**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D. C. 20459**

**FORM 10-Q**

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

**OF THESECURITIES EXCHANGE ACT OF 1934**

**FOR THEQUARTER ENDED June 30, 2006**

**COMMISSIONFILE NUMBER 0-20970**

**VISION-SCIENCES, INC.**

(Exact name of registrantas specified in its charter)

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

**(508)650-9971**

(Registrant’stelephone number, including area code)

**None**

(Former name, formeraddress, and

former fiscal yearif changed since last report)

Indicate by checkmark whether 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  x    No  o

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer.  Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act.

Large acceleratedfiler  o    Acceleratedfiler  o    Non-acceleratedfiler  x

Indicateby check mark whether the registrant is a shell company (as defined by Rule12b-2 of the Exchange Act).

Yes  o    No  x

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of July 31, 2006.

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

 

 

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**VISION-SCIENCES,INC.TABLE OF CONTENTS**
|     |                                                                                                     | **Page** |
|----------|----------------------------------------------------------------------------------------------------------|----------|
| Part I.  | Financial  Information                                                                                   |     |
|     |                                                                                                     |     |
|     | Item  1. Financial Statements                                                                            |     |
|     |                                                                                                     |     |
|     | Consolidated  Balance Sheets                                                                             | 3        |
|     |                                                                                                     |     |
|     | Consolidated Statements of Operations                                                                    | 4        |
|     |                                                                                                     |     |
|     | Consolidated Statement of Stockholders’ Equity and  Comprehensive Loss                              | 5        |
|     |                                                                                                     |     |
|     | Consolidated Statements of Cash Flows                                                                    | 6        |
|     |                                                                                                     |     |
|     | Notes to Consolidated Financial Statements                                                               | 7        |
|     |                                                                                                     |     |
|     | Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 17       |
|     |                                                                                                     |     |
|     | Item 3. Quantitative and Qualitative Disclosures about  Market Risk                                      | 26       |
|     |                                                                                                     |     |
|     | Item  4. Controls and Procedures                                                                         | 27       |
|     |                                                                                                     |     |
| Part II. | Other Information                                                                                        |     |
|     |                                                                                                     |     |
|     | Item 1A. Risk Factors                                                                                    | 28       |
|     |                                                                                                     |     |
|     | Item 6. Exhibits                                                                                         | 28       |
|     |                                                                                                     |     |
|     | Signatures                                                                                               | 29       |
|     |                                                                                                     |     |
|     | Exhibits                                                                                                 | 30       |

 

2

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**PART I - FINANCIAL INFORMATION**

**Item 1: FINANCIAL STATEMENTS**

**VISION-SCIENCES, INC. ANDSUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                                        | ** ** | **June 30,   2006** | ** ** | **March 31,   2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                                                                        | ** ** | **(Unaudited)**               | ** ** | ** **                     | ** ** |
| ASSETS                                                                                                                                                                            |       |                          |       |                           |       |
| Current Assets:                                                                                                                                                                   |       |                          |       |                           |       |
| Cash and cash  equivalents                                                                                                                                                        |       | $                             | 5,105,715  |                           | $          | 6,138,148 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $121,342 and $145,402,  respectively                                                                              |       | 1,054,798                     |       | 1,767,913                      |       |
| Inventories                                                                                                                                                                       |       | 2,879,875                     |       | 2,384,993                      |       |
| Prepaid expenses  and deposits                                                                                                                                                    |       | 55,259                        |       | 59,532                         |       |
| Total current  assets                                                                                                                                                             |       | 9,095,647                     |       | 10,350,586                     |       |
|                                                                                                                                                                              |       |                          |       |                           |       |
| Property and Equipment,  at cost:                                                                                                                                                 |       |                          |       |                           |       |
| Machinery and  equipment                                                                                                                                                          |       | 4,887,577                     |       | 4,747,964                      |       |
| Furniture and  fixtures                                                                                                                                                           |       | 251,445                       |       | 250,865                        |       |
| Leasehold  improvements                                                                                                                                                           |       | 586,796                       |       | 582,631                        |       |
|                                                                                                                                                                              |       | 5,725,818                     |       | 5,581,460                      |       |
| Less-Accumulated  depreciation and amortization                                                                                                                                   |       | 4,590,248                     |       | 4,489,529                      |       |
|                                                                                                                                                                              |       | 1,135,570                     |       | 1,091,931                      |       |
| Other assets, net of  accumulated amortization of $61,712 and $60,127, respectively                                                                                               |       | 66,920                        |       | 68,505                         |       |
| Total assets                                                                                                                                                                      |       | $                             | 10,298,137 |                           | $          | 11,511,022 |   |
|                                                                                                                                                                              |       |                          |       |                           |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                        |       |                          |       |                           |       |
| Current Liabilities:                                                                                                                                                              |       |                          |       |                           |       |
| Acceptances  payable to a bank                                                                                                                                                    |       | $                             | 23,345     |                           | $          | 61,536 |   |
| Current portion  of note payable                                                                                                                                                  |       | 21,299                        |       | 26,431                         |       |
| Accounts payable                                                                                                                                                                  |       | 669,184                       |       | 892,398                        |       |
| Accrued expenses                                                                                                                                                                  |       | 1,111,712                     |       | 1,028,146                      |       |
| Total current  liabilities                                                                                                                                                        |       | 1,825,540                     |       | 2,008,511                      |       |
|                                                                                                                                                                              |       |                          |       |                           |       |
| Long-term portion of  note payable                                                                                                                                                |       | 2,795                         |       | 4,193                          |       |
|                                                                                                                                                                              |       |                          |       |                           |       |
| Stockholders’ Equity:                                                                                                                                                        |       |                          |       |                           |       |
| Common stock,  $.01 par value — Authorized—50,000,000 shares 

Issued  and outstanding—35,166,278 shares at June 30, 2006 and 35,148,427 shares at  March 31, 2006 |       | 351,662                       |       | 351,483                        |       |
| Additional  paid-in capital                                                                                                                                                       |       | 75,810,305                    |       | 75,678,615                     |       |
| Accumulated  deficit                                                                                                                                                              |       | (67,692,165                   | )          | (66,531,780                    | )          |
| Total  stockholders’ equity                                                                                                                                                  |       | 8,469,802                     |       | 9,498,318                      |       |
| Total liabilities and  stockholders’ equity                                                                                                                                  |       | $                             | 10,298,137 |                           | $          | 11,511,022 |   |

See accompanying notesto consolidated financial statements.

