**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D. C. 20459**

 

**FORM 10-Q**

 

**QUARTERLY REPORT UNDERSECTION 13 OR 15(d)**

**OF THE SECURITIES EXCHANGE ACT OF1934**

 

**FOR THE QUARTER ENDEDDecember 31, 2007**

 

**COMMISSIONFILE NUMBER 0-20970**

 

**VISION-SCIENCES, INC.**

(Exact name of registrant as specified in itscharter)

 
| **Delaware**                                                      | **13-3430173**                        |
|-------------------------------------------------------------------|---------------------------------------|
| (State or other  jurisdiction of

incorporation or  organization) | (IRS Employer

Identification Number) |
| ** **                                                        | ** **                            |
| **40  Ramland Road South, Orangeburg, NY**                        | **10962**                             |
| (Address of principal  executive offices)                         | (Zip Code)                            |

 

**(845) 365-0600**

(Registrant’s telephone number, includingarea code)

 

**None**

 (Former name, former address, and

former fiscal year if changed since lastreport)

 

                Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirement for the past 90 days.

 

Yes x        No o

 

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

 

Large accelerated filer o  Accelerated filer o  Non-accelerated filer o  Smaller reporting company x

 

                Indicate by checkmark whether the registrant is a shell company (as defined by Rule 12b-2of the Exchange Act).

 

Yes o        No x

 

                Indicate the numberof shares outstanding of each of the issuer’s classes of common stock, as of February 19,2008

 
| **Common  Stock, par value of $.01** | **35,266,781**     |
|--------------------------------------|--------------------|
| (Title of Class)                     | (Number of Shares) |

 

 

 

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** **

**VISION-SCIENCES, INC.**

**TABLE OFCONTENTS**

 
| Part I.          | Financial  Information    |
|-----------------------|---------------------------|
|                  | Item 1.              | Financial  Statements | 3 |
|                  |                      | Consolidated  Balance Sheets | 3 |
|                  |                      | Consolidated Statements of Operations | 4 |
|                  |                      | Consolidated Statement of Stockholders’ Equity | 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 | 15 |
|                  | Item 3.              | Quantitative and Qualitative Disclosures about Market  Risk | 27 |
|                  | Item 4.              | Controls and Procedures | 27 |
|  

Part II. |  

Other Information |  

28 |
|                  | Item 1.              | Legal Proceedings | 28 |
|                  | Item 1A.             | Risk Factors | 29 |
|                  | Item 2.              | Unregistered Sales of Equity Securities and Use of  Proceeds | 34 |
|                  | Item 3.              | Defaults Upon Senior Securities | 34 |
|                  | Item 4.              | Submission of Matters To A Vote Of Stockholders | 34 |
|                  | Item 5.              | Other Information | 34 |
|                  | Item 6.              | Exhibits | 34 |
|                  | Signatures                | 35 |

 

 

 

2

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**PART I—FINANCIALINFORMATION**

**Item 1:  FINANCIAL STATEMENTS**

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

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                                            | ** ** | **December 31,  2007** | ** ** | **March 31,  2007** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **                                                                                                            | ** ** | **(Unaudited)**             | ** ** | ** **               | ** ** |
| **ASSETS**                                                                                                            |       |                        |       |                     |       |
| Current assets:                                                                                                       |       |                        |       |                     |       |
| Cash and cash equivalents                                                                                             |       | $                           | 406,172    |                     | $          | 28,955,497 |   |
| Short term investments                                                                                                |       | 20,197,372                  |       | —                   |       |
| Accrued interest receivable                                                                                           |       | 465,573                     |       | —                   |       |
| Accounts receivable, net of allowance for doubtful accounts of  $150,650 and $129,600, respectively                   |       | 949,852                     |       | 1,230,285                |       |
| Inventories                                                                                                           |       | 3,256,880                   |       | 2,102,757                |       |
| Prepaid expenses and deposits                                                                                         |       | 750,894                     |       | 111,282                  |       |
| Total current assets                                                                                                  |       | 26,026,743                  |       | 32,399,821               |       |
|                                                                                                                  |       |                        |       |                     |       |
| Property and equipment, at  cost:                                                                                     |       |                        |       |                     |       |
| Machinery and equipment                                                                                               |       | 4,590,953                   |       | 3,713,074                |       |
| Furniture and fixtures                                                                                                |       | 287,869                     |       | 307,961                  |       |
| Leasehold improvements                                                                                                |       | 594,952                     |       | 591,196                  |       |
|                                                                                                                  |       | 5,473,774                   |       | 4,612,231                |       |
| Less—accumulated depreciation and amortization                                                                   |       | 4,234,843                   |       | 4,071,537                |       |
|                                                                                                                  |       | 1,238,931                   |       | 540,694                  |       |
| Goodwill                                                                                                              |       | 378,000                     |       | —                   |       |
| Equity investment                                                                                                     |       | 667,994                     |       | —                   |       |
| Other assets, net of accumulated amortization of $70,655 and $66,200,  respectively                                   |       | 82,840                      |       | 62,393                   |       |
| Total assets                                                                                                          |       | $                           | 28,394,508 |                     | $          | 33,002,908 |   |
| ** **                                                                                                            |       |                        |       |                     |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                         |       |                        |       |                     |       |
| Current liabilities:                                                                                                  |       |                        |       |                     |       |
| Capital lease obligations and note payable                                                                            |       | $                           | 45,085     |                     | $          | 3,785 |   |
| Accounts payable                                                                                                      |       | 472,002                     |       | 591,166                  |       |
| Accrued expenses                                                                                                      |       | 1,533,314                   |       | 1,443,434                |       |
| Income taxes payable                                                                                                  |       | —                      |       | 549,000                  |       |
| Total current liabilities                                                                                             |       | 2,050,401                   |       | 2,587,385                |       |
|                                                                                                                  |       |                        |       |                     |       |
| Long term-debt: capital  lease obligations                                                                            |       | 84,504                      |       | —                   |       |
|                                                                                                                  |       |                        |       |                     |       |
| Commitments and contingencies                                                                                         |       |                        |       |                     |       |
|                                                                                                                  |       |                        |       |                     |       |
| Stockholders’ equity:                                                                                            |       |                        |       |                     |       |
| Preferred stock, $.01 par value—                                                                                 |       |                        |       |                     |       |
| Authorized—5,000,000                                                                                             |       |                        |       |                     |       |
| Issued and outstanding—none                                                                                      |       | —                      |       | —                   |       |
| Common stock, $.01 par value—                                                                                    |       |                        |       |                     |       |
| Authorized—50,000,000 shares                                                                                     |       |                        |       |                     |       |
| Issued and outstanding—35,264,281 shares at December 31, 2007  and 35,243,931 shares at March 31, 2007 |       | 352,641                     |       | 352,438                  |       |
| Additional paid-in capital                                                                                            |       | 77,095,036                  |       | 76,483,273               |       |
| Accumulated deficit                                                                                                   |       | (51,188,074                 | )          | (46,420,188              | )          |
| Total stockholders’ equity                                                                                       |       | 26,259,603                  |       | 30,415,523               |       |
| Total liabilities and stockholders’ equity                                                                       |       | $                           | 28,394,508 |                     | $          | 33,002,908 |   |

 

 

See accompanying notes to consolidatedfinancial statements.

3

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

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                           | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|----------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                           | ** ** | **2007**                                  | ** ** | **2006**                                 | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net sales                                                            |       | $                                         | 2,019,583  |                                     | $          | 2,215,615 |   | $ | 7,576,984 |   | $ | 6,513,993 |   |
| Cost of sales                                                        |       | 1,504,381                                 |       | 1,922,092                                |       | 5,241,727 |   | 5,335,946 |   |
| Gross profit                                                         |       | 515,202                                   |       | 293,523                                  |       | 2,335,257 |   | 1,178,047 |   |
|                                                                 |       |                                      |       |                                     |       |   |   |   |   |
| Selling, general and  administrative expense                         |       | 1,980,115                                 |       | 1,209,500                                |       | 5,729,083 |   | 3,472,969 |   |
| Research and development  expense                                    |       | 649,689                                   |       | 513,765                                  |       | 2,610,343 |   | 1,724,789 |   |
| Loss from operations                                                 |       | (2,114,602                                | )          | (1,429,742                               | )          | (6,004,169 | ) | (4,019,711 | ) |
|                                                                 |       |                                      |       |                                     |       |   |   |   |   |
| Interest income                                                      |       | 288,837                                   |       | 27,831                                   |       | 857,949 |   | 117,669 |   |
| Interest expense                                                     |       | (7,011                                    | )          | (270                                     | )          | (7,011 | ) | (1,126 | ) |
| Other income (expense),  net                                         |       | 132,036                                   |       | (2,549                                   | )          | 717,351 |   | (9,429 | ) |
| Loss in equity investment                                            |       | (118,912                                  | )          | —                                   |       | (332,006 | ) | — |   |
| Loss before provision for  income taxes                              |       | (1,819,652                                | )          | (1,404,730                               | )          | (4,767,886 | ) | (3,912,597 | ) |
| Provision for income taxes                                           |       | (180,000                                  | )          | —                                   |       | — |   | — |   |
| Net loss                                                             |       | $                                         | (1,999,652 | )                                        | $          | (1,404,730 | ) | $ | (4,767,886 | ) | $ | (3,912,597 | ) |
|                                                                 |       |                                      |       |                                     |       |   |   |   |   |   |   |   |   |
| Basic and diluted net loss  per common share                         |       | $                                         | (0.06      | )                                        | $          | (0.04 | ) | $ | (0.14 | ) | $ | (0.11 | ) |
| Shares used in computing basic and diluted net loss per common share |       | 35,266,781                                |       | 35,166,330                               |       | 35,266,781 |   | 35,161,713 |   |
|                                                                      |            |                                           |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to consolidatedfinancial statements.

 

 

4

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

**CONSOLIDATEDSTATEMENT OF STOCKHOLDERS’ EQUITY**

**(Unaudited)**

 
| ** **                       | ** ** | **Common Stock**      | ** ** | ** ** | ** **         | ** ** | ** **                      | ** ** | ** **               |
|----------------------------------|------------|-----------------------|------------|------------|--------------------|------------|---------------------------------|------------|--------------------------|
| ** **                       | ** ** | **Number of  Shares** | ** ** | **$**      | **.01  Par Value** | ** ** | **Additional  Paid-in-Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Total  Stockholders’  Equity** | ** ** |
| Balance, March 31,  2007    |       | 35,243,931            |       | $          | 352,438            |       | $                               | 76,483,273 |                     | $ | (46,420,188 | ) | $ | 30,415,523 |   |
| Exercise of stock options        |       | 20,350                |       | 203        |               | 20,463     |                            | —     |                     | 20,666 |   |
| Stock-based compensation         |       | —                |       | —     |               | 591,300    |                            | —     |                     | 591,300 |   |
| Net loss                         |       | —                |       | —     |               | —     |                            | (4,767,886 | )                        | (4,767,886 | ) |
|                             |       |                  |       |       |               |       |                            |       |                     |   |   |
| Balance, December 31,  2007 |       | 35,264,281            |       | $          | 352,641            |       | $                               | 77,095,036 |                     | $ | (51,188,074 | ) | $ | 26,259,603 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

 

5

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

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                    | ** ** | **Nine Months Ended  December 31, 2007** | ** ** | **Nine Months Ended  December 31, 2006** | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| Cash flows from operating  activities:                                        |       |                                          |       |                                          |       |
| Net loss                                                                      |       | $                                             | (4,767,886 | )                                             | $          | (3,912,597 | ) |
| Adjustments to reconcile net loss to net cash used for operating  activities: |       |                                          |       |                                          |       |
| Depreciation and amortization                                                 |       | 167,761                                       |       | 323,271                                       |       |
| Stock-based compensation                                                      |       | 591,300                                       |       | 380,603                                       |       |
| Loss in equity investment                                                     |       | 332,006                                       |       | —                                        |       |
| Changes in assets and liabilities:                                            |       |                                          |       |                                          |       |
| Accrued interest receivable                                                   |       | (465,573                                      | )          | —                                        |       |
| Accounts receivable                                                           |       | 280,433                                       |       | 335,313                                       |       |
| Inventories                                                                   |       | (1,154,123                                    | )          | 188,240                                       |       |
| Prepaid expenses and deposits                                                 |       | (639,612                                      | )          | (187,988                                      | )          |
| Other assets                                                                  |       | (24,902                                       | )          | —                                        |       |
| Accounts payable                                                              |       | (119,164                                      | )          | (405,198                                      | )          |
| Accrued expenses                                                              |       | 89,880                                        |       | 192,294                                       |       |
| Income taxes payable                                                          |       | (549,000                                      | )          | —                                        |       |
| Net cash used for operating activities                                        |       | (6,258,880                                    | )          | (3,086,062                                    | )          |
|                                                                          |       |                                          |       |                                          |       |
| Cash flows used for  investing activities                                     |       |                                          |       |                                          |       |
| Purchase of short term investments                                            |       | (20,197,372                                   | )          | —                                        |       |
| Acquisition of Best DMS  assets:                                              |       | (450,000                                      | )          |                                          |       |
| Purchase of property and equipment                                            |       | (627,286                                      | )          | (450,344                                      | )          |
| Purchase of equity investment                                                 |       | (1,000,000                                    | )          | —                                        |       |
| Net cash used for investing activities                                        |       | (22,274,658                                   | )          | (450,344                                      | )          |
| Cash flow used for  financing activities:                                     |       |                                          |       |                                          |       |
| Payments on capital leases                                                    |       | (36,453                                       | )          | (19,915                                       | )          |
| Payments of acceptances payable to a bank                                     |       | —                                        |       | (51,584                                       | )          |
| Exercise of stock options                                                     |       | 20,666                                        |       | 19,576                                        |       |
| Net cash used for financing activities                                        |       | 15,787                                        |       | (51,923                                       | )          |
|                                                                          |       |                                          |       |                                          |       |
| Net decrease in cash and  cash equivalents                                    |       | (28,549,325                                   | )          | (3,588,329                                    | )          |
| Cash and cash equivalents,  beginning of period                               |       | 28,955,497                                    |       | 6,138,148                                     |       |
|                                                                          |       |                                          |       |                                          |       |
| Cash and cash equivalents,  end of period                                     |       | $                                             | 406,172    |                                          | $          | 2,549,819 |   |
|                                                                          |       |                                          |       |                                          |       |
| Supplemental disclosure of  cash flow information:                            |       |                                          |       |                                          |       |
| Cash paid during the period for interest                                      |       | $                                             | —     |                                          | $          | 1,126 |   |
| Cash paid during the period for income taxes                                  |       | $                                             | 549,000    |                                          | $          | — |   |
| Supplemental noncash  transactions                                            |       |                                          |       |                                          |       |
| Capital lease - computer equipment                                            |       | $                                             | 162,257    |                                          | $          | — |   |

 

See accompanying notes to consolidatedfinancial statements.

