##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION    FORM 10-Q (Mark One)  [X]
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 For the quarterly period ended October 2, 2004  [   ]
    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
(Registrants Telephone Number, Including Area Code)   Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. x o
 Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). x o
 The Registrant had 20,502,583 shares of Common Stock, $0.01 par value per
share, outstanding as of November 1, 2004.




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ASPECT MEDICAL SYSTEMS, INC. TABLE OF CONTENTS PagePART I
    
    FINANCIAL INFORMATION
    
    
    1Item 1.
    
    Financial Statements (Unaudited)
    
    
    1Consolidated Balance Sheets as of October 2, 2004 and December 31, 2003
    
    
    1Consolidated Statements of Operations for the Three and Nine Months Ended October 2, 2004 and September 27, 2003
    
    
    2Consolidated Statements of Cash Flows for the Nine Months Ended October 2, 2004 and September 27, 2003
    
    
    3Notes to Consolidated Financial Statements
    
    
    4Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    14Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    32Item 4.
    
    Controls and Procedures
    
    
    33PART II
    
    OTHER INFORMATION
    
    
    34Item 1.
    
    Legal Proceedings
    
    
    34Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    34Item 3.
    
    Defaults Upon Senior Securities
    
    
    34Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    34Item 5.
    
    Other Information
    
    
    34Item 6.
    
    Exhibits
    
    
    34SIGNATURE
    
    
    35EXHIBIT INDEXEX-10.1 Sixth Amendment to Loan AgreementEX-31.1 Section 302 CEO CertificationEX-31.2 Section 302 CFO CertificationEX-32.1 Section 906 CEO CertificationEX-32.2 Section 906 CFO Certification




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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) October 2,
    
    December 31,2004
    
    2003(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    12,205
    
    
    $
    12,344Restricted cash
    
    
    100
    
    
    
    5,100Short-term investments
    
    
    19,991
    
    
    
    13,719Accounts receivable, net of allowance of $41 at
October 2, 2004 and $150 at December 31, 2003
    
    
    6,535
    
    
    
    5,773Current portion of investment in sales-type leases
    
    
    1,736
    
    
    
    1,797Inventory, net
    
    
    1,997
    
    
    
    1,515Other current assets
    
    
    1,291
    
    
    
    1,146Total current assets
    
    
    43,855
    
    
    
    41,394Property and equipment, net
    
    
    2,637
    
    
    
    2,996Long-term investments
    
    
    8,214
    
    
    
    Long-term investment in sales-type leases
    
    
    2,360
    
    
    
    2,613Long-term portion of notes receivable from related parties
    
    
    256
    
    
    
    737Total assets
    
    $
    57,322
    
    
    $
    47,740LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Current portion of long-term debt
    
    $
    404
    
    
    $
    679Accounts payable
    
    
    1,215
    
    
    
    1,189Accrued liabilities
    
    
    7,460
    
    
    
    7,871Deferred revenue
    
    
    1,059
    
    
    
    975Total current liabilities
    
    
    10,138
    
    
    
    10,714Long-term portion of deferred revenue
    
    
    4,921
    
    
    
    5,533Long-term debt
    
    
    225
    
    
    
    525Commitments 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, 20,498,084 and 19,502,079 shares issued
and outstanding at October 2, 2004 and December 31,
2003, respectively
    
    
    205
    
    
    
    195Additional paid-in capital
    
    
    142,830
    
    
    
    131,131Notes receivable from employees and directors
    
    
    (34
    )
    
    
    (78
    )Accumulated other comprehensive loss
    
    
    (35
    )
    
    
    (4
    )Accumulated deficit
    
    
    (100,928
    )
    
    
    (100,276
    )Total stockholders equity
    
    
    42,038
    
    
    
    30,968Total liabilities and stockholders equity
    
    $
    57,322
    
    
    $
    47,740
 The accompanying notes are an integral part of these consolidated financial statements. 1




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ASPECT MEDICAL SYSTEMS, INC. 
 CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts) Three Months Ended
    