3

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

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**
| ** **                                                            | ** ** | **Three Months Ended    June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2006**                                                    | ** ** | **2005** | ** ** |
| Net sales                                                             |       | $                                                           | 2,007,073  |   | $ | 2,532,958 |   |
| Cost of sales                                                         |       | 1,519,071                                                   |       | 1,922,818 |   |
|                                                                  |       |                                                        |       |   |   |
| Gross profit                                                          |       | 488,002                                                     |       | 610,140 |   |
|                                                                  |       |                                                        |       |   |   |
| Selling, general  and administrative expenses                         |       | 1,081,809                                                   |       | 994,944 |   |
| Research and  development expenses                                    |       | 610,204                                                     |       | 497,173 |   |
| Loss from operations                                                  |       | (1,204,011                                                  | )          | (881,977 | ) |
|                                                                  |       |                                                        |       |   |   |
| Interest income                                                       |       | 48,391                                                      |       | 45,786 |   |
| Interest expense                                                      |       | (485                                                        | )          | (967 | ) |
| Other income  (expense), net                                          |       | (4,280                                                      | )          | 6,060 |   |
|                                                                  |       |                                                        |       |   |   |
| Net loss                                                              |       | $                                                           | (1,160,385 | ) | $ | (831,098 | ) |
|                                                                  |       |                                                        |       |   |   |
| Basic and  diluted net loss per common share                          |       | $                                                           | (0.03      | ) | $ | (0.02 | ) |
|                                                                  |       |                                                        |       |   |   |
| Shares used in  computing basic and diluted net loss per common share |       | 35,152,430                                                  |       | 35,047,919 |   |

See accompanyingnotes to consolidated financial statements.

4

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

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITYand COMPREHENSIVE LOSS**

**(Unaudited)**
| ** **                                     | ** ** | **Common Stock**      | ** ** | ** **               | ** ** | ** **                      | ** ** | ** **               | ** ** | ** **                            | ** **  |
|------------------------------------------------|------------|----------------------------|------------|--------------------------|------------|---------------------------------|------------|--------------------------|------------|---------------------------------------|-------------|
| ** **                                     | ** ** | **Number  of Shares** | ** ** | **$.01  Par Value** | ** ** | **Additional  Paid-in-Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Total  Stockholders’  Equity** | ** **  | **Total   Comprehensive   Loss** | ** ** |
|                                           |       |                       |       |                     |       |                            |       |                     |       |                                  |        |   |   |
| Balance, March  31, 2006                       |       | 35,148,427                 |       | $                        | 351,483    |                            | $          | 75,678,615               |       | $                                     | (66,531,780 | ) | $ | 9,498,318 |   |   |   |
| Exercise of  stock options, net                |       | 17,851                     |       | 179                      |       | 19,219                          |       |                     |       | 19,398                                |        |   |   |
| Compensation  expense related to stock options |       |                       |       |                     |       | 112,471                         |       |                     |       | 112,471                               |        |   |   |
| Net loss                                       |       |                       |       |                     |       |                            |       | (1,160,385               | )          | (1,160,385                            | )           | $ | (1,160,385 | ) |
| Total  comprehensive loss                      |       |                       |       |                     |       |                            |       |                     |       |                                  |        | $ | (1,160,385 | ) |
|  Balance June 30, 2006                    |       | 35,166,278                 |       | $                        | 351,662    |                            | $          | 75,810,305               |       | $                                     | (67,692,165 | ) | $ | 8,469,802 |   |   |   |

See accompanyingnotes to consolidated financial statements.

5

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

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                    | ** ** | **Three Months Ended   June 30, 2006** | ** ** | **Three Months Ended  June 30, 2005** | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Cash flows from  operating activities:                                        |       |                                                            |       |                                                      |       |
| Net loss                                                                      |       | $                                                               | (1,160,385 | )                                                         | $          | (831,098 | ) |
| Adjustments to reconcile net loss to net cash used  for operating activities: |       |                                                            |       |                                                      |       |
| Depreciation and amortization                                                 |       | 102,304                                                         |       | 104,251                                                   |       |
| Stock-based compensation                                                      |       | 112,471                                                         |       | 49,684                                                    |       |
| Changes in assets and liabilities:                                            |       |                                                            |       |                                                      |       |
| Accounts receivable                                                           |       | 713,115                                                         |       | (33,593                                                   | )          |
| Inventories                                                                   |       | (494,882                                                        | )          | (363,630                                                  | )          |
| Prepaid expenses and deposits                                                 |       | 4,273                                                           |       | 15,470                                                    |       |
| Accounts payable                                                              |       | (223,214                                                        | )          | 182,216                                                   |       |
| Accrued expenses                                                              |       | 83,566                                                          |       | (162,997                                                  | )          |
|                                                                          |       |                                                            |       |                                                      |       |
| Net cash used for operating activities                                        |       | (862,752                                                        | )          | (1,039,697                                                | )          |
|                                                                          |       |                                                            |       |                                                      |       |
| Cash flows used  for investing activities                                     |       |                                                            |       |                                                      |       |
| Purchase of property and equipment, net                                       |       | (144,358                                                        | )          | (110,052                                                  | )          |
|                                                                          |       |                                                            |       |                                                      |       |
| Net cash used for investing activities                                        |       | (144,358                                                        | )          | (110,052                                                  | )          |
|                                                                          |       |                                                            |       |                                                      |       |
| Cash flows  provided by (used for) financing activities:                      |       |                                                            |       |                                                      |       |
| Payments on note payable for computer equipment                               |       | (6,530                                                          | )          | (6,047                                                    | )          |
| (Payments of) proceeds from acceptances payable to a  bank, net               |       | (38,191                                                         | )          | 59,021                                                    |       |
| Proceeds from the sale of common stock, net                                   |       | —                                                          |       | 92,593                                                    |       |
| Exercise of stock options, net                                                |       | 19,398                                                          |       | 100,775                                                   |       |
| Net cash (used for) provided by financing activities                          |       | (25,323                                                         | )          | 246,342                                                   |       |
|                                                                          |       |                                                            |       |                                                      |       |
| Net decrease in  cash and cash equivalents                                    |       | (1,032,433                                                      | )          | (903,407                                                  | )          |
| Cash and cash  equivalents, beginning of period                               |       | 6,138,148                                                       |       | 9,868,586                                                 |       |
| Cash and cash  equivalents, end of period                                     |       | $                                                               | 5,105,715  |                                                      | $          | 8,965,179 |   |
|                                                                          |       |                                                            |       |                                                      |       |
| Supplemental  Disclosure of Cash Flow Information:                            |       |                                                            |       |                                                      |       |
| Cash paid during the period for interest                                      |       | $                                                               | 485        |                                                      | $          | 967 |   |
|                                                                          |       |                                                            |       |                                                      |       |
| Supplemental  Disclosure of Non-cash Items from Financing Activities:         |       |                                                            |       |                                                      |       |
|                                                                          |       |                                                            |       |                                                      |       |
| Fair market  value of non-qualified options granted in the period             |       | $                                                               | —     |                                                      | $          | — |   |

See accompanyingnotes to consolidated financial statements.

