##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 
 FORM 10-Q
 (Mark One)
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended September 30, 2006
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to
 Commission file number: 0-24663
 
 ASPECT MEDICAL SYSTEMS, INC.
  Delaware
    
    04-2985553(State or Other Jurisdiction of
    
    (I.R.S. Employer Identification No.)Incorporation or Organization)141 Needham Street, Newton, Massachusetts
    
    02464-1505(Address of Principal Executive Offices)
    
    (Zip Code)
 (617) 559-7000
 
  þ o
  o þ o
  o þ




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##### 



PagePART I
    
    FINANCIAL INFORMATION
    
    
    1Item 1.
    
    Financial Statements
    
    
    1Consolidated Balance Sheets as of September 30, 2006 (unaudited) and December 31, 2005
    
    
    1Consolidated Statements of Operations for the Three and Nine Months Ended
September 30, 2006 and October 1, 2005 (unaudited)
    
    
    2Consolidated Statements of Cash Flows for the Nine Months Ended
September 30, 2006 and October 1, 2005 (unaudited)
    
    
    3Notes to Consolidated Financial Statements
    
    
    4Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    18Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    31Item 4.
    
    Controls and Procedures
    
    
    31PART II
    
    OTHER INFORMATION
    
    
    32Item 1A.
    
    Risk Factors
    
    
    32Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    45Item 6.
    
    Exhibits
    
    
    45SIGNATURESEx-31.1 Section 302 Certification of CEOEx-31.2 Section 302 Certification of CFOEx-32.1 Section 906 Certification of CEOEx-32.2 Section 906 Certification of CFO




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##### Table of Contents



PART I  FINANCIAL INFORMATION
 
 Item 1. FINANCIAL STATEMENTS.
 ASPECT MEDICAL SYSTEMS, INC.
 
 CONSOLIDATED BALANCE SHEETS
 (in thousands, except share data)
 September 30,
    
    
    December 31,2006
    
    
    2005(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    13,879
    
    
    $
    20,437Short-term
portion of restricted cash
    
    
    189
    
    
    
    82Short-term investments
    
    
    36,575
    
    
    
    23,254Accounts receivable, net of allowance of $213 at
September 30, 2006 and $116 at December 31, 2005
    
    
    11,168
    
    
    
    11,717Current portion of investment in sales-type leases
    
    
    1,503
    
    
    
    1,623Inventory
    
    
    6,924
    
    
    
    5,117Other current assets
    
    
    2,156
    
    
    
    1,484Total current assets
    
    
    72,394
    
    
    
    63,714Property and equipment, net
    
    
    6,068
    
    
    
    3,727Long-term
portion of restricted cash
    
    
    911
    
    
    
    Long-term investments
    
    
    11,883
    
    
    
    17,568Long-term investment in sales-type leases
    
    
    2,732
    
    
    
    2,123Total assets
    
    $
    93,988
    
    
    $
    87,132LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    2,695
    
    
    $
    2,393Accrued liabilities
    
    
    7,875
    
    
    
    10,196Deferred revenue
    
    
    3,428
    
    
    
    3,137Income taxes payable
    
    
    257
    
    
    
    Total current liabilities
    
    
    14,255
    
    
    
    15,726Long-term portion of deferred revenue
    
    
    3,644
    
    
    
    3,983Commitments and contingenciesStockholders equity:Preferred Stock, $.01 par value; 5,000,000 shares
authorized, no shares issued or outstanding
    
    
    
    
    
    
    Common Stock, $.01 par value; 60,000,000 shares
authorized, 22,269,490 and 22,281,155 shares issued
and outstanding at September 30, 2006 and December 31,
2005, respectively
    
    
    225
    
    
    
    222Treasury Stock, at cost; 276,493 shares
    
    
    (5,008
    )
    
    
    Additional paid-in capital
    
    
    165,886
    
    
    
    159,281Deferred compensation
    
    
    
    
    
    
    (498
    )Accumulated other comprehensive income (loss)
    
    
    5
    
    
    
    (84
    )Accumulated deficit
    
    
    (85,019
    )
    
    
    (91,498
    )Total stockholders equity
    
    
    76,089
    
    
    
    67,423Total liabilities and stockholders equity
    
    $
    93,988
    
    
    $
    87,132
  1




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 
 CONSOLIDATED STATEMENTS OF OPERATION
 (in thousands, except per share amounts)
 (unaudited)
 Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    October 1,
    
    
    September 30,
    
    
    October 1,2006
    
    
    2005
    
    
    2006
    
    
    2005Product revenue
    
    $
    21,145
    
    
    $
    18,602
    
    
    $
    62,767
    
    
    $
    53,683Strategic alliance revenue
    
    
    1,710
    
    
    
    991
    
    
    
    4,606
    
    
    
    1,735Total revenue
    
    
    22,855
    
    
    
    19,593
    
    
    
    67,373
    
    
    
    55,418Costs of revenue (1)
    
    
    5,317
    
    
    
    4,877
    
    
    
    16,074
    
    
    
    14,132Gross profit margin
    
    
    17,538
    
    
    
    14,716
    
    
    
    51,299
    
    
    
    41,286Operating expenses: (1)Research and development
    
    
    3,951
    
    
    
    2,695
    
    
    
    11,166
    
    
    
    7,080Sales and marketing
    
    
    8,826
    
    
    
    7,351
    
    
    
    26,687
    
    
    
    22,120General and administrative
    
    
    3,020
    
    
    
    2,532
    
    
    
    9,161
    
    
    
    7,969Total operating
expenses
    
    
    15,797
    
    
    