    Nine Months EndedOctober 2,
    
    September 27,
    
    October 2,
    
    September 27,2004
    
    2003
    
    2004
    
    2003(Unaudited)
    
    (Unaudited)
    
    (Unaudited)
    
    (Unaudited)Revenue
    
    $
    13,625
    
    
    $
    11,189
    
    
    $
    39,848
    
    
    $
    32,025Costs of revenue
    
    
    3,245
    
    
    
    2,761
    
    
    
    9,287
    
    
    
    8,027Gross profit margin
    
    
    10,380
    
    
    
    8,428
    
    
    
    30,561
    
    
    
    23,998Operating expenses:Research and development
    
    
    1,748
    
    
    
    1,626
    
    
    
    5,495
    
    
    
    5,370Sales and marketing
    
    
    6,129
    
    
    
    6,286
    
    
    
    19,443
    
    
    
    18,528General and administrative
    
    
    2,241
    
    
    
    2,070
    
    
    
    6,905
    
    
    
    6,352Total operating expenses
    
    
    10,118
    
    
    
    9,982
    
    
    
    31,843
    
    
    
    30,250Income (loss) from operations
    
    
    262
    
    
    
    (1,554
    )
    
    
    (1,282
    )
    
    
    (6,252
    )Interest income
    
    
    285
    
    
    
    215
    
    
    
    715
    
    
    
    702Interest expense
    
    
    (27
    )
    
    
    (48
    )
    
    
    (85
    )
    
    
    (156
    )Net income (loss)
    
    $
    520
    
    
    $
    (1,387
    )
    
    $
    (652
    )
    
    $
    (5,706
    )Net income (loss) per share:Basic
    
    $
    0.03
    
    
    $
    (0.07
    )
    
    $
    (0.03
    )
    
    $
    (0.29
    )Diluted
    
    $
    0.02
    
    
    $
    (0.07
    )
    
    $
    (0.03
    )
    
    $
    (0.29
    )Weighted average shares used in
computing
net income (loss) per
share:Basic
    
    
    20,461
    
    
    
    19,421
    
    
    
    19,986
    
    
    
    19,399Diluted
    
    
    22,433
    
    
    
    19,421
    
    
    
    19,986
    
    
    
    19,399
 The accompanying notes are an integral part of these consolidated financial statements. 2




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ASPECT MEDICAL SYSTEMS, INC. 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands) Nine Months EndedOctober 2,
    
    September 27,2004
    
    2003(Unaudited)
    
    (Unaudited)Cash flows from operating activities:Net loss
    
    $
    (652
    )
    
    $
    (5,706
    )Adjustments to reconcile net loss to net cash used for
operating activities Depreciation and amortization
    
    
    1,156
    
    
    
    1,556Provision for doubtful accounts
    
    
    (39
    )
    
    
    (150
    )Compensation expense related to stock options
    
    
    61
    
    
    
    27Changes in assets and liabilities Increase in accounts receivable
    
    
    (723
    )
    
    
    (505
    )(Increase) decrease in inventory
    
    
    (482
    )
    
    
    699Increase in other assets
    
    
    (165
    )
    
    
    (226
    )Decrease (increase) in investment in sales-type leases
    
    
    314
    
    
    
    (127
    )Increase (decrease) in accounts payable
    
    
    26
    
    
    
    (149
    )(Decrease) increase in accrued liabilities
    
    
    (411
    )
    
    
    390Decrease in deferred revenue
    
    
    (528
    )
    
    
    (698
    )Net cash used for operating activities
    
    
    (1,443
    )
    
    
    (4,889
    )Cash flows from investing activities:Payments on loans to related parties
    
    
    501
    
    
    
    122Acquisition of property and equipment
    
    
    (797
    )
    
    
    (492
    )Decrease in restricted cash
    
    
    5,000
    
    
    
    Purchases of marketable securities
    
    
    (29,577
    )
    
    
    (12,035
    )Proceeds from sales and maturities of marketable securities
    
    
    15,060
    
    
    
    15,987Net cash (used for) provided by investing activities
    
    
    (9,813
    )
    