6

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

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

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

The consolidated financial statements included herein have beenprepared by Vision-Sciences, Inc. and subsidiaries (the “Company”) in accordancewith accounting principles generally accepted in the United States of America,without audit, pursuant to the rules and regulations of the Securities andExchange Commission and include, in the opinion of management, all adjustments(consisting only of normal and recurring adjustments) that the Companyconsiders 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 accompanying consolidated financial statementsreflect the application of certain accounting policies 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*: The Company classifies investments withoriginal maturities of ninety days or less, consisting of commercial paper anda money market account at a bank, as cash equivalents.  Cash equivalents are stated at amortizedcost, which approximates market value*.*

c.                                       *Inventories*: Inventories are stated at the lower of cost or market using thefirst-in, first-out (FIFO) method and consist of the following:
|                 | ** ** | **June 30,** | ** ** | **March 31,** | ** ** |
|-----------------|------------|-------------------|------------|--------------------|------------|
| ** **      | ** ** | **2006**          | ** ** | **2006**           | ** ** |
| ** **      | ** ** | ** **        | ** ** | **(audited)**      | ** ** |
|            |       |              |       |               |       |
| Raw materials   |       | $                 | 1,435,246  |               | $          | 1,600,652 |   |
| Work-in-process |       | 459,474           |       | 143,803            |       |
| Finished goods  |       | 985,155           |       | 640,538            |       |
|            |       | $                 | 2,879,875  |               | $          | 2,384,993 |   |

 

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

7

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

 

Leasehold improvements are amortized over the shorter of theirestimated useful lives or the lives of the leases.

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

f.                                         *Revenue Recognition*: The following must occur before theCompany recognizes revenue: (1) persuasive evidence of an arrangement exists,(2) delivery has occurred or services have been rendered, (3) the price isfixed or determinable, (4) collectibility is reasonably assured and (5) thefair value of undelivered elements, if any, exists.  To date the Company has not entered into anymultiple element arrangements.  TheCompany recognizes revenue when title passes to the customer, generally uponshipment of products F.O.B. its plants. Since September 2003, the Company’s medical segment has distributed allof its products for the Ear-Nose-Throat (“ENT”) market in the U.S.A. and Canadathrough an agreement (the “Medtronic Agreement”) with Medtronic ENT, Inc. (“MENT”).  The initial term of the Medtronic Agreementwas three years, renewable thereafter annually, unless terminated by eitherparty.  The Medtronic Agreement does notprovide for any contingencies, nor provide any terms related to productacceptance or warranty that are different from the normal terms provided by theCompany to its other customers.

From December 2004 to May 1, 2006, the Company’s medical segmentdistributed all of its products for the urology market in the U.S.A. and Canadathrough Medtronic USA, Inc. (the Medtronic Gastroenterology/Urology business,or “MGU”) as part of a separate exclusive agreement (the “MGU Agreement”).  The MGU Agreement continued in full force andeffect until March 31, 2006, renewable thereafter annually, unless terminatedby either party.  In May 2006, theCompany and MGU terminated the MGU Agreement. Subsequent to May 1, 2006, the Company is distributing its products forthe urology market through a network of independent sales representatives.

The Company’s medical segment distributes its products for thepulmonary and GI markets through a network of independent domestic salesrepresentatives.  The Company’s medicalsegment distributes all its products outside the U.S.A. and Canada through anetwork of independent international distributors.

8

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The Company’s industrial segment distributes all its products usingdirect sales personnel and a network of independent sales representatives.

g.                                      *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.

h.                                      *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 recorded a valuationallowance equal to its net deferred tax asset due to the uncertainty ofrealizing the benefit of this asset.

i.                                        *Stock-based Compensation:*Effective April 1, 2006 the Company beganaccounting for compensation expense related to stock options in accordance withSFAS No. 123 (Revised 2004) *Share-Based Payment*(“SFAS123R”).  Prior to April 1, 2006, theCompany accounted for stock options according to Accounting Principles Board (“APB”)Opinion 25, *Accounting for Stock Issued to Employees*,and EITF 96-18, *Accounting for Equity Instruments That AreIssued to Other Than Employees for Acquiring, or in Conjunction with Selling,Goods and Services*.  TheCompany has adopted the modified prospective transition method provided forunder SFAS 123R, and consequently has not retroactively adjusted results fromprior periods.  Under this transitionmethod, compensation cost associated with stock options now includes: (i)amortization related to the remaining unvested portion of all stock optionsoutstanding at March 31, 2006, based on the fair value determined on the grantdate in accordance with the original provisions of SFAS 123, and (ii)amortization related to all stock option awards granted subsequent to March 31,2006, based upon the fair value estimated in accordance with SFAS 123R.  The compensation expense for stock-basedcompensation awards under SFAS 123R is recognized over the vesting period ofthe options, and includes an estimate for forfeitures.

In accordance with SFAS123R, the Company recorded $112,471 of stock-based compensation expense in thestatement of operations for the three months ended June 30, 2006 (“Q1 07”)in the following expense categories:

9

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| Cost of Goods Sold |   | $      | 14,453  |   |
|--------------------|--------|--------|---------|--------|
| S,G&A          |   | 86,440 |    |
| R&D            |   | 11,578 |    |
| Total              |   | $      | 112,471 |   |

At June 30, 2006, the total unamortizedstock-based compensation is approximately $930,000.  The Company will expense that amount overperiods ending March 31, 2010.  TheCompany does not expect to realize any tax benefits from future disqualifyingdispositions, if any, due to its policy of recording valuation allowances equalto its deferred tax asset.

In the three months ended June 30, 2005, theCompany recorded compensation expense of $49,684 for non-qualified stockoptions in the statement of operations in the following expense categories:

| Cost of Goods Sold |   | $      | — |   |
|--------------------|--------|--------|--------|--------|
| S,G&A          |   | 49,575 |   |
| R&D            |   | 109    |   |
| Total              |   | $      | 49,684 |   |

In Q1 07, the Company granted one option topurchase 15,000 shares of the Company’s Common Stock.  The fair value of this option measured at theoption grant date was approximately $16,518, determined using the Black-Scholesoption-pricing model, and is being recorded as an expense over the vestingperiod.  The assumptions used in theBlack-Scholes option-pricing model in the period by the Company were asfollows:
|                                        | ** ** | **June 30, 2006** | ** ** |
|----------------------------------------|------------|-----------------------------|------------|
| Risk-free interest rate                |       | 4.96                        | %          |
| Expected dividend yield                |       | —                      |       |
| Expected life                          |       | 6.25 years                  |       |
| Expected volatility                    |       | 67                          | %          |
| Weighted average value grant per share |       | $                           | 1.67       |   |
|                                        |            |                             |            |  |

 

10

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We account for optionsissued to non-employees and employees in accordance with the provisions of SFAS123R.  We grant options with vestingperiods ranging from immediate to four years. For Q1 07 we have chosen to employ the simplified method of calculatingthe expected option term, which averages an award’s weighted average vestingperiod and its contractual term.  Thecontractual term of our options is ten years. The option granted in Q1 07 vests at a rate of 25% per year for thefirst four years.  The risk-free rate isbased upon the daily Treasury yield curve for a period approximately equal tothe expected option term.  We usedhistorical data to estimate the expected price volatility and forfeiturerate.  The expected dividend yield is 0%,based on our history of not paying dividends and on the fact that we areprohibited from paying dividends under our bank agreement.