    12,578
    
    
    
    47,014
    
    
    
    37,169Income from operations
    
    
    1,741
    
    
    
    2,138
    
    
    
    4,285
    
    
    
    4,117Other income (expense):Interest income
    
    
    898
    
    
    
    522
    
    
    
    2,415
    
    
    
    1,316Interest expense
    
    
    
    
    
    
    (21
    )
    
    
    
    
    
    
    (48
    )Income before income taxes
    
    
    2,639
    
    
    
    2,639
    
    
    
    6,700
    
    
    
    5,385Provision for income taxes
    
    
    221
    
    
    
    
    
    
    
    221
    
    
    
    Net income
    
    $
    2,418
    
    
    $
    2,639
    
    
    $
    6,479
    
    
    $
    5,385Net income per share:Basic
    
    $
    0.11
    
    
    $
    0.12
    
    
    $
    0.29
    
    
    $
    0.25Diluted
    
    $
    0.10
    
    
    $
    0.11
    
    
    $
    0.27
    
    
    $
    0.23Weighted average shares used in
computing net income per share:Basic
    
    
    22,440
    
    
    
    21,664
    
    
    
    22,406
    
    
    
    21,325Diluted
    
    
    23,211
    
    
    
    24,176
    
    
    
    23,524
    
    
    
    23,737(1) Stock-based compensation
included in costs and expenses:Costs of revenue
    
    $
    107
    
    
    $
    3
    
    
    $
    318
    
    
    $
    9Research and development
    
    
    367
    
    
    
    10
    
    
    
    1,110
    
    
    
    54Sales and marketing
    
    
    616
    
    
    
    15
    
    
    
    1,844
    
    
    
    68General and administrative
    
    
    548
    
    
    
    25
    
    
    
    1,659
    
    
    
    76$
    1,638
    
    
    $
    53
    
    
    $
    4,931
    
    
    $
    207
  2




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (in thousands)
 (unaudited)
 Nine Months EndedSeptember 30,
    
    
    October 1,2006
    
    
    2005Cash flows from operating activities:Net income
    
    $
    6,479
    
    
    $
    5,385Adjustments to reconcile net income to net cash provided by
operating activities Depreciation and amortization
    
    
    1,115
    
    
    
    1,181Provision for doubtful accounts
    
    
    97
    
    
    
    109Compensation expense related to stock options and
restricted stock
    
    
    4,985
    
    
    
    207Changes in assets and liabilities Decrease (increase) in accounts receivable
    
    
    451
    
    
    
    (2,113
    )Increase in inventory
    
    
    (1,807
    )
    
    
    (2,747
    )Increase in other assets
    
    
    (672
    )
    
    
    (704
    )(Increase) decrease in investment in sales-type leases
    
    
    (490
    )
    
    
    145Increase (decrease) in accounts payable
    
    
    302
    
    
    
    (161
    )(Decrease) increase in accrued liabilities
    
    
    (2,321
    )
    
    
    461(Decrease) increase in deferred revenue
    
    
    (47
    )
    
    
    3,044Increase in income taxes payable
    
    
    257
    
    
    
    Net cash provided by operating activities
    
    
    8,349
    
    
    
    4,807Cash flows from investing activities:Increase in restricted cash
    
    
    (1,018
    )
    
    
    Payments on loans to related parties
    
    
    
    
    
    
    21Acquisition of property and equipment
    
    
    (3,456
    )
    
    
    (2,161
    )Purchases of marketable securities
    
    
    (51,260
    )
    
    
    (29,952
    )Proceeds from sales and maturities of marketable securities
    
    
    43,714
    
    
    
    31,129Net cash used for investing activities
    
    
    (12,020
    )
    
    
    (963
    )Cash flows from financing activities:Principal payments on debt related to investment in sales-type
leases
    
    
    
    
    
    
    (497
    )Purchases of treasury stock
    
    
    (5,008
    )
    
    
    Proceeds from issuance of common stock
    
    
    2,121
    
    
    
    7,555Net cash (used for) provided by financing activities
    
    
    (2,887
    )
    
    
    7,058Net decrease (increase) in cash and cash equivalents
    
    
    (6,558
    )
    
    
    10,902Cash and cash equivalents, beginning of period
    
    
    20,437
    
    
    
    14,761Cash and cash equivalents, end of period
    
    $
    13,879
    
    
    $
    25,663Supplemental disclosure of cash flow information:Interest paid
    
    $
    
    
    
    $
    48
  3




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (tabular amounts in thousands, except per share amounts)
 (unaudited)
 (1) Basis of Presentation
  (2) Summary of Significant Accounting Policies
  Principles of Consolidation
  Foreign Currency
  Cash, Cash Equivalents and Marketable Securities
  Accounting for Certain Investments
in Debt and Equity Securities
 4




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 Revenue Recognition
  Revenue Recognition, Revenue
Arrangements with Multiple Deliverables
 Accounting For Leases
    Accounting for
Contingencies
 5




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 Research and Development Costs
  Allowance for Doubtful Accounts
  Inventory
  Warranty
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    October 1,
    
    
    September 30,
    
    
    October 1,2006
    
    
    2005
    
    
    2006
    
    
    2005Beginning balance
    
    $
    201
    
    
    $
    143
    
    
    $
    159
    
    
    $
    137Warranty expense
    
    
    7
    
    
    
    34
    
    
    
    95
    
    
    
    80Deductions and other
    
    
    (11
    )
    
    
    (18
    )
    
    
    (57
    )
    