 

 

6

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

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

**1. Basis of Presentation**

 

                The consolidatedfinancial statements included here have been prepared by Vision-Sciences, Inc.and subsidiaries (the “Company” or “we” or “us”) in accordance with generallyaccepted accounting principles in the United States of America, without audit,pursuant to the rules and regulations of the Securities and ExchangeCommission and include, in the opinion of management, all adjustments(consisting only of normal and recurring adjustments) that we considernecessary for a fair presentation of such information. Certain information andfootnote disclosures normally included in financial statements have been condensedor omitted pursuant to such rules and regulations. We believe, however,that our disclosures are adequate to make the information presented notmisleading. These consolidated financial statements should be read inconjunction with the audited consolidated financial statements and notesthereto included in our latest annual report to stockholders. The results forthe interim periods presented are not necessarily indicative of results to beexpected for the full fiscal year. Our fiscal year-end is on March 31 ofeach year, and is referred to here as FY 06, FY 07 and FY 08(our current fiscal year), respectively. All amounts in the financialfootnotes, except for share and per share data, are reported in (000’s), unlessotherwise indicated. Q3 07 refers to the period from October 1, 2006to December 31, 2006; and Q3 08 refers to the period from October 1,2007 to December 31, 2007.

 

**2. Summary of Significant Accounting Policies**

 

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

 

a.*             Principlesof Consolidation*:  Theaccompanying consolidated financial statements include the accounts of theCompany and its wholly-owned subsidiaries. All material intercompany accountsand transactions have been eliminated in consolidation.

 

b.*             CashEquivalents*:  The Companyclassifies investments with original maturities of ninety days or less,consisting of commercial paper and a money market account at a bank, as cashequivalents. Cash equivalents are stated at amortized cost, which approximatesmarket value.

 

c.*             ShortTerm Investments*:  The Companyclassifies investments with original maturities of greater than 90 days inGovernment Securities and high grade Commercial Paper as Short Term Investments.The Company intends to hold these investments to maturity. The following tablesummarizes these securities classified as held to maturity:

 
| ** **                                               | ** ** | **(Unaudited)**            | ** ** | ** **              | ** ** | ** **          | ** ** |
|----------------------------------------------------------|------------|----------------------------|------------|-------------------------|------------|---------------------|------------|
| ** **                                               | ** ** | **December 31, 2007** | ** ** | **March 31, 2007** | ** ** |
| ** **                                               | ** ** | **Fair Value**        | ** ** | **Cost**                | ** ** | **Fair Value** | ** ** | **Cost** | ** ** |
| Held to maturity less than  one year:                    |       |                       |       |                    |       |                |       |   |   |
| Government securities                                    |       | $                          | 17,850     |                    | $          | 17,850              |       | $ | — |   | $ | — |   |
| Commercial paper                                         |       | 2,813                      |       | 2,813                   |       |                |       |   |   |
|                                                     |       |                       |       |                    |       |                |       |   |   |
| Total short term  investments including accrued interest |       | 20,663                     |       | 20,663                  |       | —              |       | — |   |
|                                                          |            |                            |            |                         |            |                     |            |  |  |  |  |  |  |

 

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

 
| ** **      | ** ** | **December 31,  2007  (Unaudited)** | ** ** | **March 31, 2007** | ** ** |
|-----------------|------------|------------------------------------------|------------|-------------------------|------------|
| Raw materials   |       | $                                        | 1,717      |                    | $          | 1,447 |   |
| Work-in-process |       | 366                                      |       | 273                     |       |
| Finished goods  |       | 1,174                                    |       | 383                     |       |
| ** **      | ** ** | ** **                               | ** ** | ** **              | ** ** |
| **Total**       | ** ** | **$**                                    | **3,257**  | ** **              | **$**      | **2,103** | ** ** |

 

 

 

7

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                Raw materialsinclude components purchased from independent suppliers. Most purchasedcomponents are available from multiple sources, but we also rely on severalsingle-source key suppliers. Work-in-process and finished goods inventoriesconsist of material, labor, and manufacturing overhead.

 

e.*             Depreciationand Amortization*:  The Companyprovides for depreciation and amortization using the straight-line method inamounts that allocate the cost of the assets to operations over their estimateduseful lives as follows:

 
| **Asset Classification** | ** ** | **Estimated  Useful Life** | ** ** |
|--------------------------|------------|----------------------------|------------|
| Machinery and Equipment  |       | 3-7  Years                 |       |
| Furniture and Fixtures   |       | 5  Years                   |       |

 

                Leaseholdimprovements are amortized over the shorter of their estimated useful lives orthe lives of the leases.

 

f.*              Basicand Diluted Net Loss Per Common Share*:  Basic and diluted net loss per common shareis based on the weighted average number of common shares outstanding. For theperiods ended  December 31, 2007 and2006, shares of common stock issuable pursuant to outstanding stock optionshave not been considered, as their effect would be anti-dilutive.

 

g.*             RevenueRecognition*:  The Companyrecognizes revenue in accordance with SEC Staff Accounting Bulletin No. 104,*Revenue Recognition in Financial Statements*and EITF 00-21, *Revenue Arrangementswith Multiple Deliverables.* These pronouncements require thatcertain criteria must be met before revenue can be recognized: (1) persuasiveevidence that an arrangement exists; (2) delivery has occurred or servicesrendered; (3) the fee is fixed and determinable; (4) collectabilityis reasonably assured. The Company recognizes revenue when title and risk ofloss passes to the customer, generally upon shipment of products.

 

h.*             ForeignCurrency Transactions*:  TheCompany charges foreign currency exchange gains or losses, in connection withits purchases of products from foreign vendors to operations.

 

i.*              IncomeTaxes*:  The Company accountsfor income taxes under the liability method and deferred tax assets orliabilities are computed based on the differences between the financialstatement and income tax bases of assets and liabilities as measured by theenacted tax rates. The Company has recorded a valuation allowance equal to itsnet deferred tax asset due to the uncertainty of realizing the benefit of thisasset.

 

j.*              Stock-basedCompensation*:  Effective April 1,2006 the Company began accounting for compensation expense related to stockoptions in accordance with SFAS No. 123 (Revised 2004) *Share-Based Payment* (“SFAS 123R”).Prior to April 1, 2006, the Company accounted for stock options accordingto Accounting Principles Board (“APB”) Opinion 25, *Accounting for Stock Issued to Employees.*

 

                The Company hasadopted the modified prospective transition method and consequently has notretroactively adjusted results from prior periods. Under this transitionmethod, compensation cost associated with stock options now includes: (i) amortizationrelated to the remaining unvested portion of all stock options outstanding at March 31,2006, based on the fair value determined on the grant date in accordance withthe original provisions of SFAS 123, and (ii) amortization related toall stock option awards granted subsequent to March 31, 2006, based uponthe fair value estimated in accordance with SFAS 123R. The compensationexpense for stock-based compensation awards under SFAS 123R is recognizedover the vesting period of the options, and includes an estimate for forfeitures.

 

                In accordance withSFAS 123R, the Company recorded stock-based compensation expense in thestatement of operations for Q3 08 and Q3 07, respectively, andYTD FY 08 and YTD FY 07, respectively, in the followingexpense categories:

 

| ** **                                  | ** ** | **(Unaudited)**             | ** ** |
|---------------------------------------------|------------|-----------------------------|------------|
| ** **                                  | ** ** | **Three Months Ended**      | ** ** | **Nine Months Ended** | ** ** |
| ** **                                  | ** ** | **December 31,  2007** | ** ** | **December 31,  2006** | ** ** | **December 31,  2007** | ** ** | **December 31,  2006** | ** ** |
| Cost of Goods Sold                          |       | $                           | 18         |   | $ | 15 |   | $ | 48 |   | $ | 45 |   |
| Selling,  General & Administrative |       | 143                         |       | 97 |   | 438 |   | 288 |   |
| Research &  Development            |       | 39                          |       | 25 |   | 105 |   | 48 |   |
| ** **                                  | ** ** | ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Total**                                   | ** ** | **$**                       | **200**    | ** ** | **$** | **137** | ** ** | **$** | **591** | ** ** | **$** | **381** | ** ** |

 

 

8

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                At December 31,2007, total unamortized stock-based compensation is approximately $1,458. TheCompany will expense that amount over periods ending through June 30,2013. The Company does not expect to realize any tax benefits from futuredisqualifying dispositions, if any, since it currently has a full valuationallowance against its deferred tax asset.

 

                In the nine monthsended December 31, 2007, the Company granted options to purchase a totalof 1,846,250 shares of the Company’s Common Stock to employees, non-employeeconsultants and directors. The fair value of these options measured at theoption grant date was approximately $1,458, determined using the Black-Scholesoption-pricing model. This amount is reduced by an estimated forfeiture rateand is being recorded as an expense over the vesting period. The assumptionsused in the Black-Scholes option-pricing model in the period by the Companywere as follows:

 
| ** **                              | ** ** | **December 31, 2007** | ** ** |
|-----------------------------------------|------------|----------------------------|------------|
| Risk-free interest rate                 |       | 3.45%-4.81                 | %          |
| Expected dividend yield                 |       | 0                          | %          |
| Expected life                           |       | 5.5-6.75 years        |       |
| Expected volatility                     |       | 65%-70                     | %          |
| Weighted average value  grant per share |       | $                          | 0.83       |   |
|                                         |            |                            |            |  |

 

                We grant optionswith vesting periods ranging from immediate to six years. We use the simplifiedmethod of calculating the expected option term, which averages an award’sweighted average vesting period and its contractual term. The contractual termof our options is ten years. The risk-free rate is based upon the dailyTreasury yield curve for a period approximately equal to the expected option term.We used historical data to estimate the expected price volatility andforfeiture rate. The expected dividend yield is 0%, based on our history of notpaying dividends.

 

k.*             NewAccounting Standards*:

 

                In July 2006,the Financial Accounting Standards Board (“FASB’) issued FIN 48, *Accounting for Uncertainty in Income Taxes-anInterpretation of FASB Statement No. 109*, which seeks to reducethe significant diversity in practice associated with certain aspects ofmeasurement and recognition in accounting for income taxes. FIN 48prescribes a recognition threshold and measurement attribute for financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return. It 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 yearsbeginning after December 15, 2006. Upon adoption, the cumulative effect ofany changes in net assets resulting from the application of FIN 48 will berecorded as an adjustment to retained earnings. We adopted FIN 48effective April 1, 2007, and the adoption of FIN 48 did not have amaterial impact on our results of operations, financial position or cash flow.

 

                In February 2007,the FASB issued SFAS No. 159 (SFAS 159), *The Fair Value Option forFinancial Assets and Financial Liabilities, including an amendment of FASBStatement No. 115*. SFAS 159 permits entities to choose to measuremany financial instruments at fair value that are not currently required to bemeasured at fair value. It also establishes presentation and disclosurerequirements designed to facilitate comparisons between entities that choosedifferent measurement attributes for similar types of assets and liabilities.SFAS 159 is effective for our fiscal year beginning after November 15,2007.  Adoption of this statement is notexpected to have a material impact on our financial statements or results ofoperations.

 

                In December 2007,the FASB issued SFAS No. 141(R), *Business Combinations*and SFAS No. 160, *Accounting and Reporting of NoncontrollingInterest in Consolidated Financial Statements, an amendment of ARB No. 51*.. These new standards will significantly change the accounting for andreporting of business combination transactions and noncontrolling (minority)interests in consolidated financial statements. SFAS Nos. 141(R) and 160 arerequired to be adopted simultaneously and are effective for the first annualreporting period beginning on or after December 15, 2008. Thus, we are requiredto adopt these Standards on April 1, 2009. Earlier adoption is prohibited. Weare currently evaluating the impact of adopting SFAS Nos. 141(R) and SFAS 160on our consolidated financial statements.

 

9

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**3. Stock Option Plans**

 

                Our first stockoption plan (the “1990 Plan”) allowed us to grant key employees andnon-employee consultants incentive and non-statutory stock options at the fairvalue of the stock on the date of grant. Options became exercisable at varyingdates ranging up to five years from the date of grant. Our Board of Directors(our “Board”) had authorized the issuance of options for the purchase of up to4,375,000 shares of common stock under the 1990 Plan. This plan expired in 2001and was replaced with the 2000 Plan. The terms of the 2000 Plan aresubstantially the same as the 1990 Plan. Our Board and stockholders authorizedthe issuance of options for the purchase of up to 4,500,000 shares of common stockunder the 2000 Plan, of which 5,405 shares remain available for future grants.

 

                At our annualstockholders meeting, held on August 21, 2007, our stockholders approvedour 2007 Stock Incentive Plan (the “2007 Plan”), which was previously approvedby our Board.  Under the 2007 Plan, weare authorized to issue options for the purchase of up to 4,000,000 shares ofcommon stock.  The terms of the 2007 Planare substantially the same as the 2000 Plan. As of December 31, 2007,there remain 2,646,500 shares available for future grants under the 2007 Plan.We grant options to both employees and non-employee consultants, with vestingperiods ranging from immediate to six years. For options granted in the currentyear, we have chosen to employ the simplified method of calculating the optionterm, which averages an award’s weighted average vesting period and itscontractual term. The contractual term of our options is ten years.

