed responsibility for a third program,a rebate that we agreed to provide Medtronic Xomed a cash rebate for sales ofENT SOS to new users who commit to large annual purchases of ENT SOS.  The rebate program is designed to continuefor one year, will be renewable by mutual agreement and will vary with theprice charged by Medtronic Xomed to individual users.  We are accounting for this rebate programunder EITF 01-9.  For the threemonths ended September 30, 2004 we reduced sales by approximately $39,000 forthe estimated potential maximum rebate to be granted to Medtronic Xomed forsales by Medtronic Xomed after September 1, 2004 of ENT SOS that they had paidfor, and were in their inventory on September 30, 2004.

 

We continue to providefor the potential maximum rebate for current sales to Medtronic Xomed. Althoughthe rebate program has not proved successful to date in reducing the inventoryof ENT SOS at Medtronic Xomed, we plan to continue the program for theaforementioned one year.

 

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Under the MedtronicAgreement, in order to maintain its exclusive distribution rights, MedtronicXomed is required to purchase at least 110% of the Year 1 unit volume of ENT SOSin Year 2.  There can be no assurance,however, that Medtronic Xomed will purchase the required units to maintain itsexclusive distribution rights.  As a resultof the Medtronic Agreement, the success of our domestic ENT product lines willcontinue to be substantially dependent upon the success of the marketing andsales activities of Medtronic Xomed, over which we have limited control.

 

Sales of the TNE Bx, TNED and ENT-1000 endoscopes and companion EndoSheaths totaled approximately $843,000in Q3 05, reflecting continued market penetration by Medtronic Xomed of the TNED and ENT-1000 products, and the initial shipments of our TNE Bx endoscope andcompanion EndoSheaths.  We expect salesof the TNE D and ENT-1000 products will be higher in the fourth quarter of FY05, while sales of the TNE Bx products to slow, reflecting the time it willtake Medtronic Xomed to launch the products to their sales force.

 

Both the TNE D and TNE Bxare products designed to allow ENT physicians to perform procedures in theiroffices using topical anesthetics, compared to having to perform the sameprocedures in hospitals where patients are consciously sedated, therebyincreasing patient throughput.  Beingable to see more patients, and under reimbursement procedures allowed by CMS,physicians can generate more revenue by performing these procedures in theiroffices, compared to in a hospital environment. The reimbursement rates are greater for the physician, but less overall,as there is no reimbursement for the hospital. Patients benefit also, as they avoid being consciously sedated and they experiencethe procedures with an insertion tube covered with our sterile EndoSheath.  These are new procedures for ENT physicians,and communicating the benefits of them to the ENT physician istime-consuming.  We believe ourrelationship with Medtronic Xomed is critical to the marketing and distributionprocess, as Medtronic Xomed possesses greater sales and marketing abilitiesthan we have.

 

We further delineateproducts sold to the international ENT market as follows:

 
| **ENT Products**      | ** ** | **Q3 05** | ** ** | **Q3 04** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|-----------------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| Slide-On  EndoSheaths |       | $         | 381        |      | $          | 267                      |       | $           | 114        |   | 43 | % |
| Endoscopes            |       | 185       |       | 97        |       | 88                       |       | 91          | %          |
| Other products        |       | —    |       | —    |       | —                   |       | —      | %          |
| Total  International  |       | $         | 566        |      | $          | 364                      |       | $           | 202        |   | 55 | % |

 

The increase in net salesto international distributors is primarily due to higher unit volume of ENT SOS,along with higher unit average selling prices. Effective April 1, 2004 we increased prices approximately 8% for ENT SOSand 5% for ENT endoscopes.  Unit sales ofENT SOS to the international distributors were 58,920 in Q3 05, an increase of 14,125units, compared to sales in Q3 04.  Includedin the units sold in Q3 05 were 440 units for the ENT-1000 endoscope, notavailable for sale in Q3 04.  The higherdemand came from our major distributors in Europe and Australia.  We expect unit demand from these distributorswill remain consistent with prior years for the remainder of FY 05 and in theyear ending March 31, 2006 (“FY 06”).

 

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Unit sales of ENTendoscopes in Q3 05 to international distributors were 39, compared to 28 in Q304.  Unit sales in Q3 05 included 13units of the ENT-1000, not available for sale in Q3 04.  In addition, we sold 4 TNE D endoscopes toour international distributors in Europe. We are in the early stages of selling TNE endoscopes to ourdistributors, and we plan to increase our marketing efforts by hostingsymposiums for physicians where they can experience the benefits that ourproducts can have on the efficiency of their practices and the protection ourproducts offer patients.  Sales ofendoscopes are dependent upon a variety of factors, including the timing requirementsof end users, foreign exchange rates, sales promotions of internationalcompetitors and other factors.