    
    3,582Cash flows from financing activities:Proceeds from sale of investment in sales-type leases
    
    
    
    
    
    
    266Principal payments on debt related to investment in sales-type
leases
    
    
    (575
    )
    
    
    (738
    )Proceeds from issuance of common stock
    
    
    11,648
    
    
    
    155Payments received on notes receivable from employees and
directors
    
    
    44
    
    
    
    154Net cash provided by (used for) financing activities
    
    
    11,117
    
    
    
    (163
    )Net decrease in cash and cash equivalents
    
    
    (139
    )
    
    
    (1,470
    )Cash and cash equivalents, beginning of period
    
    
    12,344
    
    
    
    11,543Cash and cash equivalents, end of period
    
    $
    12,205
    
    
    $
    10,073Supplemental disclosure of cash flow information:Interest paid
    
    $
    85
    
    
    $
    156
 The accompanying notes are an integral part of these consolidated financial statements. 3




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ASPECT MEDICAL SYSTEMS, INC. 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands except per share amounts)
(Unaudited) (1) Basis of Presentation The accompanying unaudited consolidated financial statements of Aspect
Medical Systems, Inc. (the Company) have been prepared in accordance with
accounting principles generally accepted in the United States for interim
financial information and with the instructions to Form 10-Q and Regulation
S-X. Accordingly, they do not include all of the information and footnotes
required by accounting principles generally accepted in the United States for
complete financial statements. In the opinion of management, all normal,
recurring adjustments considered necessary for a fair presentation have been
included. The unaudited consolidated financial statements and notes included
herein should be read in conjunction with the audited consolidated financial
statements for the year ended December 31, 2003 included in the Companys
Annual Report on Form 10-K filed with the Securities and Exchange Commission
(the SEC). Interim results of operations are not necessarily indicative of
the results to be expected for the full year or any other interim period. (2) Summary of Significant Accounting Policies A summary of the significant accounting policies used by the Company in
the preparation of its financial statements follows: Principles of Consolidation The consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries. All intercompany accounts and
transactions have been eliminated. Foreign Currency The functional currency of the Companys international subsidiaries is
the U.S. dollar. Foreign currency transaction gains and losses are recorded
in the consolidated statements of operations and have not been material. Cash, Cash Equivalents and Investments The Company invests its excess cash in money market accounts,
certificates of deposit, high-grade commercial paper, high grade corporate
bonds and debt obligations of various government agencies. The Company
considers all highly liquid debt instruments purchased with an original
maturity of three months or less to be cash equivalents. The Company accounts for its investments in accordance with Statement of
Financial Accounting Standards (SFAS) No. 115, Accounting for Certain
Investments in Debt and Equity Securities. In accordance with SFAS No. 115,
the Company has classified all of its investments as available-for-sale at
October 2, 2004 and December 31, 2003. The investments are reported at fair
value, with any unrealized gains and losses excluded from earnings and
reported as a separate component of stockholders equity as accumulated other
comprehensive income (loss). Investments that have contractual maturities of
more than twelve months are included in long-term investments in the
accompanying consolidated balance sheets. Revenue Recognition The Company sells its BIS monitors primarily through a combination of a
direct sales force and distributors. The Company sells its BIS Module Kits to
original equipment manufacturers who in turn sell them to the end-user. BIS
Sensors are sold through a combination of a direct sales force, distributors
and original equipment manufacturers. Direct product sales are structured as
sales, sales-type lease arrangements or sales under the Companys Equipment
Placement (EP) program. Sales, sales-type lease agreements and sales under
the EP program are subject to the Companys standard terms and conditions of
sale and do not include any customer acceptance criteria, installation or
other post shipment obligations (other than warranty) or any rights of
return. The Companys BIS monitor is a standard product and does not require
installation as it can be operated with the instructions included in the
operators manual. 4