 

                A summary of thestock option activity for employees and non-employee consultants under the1990, 2000 and 2007 plans for the nine months ended December 31, 2007 isas follows:

 
| ** **                          | ** ** | **Number of Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Weighted Average  Remaining  Contractual Term** | ** **     |
|-------------------------------------|------------|----------------------|------------|--------------------------------------|------------|---------------------------------------------------|----------------|
| Outstanding March, 31,  2007   |       | 4,703,550            |       | $                                    | 1.47       |                                              | 5.9 years |   |
| Granted                             |       | 1,830,250            |       | 1.23                                 |       |                                              |           |
| Exercised                           |       | (20,350              | )          | 1.01                                 |       |                                              |           |
| Canceled                            |       | (157,500             | )          | 1.18                                 |       |                                              |           |
|                                |       |                 |       |                                 |       |                                              |           |
| Outstanding  December 31, 2007 |       | 6,355,950            |       | $                                    | 1.40       |                                              | 6.7 years |   |
|                                |       |                 |       |                                 |       |                                              |           |
| Exercisable  December 31, 2007 |       | 3,708,950            |       | $                                    | 1.48       |                                              |           |   |

 

10

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                The followingtable summarizes information about stock options outstanding and exercisable atDecember 31, 2007:

 
| ** **                   | ** **    | ** **            | ** ** | **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** | ** ** |
| $                            | 0.79  - $1.05 |                  | 1,075,000  |                                                       | 5.5        |                                 | $          | 1.03 |   | 1,075,000 |   | $ | 1.03 |   |
| 1.06 - 1.31                  |          | 2,626,950             |       | 8.0                                                        |       | 1.15                                 |       | 699,200 |   | 1.13 |   |
| 1.32 - 1.88                  |          | 2,250,500             |       | 5.7                                                        |       | 1.54                                 |       | 1,613,000 |   | 1.58 |   |
| 2.05 - 2.28                  |          | 150,000               |       | 7.3                                                        |       | 2.13                                 |       | 100,000 |   | 2.17 |   |
| 2.70 - 3.69                  |          | 128,500               |       | 6.7                                                        |       | 3.51                                 |       | 115,500 |   | 3.59 |   |
| 4.00 - 4.30                  |          | 125,000               |       | 6.7                                                        |       | 4.18                                 |       | 106,250 |   | 4.17 |   |
|                         |          |                  | 6,355,950  |                                                       | 6.7        |                                 | $          | 1.40 |   | 3,708,950 |   | $ | 1.48 |   |

 

                In July 2003,we adopted, and our stockholders approved, a 2003 Director Option Plan (the“2003 Plan”). The terms of the 2003 Plan are similar to the 1993 DirectorsOption Plan, and include automatic grants of 4,000 shares to each outsidemember of our Board on the date of annual meeting of stockholders, so long assuch outside director does not hold at that time any outstanding options topurchase Common Stock under the Company’s 1993 Plan, which options are notfully exercisable. Options granted under the 2003 Plan are 100% vested on thedate of grant. In January 2008, our Board approved the recommendation ofthe Executive Committee to change the compensation of our outside directors,and recommended to increase the annual grant to 10,000 options per director,pending stockholder approval. If our annual meeting of stockholders is held in August ofeach year, and the number of outside directors was unchanged (currently thereare five outside directors), we would be required to grant options to purchasean aggregate of 50,000 shares in August of 2008 and 2009. During our FY 08Annual Shareholders meeting, held in August 2007, we granted 16,000options to our then four outside directors. As of December 31, 2007, thereremain 156,000 shares available for future grants under the 2003 Plan.

 

                A summary of theDirector Option Plans activity is as follows:

 
| ** **                          | ** ** | **Number of  Shares** | ** ** | **Exercise  Price Range** | ** **    | **Weighted Average  Exercise Price** | ** ** |
|-------------------------------------|------------|-----------------------|------------|---------------------------|---------------|--------------------------------------|------------|
| Outstanding March 31,  2007    |       | 88,000                |       | $                         | 1.00  - $2.10 |                                 | $          | 1.41 |   |
| Granted                             |       | 16,000                |       | 1.41                      |          | 1.41                                 |       |
| Exercised                           |       | —                |       | —                    |          | —                               |       |
| Canceled                            |       | (20,000               | )          | 1.50                      |          | 1.50                                 |       |
|                                |       |                  |       |                      |          |                                 |       |
| Outstanding  December 31, 2007 |       | 84,000                |       | $                         | 1.00  - $2.10 |                                 | $          | 1.39 |   |
|                                |       |                  |       |                      |          |                                 |       |
| Exercisable  December 31, 2007 |       | 84,000                |       | $                         | 1.00  - $2.10 |                                 | $          | 1.39 |   |

 

                The followingtable summarizes information about director stock options outstanding andexercisable at December 31, 2007:

 
| ** **                   | ** **    | ** **            | ** ** | **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     |                                                       | 3.7        |                                 | $          | 1.15 |   | 40,000 |   | $ | 1.15 |   |
| 1.41 - 1.49                  |          | 32,000                |       | 9.4                                                        |       | 1.45                                 |       | 32,000 |   | 1.45 |   |
| 1.92 - 2.10                  |          | 12,000                |       | 7.9                                                        |       | 2.03                                 |       | 12,000 |   | 2.03 |   |
| $                            |          |                  | 84,000     |                                                       | 6.5        |                                 | $          | 1.39 |   | 84,000 |   | $ | 1.39 |   |

 

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**4. Segment Information**

 

                Until the end ofour fiscal year ended March 31, 2007, (FY 07), we had threereportable segments: medical, industrial and corporate. Our medical segmentdesigns, manufactures and sells EndoSheath and endoscopes to users in thehealthcare industry. Our industrial segment designs, manufactures and sellsborescopes to a variety of users, primarily in the aircraftengine-manufacturing and aircraft engine-maintenance industries.  Our corporate segment consisted of certainadministrative expenses applicable to us as a whole. As of April 1, 2007(FY 08), we eliminated the corporate segment by consolidating it into themedical and industrial segments.

 

                In March 2007,we completed the license and sale of certain assets with respect to our ENTsheath business to Medtronic Xomed, Inc. (“Medtronic”, or “MENT”), awholly-owned subsidiary of Medtronic, Inc. This transaction resulted in athorough review of our business, including how we evaluate and report ourresults of operations. In order to enable our Chief Executive Officer to makeoperating and financial decisions about allocating our resources and assessingperformance, effective FY 08, we began operating under two reportablesegments, medical and industrial. All expenses formerly reported under thecorporate segment are allocated as follows: 95% to the medical segment and 5% to the industrial segment.

 

                We also changedour method for  inter-segment costallocations between the medical and the industrial segments. As part of ourbusiness review, we examined the resources allocated between departments andchanged the allocations accordingly. These changes affect certain expenses suchas Cost of Goods Sold (“COGS”), Research and Development (“R&D”) and Sales,Marketing and Administration (“SG&A”).

 

                We reclassifiedour FY 07 segment information according to Statement of FinancialAccounting Standard 131 (“FAS 131”) to reflect the change inreportable segments. All expenses reported during FY 07 under thecorporate segment, were allocated at a rate of 95% to the medical segment and5% to the industrial segment. We determined, however, that it is impracticableto restate our FY 07 inter-segment allocations.

 

                FAS 131provides that if an enterprise changed the structure of its internalorganization in a manner that causes the composition of its reportable segmentsto change, and if segment information for earlier periods, including interimperiods, is not restated to reflect the change, the enterprise must disclose inthe year in which the change occurs segment information for the current periodunder both the old basis and the new basis of segmentation, unless it isimpracticable to do so. We determined that it is impracticable for us to reportour new allocation methodology under the old and new basis, and we aretherefore reporting only under the new basis.

 

 

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                The three segmentsfollow the accounting policies described in the Summary Of SignificantAccounting Policies, above.   We evaluatesegment performance based upon operating income. Identifiable assets are thoseused directly in the operations of each segment and general corporate assets,such as cash and marketable securities are allocated to each segment. Oursegments are described in the following tables:

 
| **Three months ended  December 31,** | ** ** | **Medical** | ** ** | **Industrial** | ** ** | **BEST**   | ** ** | **Total**  | ** ** |
|-------------------------------------------|------------|-------------|------------|----------------|------------|------------|------------|------------|------------|
| **2007 (Q3 08)**                     | ** ** | ** **  | ** ** | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Sales to external  customers              |       | $           | 1,246      |           | $          | 598        |       | $          | 175        |   | $ | 2,019 |   |
| (Loss) income from  operations            |       | (2,530      | )          | 470            |       | (54        | )          | (2,114     | )          |
| Interest income (expense),  net           |       | 289         |       | —         |       | —     |       | 289        |       |
| Depreciation and  amortization            |       | 78          |       | 3              |       | —     |       | 81         |       |
| Other significant non-cash  items:        |       |        |       |           |       |       |       |       |       |
| Stock-based compensation                  |       | 197         |       | 3              |       | —     |       | 200        |       |
| Loss in equity investment                 |       | (119        | )          | —         |       | —     |       | (119       | )          |
| Expenditures for fixed  assets            |       | 193         |       | —         |       | 72         |       | 265        |       |
| Total assets                              |       | 25,511      |       | 2,753          |       | 130        |       | 28,394     |       |
|                                           |            |             |            |                |            |            |            |            |            |  |  |  |  |

 
| **2006 (Q3 07)**              |   |   |   |   |   |   |   |   |   |
|------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Sales to external  customers       |   | $      | 1,535  |   | $      | 681    |   | $      | — |   | $ | 2,216 |   |
| (Loss) income from  operations     |   | (1,116 | )      | (314   | )      | — |   | (1,430 | )      |
| Interest income (expense),  net    |   | 28     |   | — |   | — |   | 28     |   |
| Depreciation and  amortization     |   | 102    |   | 9      |   | — |   | 111    |   |
| Other significant non-cash  items: |   |   |   |   |   |   |   |   |   |
| Stock-based compensation           |   | 106    |   | 31     |   | — |   | 137    |   |
| Expenditures for fixed  assets     |   | 105    |   | 16     |   | — |   | 121    |   |
| Total assets                       |   | 5,937  |   | 1,777  |   | — |   | 7,714  |   |
|                                    |        |        |        |        |        |        |        |        |        |  |  |  |  |

 
| **Nine months ended December 31,** | ** ** | **Medical** | ** ** | **Industrial** | ** ** | **BEST** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|-------------|------------|----------------|------------|----------|------------|-----------|------------|
| **2007 (YTD FY 08)**               |       |        |       |           |       |     |       |      |       |
| Sales to external  customers            |       | $           | 5,623      |           | $          | 1,779    |       | $         | 175        |   | $ | 7,577 |   |
| (Loss) income from  operations          |       | (6,437      | )          | 487            |       | (54      | )          | (6,004    | )          |
| Interest income (expense),  net         |       | 858         |       | —         |       | —   |       | 858       |       |
| Depreciation and  amortization          |       | 148         |       | 20             |       | —   |       | 168       |       |
| Other significant non-cash  items:      |       |        |       |           |       |     |       |      |       |
| Stock-based compensation                |       | 582         |       | 9              |       | —   |       | 591       |       |
| Loss in equity investment               |       | (332        | )          | —         |       | —   |       | (332      | )          |
| Expenditures for fixed  assets          |       | 789         |       | 1              |       | 72       |       | 862       |       |
| Total assets                            |       | 25,511      |       | 2,753          |       | 130      |       | 28,394    |       |
|                                         |            |             |            |                |            |          |            |           |            |  |  |  |  |

 
| **2006 (YTD FY 07)**          |   |   |   |   |   |   |   |   |   |
|------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Sales to external  customers       |   | $      | 4,474  |   | $      | 2,040  |   | $      | — |   | $ | 6,514 |   |
| (Loss) income from  operations     |   | (3,449 | )      | (571   | )      | — |   | (4,020 | )      |
| Interest income (expense),  net    |   | 118    |   | — |   | — |   | 118    |   |
| Depreciation and  amortization     |   | 301    |   | 22     |   | — |   | 323    |   |
| Other significant non-cash  items: |   |   |   |   |   |   |   |   |   |
| Stock-based compensation           |   | 306    |   | 75     |   | — |   | 381    |   |
| Expenditures for fixed  assets     |   | 384    |   | 66     |   | — |   | 450    |   |
| Total assets                       |   | 5,937  |   | 1,777  |   | — |   | 7,714  |   |
|                                    |        |        |        |        |        |        |        |        |        |  |  |  |  |

 

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*** ***

*** ***

***5.  Acquisition***

 

                On October 1, 2007 we purchased theassets of BEST Dysphagia Management Services, Inc., a Florida-basedspeech pathology company which specializes in providing what is referred to asthe Bedside Endoscopic Swallowing Test (“Best”) to nursing homes,rehabilitation centers and assisted living settings via our new wholly-ownedsubsidiary BEST DMS, Inc. At the closing, we paid $450 for the assets andallocated the purchase price as follows: $72 to fixed assets and $378 toGoodwill. This purchase price allocation is preliminary and subject to change(for more information, please refer to Item 2 “Management’s Discussion andAnalysis of financial Condition and Results of Operations” below).

 

 

***6. Subsequent Events***

 

                On January 7,2008, we received 510(k) clearance (for a definition of a 510(k)clearance, see below) from the U.S. Food and Drug Administration (“FDA”) tomarket our new advanced CCD-based digital, video flexible cystoscope, whichincorporates an integrated “built–in” light source, eliminating the need for aseparate, external light source and light guide cable. Our new cystoscope isthe world’s first advanced video-based cystoscope, which is used with our newgeneration EndoSheath technology, which together provide extraordinary visionand a superior endoscopic system that facilitates quality healthcare.

 

                A 510(k) is apremarket notification submitted to the FDA to demonstrate that the device tobe marketed is at least as safe and effective, that is, substantiallyequivalent (SE), to a legally marketed device that is not subjected to the morestringent premarket approval (PMA) process. Submitters must compare theirdevice to one or more similar legally marketed devices and make and supporttheir substantial equivalency claims. A legally marketed device is (i) a devicethat was legally marketed prior to May 28, 1976 (pre-amendments device), forwhich a PMA is not required, or (ii) a device which has been reclassified fromClass III to Class II or I, or (iii) a device which has been found SE throughthe 510(k) process.  The legally marketeddevice(s) to which equivalence is drawn is commonly known as the “predicate.”  Although devices recently cleared under the510(k) process are often selected as the predicate to which equivalence isclaimed, any legally marketed device may be used as a predicate.  Legally marketed also means that thepredicate cannot be one that is in violation of the Federal Food, Drug, andCosmetic Act.