SFAS 123R requires thepresentation of pro forma information for the comparative period prior to theadoption, as if the Company had accounted for all its employee stock optionsunder the fair value method of the original SFAS 123.  The following table illustrates the effect onnet loss and loss per share if the Company had applied the fair valuerecognition provisions of SFAS 123 to stock-based employee compensation in theprior year.
|                                                       | ** ** | **Three Months Ended  June 30, 2005** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Net loss – as  reported                          |       | $                                                         | (831,098   | ) |
| Stock-based  employee compensation – as reported |       | 3,297                                                     |       |
| Pro forma  stock-based employee compensation          |       | (119,170                                                  | )          |
| Net loss - pro  forma                                 |       | $                                                         | (946,971   | ) |
|                                                  |       |                                                      |       |
| Net loss per  share – as reported                |       | $                                                         | (.02       | ) |
| Stock-based  employee compensation – as reported |       | —                                                    |       |
| Pro forma  stock-based employee compensation          |       | (.01                                                      | )          |
| Net loss per share -  pro forma                       |       | $                                                         | (.03       | ) |

11

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In the three months ended June 30, 2005, theCompany granted options to purchase 46,000 shares of the Company’s CommonStock.  The fair value of these optionsmeasured at the option grant date were approximately $69,538, determined usingthe Black-Scholes option-pricing model, and were not recorded as an expenseover the vesting period, as the Company was not accounting for options underSFAS 123R.

The assumptions used in the Black-Scholes option-pricingmodel in the period by the Company were as follows:
|                                        | ** ** | **June 30, 2005** | ** ** |
|----------------------------------------|------------|-----------------------------|------------|
| Risk-free interest rate                |       | 3.33                        | %          |
| Expected dividend yield                |       | —                      |       |
| Expected life                          |       | 5 years                     |       |
| Expected volatility                    |       | 72                          | %          |
| Weighted average value grant per share |       | $                           | 2.45       |   |
|                                        |            |                             |            |  |

12

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j.                  *New Accounting Standards:* InNovember 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 criterion specifiedin 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 fiscalyears beginning after June 15, 2005.  TheCompany believes this new standard has had no material impact on its results ofoperations for the three months ended June 30, 2006.

In July 2006, the FASB issued FIN 48, *Accountingfor Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109*,which seeks to reduce the significant diversity in practice associated withcertain aspects of measurement and recognition in accounting for income taxes.FIN 48 prescribes a recognition threshold and measurement attribute for financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return, and also provides guidance on de-recognition,classification, interest and penalties, accounting in interim periods,disclosure and transition. The provisions of FIN 48 are effective for fiscalyears beginning after December 15, 2006. Upon adoption, the cumulative effectof any changes in net assets resulting from the application of FIN 48 will berecorded as an adjustment to retained earnings. The Company is currentlyevaluating the impact, if any, that FIN 48 will have on its financial positionand results of operations.

In February 2006, the FASBissued SFAS 155, *Accounting for CertainHybrid Financial Instruments* which amends SFAS 133, *Accounting for Derivative Instruments and Hedging Activities*and SFAS 140, *Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities*.  SFAS 155 simplifies the accounting forcertain derivatives embedded in other financial instruments by allowing them tobe accounted for as a whole if the holder elects to account for the wholeinstrument on a fair value basis. SFAS 155 also clarifies and amends certain other provisions ofSFAS 133 and SFAS 140. SFAS 155 is effective for all financial instruments acquired,issued or subject to a re-measurement event occurring in fiscal years beginningafter September 15, 2006 and is therefore required to be adopted by theCompany in the first fiscal quarter of its fiscal year ending March 31,2008. The Company is currently evaluating the effect that the adoption ofSFAS 155 will have on its consolidated financial statements but does notexpect that it will have a material impact.

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**3.             Stock Option Plans**

The Company has a stock option plan (the “2000 Plan”) under which itgrants key employees and consultants stock options at the fair value of thestock on the date of grant. Options become exercisable at varying dates rangingup to five years from the date of grant. The Board of Directors and shareholders have authorized the issuance ofoptions for the purchase of up to 4,500,000 shares of common stock under the2000 Plan, of which 999,108 shares remain available for future grant.  The Company grants options to both employeesand non-employee consultants.

A summary of the stockoption activity for the three months ended June 30, 2006 is as follows:
| ** **                  | ** ** | **Number of Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Weighted Average Remaining  Contractual Term** | ** ** |
|-----------------------------|------------|--------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| Outstanding March 31,  2006 |       | 4,367,351                      |       | $                                              | 1.52       |                                                            | 6.08       |   |
| Granted                     |       | 15,000                         |       | 1.67                                           |       |                                                            |       |
| Exercised                   |       | (17,851                        | )          | 1.09                                           |       |                                                            |       |
| Canceled                    |       | (10,000                        | )          | 3.00                                           |       |                                                            |       |
| Outstanding June 30,  2006  |       | 4,354,500                      |       | $                                              | 1.52       |                                                            | 5.87       |   |
| Exercisable June 30, 2006   |       | 3,247,250                      |       | $                                              | 1.45       |                                                            |       |   |

 

The followingtable summarizes information about stock options outstanding and exercisable atJune 30, 2006:
| ** **                          | ** ** | **Outstanding**            | ** ** | **Exercisable**                                                      | ** ** |
|-------------------------------------|------------|----------------------------|------------|----------------------------------------------------------------------|------------|
| **Range of  Exercise  Prices** | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average Exercise  Price** | ** ** | **Number  of Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|                                |       |                       |       |                                                                 |       |   |   |   |   |   |   |
| $.79 - 1.05                         |       | 1,153,750                  |       | 6.71                                                                 |       | $ | 1.02 |   | 1,103,750 |   | $ | 1.02 |   |
| 1.06 - 1.31                         |       | 1,204,000                  |       | 5.49                                                                 |       | 1.14 |   | 710,875 |   | 1.17 |   |
| 1.50 - 1.88                         |       | 1,342,750                  |       | 4.30                                                                 |       | 1.64 |   | 1,175,500 |   | 1.62 |   |
| 2.05 - 2.57                         |       | 400,500                    |       | 8.57                                                                 |       | 2.29 |   | 87,500 |   | 2.40 |   |
| 2.70 - 3.34                         |       | 28,500                     |       | 8.49                                                                 |       | 2.88 |   | 7,125 |   | 2.88 |   |
| 3.69 - 4.30                         |       | 225,000                    |       | 7.84                                                                 |       | 3.96 |   | 162,500 |   | 3.88 |   |
|                                |       | 4,354,500                  |       | 5.87                                                                 |       | $ | 1.52 |   | 3,247,250 |   | $ | 1.45 |   |