    
    (58
    )Ending balance
    
    $
    197
    
    
    $
    159
    
    
    $
    197
    
    
    $
    159
 Shipping and Handling Costs
  Advertising Costs
  6




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 Property and Equipment
 Accounting for the Costs of Computer Software Developed or Obtained
for Internal Use
 Income Taxes
   Concentration of Credit Risk
  Single or Limited Source Suppliers
  7




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 Net Income Per Share
 Earnings Per Share
   Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    October 1,
    
    
    September 30,
    
    
    October 1,2006
    
    
    2005
    
    
    2006
    
    
    2005Basic:Net income
    
    $
    2,418
    
    
    $
    2,639
    
    
    $
    6,479
    
    
    $
    5,385Weighted average shares outstanding
    
    
    22,440
    
    
    
    21,664
    
    
    
    22,406
    
    
    
    21,325Basic net income per share
    
    $
    0.11
    
    
    $
    0.12
    
    
    $
    0.29
    
    
    $
    0.25Diluted:Net income
    
    $
    2,418
    
    
    $
    2,639
    
    
    $
    6,479
    
    
    $
    5,385Weighted average shares outstanding
    
    
    22,440
    
    
    
    21,664
    
    
    
    22,406
    
    
    
    21,325Effect of dilutive stock options and
restricted stock
    
    
    771
    
    
    
    2,512
    
    
    
    1,118
    
    
    
    2,412Weighted average shares assuming
dilution
    
    
    23,211
    
    
    
    24,176
    
    
    
    23,524
    
    
    
    23,737Diluted net income per share
    
    $
    0.10
    
    
    $
    0.11
    
    
    $
    0.27
    
    
    $
    0.23
 Comprehensive Income
  Stock-Based Compensation
  8




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 Share Based Payment Accounting for Stock-Based Compensation Accounting for Stock Issued to Employees Statement of Cash Flows
     WeightedWeighted
    
    
    AverageNumber of
    
    
    Average
    
    
    Remaining
    
    
    Aggregate IntrinsicShares
    
    
    Exercise Price
    
    
    Contractual Life
    
    
    ValueOutstanding at December 31, 2005
    
    
    3,949
    
    
    $
    14.86Granted
    
    
    604
    
    
    
    27.81Exercised
    
    
    (248
    )
    
    
    7.88Canceled
    
    
    (75
    )
    
    
    22.95Outstanding at September 30, 2006
    
    
    4,230
    
    
    $
    16.97
    
    
    
    6.44
    
    
    $
    15,963Vested or expected to vest at
September 30, 2006
    
    
    4,139
    
    
    $
    16.85
    
    
    
    6.40
    
    
    $
    15,878Exercisable at September 30, 2006
    
    
    2,855
    
    
    $
    14.29
    
    
    
    5.49
    
    
    $
    14,671
  9




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
  Weighted AverageNumber of
    
    
    Grant Date FairShares
    
    
    ValueNonvested at December 31, 2005
    
    
    23
    
    
    $
    21.18Granted
    
    
    30
    
    
    
    26.89Vested
    
    
    (10
    )
    
    
    23.47Nonvested at September 30, 2006
    
    
    43
    
    
    $
    24.59
  :
  Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    October 1,
    
    September 30,
    
    October 1,2006
    
    2005
    
    2006
    
    2005Options granted
    
    
    45,000
    
    
    
    73,550
    
    
    
    604,485
    
    
    
    823,800Weighted average exercise price
    
    $
    14.38
    
    
    $
    31.85
    
    
    $
    27.81
    
    
    $
    22.42Weighted average grant date
fair value
    
    $
    6.99
    
    
    $
    14.58
    
    
    $
    12.08
    
    
    $
    10.40Assumptions:Risk-free interest rate
    
    
    4.97
    %
    
    
    4.22
    %
    
    
    4.72
    %
    
    
    3.72
    %Expected term
    
    5 years
    
    5 years
    
    5 years
    
    5 yearsExpected volatility
    
    
    49
    %
    
    
    55
    %
    
    
    42
    %
    
    
    50
    %Expected dividend yield
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
     10




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
  :
   Accounting for Stock-Based Compensation
 Three Months
    
    
    Nine MonthsEnded October 1,
    
    
    Ended October 1,2005
    
    
    2005Net income:Net income as reported
    
    $
    2,639
    
    
    $
    5,385Add: Stock-based employee
compensation expense
included in reported net
income
    
    
    
    
    
    
    Deduct: Stock-based
employee compensation
expense determined under
fair value based method
for all awards
    
    
    (1,445
    )
    
    
    (4,521
    )Pro forma net income
    
    $
    1,194
    
    
    $
    864Net income per share:Basic:As reported
    
    $
    0.12
    
    
    $
    0.25Pro forma
    
    $
    0.06
    
    
    $
    0.04Diluted:As reported
    
    $
    0.11
    
    
    $
    0.23Pro forma
    
    $
    0.05
    
    
    $
    0.04
 11




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
   Use of Estimates
  Fair Value of Financial Instruments
  Recent Accounting Pronouncements
 Fair Value Measurements
 Accounting for Uncertainty in
Income Taxes  an Interpretation of FASB Statement No. 109 Accounting for Income
Taxes
 12




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 (3) Comprehensive Income
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    October 1,
    
    
    September 30,
    
    
    October 1,2006
    
    
    2005
    
    
    2006
    
    
    2005Net income
    
    $
    2,418
    
    
    $
    2,639
    
    
    $
    6,479
    
    
    $
    5,385Other comprehensive income:Unrealized gain on
marketable
securities
    
    
    51
    
    
    