 

In addition, we plan tocontinue to sign agreements favorable to us with distributors in countrieswhere we do not have a presence. However, there can be no assurance we will be able to consummate theseagreements on terms that are beneficial to us.

 

*MedicalSales – Other Markets*

 

Net sales to the GI marketdeclined in Q3 05, compared to Q3 04, due primarily to lower demand for ourproprietary sigmoidoscope EndoSheaths due to the aging of the installed base ofour sigmoidoscopes and the continued insufficiency of reimbursement rates to physiciansto support the use of the products.  Weexpect this decline to continue during FY 05 and FY 06.

 

The increase in sales ofurology products reflects the initial shipments of our new Flexible Cystoscope(“CST-2000”) with Slide-On EndoSheath System to MDT USA and to shipments tointernational distributors in Europe and Australia.  We believe the CST-2000 and EndoSheath Systemcan significantly enhance the practice efficiency of urologists by allowingthem to avoid the tedious and time-consuming reprocessing of conventionalcystoscopes, and presents the significant benefit of a sterile insertion tubefor each patient.  In addition, the useof our CST-2000 with Slide-On EndoSheath System avoids the need to reprocessendoscopes with harsh chemicals, one of which has been contraindicated for useon patients with bladder cancer.

 

*IndustrialSegment*

 

The increase in net salesof the industrial segment was due to lower demand for new borescopes, offsetpartially by higher demand for repairs of borescopes.

 

*9 Months 05 Compared to 9 Months04*

Net sales for the ninemonths ended December 31, 2004 (“9M 05”) were $7,635,167, an increase of $850,155,or 13%, compared to the nine-month period ended December 31, 2003 (“9M 04”).  During 9M 05 net sales of the medical segmentincreased by $827,131, or 19% to $5,265,728, and net sales of the industrialsegment increased by $23,024, or 1%, to $2,369,439, compared to 9M 04.  In the medical segment net sales and changesin net sales by market were as follows ($000’s):

 
| **Market** | ** ** | **9M 05** | ** ** | **9M 04** | ** ** | **Increase (Decrease)** | ** ** | **Percent** | ** ** |
|------------|------------|-----------|------------|-----------|------------|-------------------------|------------|-------------|------------|
| ENT        |       | $         | 4,288      |      | $          | 3,804                   |       | $           | 484        |   | 13 | % |
| GI         |       | 248       |       | 418       |       | (170                    | )          | (41         | )%         |
| Urology    |       | 358       |       | —    |       | 358                     |       | 100         | %          |
| Pulmonary  |       | 35        |       | 53        |       | (18                     | )          | (34         | )%         |
| Other      |       | 336       |       | 163       |       | 173                     |       | 106         | %          |
| Total      |       | $         | 5,265      |      | $          | 4,438                   |       | $           | 827        |   | 19 | % |

 

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*MedicalSales – ENT Market*

 

Sales to the ENT marketinclude products for domestic and international customers as follows:

 
| **ENT Market** | ** ** | **9M 05** | ** ** | **9M 04** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|----------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| Domestic       |       | $         | 2,752      |      | $          | 2,389                    |       | $           | 363        |   | 15 | % |
| International  |       | 1,536     |       | 1,415     |       | 121                      |       | 9           | %          |
| Total ENT      |       | $         | 4,288      |      | $          | 3,804                    |       | $           | 484        |   | 13 | % |

 

We further delineateproducts sold to the domestic ENT market as follows:

 
| **ENT Products**      | ** ** | **9M 05** | ** ** | **9M 04** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|-----------------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| Slide-On  EndoSheaths |       | $         | 1,101      |      | $          | 1,347                    |       | $           | (246       | ) | (18 | )% |
| Endoscopes            |       | 1,539     |       | 944       |       | 595                      |       | 63          | %          |
| Other products        |       | 112       |       | 98        |       | 14                       |       | 14          | %          |
| Total Domestic        |       | $         | 2,752      |      | $          | 2,389                    |       | $           | 363        |   | 15 | % |

 

Net sales of ENT SOS decreasedin the nine months ended December 31, 2004, because of the reasons discussedabove.  The increase in net sales ofendoscopes for the period reflects net sales in Q3 05 of our TNE Bx endoscopeand also higher sales in 9M 05 of our ENT-1000 endoscope, offset partially bylower net sales of our ENT-2000 endoscope to Medtronic Xomed.  The increase in net sales of other productsreflects sales of products to ENT physicians for the diagnosis of swallowingdisorders.