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In July 2003, the Company adopted, and the stockholders approved, a2003 Director Option Plan (the “2003 Plan”). The terms of the 2003 Plan include automatic grants of 4,000 shares toeach outside director on each date on which an annual meeting of thestockholders of the Company is held, provided that such outside director doesnot hold on such date any outstanding options to purchase Common Stock of theCompany’s 1993 Plan, which options are not fully exercisable.  Options granted under the 2003 Plan are 100%vested on the date of grant.  If theCompany’s annual meeting of stockholders is held in August of each year, theCompany will grant options to purchase 16,000 shares in each of 2006, 2007 and2008.

A summary of the 2003 Plan activity is as follows:

|                             | ** ** | **Number  of Shares** | ** ** | **Exercise  Price Range** | ** **   | **Weighted  Average  Exercise Price** | ** ** |
|-----------------------------|------------|----------------------------|------------|--------------------------------|--------------|--------------------------------------------|------------|
| Outstanding  March 31, 2006 |       | 72,000                     |       | $                              | 1.00 - $2.10 |                                       | $          | 1.39 |   |
| Granted                     |       | —                     |       | —                         |         | —                                     |       |
| Exercised                   |       | —                     |       | —                         |         | —                                     |       |
| Canceled                    |       | —                     |       | —                         |         | —                                     |       |
| Outstanding June  30, 2006  |       | 72,000                     |       | $                              | 1.00 - $2.10 |                                       | $          | 1.39 |   |
| Exercisable June 30,  2006  |       | 72,000                     |       | $                              | 1.00 - $2.10 |                                       | $          | 1.39 |   |

 

The following tablesummarizes information about director stock options outstanding and exercisableat June 30, 2006:

** **

|                                     | ** ** | **Outstanding** | ** **                 | **Exercisable** | ** **                                                       |
|-------------------------------------|------------|-----------------|----------------------------|-----------------|------------------------------------------------------------------|
| **Range of  Exercise  Prices** | ** ** | ** **      | **Number of  Shares** | ** **      | **Weighted  Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  of Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                                |       |            |                       |            |                                                             |   |   |   |   |   |   |   |
| $1.00 – 1.30                   |       |            | 40,000                     |            | 5.19                                                             |   | $ | 1.15 |   | 40,000 |   | $ | 1.15 |   |
| 1.50 – 1.92                    |       |            | 24,000                     |            | 2.71                                                             |   | 1.57 |   | 24,000 |   | 1.57 |   |
| 2.06 – 2.10                    |       |            | 8,000                      |            | 9.41                                                             |   | 2.08 |   | 8,000 |   | 2.08 |   |
|                                |       |            | 72,000                     |            | 4.83                                                             |   | $ | 1.39 |   | 72,000 |   | $ | 1.39 |   |

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**4.             Segment Information**

TheCompany has three 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.

All segments follow the accounting policies described in the summary ofsignificant accounting policies.  TheCompany evaluates segment performance based upon operating income.  Identifiable assets are those used directlyin the operations of each segment. Corporate assets include cash, marketable securities and the assets ofVision-Sciences, Ltd.  Data regardingmanagement’s view of the Company’s segments are provided in the followingtables.
| **Three months ended June 30,** | ** ** | **Medical** | ** ** | **Industrial** | ** ** | **Corporate** | ** ** | **Adjustments** | ** ** | **Total**  | ** ** |
|-----------------------------------------------------|------------|-------------|------------|----------------|------------|---------------|------------|-----------------|------------|------------|------------|
| **2006**                                            |       |        |       |           |       |          |       |            |       |       |       |
| Sales to external  customers                        |       | $           | 1,351,590  |           | $          | 655,483       |       | $               | —     |       | $          | — |   | $ | 2,007,073 |   |
| Intersegment sales                                  |       | —      |       | 482,641        |       | —        |       | (482,641        | )          | —     |       |
| Operating income (loss)                             |       | (759,742    | )          | (143,085       | )          | (301,184      | )          | —          |       | (1,204,011 | )          |
| Interest income  (expense), net                     |       | —      |       | —         |       | 47,906        |       | —          |       | 47,906     |       |
| Depreciation and  amortization                      |       | 96,254      |       | 6,050          |       | —        |       | —          |       | 102,304    |       |
| Other significant  non-cash items:                  |       |        |       |           |       |          |       |            |       |       |       |
| Stock-based  compensation                           |       | 37,823      |       | 18,263         |       | 56,385        |       | —          |       | 112,471    |       |
| Expenditures for fixed  assets                      |       | 132,747     |       | 11,611         |       | —        |       | —          |       | 144,358    |       |
| Total assets                                        |       | 3,930,785   |       | 2,094,035      |       | 5,191,670     |       | (918,353        | )          | 10,298,137 |       |
| ** **                                          |       |        |       |           |       |          |       |            |       |       |       |
| **2005**                                            |       |        |       |           |       |          |       |            |       |       |       |
| Sales to external  customers                        |       | $           | 1,909,329  |           | $          | 623,629       |       | $               | —     |       | $          | — |   | $ | 2,532,958 |   |
| Intersegment sales                                  |       | —      |       | 828,791        |       | —        |       | (828,791        | )          | —     |       |
| Operating income (loss)                             |       | (612,523    | )          | (14,042        | )          | (255,412      | )          | —          |       | (881,977   | )          |
| Interest income  (expense), net                     |       | —      |       | —         |       | 44,819        |       | —          |       | 44,819     |       |
| Depreciation and  amortization                      |       | 89,443      |       | 14,808         |       | —        |       | —          |       | 104,251    |       |
| Other significant  non-cash items:                  |       |        |       |           |       |          |       |            |       |       |       |
| Stock-based  compensation                           |       | 46,575      |       | 62             |       | 3,047         |       | —          |       | 49,684     |       |
| Expenditures for fixed  assets                      |       | 102,227     |       | 7,825          |       | —        |       | —          |       | 110,052    |       |
| Total assets                                        |       | 3,474,384   |       | 1,786,976      |       | 9,051,134     |       | (80,498         | )          | 14,231,996 |       |

 

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## **Item2.  MANAGEMENT’S DISCUSSION AND ANALYSISOFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

**Executive Summary**

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

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

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, 2003, we have been distributing all of our productsfor the ENT market in the U.S.A. and Canada through MENT as part of theMedtronic Agreement. The initial term of the Medtronic Agreement is threeyears.  Thereafter, the Medtronic Agreementis automatically renewed for successive one-year periods, unless terminated byeither party upon advance written notice. Under the Medtronic Agreement, we have granted MENT exclusivedistribution rights in the U.S.A. and Canada to market and sell our ENT and TNEEndoSheaths and endoscopes to ENT practitioners.  MENT fulfilled certain minimum purchaserequirements for the initial twelve-month period of the term.