    
    
    
    
    88
    
    
    
    7Comprehensive income
    
    $
    2,469
    
    
    $
    2,639
    
    
    $
    6,567
    
    
    $
    5,392
 (4) Investment in Sales-Type Leases
  September 30,
    
    
    December 31,2006
    
    
    2005Total minimum lease payments receivable
    
    $
    6,040
    
    
    $
    5,275Less:Unearned interest income
    
    
    949
    
    
    
    752Allowance for lease payments
    
    
    854
    
    
    
    777Net investment in sales-type leases
    
    
    4,235
    
    
    
    3,746Less  current portion
    
    
    1,503
    
    
    
    1,623$
    2,732
    
    
    $
    2,123
 (5) Inventory
  September 30,
    
    
    December 31,2006
    
    
    2005Raw materials
    
    $
    3,512
    
    
    $
    2,939Work-in-progress
    
    
    102
    
    
    
    145Finished goods
    
    
    3,310
    
    
    
    2,033$
    6,924
    
    
    $
    5,117
 13




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 (6) Segment Information and Enterprise Reporting
   Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    October 1,
    
    
    September 30,
    
    
    October 1,2006
    
    
    2005
    
    
    2006
    
    
    2005Geographic Area by RegionDomestic
    
    $
    18,031
    
    
    $
    14,628
    
    
    $
    52,692
    
    
    $
    41,820International
    
    
    4,824
    
    
    
    4,965
    
    
    
    14,681
    
    
    
    13,598Total
    
    $
    22,855
    
    
    $
    19,593
    
    
    $
    67,373
    
    
    $
    55,418
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    October 1,
    
    September 30,
    
    October 1,2006
    
    2005
    
    2006
    
    2005Geographic Area by RegionDomestic
    
    
    79
    %
    
    
    75
    %
    
    
    78
    %
    
    
    75
    %International
    
    
    21
    
    
    
    25
    
    
    
    22
    
    
    
    25Total
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
  (7) Commitments and Contingencies
  14




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 (8) Related Party Transactions
   (9) Loan Agreements
    (10) Agreements with Boston Scientific Corporation
 2002 Strategic Alliance
  15




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
  2002 Line of Credit Agreement
  2004 Stock Purchase Agreement
  2005 Product Development and Distribution Agreement
  16




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
   (11) Stock Repurchase Program
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Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
 Overview
 ®
  InitialCommercial
    
    Date of Clearance ofProduct
    
    Shipment
    
    510 (k) Notification
    
    DescriptionBIS VIEW
    
    Pending
    
    Pending
    
    Value-priced standalone monitor
which has fewer optional user configurations compared with the BIS
VISTA monitor.BIS VISTA
    
    
    2006
    
    
    September 2005
    
    Monitor which offers an enhanced display and user interface, as well as
greater processing capability.BISx System
    
    
    2004
    
    
    February 2004
    
    BIS monitoring solution that provides the processing technology required
to obtain BIS information from a single device the approximate size of a
hockey puck. The BISx system is designed to integrate with a wide range
of patient monitoring platforms sold by original equipment
manufacturers.BIS XP System
    
    
    2001
    
    
    June 2001
    
    Latest version of BIS system offering enhanced performance capabilities
and expanded benefits as compared to the previous version of the BIS
system, designed to enable more precise measurement of brain activity to
assess the level of consciousness.BIS Module Kit  4
Channel Support
    
    
    2001
    
    
    October 2000
    
    Same as standard BIS Module Kit plus 4 channel EEG monitoring capability.A-2000 BIS Monitor
    
    
    1998
    
    
    February 1998
    
    Compact, lightweight, portable third-generation BIS monitor.BIS Module Kit
    
    
    1998
    
    
    October 2000
    
    Components of BIS monitoring technology that are integrated into
equipment sold by original equipment manufacturers.Semi-Reusable (SRS) 
Sensor
    
    
    2005
    
    
    February 2005
    
    Semi-reusable version of a BIS Sensor that uses the same algorithm and
hardware as our disposable sensors. Currently available only in markets
outside the United States, excluding Japan.BIS Extend Sensor
    
    
    2002
    
    
    October 2000
    
    Disposable sensor with electronic memory device for use with A-2000 BIS
Monitor, BIS Module Kit and BISx System that was designed for patients
who are typically monitored for extended periods.
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InitialCommercial
    
    Date of Clearance ofProduct
    
    Shipment
    
    510 (k) Notification
    
    DescriptionBIS Pediatric Sensor
    
    
    2001
    
    
    October 2000
    
    Disposable sensor with
electronic memory
device for use with
A-2000 BIS Monitor,
BIS Module Kit and
BISx System that is
smaller and designed
to be easier to apply
to children.BIS Quatro Sensor
    
    
    2001
    
    
    October 2000
    
    Disposable sensor with
electronic memory
device for use with
A-2000 BIS Monitor,
BIS Module Kit and
BISx System that is
designed to offer
enhanced performance
in deep anesthetic
states and enhanced
resistance to
interference from
noise sources.BIS Sensor Plus
    
    
    2001
    
    
    January 2000
    
    Second-generation
disposable sensor for
use with the A-2000
BIS Monitor and BIS
Module Kit.BIS Standard Sensor
    
    
    1997
    
    
    October 1996
    
    Disposable sensor for
use with A-2000 BIS
Monitor, A-1050 EEG
Monitor with BIS and
BIS Module Kit
  Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    October 1,
    