 

We further delineateproducts sold to the international ENT market as follows:

 
| **ENT Products**      | ** ** | **9M 05** | ** ** | **9M 04** | ** ** | **Increase (Decrease)** | ** ** | **Percent** | ** ** |
|-----------------------|------------|-----------|------------|-----------|------------|-------------------------|------------|-------------|------------|
| Slide-On  EndoSheaths |       | $         | 1,138      |      | $          | 1,098                   |       | $           | 40         |   | 4 | % |
| Endoscopes            |       | 394       |       | 317       |       | 77                      |       | 24          | %          |
| Other products        |       | 4         |       | —    |       | 4                       |       | 100         |       |
| Total  International  |       | $         | 1,536      |      | $          | 1,415                   |       | $           | 121        |   | 9 | % |

 

The higher net sales ofENT SOS and endoscopes to the international market were due primarily to the causesin Q3 05 as explained above.

 

*IndustrialSegment*

 

The increase in net salesfor the 9M 05 compared to 9M 04 was due to higher demand for repairs ofborescopes, offset by lower demand for new borescopes.

 

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Gross Profit

*Q3 05 Compared to Q3 04*

Gross profit was $786,870in Q3 05, a decrease of $104,799, compared to gross profit in Q3 04.  Gross profit decreased by approximately $12,000in the medical segment, and by approximately $93,000 in the industrialsegment.  Gross profit in the medicalsegment increased due to higher volume of endoscopes, but this was more than offsetby the lower volume and price of ENT SOS. We did benefit from the lower costs of production of ENT SOS andEndoSheaths for the GI market at 3BY, but this was more than offset by thehigher costs incurred for the initial production of our new EndoSheath styles,such as the EndoSheaths for TNE and cystoscopes that we manufactured in ourNatick, Mass facility.  In the industrialsegment, the decrease in gross profit was due primarily to a decrease in salesvolume.

 

In FY 04, we began theprocess of moving the manufacturing of our EndoSheaths to 3BY Ltd, asub-contractor in Israel, to reduce the manufacturing cost of theseproducts.  We advanced $267,500 to thesub-contractor for the purchase and installation of machinery to produce ENTEndoSheaths.  We received the firstcommercial shipments of these products in the three months ending September 30,2004.  We expect to produce a lowerquantity of ENT SOS in FY 05 than we had planned, increasing the riskassociated with repayment of the advance. To eliminate this risk and to secure title to this equipment, we tookownership of the equipment in the three months ended December 31, 2004.

 

*9M 05 Compared to 9M 04*

The gross profit for 9M05 was $2,120,273, a decrease of $330,966, compared to the gross profit in 9M04.  The gross profit of the medicalsegment decreased by approximately $236,000, while the gross profit of theindustrial segment decreased by approximately $95,000.  The causes of the reduction in gross profitfor the 9M 05 compared to 9M 04 were primarily the same as in Q3 05, explainedabove.

 

Operating Expenses

 

*Selling,General and Administrative Expenses*

 

*Q3 05 Compared to Q3 04*

The increase in selling,general and administrative (“SG&A”) expenses in Q3 05 was due primarily to theaccrual of severance payments for the termination of an employee of the industrialsegment, and increased spending for legal fees related to intellectual property.

 

*9M 05 Compared to 9M 04*

The increase in S,G&Aexpenses for the 9M 05 compared to 9M 04 was due primarily to higher marketingand promotion costs related to launching new products, and the severance costsreferred to above.

 

*Researchand Development Expenses*

 

*Q3 05 Compared to Q3 04*

The increase in R&Dexpenses in Q3 05, compared to Q3 04 was due primarily to additional spendingfor materials and personnel hired to work on developing new products for themedical segment.  We expect costs forR&D will continue to be higher in FY 05, compared to FY 04, as we increaseour efforts to develop new products for medical markets, both those that will utilizethe technology inherent in our EndoSheaths, and other products for the medicalmarket.

 

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*9M 05 Compared to 9M 04*

The increase in R&Dexpenses for 9M 05, compared to 9M 04 was due primarily to the same reasons asexplained above.