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We believe the marketing and sales capabilities of MENT havefacilitated and will continue to facilitate the introduction of new products tothe ENT market by allowing quicker market acceptance of these products than ifwe marketed them ourselves.  As a resultof this agreement, the success of our ENT product line is substantiallydependent upon the success of the marketing and sales activities of MENT, overwhich we have limited control.

In December 2004, we signed the MGU Agreement with MGU, granting MGUthe exclusive right to distribute our new cystoscope with Slide-On EndoSheathSystem to urologists in the United States and Canada.  The term of the MGU Agreement was throughMarch 31, 2006, renewable for successive one-year periods unless either partynotified the other party in writing at least 90 days prior to the end of anyterm that it did not want to renew.  InMay 2006, we and MGU mutually terminated the MGU Agreement, due to lower salesthan we expected, and a change in strategy by MGU.  MGU has decided to put greater focus ontherapies and narrow its overall uro-diagnostics product offerings, whichincluded our products.  We decided toexplore other forms of distribution for our flexible cystoscope and Slide-OnEndoSheath System, including through a network of independent salesrepresentatives. We are in the process of establishing a network of independentsales representatives for the domestic urology market.  We expect developing this network will takebetween 6 and 9 months.  We willcontinually assess our progress in this area, and could abandon our efforts ifthey do not prove to be successful during that time frame.

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

#### *Cost Reduction*

During the fiscal year ending March 31, 2007 (“FY 07”), we plan tocontinue the efforts begun in the fiscal year ended March 31, 2006 (“FY 06”) toreduce the cost of materials and labor across our endoscope and EndoSheathproduct lines.  These plans include there-configuration of the manufacturing line that produces our ENT and TNEEndoSheaths by combining equipment we brought back from a foreignsub-contractor with equipment we have in our Natick, MA facility.  We expect the re-configuration will becompleted in the fall of 2006, and expect it will result in a reduction in theunit cost of our ENT Slide-On EndoSheath of approximately 25%.  We also plan to continue a development projectthat we expect will result in automating many of the processes performed in themanufacture of EndoSheaths.

#### *New Products*

In May 2005, we received clearance from the FDA to market our newENT-3000 portable endoscope with battery powered LED light source.  During FY 07, our product development plansinclude the design of a new family of videoscopes with a miniature digitalcamera mounted on the distal end of the insertion tube, and design and costimprovements to our TNE and cystoscopes.

18

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#### *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, the defense market and a variety of specialized industrialmarkets.

#### *CorporateSegment*

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

Critical AccountingPolicies and Estimates

This discussion and analysis of ourfinancial condition and results of operations is based upon our ConsolidatedFinancial Statements, which have been prepared in accordance with generally acceptedaccounting principles in the United States of America.  See the Notes to the Consolidated FinancialStatements included elsewhere herein. Certain of our accounting policies require the application of judgmentin selecting the appropriate assumptions for calculating financialestimates.  By their nature thesejudgments are subject to an inherent degree of uncertainty.  We periodically evaluate the judgments andestimates used for our critical accounting policies to ensure that suchjudgments and estimates are reasonable for our interim and year-end reportingrequirements.  These judgments andestimates are based upon our historical experience, current trends andinformation available from other sources, as appropriate.  If different conditions result from thoseassumptions used in our judgment, the results could be materially differentfrom our estimates.  Our criticalaccounting policies include the following:

### *RevenueRecognition*

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

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*OptionsIssued*

We account for optionsissued to non-employees and employees in accordance with the provisions of SFAS123R.  We use the Black-Scholesoption-pricing model for determining the value of options issued, and weexpense that value over the vesting period of the options.  We grant options with vesting periods rangingfrom immediate to four years.  For Q1 07we have chosen to employ the simplified method of calculating the expectedoption term, which averages an award’s weighted average vesting period and itscontractual term.  The contractual termof our options is ten years.  The optiongranted in Q1 07 vests at a rate of 25% per year for the first four years.  The risk-free rate is based upon the dailyTreasury yield curve for a period approximately equal to the expected optionterm.  We used historical data toestimate the expected price volatility and forfeiture rate.  The expected dividend yield is 0%, based onour history of not paying dividends and on the fact we are prohibited frompaying dividends under our bank agreement.

*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

Netsales for the three months ended June 30, 2006 (“Q1 07”) were $2,007,073, adecrease of $525,885, or 21%, compared to the three-month period ended June 30,2005 (“Q1 06”).  During Q1 07, net salesof the medical segment decreased by $557,739, or 29%, to $1,351,590, and netsales of the industrial segment increased by $31,854, or 5%, to $655,483,compared to Q1 06.  In the medicalsegment, we track sales of endoscopes and EndoSheaths by market.  We also track sales of peripheral items thatcan be sold to more than one market. Sales of other products include sales to the GI and pulmonary marketsand sales of repairs and accessories.  Sales by segment and category in Q1 07 and Q1 06 were as follows ($000’s):

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| **Category**     | ** ** | **Q1 07** | ** ** | **Q1 06** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|------------------|------------|----------------|------------|----------------|------------|--------------------------|------------|-------------|------------|
| ENT              |       | $              | 1,032      |           | $          | 1,191                    |       | $           | (159       | ) | (13 | )% |
| Urology          |       | 75             |       | 347            |       | (272                     | )          | (78         | )%         |
| Peripherals      |       | 69             |       | 122            |       | (53                      | )          | (43         | )%         |
| Other            |       | 176            |       | 249            |       | (73                      | )          | (29         | )%         |
| Total medical    |       | $              | 1,352      |           | $          | 1,909                    |       | $           | (557       | ) | (29 | )% |
| Total industrial |       | 655            |       | 624            |       | 31                       |       | 5           | %          |
| Total VSCI       |       | $              | 2,007      |           | $          | 2,533                    |       | $           | (526       | ) | (21 | )% |

 