    September 30,
    
    October 1,2006
    
    2005
    
    2006
    
    2005(dollars in thousands)Domestic revenue
    
    $
    18,031
    
    
    $
    14,628
    
    
    $
    52,692
    
    
    $
    41,820Percent of total revenue
    
    
    79
    %
    
    
    75
    %
    
    
    78
    %
    
    
    75
    %International revenue
    
    $
    4,824
    
    
    $
    4,965
    
    
    $
    14,681
    
    
    $
    13,598Percent of total revenue
    
    
    21
    %
    
    
    25
    %
    
    
    22
    %
    
    
    25
    %Total revenue
    
    $
    22,855
    
    
    $
    19,593
    
    
    $
    67,373
    
    
    $
    55,418BIS Sensor revenue
    
    $
    16,126
    
    
    $
    13,458
    
    
    $
    47,578
    
    
    $
    39,081Percent of total revenue
    
    
    71
    %
    
    
    69
    %
    
    
    71
    %
    
    
    71
    %Equipment revenue
    
    $
    5,019
    
    
    $
    5,144
    
    
    $
    15,189
    
    
    $
    14,602Percent of total revenue
    
    
    22
    %
    
    
    26
    %
    
    
    22
    %
    
    
    26
    %Strategic alliance revenue
    
    $
    1,710
    
    
    $
    991
    
    
    $
    4,606
    
    
    $
    1,735Percent of total revenue
    
    
    7
    %
    
    
    5
    %
    
    
    7
    %
    
    
    3
    %Total revenue
    
    $
    22,855
    
    
    $
    19,593
    
    
    $
    67,373
    
    
    $
    55,418
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Share-Based
Payment Accounting for Stock Issued to Employees
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Quarterly Developments
  Critical Accounting Policies and Estimates
  Revenue Recognition
 Revenue
Recognition, Revenue Arrangements with Multiple
Deliverables
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Accounting For Leases
  Stock-Based Compensation
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Allowance for Doubtful Accounts
  Inventories
  Warranty
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Results of Operations
  Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    October 1,
    
    September 30,
    
    October 1,2006
    
    2005
    
    2006
    
    2005Revenue
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Costs of revenue
    
    
    23
    
    
    
    25
    
    
    
    24
    
    
    
    25Gross profit margin
    
    
    77
    
    
    
    75
    
    
    
    76
    
    
    
    75Operating expenses:Research and development
    
    
    17
    
    
    
    14
    
    
    
    16
    
    
    
    13Sales and marketing
    
    
    39
    
    
    
    37
    
    
    
    40
    
    
    
    40General and administrative
    
    
    13
    
    
    
    13
    
    
    
    14
    
    
    
    14Total operating expenses
    
    
    69
    
    
    
    64
    
    
    
    70
    
    
    
    67Income from operations
    
    
    8
    
    
    
    11
    
    
    
    6
    
    
    
    8Interest income, net
    
    
    4
    
    
    
    2
    
    
    
    4
    
    
    
    2Income before income taxes
    
    
    12
    %
    
    
    13
    %
    
    
    10
    %
    
    
    10
 Three and Nine Months Ended September 30, 2006 Compared with the Three and Nine Months Ended
October 1, 2005
 Three Months Ended
    
    
    Nine Months EndedPercentage
    
    
    
    
    
    
    
    
    
    
    PercentageSeptember 30,
    
    
    October 1,
    
    
    Increase
    
    
    September 30,
    
    
    October 1,
    
    
    Increase2006
    
    
    2005
    
    
    (Decrease)
    
    
    2006
    
    
    2005
    
    
    (Decrease)(in thousands, except
    
    
    
    
    
    (in thousands, except unitunit amounts)
    

    

    

    

    
    amounts)Revenue  WorldwideBIS Sensor
    
    $
    16,126
    
    
    $
    13,458
    
    
    
    20
    %
    
    $
    47,578
    
    
    $
    39,081
    
    
    
    22
    %BIS monitor
    
    
    3,408
    
    
    
    3,034
    
    
    
    12
    %
    
    
    9,726
    
    
    
    8,879
    
    
    
    10
    %Original equipment manufacturer products
    
    
    1,044
    
    
    
    1,490
    
    
    
    (30
    %)
    
    
    3,815
    
    
    
    3,848
    
    
    
    (1
    %)Other equipment and accessories
    
    
    567
    
    
    
    620
    
    
    
    (9
    %)
    
    
    1,648
    
    
    
    1,875
    
    
    
    (12
    %)Total Equipment
    
    
    5,019
    
    
    
    5,144
    
    
    
    (2
    %)
    
    
    15,189
    
    
    
    14,602
    
    
    
    4
    %Total product revenue
    
    
    21,145
    
    
    
    18,602
    
    
    
    14
    %
    
    
    62,767
    
    
    
    53,683
    
    
    
    17
    %Strategic alliance
    
    
    1,710
    
    
    
    991
    
    
    
    73
    %
    
    
    4,606
    
    
    
    1,735
    
    
    
    165
    %Total revenue
    
    $
    22,855
    
    
    $
    19,593
    
    
    
    17
    %
    
    $
    67,373
    
    
    $
    55,418
    
    
    
    22
    %Unit Analysis  WorldwideBIS Sensors
    
    
    1,144,000
    
    
    
    991,000
    
    
    
    15
    %
    
    
    3,354,000
    
    
    
    2,814,000
    
    
    
    19
    %BIS monitors
    
    
    1,094
    
    
    
    787
    
    
    
    39
    %
    
    
    3,139
    
    
    
    2,212
    
    
    
    42
    %Original equipment manufacturer
BIS products
    
    
    1,198
    
    
    