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands except per share amounts)
(Unaudited) The Company recognizes revenue from product sales when earned in
accordance with Staff Accounting Bulletin (SAB) No. 104, Revenue
Recognition,and Emerging Issues Task Force (EITF) 00-21, Revenue
Arrangements with Multiple Deliverables. Revenue is recognized when
persuasive evidence of an arrangement exists, product delivery has occurred
or services have been rendered, the price is fixed or determinable and
collectibility is reasonably assured. For product sales, revenue is not
recognized until title and risk of loss have transferred to the customer. The Company follows SFAS No. 13, Accounting For Leases, for its
sales-type lease agreements. Under the Companys sales-type leases,
customers purchase BIS Sensors and the BIS monitor for the purchase price of
the BIS Sensors plus an additional charge per BIS Sensor to pay for the
purchase price of the BIS monitor and related financing costs over the term
of the agreement. In accordance with SFAS No. 13, the minimum lease payment,
consisting of the additional charge per BIS Sensor, less the unearned
interest income, which is computed at the interest rate implicit in the
lease, is recorded as the net investment in sales-type leases. The Company
recognizes equipment revenue under sales-type lease agreements either at
shipment or delivery in accordance with the agreed upon contract terms with
interest income recognized over the life of the sales-type lease. The cost
of the BIS monitor acquired by the customer is recorded as costs of revenue
in the same period. In addition, the Company reviews and assesses the net realizability of
its investment in sales-type leases at each reporting period. This review
includes determining, on a customer specific basis, if a customer is
significantly underperforming relative to the customers cumulative level of
committed BIS Sensor purchases as required by the sales-type lease agreement.
If a customer is underperforming, the Company records an allowance for lease
payments as a charge to revenue to reflect the lower estimate of the net
realizable investment in sales-type lease balance. As of October 2, 2004, the Company does not consider any sales-type
lease agreement, against which an allowance for lease payments has been
established, an impaired asset. Under the Companys EP program, the customer is granted the right to use
the BIS monitors for a mutually agreed upon period of time. During this
period, the customer purchases BIS Sensors at a price that includes a premium
above the list price of the BIS Sensors to cover the rental of the equipment,
but without any minimum purchase commitments. At the end of the agreed upon
period, the customer has the option of purchasing the BIS monitors,
continuing to use them under the EP program or returning them to the Company.
Under the EP program, no equipment revenue is recognized as the equipment
remains the Companys property and title does not pass to the customer, and
the criteria for sales-type leases under SFAS No. 13 are not met. The BIS
monitors under the EP program are depreciated over two years and the
depreciation is charged to costs of revenue. BIS Sensor revenue is
recognized either at shipment or delivery of the BIS Sensors in accordance
with the agreed upon contract terms. The Companys obligations under warranty are limited to repair or
replacement of any product that the Company reasonably determines to be
covered by the warranty. The Company records an estimate for its total
warranty obligation in accordance with SFAS No. 5, Accounting for
Contingencies. In connection with the Stock Purchase Agreement and OEM Product
Development Agreement with Boston Scientific Corporation (BSC) discussed in
Note 9, the Company recorded approximately $6,300,000 of deferred revenue in
August 2002. The deferred revenue is being recognized ratably over the term
of the OEM product development and distribution agreement with BSC, which
represents the Companys best estimate of its period of significant
continuing obligation to provide BSC exclusive distribution rights to newly
developed technology. The term of the OEM product development and
distribution agreement continues until such time that BSC is no longer
distributing the Companys products, but in no event will extend beyond
December 31, 2012. Research and Development Costs The Company charges research and development costs to operations as
incurred. Research and development costs include costs associated with new
product development, product improvements and extensions, clinical studies
and project consulting expenses. 5