*MedicalSales — ENT Market*

Net sales to the ENTmarket include products for domestic and international customers as follows($000’s):
| **ENT Market** | ** ** | **Q1 07** | ** ** | **Q1 06** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|---------------------|------------|----------------|------------|----------------|------------|--------------------------|------------|-------------|------------|
| Domestic            |       | $              | 532        |           | $          | 556                      |       | $           | (24        | ) | (4 | )% |
| International       |       | 500            |       | 635            |       | (135                     | )          | (21         | )%         |
| Total ENT           |       | $              | 1,032      |           | $          | 1,191                    |       | $           | (159       | ) | (13 | )% |

 

We further delineateproducts sold to the domestic ENT market as follows ($000’s):
| **Products**          | ** ** | **Q1 07** | ** ** | **Q1 06** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|-----------------------|------------|----------------|------------|----------------|------------|--------------------------|------------|-------------|------------|
| Slide-On  EndoSheaths |       | $              | 403        |           | $          | 172                      |       | $           | 231        |   | 134 | % |
| Endoscopes            |       | 129            |       | 384            |       | (255                     | )          | (66         | )%         |
| Total Domestic ENT    |       | $              | 532        |           | $          | 556                      |       | $           | (24        | ) | (4 | )% |

 

The primary reason for the decrease in sales of products to thedomestic ENT market was lower demand for our TNE endoscopes from MENT.  In addition, there was lower demand for ourENT endoscopes.  Usage of TNE endoscopesby ENT physicians allows them to perform procedures in their offices thatcurrently are performed by GI physicians in hospitals.  Educating this market on the advantages ofthese procedures has proven more difficult than we or MENT hadanticipated.  We expect these procedureswill be more popular among ENT physicians in the future to diagnose and treatgastroenterology reflux disease (“GERD”), especially as the populationages.  A TNE procedure allows patients toreceive topical anesthetics in a physician’s office, as opposed to the morecommon Trans Oral Esophagoscopy procedure that requires a patient to beconsciously sedated in a hospital.   Apatient who undergoes a TNE procedure can recover more quickly than one who isconsciously sedated.  In addition,physicians can receive higher reimbursement rates, and treat more patients in agiven day, by performing these procedures in their offices, than by performingthem in hospitals.  It is our view thatthese procedures will increase in the future because the inconvenience to thepatient is less and the total cost is less when they are done in an office.  However, it will take time to educate andtrain the physicians and educate the patient population on these advantages.

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Sales of our ENT Slide-On EndoSheath (“ENT SOS”) increased in Q1 07,compared to Q1 06, when MENT was in the process of selling the inventory it hadpurchased in the first year of the Medtronic Agreement.  In Q1 07, we sold 53,749 units of our basicENT SOS to MENT, an increase of 30,279 units compared to Q1 06.  This quantity is approximately what weexpected to sell in Q1 07.  For all of FY07, we expect to sell 200,000 units of these EndoSheaths to MENT.

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

We further delineateproducts sold to the international ENT market as follows ($000’s):
| **Products**          | ** ** | **Q1 07** | ** ** | **Q1 06** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|-----------------------|------------|----------------|------------|----------------|------------|--------------------------|------------|-------------|------------|
| Slide-On  EndoSheaths |       | $              | 481        |           | $          | 434                      |       | $           | 47         |   | 11 | % |
| Endoscopes            |       | 19             |       | 201            |       | (182                     | )          | (91         | )%         |
| Total International   |       | $              | 500        |           | $          | 635                      |       | $           | (135       | ) | (21 | )% |

 

The decrease in net salesto international distributors is primarily due to lower demand for ENTendoscopes and TNE endoscopes, offset partially by higher demand for ENTSOS.  Sales of endoscopes are dependent upona variety of factors, including the timing requirements of end users, foreignexchange rates, sales promotions of international competitors and otherfactors.  Unit sales of ENT endoscopes inQ1 07 to international distributors were 4, compared to 49 in Q1 06.  We are in the early stages of selling TNEendoscopes to our distributors, and we plan to increase our sales of thisproduct by increasing the number of distributors in countries where we do nothave representation.  However, there canbe no assurance we will be able to consummate these agreements on terms thatare beneficial to us.  Unit sales of ENTSOS to the international distributors were 76,340 in Q1 07, an increase of8,460 units, compared to unit sales in Q1 06.

*MedicalSales — Urology*

Thedecrease in sales of urology products reflects primarily the cancellation ofthe MGU Agreement with MGU.  In May 2006,we and MGU mutually terminated the MGU Agreement, due to lower sales than weexpected, and a change in strategy by MGU. MGU decided to put greater focus on therapies and narrow its overalluro-diagnostics product offerings, which included our products.   We decided to explore other forms ofdistribution for our flexible cystoscope and Slide-On EndoSheath System,including through a network of independent sales representatives.  We expect developing this network will takebetween 6 and 9 months.  We willcontinually assess our progress in this area, and could abandon our efforts ifthey do not prove to be successful during that time frame.

We believe the CST-2000and EndoSheath System can significantly enhance the practice efficiency ofurologists by allowing them to avoid the tedious and time-consumingreprocessing of conventional cystoscopes, and presents the significant benefitof a sterile insertion tube for each patient. In addition, the use of our CST-2000 with Slide-On EndoSheath Systemavoids the need to reprocess endoscopes with harsh chemicals, one of which hasbeen contraindicated for use on patients with bladder cancer.

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*Medical Sales — Peripherals and Other*

Sales of peripheral andother products declined in Q1 07, compared to Q1 06, due primarily to lowerdemand for our GI and pulmonary EndoSheaths. We have a small installed base of users of these products, and we planto continue to supply them with EndoSheaths in FY 07.  However, we do not plan to promote theseproducts.  As a result, we expect sale ofthese products will continue to decline during FY 07, compared to FY 06.  In addition, we experienced lower demand forlight sources and other accessories.

*Industrial Segment*

The increase in net salesof the industrial segment was due to higher demand in the market for newfiberscopes and repairs to fiberscopes.

Gross Profit

Gross profit was $488,002in Q1 07, a decrease of $122,138, compared to gross profit in Q1 06.  Gross profit increased by approximately$2,000 in the medical segment, and decreased by approximately $124,000 in theindustrial segment.  Gross profit in themedical segment increased due to higher volume of domestic sales of ENT SOS,but decreased due to the lower volume of ENT endoscopes, peripherals and otherproducts.  In the industrial segment, thedecrease in gross profit was due primarily to an increase in overhead costsassociated with improving our manufacturing and quality control of endoscopes.

Operating Expenses

*Selling, General and Administrative Expenses*

The increase in selling,general and administrative (“SG&A”) expenses in Q1 07 was due primarily tohigher spending for personnel, including stock-based compensation, ofapproximately $42,000; higher spending on product promotion and travel formedical products of approximately $14,000; higher costs for professional feesof approximately $24,000; and higher commission costs for industrial productsof approximately $9,000.