    1,350
    
    
    
    (11
    %)
    
    
    3,992
    
    
    
    3,714
    
    
    
    7
    %Installed base
    
    
    37,852
    
    
    
    29,650
    
    
    
    28
    %
    
    
    37,852
    
    
    
    29,484
    
    
    
    28
    %
 Revenue.
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Expense Overview
 Three Months Ended
    
    
    
    
    
    Nine Months EndedSeptember 30,
    
    October 1,
    
    Percentage
    
    September 30,
    
    October 1,
    
    Percentage2006
    
    2005
    
    Increase
    
    2006
    
    2005
    
    Increase(in thousands)
    
    (Decrease)
    
    (in thousands)
    
    (Decrease)ExpensesResearch and development
    
    $
    3,951
    
    
    $
    2,695
    
    
    
    47
    %
    
    $
    11,166
    
    
    $
    7,080
    
    
    
    58
    %Sales and marketing
    
    $
    8,826
    
    
    $
    7,351
    
    
    
    20
    %
    
    $
    26,687
    
    
    $
    22,120
    
    
    
    21
    %General and administrative
    
    $
    3,020
    
    
    $
    2,532
    
    
    
    19
    %
    
    $
    9,161
    
    
    $
    7,970
    
    
    
    15
    %
 Research and Development.
  Sales and Marketing.
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General and Administrative.
  Interest Income.
 Interest Expense.
 Net Income.
 Liquidity and Capital Resources
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Agreements with Boston Scientific Corporation
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Cash provided by operations.
 Cash used for investing activities.
 Cash used for financing activities.
  Off-Balance Sheet Arrangements
  Income Taxes
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Effects of Inflation
  Recent Accounting Pronouncements
 Fair Value Measurements
 Accounting for Uncertainty in
Income Taxes  an Interpretation of FASB Statement No. 109 Accounting for Income
Taxes
 Forward-Looking Statements
 This Quarterly Report on Form 10-Q contains, in addition to historical information,
forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of
1934, including information relating to our ability to maintain profitability, information with
respect to market acceptance of our BIS system, continued growth in sales of our BIS monitors,
original equipment manufacturer products and BIS Sensors, our dependence on the BIS system,
regulatory approvals for our products, our ability to remain competitive and achieve future growth,
information with respect to other plans and strategies for our business and factors that may
influence our revenue for the fiscal quarter ending December 31, 2006 and thereafter. These
forward-looking statements involve risks and uncertainties and are not guarantees of future
performance. Words such as expect, anticipate, intend, plan, believe, seek, estimate
and variations of these words and similar expressions are intended to identify forward-looking
statements. Our actual results could differ significantly from the results discussed in these
forward-looking statements. The important factors discussed under Part II  Item 1A. Risk Factors
below represent some of the current challenges to us that create risk and uncertainty. In addition,
subsequent events and developments may cause our expectations to change. While we may elect to
update these forward-looking statements we specifically disclaim any obligation to do so, even if
our expectations change.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk.
 Interest Rate Exposure
   Foreign Currency Exposure
  
 Item 4. Controls and Procedures.
 (a)
    
    Evaluation of Disclosure Controls and Procedures.Our management, with the participation of our chief executive officer and chief financial
officer evaluated the effectiveness of our disclosure controls and procedures as of September
30, 2006. The term disclosure controls and procedures, as defined in Rules 13a-15(e) and
15d-15(e) under the Exchange Act, means controls and other procedures of a company that are
designed to ensure that information required to be disclosed by a company in the reports that
it files or submits under the Exchange Act is recorded, processed, summarized and reported,
within the time periods specified in the SECs rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to ensure that
information required to be disclosed by a company in the reports that it files or submits
under the Exchange Act is accumulated and communicated to the companys management, including
its principal executive and principal financial officers, as appropriate to allow timely
decisions regarding required disclosure. Management recognizes that any controls and
procedures, no matter how well designed and operated, can provide only reasonable assurance
of achieving their objectives and management necessarily applies its judgment in evaluating
the cost-benefit relationship of possible controls and procedures. Based on the evaluation
of our disclosure controls and procedures as of September 30, 2006, our chief executive
officer and chief financial officer concluded that, as of such date, our disclosure controls
and procedures were effective at the reasonable assurance level.(b)
    
    Changes in Internal Controls.No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and
15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended September 30, 2006
that has materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting.
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PART II  OTHER INFORMATION
 
 Item 1A. Risk Factors
  We will not continue to be profitable if hospitals and anesthesia providers do not buy and use our
BIS system and purchase our BIS Sensors in sufficient quantities.
   We depend on our BIS system for substantially all of our revenue, and if the BIS system does not
gain widespread market acceptance, then our revenue will not grow.
  Various factors may adversely affect our quarterly operating results through the fourth fiscal
quarter of 2006.
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Fluctuations in our quarterly operating results could cause our stock price to decrease.
  
    
    the timing and volume of customer orders for our BIS system,
    
    market acceptance of our BIS VISTA,
    
    use of and demand for our BIS Sensors,
    
    transition of sales focus from BIS monitors to original equipment manufacturer products,
    
    customer cancellations,
    
    introduction of competitive products,
    
    regulatory approvals,
    
    changes in management,
    
    turnover in our direct sales force,
    
    effectiveness of new marketing and sales programs,
    
    communications published by industry organizations or other professional entities in the
anesthesia community that are unfavorable to our business,
    
    reductions in orders by our distributors and original equipment manufacturers, and
    
    the timing and amount of our expenses.
  If the estimates we make, and the assumptions on which we rely, in preparing our financial
statements prove inaccurate, our actual results may vary from those reflected in our financial
statements.
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We may need additional financing for our future capital needs and may not be able to raise
additional funds on terms acceptable to us, or at all.
  