 

*Stock-basedCompensation Expenses*

 

We incurred stock-basedcompensation costs during FY 05, due primarily to grants in April 2004 and July2004 of non-qualified options to purchase 100,000 shares and 50,000 shares,respectively, of our Common Stock to an outside consultant.  These grants were in accordance with anagreement entered into with that consultant in January 2003.  The value of the non-qualified options weredetermined to be approximately $371,000, using the Black-Scholes option-pricingmodel, and will be recorded in our statements of operations over the vestingperiod of the options.  We recordedapproximately $62,000 and $123,000 of expense in Q3 05 and 9M 05, respectively,related to these non-qualified options.  Inaddition, during the three months ended June 30, 2003, the compensationcommittee of our board of directors authorized the issuance of non-qualifiedoptions to purchase 1,295,000 shares of common stock to certain of ouremployees.  These options were pricedbelow the fair market price of our common stock on the date of grant.  Accordingly, we will recognize compensation expensetotaling approximately $65,000 from June 2003 through December 2007, thevesting period of these options.  In Q305 and 9M 05, we incurred approximately $3,000 and $9,000, respectively, ofexpense related to these options in our statements of operations.

 

Operating Income (Loss)

 

Operating income (loss)by segment was as follows ($000’s):

 
| **Segment** | ** ** | **Q3 05** | ** ** | **Q3 04** | ** ** | **Change** | ** ** | **9M 05** | ** ** | **9M 04** | ** ** | **Change** | ** ** |
|-------------|------------|-----------|------------|-----------|------------|------------|------------|-----------|------------|-----------|------------|------------|------------|
| Medical     |       | $         | (339       | )         | $          | 67         |       | $         | (406       | )         | $          | (1,009     | )          | $ | 108 |   | $ | (1,117 | ) |
| Industrial  |       | (27       | )          | 102       |       | (129       | )          | (58       | )          | 81        |       | (139       | )          |
| Corporate   |       | (429      | )          | (152      | )          | (277       | )          | (951      | )          | (1,350    | )          | 399        |       |
| Total       |       | $         | (795       | )         | $          | 17         |       | $         | (812       | )         | $          | (2,018     | )          | $ | (1,161 | ) | $ | (857 | ) |

 

In the medical segment, thelower gross profit, and higher spending for S,G&A and R&D resulted in anoperating loss for Q3 05.  In theindustrial segment, the lower gross profit due to lower sales volume and tohigher costs associated with initial production of new endoscope styles for themedical segment were the primary causes for the operating loss in Q3 05.  The larger losses in 9M 05 for these twosegments were due primarily to these same reasons.  In the corporate segment, the severance costsrelated to the termination of an industrial segment employee and an unfavorablecomparison to a credit for stock-based compensation costs in Q3 04 were theprimary causes for the higher loss.  For9M 05, the corporate segment incurred lower costs for stock-based compensationdue to the change in character of non-qualified options granted tonon-employees from liability instruments to equity instruments in March 2004.

 

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Liquidity and CapitalResources

 

AtDecember 31, 2004, our principal source of liquidity was working capital ofapproximately $2.26 million, including $0.7 million in cash and cashequivalents.  At December 31, 2004, wehad acceptances payable to a bank totaling approximately $60,000.  We have pledged $125,000 to secure theacceptances payable.

 

Wealso have an agreement with a bank, which includes a revolving line of creditunder which we may borrow up to $1,000,000, net of up to $250,000 of anyoutstanding letters of credit and banker’s acceptances.  Borrowings under this loan arrangement mustbe fully cash collateralized.  Theagreement also stipulates that when we achieve positive cash flow, as definedin the agreement, we will be eligible to negotiate changes to this loanarrangement that may include changing the borrowing base for revolving loans,and the release of the pledged cash collateral.

 

Ourcash and cash equivalents decreased by approximately $2,025,000 in the ninemonths ended December 31, 2004, due primarily to cash used for operations ofapproximately $1,846,000 and cash used for investing activities ofapproximately $545,000.  These uses wereoffset by the exercise of stock options by employees and non-employees,resulting in approximately $371,000 of cash generated.  We expect that our current balance of cashand cash equivalents will not be sufficient to fund our operations for the nexttwelve months.

 

We have incurred lossessince our inception, and losses are expected to continue at least during FY05.  We have funded the lossesprincipally with the proceeds from public and private equity financings.  The private equity financings have includedsales of new common stock to two employees who are also directors, to other independentdirectors and independent private individuals.