 

                Until thesubmitter receives an order declaring a device SE, the submitter may notproceed to market the device. Once the device is determined to be SE, it canthen be marketed in the U.S. The SE determination is usually made within 90days and is made based on the information submitted by the submitter.

 

                On January 17,2008, we filed with the Securities and Exchange a Registration Statement on Form S-8relating to 4,000,000 shares of our common stock, $.01 par value for issuanceunder our 2007 Stock Incentive Plan.

 

                On January 18, 2008, weentered into a $10.0 million revolving line of credit agreement with MerrillLynch Bank USA (the “Bank”), pursuant to the terms of a Merrill Lynch LoanManagement Account Agreement (the “Loan Agreement”). The Loan Agreement permitsus to borrow funds from the Bank from time-to-time at fixed, variable or termrates. The current rate for our borrowing is set at LIBOR plus 1.75%. Anyoutstanding amounts for variable rate borrowings may be repaid at our option atany time without penalty or premium. If we repay a fixed advance or termadvance prior to its scheduled repayment date, we may be required to pay abreakage fee to the Bank. The amount of advances available under the LoanAgreement varies from time-to-time and is based on the value of, and securedby, the securities we maintain with Merrill Lynch, Pierce Fenner, &Smith Incorporated.  Under the LoanAgreement, the Bank has the right to demand repayment, in whole or in part, atany time, of any outstanding amounts.  Asof today, we have not requested any advances under the Loan Agreement.

 

                Our lease for our Natick, MAoperations located at 9 Strathmore Road in Natick, MA expires on April 30,2008.  We are in the process ofrelocating our Natick operations to our Orangeburg, NY facilities.  This will not be completed until December 31,2008.  Accordingly, we signed a shortterm lease to relocate our Natick facility to a near-by location in Natick, MA.

 

                During this quarter, our disputewith Pentax resulted in a temporary shortage of parts for the manufacturing andrepair of fiberscopes. Based on in-house orders at the end of Q3, we calculatedthat in this quarter, because of the Pentax dispute, we lost revenues forscopes and accessories totaling $756, and repair orders for a total of $26thousand. 

 

                On February 12, 2008, we reacheda satisfactory arrangement for the transition of our supply relationship withPentax.   Under the terms of the agreemententered into with Pentax, we resolved our pending dispute with Pentax andagreed to dismiss all related legal proceedings over pricing, volumes anddelivery schedules for the components supplied by Pentax.  The agreement modified the terms of ourSupply Agreement with Pentax, dated March 16, 1992, as amended, by, among otherthings (i) moving forward the termination date of the supply relationship toFebruary 28, 2009 from March 15, 2009, and (ii) providing an agreed uponpurchase order and delivery schedule of components from Pentax through February28, 2009.

 

                We expect that the agreementreached with Pentax will enable us to meet our estimated productionrequirements for fiberscopes over the next twelve months, and will give ussufficient time to secure alternative manufacturing or supply arrangements withrespect to the components supplied by Pentax, and to meet our expected futureproduction requirements for fiberscopes. Pentax’s supply arrangement is limitedto components used in our fiberscopes only. Pentax does not supply componentsused in any other of our products, including any of our products underdevelopment, or any of our video-based scopes. 

 

                The dispute is partiallyaffecting our Q4 08 Revenues. For more details, please refer to “Item 1. LegalProceedings” in Part II–Other Information.

 

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

 

**Executive Summary**

 

                This QuarterlyReport on Form 10-Q contains forward-looking statements within the meaningof 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. Generally, words suchas “expect” “believe”, “anticipate”, “may”, “will”, “plan”, “intend”,“estimate”, “could”, and other similar expressions are intended to identifyforward-looking statements. The forward-looking statements are based on ourfuture plans, strategies, projections and predictions. These forward-lookingstatements involve risks and uncertainties, and our actual results may differsignificantly from those discussed in the forward-looking statements. Factorsthat might cause such a difference could include the availability of capitalresources, the availability of third-party reimbursement, governmentregulation, the availability of raw material components, competition,technological difficulties, the completion of obligations under our contractwith Medtronic, general economic conditions and other risks detailed in ourmost recent Annual Report on Form 10-K and any subsequent periodic filingswe made with the Securities and Exchange Commission. We do not undertake anobligation to update our forward-looking statements to reflect future events orcircumstances.

 

                Our fiscalyear-end is on March 31 of each year, and is referred to here as FY 06,FY 07 and FY 08 (our current fiscal year), respectively. Q3 07refers to the period from October 1, 2006 to December 31, 2006; andQ3 08 refers to the period from October 1, 2007 to December 31,2007.

 

                We design,develop, manufacture and market products for endoscopy – the science of usingan instrument, known as an endoscope – to provide minimally invasive access toareas not readily visible to the human eye. We now operate in three reportingsegments: medical, industrial and BEST DMS.

 

*Medical Segment*

 

*                Ourmedical segment* designs, manufactures and sells our Slide-On®EndoSheath® Systems (“EndoSheath” or “Slide-On EndoSheath” or “Sheath”), whichconsists of our Slide-On EndoSheath sterile disposable covers and ourproprietary endoscopes. The insertion tube, which is protected by the Sheath,is the part of the endoscope that enters the patient’s body. The use of aSheath gives health-care providers several economic advantages, as it allowsthem to avoid the burdensome cleaning and high-level disinfection required ofendoscopes, reduces repair costs to endoscopes caused by exposure to harshchemicals used in the cleaning and disinfection process, and allows health-careproviders to avoid investing in multiple endoscopes. Furthermore, theEndoSheath technology enables physicians to configure their EndoSheath systemfor specific procedures. For example, in fields like Urology, our EndoSheathsare offered in models with various size channels, which, unlike conventionalflexible endoscopes, allow the healthcare provider the ability to customize theinsertion tube to the procedure (e.g., diagnostic cystoscopy, which can utilizea small channel, or therapeutic cystoscopy, which requires a larger channel).Our EndoSheath technology also provides a sterile device, offering patients acontaminant-free insertion tube for each procedure. The EndoSheath reduces therisk of cross-contamination from the reuse of conventional flexible endoscopes,which are difficult to clean and disinfect.

 

*Industrial Segment*

 

*                Ourindustrial segment* designs, manufactures and markets flexibleendoscopes, called borescopes. Our industrial segment also manufactures all theflexible endoscopes marketed through the medical segment. The industrialsegment markets are primarily aircraft maintenance, jet engine manufacturing,defense and other specialized industries.

 

*BEST DMS Segment*

 

*Our BEST DMS segment*, is a service-based segment,  providing the Bedside Endoscopic SwallowingTest to nursing homes, rehabilitation centers and assisted living settings viaour newly formed wholly-owned subsidiary BEST DMS, Inc.

 

*Sales Distribution—Medical Segment*

 

                The end users ofour disposable EndoSheaths, flexible endoscopes and related products areotolaryngologists (ear, nose and throat, or ENT, doctors), urologists andgastroenterologists in hospitals, medical clinics and physicians’ offices. 

 

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Since September 2003 we have been distributing all of our productsfor the ENT markets in the United States and Canada through Medtronic ENT(“MENT”, or “Medtronic”), under the MENT Agreement. As part of the license andsale of the ENT sheath business to MENT during March 2007, MENT startedthe manufacturing of the ENT EndoSheaths and also continues to distribute, marketand sell our ENT endoscope line worldwide, on a co-branded basis, throughMENT’s global sales force.

 

                From December 2004to May 2006, we distributed all of our urology market products in theU.S.A. and Canada through Medtronic USA, Inc. (the MedtronicGastroenterology/Urology business, or “MGU”). In May 2006, we terminatedour distribution agreement with Medtronic Inc. (the “MGU Agreement”). Wedecided to explore other forms of distribution for our Slide-On EndoSheathflexible cystoscopy System (“CST”), including utilizing a network ofindependent sales representatives. This network has continued to expand duringFY 08, and we intend to continue its expansion during the 4thquarter of FY 08 and beyond. We will continually assess our progress in this area,and could change our direction if a more efficient sales channel, or betterarrangements are identified.

 

*Sales Distribution—Industrial Segment*

 

                Our borescopes aresold directly by our Machida subsidiary and through a global network ofindependent sales representatives.

 

*NewProducts and Markets*

 

**The BEST DMS Acquisition**

 

                On October 1, 2007 we purchased the assets ofBEST Dysphagia Management Services, Inc., a Florida-based speech pathologycompany which specializes in providing what is referred to as the BedsideEndoscopic Swallowing Test (“Best”) to nursing homes, rehabilitation centersand assisted living settings via our new wholly-owned subsidiary BEST DMS, Inc.  At the closing, we paid $450 for the assetsand allocated the purchase price as follows: $72 to fixed assets and $378 toGoodwill. This purchase price allocation is preliminary and subject to change.

 

                BEST is a comprehensivedysphagia (swallowing) evaluation, performed by a speech-language pathologistclinically privileged to perform endoscopy. Patients may be recommended for aBEST because of symptoms suggesting swallowing problems that may include: congestion; wet-gurggly or weak voice; fever, pneumonia or chronic bronchitis;chronic weight loss and/or a decreasing desire to eat; coughing and/or chokingon meals or medications; and pressure in a patient’s chest during eating ordrinking.

 

                The procedure involves inserting anendoscopic tube through the nose and down to the patient’s throat.  The test is mildly uncomfortable at most, withpatients feeling like they need to clean their nose of an obstruction. Most patients report that the uncomfortable feeling subsides in 60-90 secondsas the nasal passage adjusts to the endoscope sitting on the floor of thenose.  Patients suffering from dementia and Alzheimer’s Disease areapproached with a special protocol to create a calm and non-threateningenvironment.

 

                We believe that the benefits of BEST overother types of instrumentation and evaluations include: No limit on the lengthof time available during the BEST****to diagnosedysphagia accurately; patients are tested with the food and liquid that theyconsume daily; no X-ray exposure or barium coated food substances are involved;patients can be tested in any position, regardless of contracture, posture orcooperation level; full color view of the swallowing structures; and immediaterecommendations to enable quick intervention on behalf of the patients.

 

                In a dysfunctional swallow, some aspectsof a patient’s ability to coordinate a swallow is interrupted or slowed downbecause of a medical problem or a combination of conditions.  Some commonexamples include:

 

 

·                  Patient has suffers a CVA(cerebral vascular accident or stroke) with hemiparesis (paralysis on one sideof the body);

 

·                  A Parkinson’s diseasepatient suffers from reduced coordination and chronic fatigue;

 

·                  A patient with GERD (Gastro Esophageal Reflux Disease)or a Hiatal Hernia, (an abnormal condition in which part of the stomachprotrudes upward through the esophagel cleft in the diaphragm, sometimescausing a backflow of acid stomach contents into the esophagus, with or withoutfeeding tube) may be having reflux when the swallow is initiated (food orliquid in essence coming up into the throat while food or liquid is trying to godown to the stomach through the esophagus);

 

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·        Patients with copious secretions,tracheostomy placement, and/or generalized weakness may also be at added riskbecause of muscular weakness in swallowing, inability to handle theirsecretions, and lack of sensitivity in the pharynx; and

 

·        Alzheimer’s or dementia patients may beholding food in the mouth because the swallow is not being stimulated.

 

BEST DMS is paid directly by the facility where thetest is performed. The facilities are reimbursed for the BEST test in a numberof different ways, depending on the patient’s type of insurance coverage:

 

i.                  For Medicare A customers, under PPS, the full cost ofthe BEST is paid by the nursing facility that contracts for BEST services. ThePPS minutes are counted in the RUG level ( level of care for which the patientqualifies);

 

ii.               For Medicare B customers, the cost of the BEST is  reimbursed by Medicare to the facility. There may be a co-pay (usually 20%) for which the patient is responsible, justas in speech therapy services;

 

iii.            For managed care customers, BEST is performed underagreement, and with the approval of the Managed Care Provider. Either thenursing facility contracting for the BEST or the BEST will be reimbursed forthe cost of the test; and

 

iv.           For private insurance customers, the BEST is performedwith approval from the insurance company and the facility is reimbursed by theprivate insurer.

 

 

**Research and Development**

 

During our current fiscal year (FY 08),we continued to develop and design our new family of videoscopes, with aminiature digital camera mounted on the distal end of the insertion tube. Thisvideoscope line includes the ENT-5000 (Ear, Nose and Throat) videoscope, theTNE-5000 (Transnasal  Esophagoscopy)videoscopes and our Urology’s video-based flexible Cystoscope, the CST-5000.We  plan to launch this family ofvideoscopes during the end of our current fiscal year (Q4 08).  For the industrial market, we intend torelease a new line of video borescopes during towards the end of our nextfiscal year.

 

Our videoscopes all include an integrated“built-in” light source, eliminating the need for an external light source andlight guide cable. Our videoscopes are believed to be the first in the worldthat do not contain difficult-to-clean operating channels associated withscopes from other manufacturers. Instead, our scopes are used in combinationwith our patented, disposable, sterile Slide-On EndoSheath technology whichcovers the entire scope, and prevents any contact between the patient and thescope’s insertion tube. Our proprietary EndoSheath technology isolates theendoscope from the patient, and contains a disposable operative channel. Thisprevents instrumentation and patient tissue biopsies from coming in contactwith the reusable scope, in contrast to the built-in channel of conventionalscopes from other manufacturers. Our EndoSheath technology eliminates the needfor elaborate high-level disinfection between procedures, leading to rapidequipment turnover; reducing capital investment for additional scope inventory;reducing staff exposure to toxic chemicals and dramatically lowering repair andmaintenance costs.

 

                The ENT-5000flexible video laryngoscope is inserted through the nose down to the throat,providing precise, vivid images of the internal structures of the nasal cavity,vocal folds, larynx and other areas of the throat. The TNE-5000 flexible videotransnasal esophagoscope allows  forvisualization and diagnosis further down to the esophagus and  the stomach. The CST-5000 flexible videocystoscope provides vivid images of the internal structure of the bladder.