    
    the research and development costs of our products currently under development increase
beyond current estimates,
    
    we decide to expand faster than currently planned,
    
    we develop new or enhanced services or products ahead of schedule,
    
    we decide to undertake new sales and/or marketing initiatives,
    
    we are required to defend or enforce our intellectual property rights,
    
    sales of our products do not meet our expectations domestically or internationally,
    
    we need to respond to competitive pressures, or
    
    we decide to acquire complementary products, businesses or technologies.
  Cases of awareness with recall during monitoring with the BIS system could limit market acceptance
of the BIS system and could expose us to product liability claims.
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We may not be able to compete with new products or alternative techniques developed by others,
which could impair our ability to remain competitive and achieve future growth.
  
    
    other new monitoring products, based on new or improved technologies,
    
    new products or technologies used on patients or in the operating room during surgery in
lieu of monitoring devices,
    
    electrical or mechanical interference from new or existing products or technologies,
    
    alternative techniques for evaluating the effects of anesthesia,
    
    significant changes in the methods of delivering anesthesia, and
    
    the development of new anesthetic agents.
  If we do not maintain our relationships with the anesthesia community, our growth will be limited
and our business could be harmed. If anesthesiologists and other healthcare providers do not
recommend and endorse our products, our sales may decline or we may be unable to increase our sales
and profits.
   Negative publicity or unfavorable media coverage could damage our reputation and harm our
operations
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If we do not successfully develop or acquire and introduce enhanced or new products we could lose
revenue opportunities and customers.
  
    
    identify in a timely manner new market trends;
    
    assess customer needs;
    
    successfully develop or acquire competitive products;
    
    complete regulatory clearance in a timely manner;
    
    successfully develop cost effective manufacturing processes;
    
    introduce such products to our customers in a timely manner; and
    
    achieve market acceptance.
  
    
    we may not successfully adapt the BIS system to function properly for procedural
sedation, when used with anesthetics we have not tested or with patient populations we
have not studied, such as infants, and
    
    our technology is complex, and we may not be able to develop it further for
applications outside anesthesia monitoring, such as the diagnosis and tracking of
neurological diseases.
   If our clinical trials are delayed or unsuccessful, our business could be adversely affected.
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
    
    delays or the inability to obtain required approvals from institutional review boards
or other governing entities at clinical sites selected for participation in our clinical
trials,
    
    delays in enrolling patients and volunteers into clinical trials,
    
    lower than anticipated retention rates of patients and volunteers in clinical trials,
    
    negative results from clinical trials for any of our potential products, including
those involving the management of depression and the early diagnosis and tracking of
Alzheimers disease, and
    
    failure of our clinical trials to demonstrate the efficacy or clinical utility of our
potential products.
  If we do not develop and implement a successful sales and marketing strategy, we will not expand
our business.
  
    
    provide or assure that distributors and original equipment manufacturers provide the
technical and educational support customers need to use the BIS system successfully,
    
    promote frequent use of the BIS system so that sales of our disposable BIS Sensors
increase,
    
    establish and implement successful sales and marketing and education programs that
encourage our customers to purchase our products or the products that are made by original
equipment manufacturers incorporating our technology,
    
    manage geographically dispersed operations, and
    
    modify our products and marketing and sales programs for foreign markets.
 We encourage our direct sales force, distributors and original equipment manufacturers to maximize
the amount of our products they sell and they may engage in aggressive sales practices that may
harm our reputation.
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Our third-party distribution and original equipment manufacturer relationships could negatively
affect our profitability, cause sales of our products to decline and be difficult to terminate if
we are dissatisfied.
  We may not be able to generate enough additional revenue from our international expansion to offset
the costs associated with establishing and maintaining foreign operations.
  We may not be able to meet the unique operational, legal and financial challenges that we will
encounter in our international operations, which may limit the growth of our business.
  
    
    failure of local laws to provide adequate protection against infringement of our
intellectual property,
    
    protectionist laws and business practices that favor local competitors, which could slow
our growth in international markets,
    
    difficulties in terminating or modifying distributor arrangements because of restrictions
in markets outside the United States,
    
    less acceptance by foreign anesthesia providers of the use of disposable products, such as BIS Sensors,
    
    delays in regulatory approval of our products,
    
    currency conversion issues arising from sales denominated in currencies other than the United States dollar,
    
    foreign currency exchange rate fluctuations,
    
    longer sales cycles to sell products like the BIS system to hospitals and outpatient
surgical centers, which could slow our revenue growth from international sales, and
    
    longer accounts receivable payment cycles and difficulties in collecting accounts
receivable.
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We may experience customer dissatisfaction and our reputation could suffer if we fail to
manufacture enough products to meet our customers demands.
  Our reliance on sole-source suppliers could adversely affect our ability to meet our customers
demands for our products in a timely manner or within budget.
  We
plan to relocate our facilities in December 2006 and it may cause disruption to our operations and
our business.
  We may be required to bring litigation to enforce our intellectual property rights, which may
result in substantial expense and may divert our attention from the implementation of our business
strategy.
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We may be sued by third parties which claim that our products infringe on their intellectual
property rights, particularly because there is substantial uncertainty about the validity and
breadth of medical device patents.
  