 

On February 14, 2005, wesold in a private equity placement an aggregate of 3,703,702 shares of CommonStock at a price of $2.70 per share, raising gross proceeds to the Company ofapproximately $10,000,000.  Two financialinvestors, who are independent of the Company, acquired approximately$8,000,000 of the Common Stock sold, and two significant shareholders/directorsacquired the remaining shares sold.  Inaddition, as part of the transaction, the Company issued warrants to purchasean additional 1,103,704 shares of Common Stock to the investors who areindependent of the Company, and to the placement agent.  The warrants will be exercisable immediatelyover five years at a price of $3.75 per share. We will receive all the proceedsin exchange for newly issued shares of Common Stock, net of a placement fee ofapproximately $480,000.  The Company has notagreed to file any registration statement covering the resale of any of theCommon Stock or Warrants acquired by the investors in the transaction

 

We expect total spendingfor property and equipment to be approximately $700,000 for FY 05.

 

We conduct our operations in certain facilities leasedfrom non-related parties.  These leasesexpire on various dates through October 31, 2006.  In addition, we have operating leases forcertain office equipment leased from non-related parties.  These leases expire on various dates throughMay 2006.  The following chart summarizesour contractual obligations as of March 31, 2004.

 
| **Contractual Obligation** | ** ** | **Total** | ** ** | **Due within 1 year** | ** ** | **Due in 1-3 years** | ** ** |
|----------------------------|------------|-----------|------------|-----------------------|------------|----------------------|------------|
| Operating leases           |       | $         | 701,347    |                  | $          | 331,723              |       | $ | 369,624 |   |
| Capital lease              |       | 45,150    |       | 18,837                |       | 26,313               |       |
|                            |            |           |            |                       |            |                      |            |  |  |  |

 

We have no off-balancesheet arrangements that have, or are reasonably likely to have, a current orfuture effect on our financial condition, changes in financial condition,revenues or expenses, results of operations, liquidity, capital expenditures orcapital resources.

 

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## **Item 3**. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

## ** **

In the normal course ofbusiness, we are subject to the risks associated with fluctuations in interestrates and changes in foreign currency exchange rates.

 

#### *Interestand Market Risk*

#### * *

We currently invest ourexcess cash in a money market account at our bank.  We have not used derivative financialinstruments in our investment portfolio. We attempt to limit our exposure to interest rate and credit risk byplacing our investments with high-quality financial institutions and haveestablished investment guidelines relative to diversification and maturitiesdesigned to maintain safety and liquidity.

 

Investments in bothfixed-rate and floating-rate interest earning instruments carry a degree ofinterest 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 market valuedue to changes in interest rates.

 

#### *ForeignCurrency Exchange*

#### * *

We face exposure, due topurchases of raw materials from Japanese suppliers, to adverse movements in thevalue of the Japanese Yen.  This exposuremay change over time, and could have a materially adverse effect on ourfinancial results.  We may attempt tolimit this exposure by purchasing forward contracts, as required.  Most of our Japanese Yen liabilities aresettled within 90 days of receipt of materials. At December 31, 2004, our liabilities relating to Japanese Yen wereapproximately $185,000.

 

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## **Item 4**. CONTROLS AND PROCEDURES

## ** **

*a)**            Evaluation ofDisclosure Controls and Procedures.*

 

Based on an evaluation ofour disclosure controls and procedures (as defined in Rules 13a-15(a) and 15d-15(e)under the Securities Exchange Act of 1934), the chief executive officer andchief financial officer have concluded that our disclosure controls andprocedures as of the end of the three months ended December 31, 2004, aredesigned to ensure that information required to be disclosed by us in thereports that we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the SEC’s rulesand forms and are operating in an effective manner.

 

*b)**            Changes in InternalControls Over Financial Reporting.*

 

There were no significantchanges in our internal controls over financial reporting or in other factorsthat could significantly affect these controls during the fiscal quarter ended December31, 2004.

 

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**PART II****- OTHER INFORMATION**

 

**Item 4.  None**

 

**Item 5.  None**

 

**Item 6****.  Exhibits and Reports on Form 8-K**

 

(a)                                  Exhibits

 

10.1             ExclusiveDistribution Agreement, dated December 29, 2004, by and between the Registrantand Medtronic USA, Inc.

 

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.

 

(b)                                 Reportson Form 8-K

On February 10, 2005, wefurnished a current report on Form 8-K attaching our press release announcingour financial results for the third quarter ended December 31, 2004.

 

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##### **SIGNATURES**

##### ** **

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

VISION-SCIENCES,INC.

 

 
| Date:  | February  14, 2005                                                                                                               | /s/  Ron Hadani     |   |
|--------|----------------------------------------------------------------------------------------------------------------------------------|---------------------|--------|
|   | Ron  Hadani                                                                                                                      |
|   | President,  CEO (Duly Authorized Officer)                                                                                        |
|   |                                                                                                                             |
|   |                                                                                                                             |
| Date:  | February  14, 2005                                                                                                               | /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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