*Researchand Development Expenses*

Theincrease in research and development (“R&D”) expenses in Q1 07, compared toQ1 06 was due primarily to additional spending for materials and personnelhired to work on developing our new videoscope.  We expect R&D expenses will continue to behigher in FY 07, compared to FY 06, as we increase our efforts to develop thisnew family of videoscopes.

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Operating Income (Loss)

Operatingincome (loss) by segment was as follows ($000’s):
| Segment    | ** ** | **Q1 07** | ** ** | **Q1 06** | ** ** | **Change** | ** ** |
|------------|------------|----------------|------------|----------------|------------|------------|------------|
| Medical    |       | $              | (760       | )              | $          | (613       | )          | $ | (147 | ) |
| Industrial |       | (143           | )          | (14            | )          | (129       | )          |
| Corporate  |       | (301           | )          | (255           | )          | (46        | )          |
| Total      |       | $              | (1,204     | )              | $          | (882       | )          | $ | (322 | ) |

 

In the medical segment,higher spending for SG&A and R&D resulted in an increase to theoperating loss for Q1 07.  In theindustrial segment, the lower gross profit was the primary cause for theincrease in the operating loss in Q1 07. In the corporate segment, higher charges for professional fees andstock-based compensation resulted in an increased loss in Q1 07.

Liquidity and CapitalResources

At June 30, 2006, ourprincipal source of liquidity was working capital of approximately $7.3million, including $5.1 million in cash and cash equivalents.  At June 30, 2006, we had acceptances payableto a bank totaling approximately $23,000. We have pledged $125,000 to support these acceptances.

In July 2006, we renewed our bank agreement, which is subject torenewal again in July 2007.  This bankagreement includes a revolving line of credit under which we may borrow up to$250,000, including any outstanding letters of credit and banker’sacceptances.  Borrowings under these loanarrangements would bear interest at the prime rate, and would be collateralizedby our assets.  In addition, we have anequipment line with the bank, providing for us to borrow up to $750,000 for thepurchase of new equipment until July 31, 2007. At that time, any borrowings under the equipment line would becomepayable as a note, over a three-year period, at the bank’s prime rate.  Alternatively, we could arrange for otherfinancing of the equipment at that time, and repay any amounts drawn down underthat line.  The agreement also stipulatesthat we have the greater of $2.0 million, or one-half of our cash and cashequivalents, on deposit or invested at the bank.  In Q1 07, we did not utilize the equipmentline.

Ourcash and cash equivalents decreased by approximately $1,032,000 in the threemonths ended June 30, 2006, due primarily to cash used for operations of approximately$863,000, cash used for investing activities of approximately $144,000, andcash used for financing of approximately $25,000.  We expect that our current balance of cashand cash equivalents will 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 FY07.  We have funded the lossesprincipally with the proceeds from public and private equity financings.

We expect total spendingfor property and equipment to be approximately $1,500,000 for FY 07.

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We conduct our operationsin certain leased facilities.  Theseleases expire on various dates through August 31, 2010.  In addition, we have operating leases forcertain office equipment.  These leasesexpire on various dates through April 2009. The following chart summarizes our contractual obligations as of June30, 2006.
| **Contractual Obligation** | ** ** | **Total** | ** ** | **Due within 1 Year** | ** ** | **Due in 1-3 years** | ** ** | **Due in 3-5 Years** | ** ** |
|---------------------------------|------------|-----------|------------|--------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
| Operating leases                |       | $         | 1,142,167  |                                 | $          | 393,414                             |       | $                                   | 681,045    |   | $ | 67,708 |   |
| Capital lease                   |       | 24,094    |       | 21,299                               |       | 2,795                               |       | —                              |       |
|                                 |            |           |            |                                      |            |                                     |            |                                     |            |  |  |  |  |

 

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, revenuesor expenses, results of operations, liquidity, capital expenditures or capitalresources.

Recently IssuedAccounting Standards

InNovember 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,this Statement requires that allocation of fixed production overheads to thecost of production be based on normal capacity of the productionfacilities.  This pronouncement iseffective for fiscal years beginning after June 15, 2005.  The Company believes this new standard hashad no material impact on its results of operations for the three months endedJune 30, 2006.

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

InFebruary 2006, the FASB issued SFAS 155, *Accountingfor Certain Hybrid Financial Instruments* which amends SFAS 133,*Accounting for Derivative Instruments and HedgingActivities* and SFAS 140, *Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities*.  SFAS 155 simplifies the accounting forcertain derivatives embedded in other financial instruments by allowing them tobe accounted for as a whole if the holder elects to account for the wholeinstrument on a fair value basis. SFAS 155 also clarifies and amends certain other provisions ofSFAS 133 and SFAS 140. SFAS 155 is effective for all financial instruments acquired,issued or subject to a remeasurement event occurring in fiscal years beginningafter September 15, 2006 and is therefore required to be adopted by theCompany in the first fiscal quarter of its fiscal year ending March 31,2008. The Company is currently evaluating the effect that the adoption ofSFAS 155 will have on its consolidated financial statements but does notexpect that it will have a material impact.

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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.

#### *Interest and Market Risk*

Wecurrently invest our excess 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 marketvalue due to changes in interest rates.

#### *Foreign Currency 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 June 30, 2006, our liabilities relating to Japanese Yen wereapproximately $26,000.

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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-14(c) and15d-14(c) under the Securities Exchange Act of 1934), the chief executiveofficer and chief financial officer have concluded that our disclosure controlsand procedures as of the end of the three months ended June 30, 2006, areeffective.

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

Therewere no changes in our internal controls over financial reporting that occurredduring the fiscal quarter ended June 30, 2006 that have materially affected, orare reasonable likely to materially affect, our internal controls overfinancial reporting.

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**PART II - OTHER INFORMATION**

**Item 1A.RISK FACTORS**

The risk factorsincluded in the Company’s Annual Report on Form 10-K for the fiscal year endedMarch 31, 2006 have not materially changed.

**Item6.  EXHIBITS**

Exhibits

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

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

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

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**SIGNATURES**

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.
| VISION-SCIENCES, INC. |
|-----------------------|
|                  |
|                  |   |   |
| Date: August 14, 2006 |   | /s/ Ron Hadani |   |
|                  |   | Ron Hadani |   |
|                  |   | President, CEO (Duly Authorized Officer) |
|                  |   |   |
|                  |   |   |
| Date: August 14, 2006 |   | /s/ James A. Tracy |   |
|                  |   | James A. Tracy |   |
|                  |   | Vice President Finance, Chief Financial Officer and  Controller (Principal Financial Officer and Principal  Accounting  Officer) |
|                       |  |  |  |  |  |  |

 

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