    
    cease selling, incorporating or using any of our products that incorporate the challenged
intellectual property, which would adversely affect our revenue,
    
    obtain a license from the holder of the infringed intellectual property right, which
license may not be available on reasonable terms, if at all, and
    
    redesign our products, which may be costly, time-consuming and may not be successful.
 We could be exposed to significant product liability claims which could divert management attention
and adversely affect our cash balances, our ability to obtain and maintain insurance coverage at
satisfactory rates or in adequate amounts and our reputation.
  Several class action lawsuits have been filed against the underwriters of our initial public
offering which may result in negative publicity and potential litigation against us that would be
costly to defend and the outcome of which is uncertain and may harm our business.
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Boston Scientific Corporation may be able to affect corporate actions requiring stockholder
approval because it owns a significant amount of our common stock. Additionally, if our strategic
alliance with Boston Scientific Corporation is not successful, our operating results could be
adversely affected.
  We may not reserve amounts adequate to cover product obsolescence, claims and returns, which could
result in unanticipated expenses and fluctuations in operating results.
  We may not be able to compete effectively, which could result in price reductions and decreased
demand for our products.
  Our ability to market and sell our products and generate revenue depends upon receipt of domestic
and foreign regulatory approval of our products and manufacturing operations.
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Even if we obtain the necessary FDA clearances or approvals, if we or our suppliers fail to comply
with ongoing regulatory requirements our products could be subject to restrictions or withdrawal
from the market.
  
    
    untitled letters, warning letters, fines, injunctions and civil penalties,
    
    administrative detention, which is the detention by the FDA of medical devices
believed to be adulterated or misbranded,
    
    customer notification, or orders for repair, replacement or refund,
    
    voluntary or mandatory recall or seizure of our products,
    
    operating restrictions, partial suspension or total shutdown of production,
    
    refusal to review pre-market notification or pre-market approval submissions,
    
    rescission of a substantial equivalence order or suspension or withdrawal of a pre-market approval, and
    
    criminal prosecution.
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We may be subject, directly or indirectly, to federal and state healthcare fraud and abuse laws and
regulations and, if we are unable to fully comply with such laws, could face substantial penalties.
  If we do not retain our senior management and other key employees, we may not be able to
successfully implement our business strategy.
  If we do not attract and retain skilled personnel, or if we do not maintain good relationships with
our employees, we will not be able to expand our business.
   Our employees may engage in misconduct or other improper activities, including insider trading.
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Failure of users of the BIS system, or users of future products we may develop, to obtain adequate
reimbursement from third-party payors could limit market acceptance of the BIS system and other
products, which could prevent us from sustaining profitability.
   Transactions engaged in by our largest stockholders, our directors or executives involving our
common stock may have an adverse effect on the price of our stock.
   We have various mechanisms in place to discourage takeover attempts, which may reduce or eliminate
our stockholders ability to sell their shares for a premium in a change of control transaction.
  
    
    preferred stock that could be issued by our board of directors to make it more
difficult for a third party to acquire, or to discourage a third party from acquiring,
a majority of our outstanding voting stock,
    
    classification of our directors into three classes with respect to the time for which they hold office,
    
    non-cumulative voting for directors,
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
    
    control by our board of directors of the size of our board of directors,
    
    limitations on the ability of stockholders to call special meetings of stockholders,
    
    inability of our stockholders to take any action by written consent, and
    
    advance notice requirements for nominations of candidates for election to our board
of directors or for proposing matters that can be acted upon by our stockholders at
stockholder meetings.
  
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
  ISSUER PURCHASES OF EQUITY SECURITIES (1)
 (c) Total Number of
    
    
    (d) MaximumShares Purchased as
    
    
    Number of Shares(a) Total Number
    
    
    
    
    
    
    Part of Publicly
    
    
    that May Yet beof Shares
    
    
    (b) Average Price
    
    
    Announced Plans or
    
    
    Purchased Under thePeriod
    
    Purchased
    
    
    Paid per Share
    
    
    Programs
    
    
    Plans or ProgramsAugust 10, 2006  August 31, 2006
    
    
    124,469
    
    
    $
    17.65
    
    
    
    124,469
    
    
    
    1,875,531September 1, 2006  September 22, 2006
    
    
    152,024
    
    
    $
    18.44
    
    
    
    152,024
    
    
    
    1,723,507Total
    
    
    276,493
    
    
    $
    18.08
    
    
    
    276,493
    
    
    
    1,723,507
 
 (1)
    
    All of the shares in this table were repurchased pursuant to our Share Repurchase Program
which was announced on August 4, 2006. Pursuant to the Share Repurchase Program, we may repurchase
up to 2,000,000 shares of our common stock on the open market or in privately negotiated
transactions. The timing and amount of any shares repurchased is
determined by a Committee of our Board of Directors. Repurchases may
also be made under a Rule 10b5-1 plan which would permit shares to be
repurchased during the periods of each fiscal quarter when trading in
our common stock is restricted under our insider trading policy. 
 Item 6. Exhibits.
  45




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SIGNATURE
  ASPECT MEDICAL SYSTEMS, INC.Date: November 9, 2006
    By:
    /s/ Michael FalveyMichael FalveyVice President and Chief Financial Officer
(Principal Financial and Accounting Officer) 46




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##### Table of Contents



EXHIBIT INDEX
 EXHIBITNUMBER
    
    EXHIBIT31.1
    
    Certification by Chief Executive Officer Pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as
amended.31.2
    
    Certification by Chief Financial Officer Pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as
amended.32.1
    
    Certification by Chief Executive Officer Pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.32.2
    
    Certification by Chief Financial Officer Pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.