 

These lightweight videoscopes facilitatediagnostic and therapeutic procedures without general anesthesia or intravenoussedation.  During the procedure, thepatient’s comfort is enhanced by the scope’s use of the smallest diameterinsertion tube known to date.  The tip ofthe insertion tube contains a high resolution , tiny CCD (charge coupleddevice) based video camera, offering a sharp, high-resolution, vibrant fullscreen image.

 

Our new videoscope with the EndoSheathtechnology is poised to replace existing, pervasive fiber-optic technology.While gastroenterologists have been using costly conventional video endoscopesfor years, other specialties were forced to use the old fiber technology due tohigh conversion costs. This is the first time physicians will have theopportunity to have a videoscope uniquely combined with the practice-efficiencyof the EndoSheath Technology.

 

 

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                During Q3, as aresult of our dispute with Pentax, we started developing our next generation,improved family of medical and industrial fiber scopes. This new line offiberscopes, scheduled to be released by the end of our next fiscal year (FY‘09), will no longer use any Pentax supplied parts.

 

We are also working on improving ourmanufacturing processes, which we believe will result in lower costs to produceour endoscopes and EndoSheaths.

 

In addition to the above research and developmentprojects, we are at various stages of exploration of opportunities in, anddevelopment of products for use in the medical fields of gynecology,pulmonology and gastroenterology, among others.

 

**The MINOS Medical Inc. Investment**.

 

In April 2007, we executed a definitiveinvestment agreement under which we acquired a strategic interest in Minos Medical, Inc. (“Minos”).Minos is a privately held California-based development-stage medical devicecompany concentrating in the emerging field of N.O.T.E.S. (Natural OrificeTrans-luminal Endoscopic Surgery). N.O.T.E.S. is a new frontier in surgery,focusing on using natural orifices to enter the body to facilitate  surgical procedures that require noincisions. We invested $1 million in cash and have agreed to expend $165,000 indevelopment costs in collaboration with Minos, in order to exploit certainsurgical procedures. We accounted for this transaction on our balance sheet asan equity investment.

 

                N.O.T.E.S. is oneof our long term targeted fields, and we are actively looking for acquiringrelated technologies and product lines. Our investment in Minos is our firstpublicly announced step towards positioning us in the forefront of this newfield. N.O.T.E.S. represents the next generation of surgical procedures, goingbeyond minimally invasive laparoscopic surgery to achieve surgery withoutincisions. We are confident that Minos will be a valuable strategic partner forus as we pursue a leading position in the emerging N.O.T.E.S. field.

 

**Other Developments**

 

Earlier in FY 08, an expansion audit was successfullycompleted in our manufacturing facility in Orangeburg, New York, and we wereawarded ISO certification.  Thiscertification allowed us to start shipping scopes from our Orangeburg facility,in addition to shipments from our plant in Natick, Massachusetts.  This development will improve ourproductivity and reduce our shipping costs.

 

In October 2007 we announced that wewill consolidate all of our operations into our facility in Orangeburg, NewYork. As a result of this consolidation, we will be closing our facility inNatick, Massachusetts. We will transition this consolidation in a controlledfashion to prevent any disruption of activities. It is expected that theclosing of the Natick facility will occur over the next 12 months.

 

                Consolidating ourfacilities will allow us to achieve greater efficiencies between our endoscopedesign and manufacturing activities, currently taking place in Orangeburg, NY,and the EndoSheath design and manufacturing activities, currently taking placein Natick, MA. This is strategically necessary as we prepare for acceleratedgrowth with the introduction of new products and as we enter new markets. OurResearch and Development groups will be also able to work more closely,allowing us to accelerate our ability to bring new products to market.

 

In December 2007, Medtronic also paid usthe second installment of the first milestone payment achieved under theTransition Services Agreement with Medtronic. This agreement requires Medtronic to make certain payments to us basedon achievement of certain post-closing milestones related to the transition ofmanufacturing capability.  We have thusfar met the first milestone, for a total of $1,000,000 out of an anticipatedtotal of $4,000,000.

 

 

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***Critical Accounting Policies andEstimates***

 

                This discussionand analysis of our financial condition and results of operations is based uponour Consolidated Financial Statements, which have been prepared in accordancewith generally accepted accounting principles (“GAAP”) in the United States ofAmerica, see the Notes to the Consolidated Financial Statements includedelsewhere herein. Certain of our accounting policies require the application ofjudgment in selecting the appropriate assumptions for calculating financialestimates. By their nature these judgments are subject to an inherent degree ofuncertainty. We periodically evaluate the judgments and estimates used for ourcritical accounting policies to ensure that such judgments and estimates arereasonable for our interim and year-end reporting requirements. These judgmentsand estimates are based upon our historical experience, current trends andinformation available from other sources, as appropriate. If differentconditions result from those assumptions used in our judgment, the resultscould be materially different from our estimates. Our critical accountingpolicies include the following:

 

*Revenue Recognition*

 

                We recognizerevenue in accordance with SEC Staff Accounting Bulletin No. 104, *Revenue Recognition in Financial Statements*and EITF 00-21, *Revenue Arrangementswith Multiple Deliverables.* These pronouncements require thatcertain basic criteria must be met before revenue can be recognized: (1) persuasiveevidence that an arrangement exists; (2) delivery has occurred or servicesrendered; (3) the fee is fixed and determinable; (4) collectabilityis reasonably assured. The Company recognizes revenue when title passes to thecustomer, generally upon shipment of products.

 

*Options Issued*

 

                Effective April 1,2006 we began accounting for compensation expense related to stock options inaccordance with SFAS No. 123 (Revised 2004) *Share-Based Payment* (“SFAS 123R”). Prior to April 1,2006, we accounted for stock options according to Accounting Principles Board(“APB”) Opinion 25, *Accounting for StockIssued to Employees.*

 

                We adopted themodified prospective transition method and consequently have not retroactivelyadjusted results from prior periods. Under this transition method, compensationcost associated with stock options now includes: (i) amortization relatedto the remaining unvested portion of all stock options outstanding at March 31,2006, based on the fair value determined on the grant date in accordance withthe original provisions of SFAS 123, and (ii) amortization related toall stock option awards granted subsequent to March 31, 2006, based uponthe fair value estimated in accordance with SFAS 123R. The compensationexpense for stock-based compensation awards under SFAS 123R is recognizedover the vesting period of the options, and includes an estimate forforfeitures.

 

                In accordance withSFAS 123R, the Company recorded $200 and $137 of stock-based compensationexpense in the statement of operations for Q3 08 and for Q3 07,respectively, in the following expense categories:

 
| ** **                                  | ** ** | **Q3 08** | ** ** | **Q3 07** | ** ** |
|---------------------------------------------|------------|----------------|------------|----------------|------------|
| Cost of Goods Sold                          |       | $              | 18         |           | $          | 15 |   |
| Selling,  General & Administrative |       | 143            |       | 97             |       |
| Research &  Development            |       | 39             |       | 25             |       |
|                                        |       |           |       |           |       |
| **Total**                                   | ** ** | **$**          | **200**    | ** **     | **$**      | **137** | ** ** |

 

In accordance with SFAS 123R, werecorded $591 and $381 of stock-based compensation expense in the statement ofoperations for the nine month period ended December 31, 2007 (“Fiscal Yearto Date 08”or “YTD 08”) and for the nine month period ended December 31,2006 (“Fiscal Year to Date 07”or “YTD 07”), in the following expensecategories:

 
| ** **                                  | ** ** | **YTD 08** | ** ** | **YTD 07** | ** ** |
|---------------------------------------------|------------|-----------------|------------|-----------------|------------|
| Cost of Goods Sold                          |       | $               | 48         |            | $          | 45 |   |
| Selling,  General & Administrative |       | 438             |       | 288             |       |
| Research &  Development            |       | 105             |       | 48              |       |
|                                        |       |            |       |            |       |
| **Total**                                   | ** ** | **$**           | **591**    | ** **      | **$**      | **381** | ** ** |

 

                At December 31,2007, the total unamortized stock-based compensation is approximately $1,458.We will expense that amount over periods ending through June 30, 2013. Wedo not expect to realize any tax benefits from future disqualifyingdispositions, if any, due to its policy of recording valuation allowances equalto its deferred tax asset.

 

 

 

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                In the nine monthsended December 31, 2007, we granted options to purchase a total of 1,846,250shares of our Common Stock. A total of 426,750 of these options were grantedfrom our 2000 Stock Incentive Plan (the “2000 Plan”), 1,403,500 of theseoptions were granted from the our 2007 Stock Incentive Plan (the “2007 Plan”)and 16,000 of these options were granted from our 2003 Directors Stock OptionPlan (the “2003 Directors Plan”). The fair value of these options measured atthe option grant date was approximately $1,458, determined using theBlack-Scholes option-pricing model. This amount is reduced by an estimatedforfeiture rate and is being recorded as an expense over the vesting period.The assumptions used in the Black-Scholes option-pricing model in the period bythe Company were as follows:

 
| ** **                              | ** ** | **December 31, 2007** | ** ** |
|-----------------------------------------|------------|----------------------------|------------|
| Risk-free interest rate                 |       | 3.45%-4.81                 | %          |
| Expected dividend yield                 |       | 0                          | %          |
| Expected life                           |       | 5.5  - 6.75 years     |       |
| Expected volatility                     |       | 65%  - 70                  | %          |
| Weighted average value  grant per share |       | $0.83                      |       |

 

                We account foroptions issued to directors, non-employees and employees in accordance with theprovisions of SFAS 123R. We grant options with vesting periods ranging fromimmediate to six years. We use the simplified method of calculating theexpected option term, which averages an award’s weighted average vesting periodand its contractual term. The contractual term of our options is ten years. Therisk-free rate is based upon the daily Treasury yield curve for a periodapproximately equal to the expected option term. We used historical data toestimate the expected price volatility and forfeiture rate. The expecteddividend yield is 0%, based on our history of not paying dividends.

 

*Income Taxes*

 

                Under our incometax policy, 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 losses and taxcredit carry-forwards. The evaluation of the recoverability of any tax assetsrecorded on the balance sheet is subject to significant judgment. We providedvaluation allowances for all our deferred tax assets to date. During Q2 08,we recorded a recovery of income taxes in the amount of $180, in anticipationof filing a certain state annual return during the last quarter of our FY08.  We have now filed our tax returnsfor all jurisdictions, and we have recorded the following adjustments: (i) Wereversed the above mentioned tax recovery and booked a total of $188 in taxliability; (ii) we booked an additional $31 tax liability for other statejurisdictions; (iii) for federal taxes, we recorded a recovery of incometax of $39. Total net change to our valuation allowance is $180. These taxliabilities stem from our FY 07 net income of $20 million, resulting from oursale of certain assets to Medtronic.

 

 

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**Results of Operations**

 

***Net Sales***

 

***Three-month period ended December 31, 2007compared to the Three-month period ended December 31, 2006 in (000’s)***

 

                Net sales for thethree months ended December 31, 2007, (“Q3 08”), were $2,019, adecrease of $197, or (9)%, compared to the three-month period ended December 31,2006 (“Q3 07”). During Q3 08, net sales of medical segment decreasedby $289, or 19%, to $1,246, and net sales of the industrial segment decreasedby $83, or 12%, to $598. Sales of our new segment, BEST, contributed $175.  Sales by segment and category in Q3 08and Q3 07 were as follows:

 
| **Category**                          | ** ** | **Q3 08** | ** ** | **Q3 07** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|---------------------------------------|------------|----------------|------------|----------------|------------|--------------------------|------------|-------------|------------|
| Scopes                                |       | $              | 456        |           | $          | 417                      |       | $           | 39         |   | 9 | % |
| Sheaths                               |       | 488            |       | 930            |       | (442                     | )          | (48         | )%         |
| Repairs, Peripherals and  Accessories |       | 302            |       | 188            |       | 114                      |       | 61          | %          |
| **Total Medical**                     | ** ** | **1,246**      | ** ** | **1,535**      | ** ** | **(289**                 | **)**      | **(19**     | **)%**     |
|                                  |       |           |       |           |       |                     |       |        |       |
| Scopes                                |       | 423            |       | 467            |       | (44                      | )          | (9          | )%         |
| Repairs, Peripherals and  Accessories |       | 175            |       | 214            |       | (39                      | )          | (18         | )%         |
| **Total Industrial**                  | ** ** | **598**        | ** ** | **681**        | ** ** | **(83**                  | **)**      | **(12**     | **)%**     |
| ** **                            | ** ** | ** **     | ** ** | ** **     | ** ** | ** **               | ** ** | ** **  | ** ** |
| BEST Services                         |       | 175            |       | —         |       | 175                      |       | —      |       |
| **Total Best**                        | ** ** | **175**        | ** ** | **—**     | ** ** | **175**                  | ** ** | **—**  | ** ** |
| ** **                            | ** ** | ** **     | ** ** | ** **     | ** ** | ** **               | ** ** | ** **  | ** ** |
| **Total Sales**                       | ** ** | **$**          | **2,019**  | ** **     | **$**      | **2,216**                | ** ** | **$**       | **(197**   | **)** | **(9** | **)%** |

 

*                MedicalSales—Scope Products*

 

                Net Sales to themedical scope market include products used for the ENT (including TNE) andUrology customers as follows:

 
| **Scope Market**  | ** ** | **Q3 08** | ** ** | **Q3 07** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|-------------------|------------|----------------|------------|----------------|------------|--------------------------|------------|-------------|------------|
| ENT and TNE       |       | $              | 311        |           | $          | 371                      |       | $           | (60        | ) | (16 | )% |
| Urology and Other |       | 145            |       | 46             |       | 99                       |       | 215         | %          |
| ** **        | ** ** | ** **     | ** ** | ** **     | ** ** | ** **               | ** ** | ** **  | ** ** |
| **Total Scope**   | ** ** | **$**          | **456**    | ** **     | **$**      | **417**                  | ** ** | **$**       | **39**     | ** ** | **9** | **%** |

 

Overall scope sales increased from $417 to$456 mainly due to more than doubling our sales to the Urology market. Theincrease was offset by a reduction of 16% in ENT scope sales, resulting from ashortage of parts from Pentax. During this quarter, our dispute with Pentax,(which was settled on February 12, 2008 – please refer to “Item 1. LegalProceedings” in Part II-Other Information), resulted in a temporary shortage ofparts for the manufacturing and repair of fiberscopes. Based on in-house ordersat the end of Q3 08, we calculated that in this quarter, because of the PentaxDispute we lost revenues for scopes and accessories totaling $756, and repairorders for a total of $26. 

 

Our ENT scopes are marketed globally by MENT.As a result of our exclusive ENT distribution agreement with MENT, the successof our ENT endoscope lines depends substantially upon the success of themarketing and sales activities of MENT, over which we have limited control.

 

 

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*                MedicalSales—EndoSheath Products*

 

                Net Sales ofEndoSheaths include products used for the ENT (including TNE) and Urologycustomers as follows:

 
| **Products**      | ** ** | **Q3 08** | ** ** | **Q3 07** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|-------------------|------------|----------------|------------|----------------|------------|--------------------------|------------|-------------|------------|
| ENT and TNE       |       | $              | 343        |           | $          | 884                      |       | $           | (541       | ) | (61 | )% |
| Urology and Other |       | 145            |       | 46             |       | 99                       |       | 215         | %          |
|              |       |           |       |           |       |                     |       |        |       |
| **Total Sheaths** | ** ** | **$**          | **488**    | ** **     | **$**      | **930**                  | ** ** | **$**       | **(442**   | **)** | **(48** | **)%** |

 

                Sales of our ENTsheaths decreased in Q3 08, compared to Q3 07, as MENT decreased itspurchases from us, as a result of commencing its own manufacturing of certainENT sheaths as part of the Medtronic Transition Agreement of March 26,2007. As of December 2007, MENT ceased its orders of ENT Sheaths from us.

 

                The increase insales of Urology sheaths reflects our continued focus on this part of themedical segment. In May 2006, we terminated the MGU Agreement. We decidedto explore other forms of distribution for our Slide-On EndoSheath flexiblecystoscopy System, including utilizing a network of independent salesrepresentatives. This network has continued to expand during FY 08, and we willcontinue to expand it during the fourth quarter of FY 08 and beyond. Althoughcurrent performance reflects an increase in sales as a result of these efforts,we will continually assess our progress in this area, and could abandon ourefforts if they do not prove to be successful.

 

                We believe the CSTEndoSheath 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.

 

*                MedicalSales—Repairs, Peripherals and Accessories*

 

                Sales ofperipheral and accessory products increased in Q3 08, compared toQ3 07, due primarily to the higher demand for our medical scopes.

 

*Industrial Segment*

 

                The decrease innet sales of the industrial segment was due to lower demand in the market fornew fiberscopes and repairs to fiberscopes.

 

***Nine-month period ended December 31, 2007compared to the Nine-month period ended December 31, 2006 in (000’s)***

 

                Net sales for thenine months ended December 31, 2007 (“YTD 08”), were $7,577, an increaseof $1,063, or 16%, compared to the nine month period ended December 31,2006 (“YTD 07”). During YTD 08, net sales of medical segmentincreased by $1,149, or 26%, to $5,623; net sales of the industrial segmentdecreased by $261, or 13%, to $1,779.  Netsales of the new BEST segment contributed $175.  Sales by segment and category duringYTD 08 and YTD 07 were as follows:

 
| **Category**                          | ** ** | **YTD 08** | ** ** | **YTD 07** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|---------------------------------------|------------|-----------------|------------|-----------------|------------|--------------------------|------------|-------------|------------|
| Scopes                                |       | $               | 2,454      |            | $          | 1,070                    |       | $           | 1,384      |   | 129 | % |
| Sheaths                               |       | 2,007           |       | 2,788           |       | (781                     | )          | (28         | )%         |
|                                  |       |            |       |            |       |                     |       |        |       |
| Repairs, Peripherals and  Accessories |       | 1,162           |       | 616             |       | 546                      |       | 89          | %          |
| **Total Medical**                     | ** ** | **5,623**       | ** ** | **4,474**       | ** ** | **1,149**                | ** ** | **26**      | **%**      |
| ** **                            | ** ** | ** **      | ** ** | ** **      | ** ** | ** **               | ** ** | ** **  | ** ** |
| Scopes                                |       | 1,151           |       | 1,152           |       | (1                       | )          | (0          | )%         |
| Repairs, Peripherals and  Accessories |       | 628             |       | 888             |       | (260                     | )          | (29         | )%         |
| **Total Industrial**                  | ** ** | **1,779**       | ** ** | **2,040**       | ** ** | **(261**                 | **)**      | **(13**     | **)%**     |
| ** **                            | ** ** | ** **      | ** ** | ** **      | ** ** | ** **               | ** ** | ** **  | ** ** |
| BEST Services                         |       | 175             |       | —          |       | 175                      |       | —      |       |
| **Total Best**                        | ** ** | **175**         |       | —          | ** ** | **175**                  |       | —      |       |
| ** **                            | ** ** | ** **      |       |            | ** ** | ** **               |       |        |       |
| **Total Sales**                       | ** ** | **$**           | **7,577**  | ** **      | **$**      | **6,514**                | ** ** | **$**       | **1,063**  | ** ** | **16** | **%** |

 

 

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*Medical Sales—Scope Products*

 

                Net sales to themedical scope market include products for ENT/ TNE and Urology customers asfollows:

 
| **Scope Market**  | ** ** | **YTD 08** | ** ** | **YTD 07** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|-------------------|------------|-----------------|------------|-----------------|------------|--------------------------|------------|-------------|------------|
| ENT and TNE       |       | $               | 2,071      |            | $          | 916                      |       | $           | 1,155      |   | 126 | % |
| Urology and Other |       | 383             |       | 154             |       | 229                      |       | 149         | %          |
|              |       |            |       |            |       |                     |       |        |       |
| **Total Scope**   | ** ** | **$**           | **2,454**  | ** **      | **$**      | **1,070**                | ** ** | **$**       | **1,384**  | ** ** | **129** | **%** |

 

                The primaryreasons for the rise in sales of products to the medical scope market were (i) anincrease in orders (earlier in this fiscal year) from our exclusive distributorfor ENT products, MENT, and (ii) the increase of sales of Cystoscopes as aresult of the growth of our sales force. We previously sold our ENT products tothe international markets through our own network of independent foreigndistributors. As of Q1 08, we sell all our ENT products for the domestic andinternational markets through MENT, our global ENT scope distributor.

 

                As a result of ourexclusive ENT distribution agreement with MENT, the success of our ENTendoscope lines is substantially dependent upon the success of the marketingand sales activities of MENT, over which we have limited control.

 

During this quarter, our dispute with Pentax,(which was settled on February 12, 2008 - please refer to “Item 1. LegalProceedings” in Part II- Other Information, resulted in a temporaryshortage of parts for the manufacturing and repair of fiberscopes. Based onin-house orders at the end of Q3 08, we calculated that in this quarter,because of the Pentax dispute we lost revenues for scopes and accessoriestotaling $756, and repair orders for a total of $26.

 

*                MedicalSales—EndoSheath Product*

 

                Net Sales ofEndoSheaths include products used for the ENT (including TNE) and Urologycustomers as follows:

 
| **Products**      | ** ** | **YTD 08** | ** ** | **YTD 07** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|-------------------|------------|-----------------|------------|-----------------|------------|--------------------------|------------|-------------|------------|
| ENT and TNE       |       | $               | 1,624      |            | $          | 2,634                    |       | $           | (1,010     | ) | (38 | )% |
| Urology and Other |       | 383             |       | 154             |       | 229                      |       | 149         | %          |
| ** **        | ** ** | ** **      | ** ** | ** **      | ** ** | ** **               | ** ** | ** **  | ** ** |
| **Total Sheaths** | ** ** | **$**           | **2,007**  | ** **      | **$**      | **2,788**                | ** ** | **$**       | **(781**   | **)** | **(28** | **)%** |

 

                Sales of our ENTSheath decreased in the first 9 months of FY 08 vs. FY 07, by $1,010,or 38%, as MENT decreased its purchases from us, as a result of commencing itsown manufacturing of certain ENT sheaths as part of the Medtronic TransitionAgreement of March 26, 2007. As of December 2007, MENT ceased itsorders of ENT Sheaths from us.

 

                The increase insales of Urology EndoSheath products, by $229, or 149% reflects our focus onthis medical segment. In May 2006, we terminated the MGU Agreement withMedtronic, Inc. We decided to explore other forms of distribution for ourSlide-On EndoSheath flexible cystoscopy System, the CST-2000 and the CST-2000A,including utilizing a network of independent sales representatives. Althoughthis network has continued to expand during FY 08 we believe it will takean additional 9 to 12 months to complete the build up of an effectiveindependent sales representative network. Although current performance reflectsan increase in sales as a result of these efforts, we will continually assessour progress in this area, and could abandon our efforts if they do not proveto be successful during that time frame.

 

                We believe the CSTEndoSheath 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. Use of our CST cystoscope withthe Slide-On EndoSheath sterile, single-use cover, also avoids the need toreprocess endoscopes with harsh chemicals, one of which has beencontraindicated for use on patients with bladder cancer.

 

*                MedicalSales—Repairs, Peripherals and Accessories*

 

                Sales ofperipheral and accessory products increased in Q3 08, compared toQ3 07, is directly correlated to the higher demand for our medical scopes

 

 

 

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*Industrial Segment*

 

                The decrease innet sales of the industrial segment was due to lower demand in the market fornew borescopes and repair services.

 

***Gross Profit***

 

***Three-month period ended December 31, 2007compared to the Three-month period ended December 31, 2006***

 

                Gross profit was$515 in Q3 08, an increase of $222, compared to gross profit in Q3 07. For thisquarter, gross profit for the medical segment was a loss of $150, Industrialsegment contributed $597 and BEST contributed $68. Gross profit as percent ofnet sales was 25% in Q3 08 vs. 13% in Q3 07. 

 

***Nine-month period ended December 31, 2007compared to the Nine-month period ended December 31, 2006***

 

                Gross profit was$2,335 in YTD 08, an increase of $1,157 compared to gross profit in YTD 07.Gross profit increased by approximately $1,149 in the medical segment primarilyas a result of production efficiencies that were accomplished with increasedproduction, and decreased by approximately $60 in the industrial segment due tolower sales. BEST contributed $68. Gross profit as a percent of net sales was31% in YTD 08 vs. 18% in YTD 07.

 

***Operating Expenses***

 

***Three-month period ended December 31, 2007compared to the Three-month period ended December 31, 2006***

 

*                Selling,General and Administrative Expenses*

 

                Selling, generaland administrative (“SG&A”) expenses in Q3 08 were $1,980, an increaseof $771, or 64%, compared to Q3 07.  This increase resulted primarily from higherspending for personnel, including salaries and stock-based compensation, ofapproximately $143, $85 in legal expenses related to the Pentax dispute and$122 from the BEST segment.  Theincreased level of expense reflects our commitment to establish the company’sinfrastructure to support our projected future accelerated growth.

 

*                Researchand Development Expenses*

 

                Research anddevelopment (“R&D”) expenses in Q3 08 were $650, an increase of $136,or 26%, as compared to Q3 07.  Thisincrease resulted primarily from additional spending for materials andpersonnel developing our new lines of videoscope and EndoSheath products. Weexpect R&D expenses will continue to increase in FY 08, compared toFY 07, as we are developing a new family of fiberscopes to replace ourcurrent fiberscopes, and continue working on the videoscopes as well as othernew products.

 

***Nine-month period ended December 31, 2007 compared tothe Nine-month period ended December 30, 2006***

 

*                Selling,General and Administrative Expenses*

 

                SG&A expenses forYTD 08 were $5,729, as compared to $3,473 YTD 07, an increase of$2,256, or 65%.  The increase resulted primarilyfrom  higher spending for personnel,including salaries and stock-based compensation, of approximately $438.  Personnel expenses growth were mainly for theaddition of new sales and marketing personnel to support and grow our networkof independent sales representatives, and the introduction process of our newfamily of videoscopes. In addition, we had higher spending on product promotionand travel related to our medical products of approximately $225, and higherexpenses for professional fees of approximately $150. The increased level ofexpense reflects our commitment to build —up the Company’s infrastructure tosupport our future growth.  BEST SG&Awere $122.

 

*                Researchand Development Expenses*

 

                R&D expenses forYTD 08 were $2,610, as compared to $1,725 in YTD 07, an increase of$885, or 51%.  This increase resulted primarilyfrom additional spending for materials and personnel developing our new linesof videoscope and EndoSheath products. We expect R&D expenses will continueto increase in FY 08, compared to FY 07, as we increase 

 

 

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our efforts to develop this new family of videoscopes, a new family offiberscopes to replace our current line of products, as well as other new products.

 

***Loss from Operations***

 

***Three-month period ended December 31, 2007compared to the Three-month period ended December 31, 2006***

 

                (Loss) income fromoperations by segment was as follows ($000’s):

 
| **Segment** | ** ** | **Q3 08** | ** ** | **Q3 07** | ** ** | **Change** | ** ** |
|-------------|------------|----------------|------------|----------------|------------|------------|------------|
| Medical     |       | $              | (2,530     | )              | $          | (1,116     | )          | $ | (1,414 | ) |
| Industrial  |       | 470            |       | (314           | )          | 784        |       |
| BEST        |       | (54            | )          | —         |       | (54        | )          |
|        |       |           |       |           |       |       |       |
| **Total**   | ** ** | **$**          | **(2,114** | **)**          | **$**      | **(1,430** | **)**      | **$** | **(684** | **)** |

 

                In the medicalsegment, the improved gross profit was offset by the higher spending forSG&A and R&D, resulting in increased loss from operations forQ3 08. In the industrial segment, the higher gross profit was the primarycause for the increase in profit in Q3 08. The BEST segment increased our loss by $54.

 

***Nine-month period ended December 31, 2007compared to the Nine-month period ended December 31, 2006***

 

                (Loss) income fromoperations by segment was as follows ($000’s):

 
| **Segment** | ** ** | **YTD 08** | ** ** | **YTD 07** | ** ** | **Change** | ** ** |
|-------------|------------|-----------------|------------|-----------------|------------|------------|------------|
| Medical     |       | $               | (6,437     | )               | $          | (3,449     | )          | $ | (2,988 | ) |
| Industrial  |       | 487             |       | (571            | )          | 1,058      |       |
| BEST        |       | (54             | )          | —          |       | (54        | )          |
|        |       |            |       |            |       |       |       |
| **Total**   | ** ** | **$**           | **(6,004** | **)**           | **$**      | **(4,020** | **)**      | **$** | **(1,984** | **)** |

 

                In the medicalsegment, the reduction in gross margin and higher spending for SG&A andR&D, resulted in the increased loss from operations for YTD 08. In theindustrial segment, the higher gross profit was the primary cause for the increasesin profit in YTD 08.  The BESTsegment increased our loss by $54.

 

***Liquidity and Capital Resources***

 

                At December 31,2007, our principal source of liquidity was working capital of approximately $24.0 million,including $20.2 million in cash and short term investments.

 

                Our cash and cashequivalents decreased by approximately $28.5 million in the nine monthsended December 31, 2007, due primarily to cash used for investing activitiesof approximately $22.3 million (including a $20.2 million purchase of shortterm investments and $1 million investment in MINOS); cash used for operationsof approximately $6.3 million (including $0.45 million for the BESTDMS acquisition). We expect that our current balance of cash and short terminvestments will be sufficient to fund our operations for at least the nexttwelve months.

 

In April 2007, we executed a definitiveinvestment agreement under which we acquired a strategic interest in Minos Medical, Inc. (“Minos”).Minos is a privately held California based development stage medical devicecompany concentrating in the emerging field of N.O.T.E.S. (Natural OrificeTrans-luminal Endoscopy Surgery). N.O.T.E.S. is a new frontier in surgery,focusing on using natural orifices to enter the body to facilitate  surgical procedures that require noincisions. We invested $1 million in cash and have agreed to expend $165,000 indevelopment costs in collaboration with Minos, in order to exploit certainsurgical procedures. We accounted for this transaction on our Balance Sheet asan Equity Investment.

 

On January 18,2008, we entered into a $10.0 million revolving line of credit agreement withMerrill Lynch Bank USA (the “Bank”), pursuant to the terms of a Merrill LynchLoan Management Account Agreement (the “Loan Agreement”). The Loan Agreementpermits us to borrow funds from the Bank from time-to-time at fixed, variableor term rates. The current rate for our borrowing is set at LIBOR plus 1.75%.Any outstanding amounts for variable rate borrowings may be repaid at our optionat any time without penalty or premium. If we repay a fixed advance or termadvance prior to its 

 

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scheduled repayment date,we may be required to pay a breakage fee to the Bank. The amount of advancesavailable under the Loan Agreement varies from time to time and is based on thevalue of, and secured by, the securities we maintain with Merrill Lynch,Pierce, Fenner & Smith Incorporated. Under the Loan Agreement, theBank has the right to demand repayment, in whole or in part, at any time, ofany outstanding amounts. As of today, we have not requested any advances underthe Loan Agreement.

 

                We have incurredlosses since our inception, and losses are expected to continue at least duringFY 08. We have funded the losses principally with the proceeds from publicand private equity financings, and the sale of certain assets to Medtronic.

 

                We expect total spendingfor property and equipment to be approximately $1.5 million forFY 08.

 

                We conduct ouroperations in certain leased facilities. These leases expire on various datesthrough August 31, 2010. In addition, we have operating leases for certainoffice equipment. At December 31, 2007, the minimum lease and rentcommitments are as follows:

 
| **Fiscal Year** | ** ** | **Commitments** | ** ** |
|-----------------|------------|-----------------|------------|
| 2008            |       | $               | 154        |   |
| 2009            |       | 749             |       |
| 2010            |       | 346             |       |
| 2011            |       | 120             |       |
| ** **      | ** ** | ** **      | ** ** |
| **Total**       | ** ** | **$**           | **1,369**  | ** ** |

 

                The above tableincludes a new lease for temporary premises in Natick, MA, which will start on March 1,2008 and will expire between September and December 2008, whichexpiration will be determined by the status of relocating our Natick operationsto Orangeburg, NY.

 

                We have nooff-balance sheet arrangements that have, or are reasonably likely to have, acurrent or future effect on our financial condition, changes in financialcondition, revenues or expenses, results of operations, liquidity, capitalexpenditures or capital resources.

 

***Recently Issued Accounting Standards***

 

                In July 2006,the Financial Accounting Standards Board (“FASB”) issued FIN 48, *Accounting for Uncertainty in Income Taxes-anInterpretation of FASB Statement No. 109*, which seeks to reducethe significant diversity in practice associated with certain aspects ofmeasurement and recognition in accounting for income taxes. FIN 48prescribes a recognition threshold and measurement attribute for financialstatement recognition and measurement of a tax position taken, or expected tobe taken, in a tax return. It also provides guidance on de-recognition,classification, interest and penalties, accounting in interim periods,disclosure and transition. The provisions of FIN 48 are effective forfiscal years beginning after December 15, 2006. Upon adoption, the cumulativeeffect of any changes in net assets resulting from the application ofFIN 48 will be recorded as an adjustment to retained earnings. We adoptedFIN 48 effective April 1, 2007, and the adoption of FIN 48 didnot have a material impact on our results of operations, financial position orcash flow.

 

                In February 2007,the FASB issued SFAS No. 159 (SFAS 159), *The Fair Value Option forFinancial Assets and Financial Liabilities, including an amendment of FASBStatement No. 115*. SFAS 159 permits entities to choose to measuremany financial instruments at fair value that are not currently required to bemeasured at fair value. It also establishes presentation and disclosurerequirements designed to facilitate comparisons between entities that choosedifferent measurement attributes for similar types of assets and liabilities.SFAS 159 is effective for our fiscal year beginning after November 15,2007.  Adoption of this statement is notexpected to have a material impact on our financial statements or results ofoperations.

 

                In December 2007,the FASB issued SFAS No. 141(R), *Business Combinations*andSFAS No. 160*, Accounting and Reporting of NoncontrollingInterest in Consolidated Financial Statements, an amendment of ARB No. 51*.These new standards will significantly change the accounting for and reportingof business combination transactions and noncontrolling (minority) interests inconsolidated financial statements. SFAS Nos. 141(R) and 160 are required to beadopted simultaneously and are effective for the first annual reporting periodbeginning on or after December 15, 2008. Thus, we are required to adopt theseStandards on April 1, 2009. Earlier adoption is prohibited.  We are currently evaluating the impact ofadopting SFAS Nos. 141(R) and SFAS 160 on our consolidated financialstatements.

 

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

 

                In the normalcourse of business, we are subject to the risks associated with fluctuations ininterest rates and changes in foreign currency exchange rates.

 

*Interest and Market Risk*

 

                We currentlyinvest our excess cash in a money market account at our bank. We have not usedderivative financial instruments in our investment portfolio. We attempt tolimit our exposure to interest rate and credit risk by placing our investmentswith high-quality financial institutions and have established investmentguidelines relative to diversification and maturities designed to maintainsafety and liquidity.

 

                Investments inboth fixed-rate and floating-rate interest earning instruments carry a degreeof interest rate risk. Fixed-rate securities may have their fair market valueadversely impacted due to a rise in interest rates, while floating-ratesecurities may produce less income than expected 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.

 

Our Loan Agreementwith Merrill Lynch Bank USA described above permits us to borrow funds from theBank from time-to-time at fixed, variable or term rates. The current rate for ourborrowing is set at LIBOR plus 1.75%. If interest rates rise unexpectedly,interest we owe on amounts outstanding under the Loan Agreement willincrease.  As of today, we have notrequested any advances under the Loan Agreement.

 

*Foreign Currency Exchange*

 

                We face exposure,due to purchases of raw materials from foreign suppliers, to adverse movementsin the value of certain foreign currencies. This exposure may change over time,and could have an adverse effect on our financial results. We may attempt tolimit this exposure by purchasing forward contracts, as required. Currently wedo not have forward contracts. Most of our foreign exchange liabilities aresettled within 90 days of receipt of materials. As of December 31,2007, our liabilities related to foreign currency were not material.

 

**Item 4.  CONTROLS AND PROCEDURES**

 

*Evaluation of Disclosure Controls and Procedures.*

 

                We maintaindisclosure controls and procedures that are designed to ensure that informationrequired to be disclosed in our Exchange Act reports are recorded, processed,summarized and reported within the time periods specified in the SEC’s rulesand forms, and that such information is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate, to allow timely decisions regarding required disclosure basedon the definition of “disclosure controls and procedures” in Rule 13a-15(e). Indesigning and evaluating the disclosure controls and procedures, managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and management necessarily is required to apply itsjudgment in evaluating the cost-benefit relationship of possible controls andprocedures.

 

                We carried out anevaluation, under the supervision and with the participation of our seniormanagement, including our Chief Executive Officer and Chief Financial Officer,of the effectiveness of the design and operation of our disclosure controls andprocedures as of December 31, 2007. Based upon the foregoing, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures were not effective at that date due to a materialweakness relating to a lack of adequate resources within the accounting andfinance department, resulting primarily from our newly-hired controllerresigned on very short notice to pursue an opportunity closer to his home. Theeffect of the lack of resources has resulted in certain reviews of financialinformation not being performed on a timely basis or at all, leading toadjustments being made after the books and records are closed. The term“material weakness” means a deficiency, or a combination of deficiencies, ininternal control over financial reporting such that there is a reasonablepossibility that a material misstatement of the Company’s annual or interimfinancial statements will not be prevented or detected on a timely basis. Tocorrect this material weakness we have retained an outside certified publicaccountant on a consulting basis, and we initiated an employment search processto fill several new staff positions.

 

                Except as providedin the prior  paragraphs, there have beenno changes in our internal controls over financial reporting during the quarterended December 31, 2007 that have materially affected, or are reasonably likelyto materially affect our internal controls over financial reporting.

 

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**PART II—OTHERINFORMATION**

 

**Item 1.  LEGAL PROCEEDINGS**

 

                On November 15, 2007, Pentax Corporation(“Pentax”), our solesupplier of certain critical components for our line of fiberscopes informed usthat it intended to significantly increase the price and limit the quantitiesof certain components it supplied to us. We require these components toproduce our three models of ENT fiberscopes, our two models of TNE fiberscope,our fiber Cystoscope for the medical segment and some of our borescopes for theindustrial segment. Pentax, a competitor of ours and a beneficialowner of approximately 5.0% of our Common Stock, unilaterally took theseactions. We concludedthat as a result of Pentax’s actions, we would not receive sufficient quantitiesof components required for the production of these products through at leastthe third quarter of this fiscal year, which ended on December 31, 2007.

 

                Pentax has beensupplying us with these components pursuant to a Supply Agreement dated March 16,1992, as amended on October 1, 2002. This agreement has been automaticallyand continuously renewed since it was executed, and was due to expire on March 2009.  Pentaxdoes not supply, nor does this have any effect on our ability to produce ourother products, including our recently introduced family of advancedvideoscopes.

 

                On December 3,2007, we filed an Arbitration Demand with the International Center for DisputeResolution of the American Arbitration Association in New York City. As aresult of this demand for arbitration, negotiations commenced with Pentax to resolve thisdispute. Our goal is to have Pentax supply us with components in the quantitiesand prices that are necessary to meet our needs based on our forecast for neworders and for repairs. During this period we will seek to develop our nextgeneration line of fiberscopes, and obtain FDA clearance. Since we are stillnegotiating with Pentax, we are unable at this point to quantify the impact onour revenues and results of operations.

 

On February 12, 2008, we reached a satisfactory arrangement for thetransition of our supply relationship with Pentax. Under the terms of theagreement entered into with Pentax, we resolved our pending disputes and agreedto dismiss all related legal proceedings, over pricing, volumes and deliveryschedules for the components supplied by Pentax.  The agreement modified the terms of ourSupply Agreement with Pentax, dated March 16, 1992, as amended, by, among otherthings (i) moving forward the termination date of the supply relationship toFebruary 28, 2009 from March 15, 2009, and (ii) providing an agreed uponpurchase order and delivery schedule of components from Pentax through February28, 2009.

 

We expect that the agreement reached with Pentax will enable us to meetour estimated production requirements for fiberscopes over the next twelvemonths, and will give us sufficient time to secure alternative manufacturing,or supply arrangements with respect to the components supplied by Pentax, tomeet our expected future production requirements for fiberscopes. Our Q4 08revenues will be partially impacted by the shortage of Pentax components until weramp up production to full capacity. Pentax’s supply arrangement is limited tocomponents used in our fiberscopes only. Pentax does not supply components used in any other of our products,including any of our products under development, or any of our video-basedscopes. 

 

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**Item 1A.  RISK FACTORS**

 

                Set forth below and elsewhere in this report and in other documents wefile with the SEC are descriptions of the risks and uncertainties that couldcause our actual results to differ materially from the results contemplated bythe forward-looking statements contained in this report. The description belowincludes any material changes to, and amends and  supersedes, the description of the riskfactors affecting our business previously disclosed in “Part I,Item 1A. Risk Factors” of our Annual Report on Form 10-K for thefiscal year ended March 31, 2007.

 

                ***Our controller position isvacant, and we may have difficulty filling the position. Failure to fill thisposition may reduce our ability to accurately report our financial results.***

                Senior members of our accounting staff, including ourcontroller, have historically coordinated the management and application of ouraccounting systems and directed our financial activities, including preparingreports which summarize and forecast our business activities, including ourfinancial position in the areas of income, expenses, and earnings, based onpast, present, and expected operations. As a result, our ability to accurately measure our financial activitiesand manage our growth is largely dependent on the efforts and abilities of oursenior accountants.  Our controller, whohad been with us for only a short period, recently resigned on brief notice totake a position closer to his home. We are aware, and our auditors haveconfirmed, that without additional employees to fill our financial andadministrative functions, our limited accounting staff represents a risk to theCompany's  internal controls.  We are in the process of recruiting qualifiedadditional employees and/or consultants in a financial and accountingcapacity.  If we are unable to recruit,hire in the near term and retain qualified employees and/or consultants withfinancial and accounting functions, it is reasonably likely to materiallyaffect our internal controls over financial reporting.  Even if we are able to retain qualified staffin this capacity, any system of controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance that the desiredobjectives are met.  The market forqualified management-level accounting personnel is very competitive and we canmake no assurance that we will be able to quickly hire a controller withappropriate qualifications. Although we have retained outside staff on aconsulting basis for the interim, a failure to hire a controller withappropriate qualifications in the near future may have a material adverseeffect on our ability to manage our accounting activities, report our resultsand complete our required filings in a timely manner.

 

***                Wecurrently******purchase******certain criticalcomponents from several single source manufacturers under various  supplyagreements, and if these manufacturers are unable or unwilling to produce components,meeting our specifications in quantities that meet our production needs, ourbusiness will be harmed.***

 

We currently purchase certain critical components from several singlesource manufacturers under various supply agreements, and if thesemanufacturers are unable or unwilling to produce components, meeting ourspecifications in quantities that meet our production needs,*our business will be harmed.*

 

In our the medical and the industrial segments, we purchase certaincritical components for the majority of fiberscopes, such as image bundles,solely from a key supplier, Pentax, which is a competitor of ours. Thesecomponents are being purchased pursuant to a supply agreement now due to expirein February 2009. Although we recently settled our dispute with Pentax, ouragreement with them ends in one year and will not to be renewed.

 

We believe that while substitute components, which are currentlyproduced by sources other than Pentax, will be available, and we are startingthe design a new line of fiberscopes, a process which requires additionalregulatory clearances. Moreover, these substitute components may not beimmediately available in quantities and the quality needed by us. Our inabilityto obtain a sufficient quantity of such critical components on favorable termsand to obtain the required regulatory clearances for our new line offiberscopes soon enough to permit us to produce them in sufficient quantitiesto meet customer demand could materially adversely affect our business.

 

With respect to our new, digital, video-based flexible scopes, we alsodepend on several single source manufacturers for certain critical components.  The success of our new videoscopes willdepend in part, on our ability to manufacture these videoscopes in sufficientquantities to meet customer demand.  Thefailure or inability of one of these key suppliers to meet our production andquality needs could have a material adverse effect on the sales of our newvideoscopes, their acceptance into the marketplace and our long term prospects.

 

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***                We expect grossmargin to vary over time, and our level of product gross margin may not besustainable***

 

**               **Our level of product gross margins may not besustainable and may continue to be adversely affected by numerous factors,including:

 

                       ·      Changes in customer, geographic, orproduct mix

                       ·      Introduction of new products, includingthe introduction of the new family of videoscopes 

                       ·      Our ability to reduce production costs 

                       ·      Our entry into new markets, includingmarkets with different pricing and cost structures, through acquisitions, suchas our acquisition of the assets of BEST Dysphasia, Inc., or internaldevelopment 

                       ·      Increases in material or labor costs 

                       ·      Changes in shipment volume 

                       ·      Loss of cost savings due to changes incomponent pricing including the affect of foreign exchange rates for componentspurchased overseas

                       ·      Increased price competition, especiallydue to the anticipated introduction of our family of videoscopes 

                       ·      Changes in distribution channels

                       ·      Increased warranty costs

 

***                Wedepend on a small group of independent distributors for all of our revenues,and this dependence is likely to continue in the future.  Although we intend to expand this group,there is no assurance that we will be able to manage them.***

 

                In our medical and industrial segments, we depend ondistributors of medical devices and supplies and industrial equipment,respectively, for all of our product sales. Other than our ENT distributor, Medtronic, we do not have long-termcontracts with our distributors, but rather typically sell to them on aunit-by-unit basis. We expect this relatively small  group of distributors, which may change fromyear to year, to generate all of our product-sales revenue.  We cannot assure you that any distributorwill continue to purchase our products at the same levels as in prior years orthat such relationships will continue. We expect that in any given period arelatively small, and changing, number of distributors will continue to accountfor all of our product-sales revenues.

 

                Further, although we intend to significantly expandour current network of distributors, there is no assurance that we will succeedin doing so in the short term.  As weexpand our distribution network, our inability to effectively manage thislarger group may adversely impact our reputation among end users of our products,interfere with our ability to service existing customers and reduce ourrevenues from product sales, as further described below.

 

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***                We needto expand our urology outside sales force to maintain and grow our business and product-sale revenues. Our failureto expand and maintain an effective sales force or successfully develop ourrelationship with other distributors, may materially and adversely affect ourbusiness, prospects and brand.***

 

                We currently market and sell our existingfiber-scopes for our ENT business through a single distributor, Medtronic, andour other scopes through other outside distributors and sales representatives.As part of our growth plan, we intend to increase the number of distributors weutilize to distribute our fiberscopes and videoscopes.  We have limited experience in managing alarge sales force and distributor network. We cannot assure you that we will beable to maintain an effective sales force or successfully develop ourrelationships with third-party, outside distributors. If we fail to do any oneof those, our sales could fail to grow or could even decline, and our abilityto grow our business could be adversely affected. The expansion of our salesforce and distribution network is also likely to require a significantinvestment of financial resources and management efforts, and the benefits, ifany, which we gain from such expansion, may not be sufficient to generate anadequate return on our investment.

 

***                If wefail to effectively manage our distribution network, our business, prospectsand brand may be materially and affected by actions taken by our distributors.***

 

                We have a limited ability to manage the activities ofour third-party, outside distributors, who are independent from us. Ourdistributors could take one or more of the following actions, any of whichcould have a material adverse effect on our business, prospects and brand:

 

·                  sell products that compete withour products in breach of their non-competition agreements with us;

·                  fail to adequately promoteour products; or

·                  fail to provide proper service to our end-users.

 

                Failure to adequately manage our distributionnetwork, or the non-compliance of our distributors with their obligations underdistribution agreements with us, could harm our corporate image among end usersof our products and disrupt our sales, resulting in a failure to meet our salesgoals. Although we do not have significantly large overseas sales, foreigngovernments have increased their anti-bribery efforts in the healthcare sectorto reduce improper payments received by hospital administrators and doctors inconnection with the purchase of pharmaceutical products and medical devices. Toour knowledge, none of our distributors engages in corrupt practices. However,our distributors may violate these laws or otherwise engage in illegalpractices with respect to their sales or marketing of our products which wouldadversely affect our corporate image and business.

 

***                If wefail to increase awareness and acceptance of our new videoscope system in themedical community, we will not be able to grow or even sustain our business.***

 

                Our new, digital, video-based flexible scopes, whichcome with an integrated “built-in’’ light source, eliminating the need for aseparate camera head, light cable and optical coupler, use new  CCD technology, as opposed to olderfiber-optic technology. To penetrate the potential market for this family ofvideoscopes, we must increase market awareness and use of our new technology,which depends on, among other things, the following:

 

·                  the general levels of awareness and acceptance in themedical community of our family of videoscopes;

·                  the effectiveness of our videoscope system, which weintend to further refine through research and development activities;

·                  the relative costs and benefits of treatment using ourvideoscope system as compared to other treatments;

·                  the financial or other benefits gained by doctors thatuse our videoscope with our EndoSheath system;

·                  the amount of resources we have available to increaseproduct awareness and to educate potential purchasers and users of ourvideoscope system;

·                  our ability to continue to develop and enhance ourfamily of videoscopes;

·                  our ability to provide good technical support andcustomer service; and

·                  our ability to keep up with technological changesand remain competitive.

 

                We may not have the financial and operationalresources required to promote awareness and acceptance of our new videoscopessystems as widely or rapidly as is necessary to grow or sustain our business.Even if we were 

 

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to devote a substantialportion of our resources to promoting our product, we may not succeed inraising the levels of awareness and acceptance of our videoscopes as quickly asis necessary to grow or sustain our business, if at all. If we fail to increaseawareness and acceptance of our videoscopes in the medical community, we willnot be able to grow, or even sustain, our business as planned, harming ourfinancial condition and results of operations.

 

***                We maynot succeed in sustaining a market for our new videoscopes.***

 

                Certain of our new line of videoscopes only recentlyreceived 510k clearance from the FDA. Going forward, the long-term success ofour videoscope system depends on several factors, including our ability to:

 

·                  successfully promote product awareness of our videoscopes;

·                  competitively price our videoscopes andadd-on components;

·                  develop new applications to expand ourfamily of videoscopes;

·                  select effective distributors; and

·                  obtain additional regulatory approvals orclearances for new componentsor systems ina timely manner.

 

                Existing videoscope technology is a well-establishedmethod for obtaining clinical diagnoses. As a result, our videoscopes arecompeting in a market in which there are already several established industryplayers. We cannot assure you that we will be able to successfully market orsell our videoscopes in the future. We also cannot assure you that ourvideoscopes, or any future enhancements to our videoscopes, will generateadequate revenue to offset our investments and costs in acquiring, developingor marketing our videoscopes. If there is insufficient demand for ourvideoscopes, our business, financial condition and results of operations may beharmed. In addition, any announcement of new products, services or enhancementsby us or our competitors may cause our customers to cancel or postponepurchasing decisions for our existing products in anticipation of these newproducts, services or enhancements.

 

***                Rapidgrowth and a rapidly changing operating environment may strain our limitedresources.***

                

                Our growth strategy includes our efforts to build ourbrand, develop new products, increase market penetration of our new videoscopesand develop a new line of fiber-based scopes to replace those manufactured withcomponents supplied by Pentax. This growth strategy requires significantcapital resources, and we may not generate an adequate return on ourinvestment. Our growth may involve the acquisition of new technologies,businesses, products or services or the creation of strategic alliances inareas in which we do not currently operate. This could require our managementto develop expertise in new areas, manage new business relationships andattract new types of customers. We may also experience difficulties integratingthese acquired businesses, products or services into our existing business andoperations. The success of our growth strategy also depends in part on ourability to utilize our financial, operational and management resources and toattract, train, motivate and manage an increasing number of employees. Thesuccess of our growth strategy depends on a number of internal and externalfactors, such as:

 

·                  the growth of the market for medicaldevices and supplies;

·                  our ability to simultaneously develop anew line of fiber-based scopes and expand our videoscope family;

·                  increase customer awareness andacceptance of our products;

·                  continued enhancement of our research anddevelopment capabilities;

·                  competition from other manufacturers ofthese devices; and

·                  competition from other companies thatoffer these products, many of which are beyond our control.

 

                We may not be able to implement our growth strategysuccessfully or manage our expansion effectively.

 

                Further, as we ramp up our manufacturing operationsto accommodate our planned growth, we may encounter difficulties associatedwith increasing production scale, including shortages of qualified personnel tooperate our equipment, assemble our products or manage manufacturingoperations, as well as shortages of key raw materials or components for ourproducts. In addition, we may also experience difficulties in producingsufficient quantities of products or in achieving desired product quality. If weare unable to successfully operate and manage our manufacturing operations tomeet our needs, we may not be able to provide our customers with the quantityor quality of products they require in a timely manner. This could cause us tolose customers and result in reduced product-sale revenues.

 

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***                Ourcosts could substantially increase if we experience a significant number ofwarranty claims.***

 

                We provide 12-month product warranties againsttechnical defects of our fiberscopes, and intend to offer a similar warrantyfor our new line of videoscopes.  Ourproduct warranty requires us to repair defects arising from product design andproduction process, and if necessary, replace defective components. Historically,we have received a limited number of warranty claims for our fiberscopes, butwe are introducing a new line of videoscopes. The costs associated with our warranty claims have historically beenrelatively low. Thus, we generally do not accrue a significant liabilitycontingency for potential warranty claims. As we only recently developed ourvideoscope line, we do not currently have historical data on potential warrantyclaims.

 

                If we experience an increase in warranty claims, orif our repair and replacement costs associated with warranty claims increasesignificantly, we will begin to incur liabilities for potential warranty claimsafter the sale of our products. An increase in the frequency of warranty claimsor amount of warranty costs may harm our reputation and could have a materialadverse effect on our financial condition and results of operations.

 

***                Newproduct development in the medical device and supply industry is both costlyand labor-intensive and has a very low rate of successful commercialization*****.**

 

                Our success will depend in part on our ability toenhance our existing products and technologies, through the development ofalternate manufacturing lines for our fiberscopes, and to develop and acquirenew products, such our videoscopes. The development process for medicaltechnology is complex and uncertain, as well as time-consuming and costly.Product development requires the accurate assessment of technological andmarket trends as well as precise technological execution. We cannot assure youthat:

 

·                  our product or technology developmentwill be successfully completed;

·                  necessary regulatory clearances orapprovals will be granted by the FDA or other regulatory bodies as required ona timely basis, or at all; or

·                  any product or technology we develop canbe commercialized or will achieve market acceptance.

 

                We may also be unable to locate suitable products ortechnologies to acquire or acquire such products or technologies oncommercially reasonable terms. Failure to develop or acquire, obtain necessaryregulatory clearances or approvals for, or successfully commercialize or marketpotential new products or technologies could have a material adverse effect onour financial condition and results of operations.

 

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**Item 2.  Unregistered Sales of Equity Securities andUse of Proceeds.**

 

                N/A.

 

**Item 3.  DEFAULTS UPON SENIOR SECURITIES**

 

                N/A.

 

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

 

                N/A.

 

**Item 5.  OTHER INFORMATION**

 

                N/A.

 

**Item 6.  EXHIBITS**

 
| **Exhibits** | ** ** | ** **                                                                                                                                                                               |
|--------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1         |       | Certification of Chief Executive Officer pursuant to  Rule 13a-15(e)/15d-15(e), promulgated under the Securities Exchange Act  of 1934, as amended.                                 |
| 31.2         |       | Certification of Chief Financial Officer pursuant to  Rule 13a-15(e)/15d-15(e), promulgated under the Securities Exchange Act  of 1934, as amended.                                 |
| 32           |       | Certification of 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 therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                         | VISION-SCIENCES, INC.                                                                                                      |
|------------------------------|---------------------------------------------------------------------------------------------------------------------------------|
|                         |                                                                                                                            |
| Date: February 19, 2008 | /s/ RON HADANI                                                                                                                  |
|                         | Ron Hadani *President, CEO (Duly Authorized Officer)*                                                                           |
|                         |                                                                                                                            |
| Date: February 19, 2008 | /s/ YOAV M. COHEN                                                                                                               |
|                         | Yoav M. Cohen *Vice President Finance, Chief Financial  Officer (Principal Financial Officer and Principal Accounting Officer)* |

 

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