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands except per share amounts)
(Unaudited) Accounts Receivable Estimates are used in determining the Companys allowance for doubtful
accounts based on the Companys historical collections experience, historical
write-offs of its receivables, current trends, credit policy and a percentage
of the Companys accounts receivable by aging category. The Company also
reviews the credit quality of its customer base as well as changes in its
credit policies. The Company continually monitors collections and payments
from its customers. Inventory The Company values inventory at the lower of cost or estimated market,
and determines cost on a first-in, first-out basis. The Company regularly
reviews inventory quantities on hand and records a provision for excess or
obsolete inventory primarily based on production history and on its estimated
forecast of product demand. The medical device industry in which the Company
markets its products is characterized by rapid product development and
technological advances that could result in obsolescence of inventory.
Additionally, the Companys estimates of future product demand may prove to
be inaccurate, in which case it would need to change its estimate of the
provision required for excess and obsolete inventory. If revisions are
deemed necessary, the Company would recognize the adjustments in the form of
a charge to its costs of revenue at the time of the determination. Warranty Equipment that the Company sells is generally covered by a warranty
period of one year. The Company accrues a warranty reserve for estimated
costs to provide such warranty services. The Companys estimate of costs to
service its warranty obligations is based on historical experience and an
expectation of future conditions. Warranty expense for the three and nine
months ended October 2, 2004 and September 27, 2003 and accrued warranty
cost, included in accrued liabilities in the consolidated balance sheet at
October 2, 2004 was as follows: Three Months Ended
    
    Nine Months EndedOctober 2,
    
    September 27,
    
    October 2,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Beginning balance
    
    $
    156
    
    
    $
    163
    
    
    $
    147
    
    
    $
    368Warranty expense
    
    
    14
    
    
    
    6
    
    
    
    64
    
    
    
    (169
    )Deductions and other
    
    
    (31
    )
    
    
    (24
    )
    
    
    (72
    )
    
    
    (54
    )Ending balance
    
    $
    139
    
    
    $
    145
    
    
    $
    139
    
    
    $
    145
 Guarantees The Company guarantees operating lease obligations of its subsidiaries
for the lease of automobiles. The maximum potential future payment under
these financial guarantees was approximately $287,000 at October 2, 2004. Shipping and Handling Costs Shipping and handling costs are included in costs of revenue. Advertising Costs Advertising costs are expensed as incurred. These costs are included in
sales and marketing expense in the consolidated statements of operations. 6




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands except per share amounts)
(Unaudited) Property and Equipment Property and equipment is recorded at cost and depreciated using the
straight-line method over the estimated useful lives of the related
equipment. Equipment held under capital leases is stated at the lower of the
fair market value of the equipment or the present value of the minimum lease
payments at the inception of the lease, and is amortized using the
straight-line method over the shorter of the lives of the related assets or
the term of the leases. Repair and maintenance expenditures are charged to
expense as incurred. The Company does not develop software for internal use
and the costs of software acquired for internal use are accounted for in
accordance with the American Institute of Certified Public Accountants
Statement of Position 98-1, Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use. Income Taxes The Company accounts for income taxes in accordance with SFAS No. 109,
Accounting for Income Taxes. Under this method, deferred tax assets and
liabilities are recognized for the expected future tax consequences,
utilizing currently enacted tax rates, of temporary differences between the
carrying amounts and the tax basis of assets and liabilities. Deferred tax
assets are recognized, net of any valuation allowance, for the estimated
future tax effects of deductible temporary differences and tax operating loss
and credit carryforwards. Concentration of Credit Risk Financial instruments that potentially expose the Company to
concentrations of credit risk primarily consist of cash, cash equivalents,
investments, accounts receivable and investment in sales-type lease
receivables. To minimize the financial statement risk with respect to
accounts receivable and investment in sales-type lease receivables, the
Company maintains reserves for potential credit losses and such losses, in
the aggregate, have not exceeded managements expectations. The Company
maintains cash, cash equivalents and investments with various financial
institutions. The Company performs periodic evaluations of the relative
credit quality of investments and Company policy is designed to limit
exposure to any one institution or type of investment. The primary objective
of the Companys investment strategy is the safety of the principal invested.
The Company does not maintain foreign exchange contracts or other
off-balance sheet financial investments. Single or Limited Source Suppliers The Company currently obtains certain key components of its products
from single or limited sources. The Company purchases components pursuant to
purchase orders rather than long-term supply agreements and generally does
not maintain large volumes of inventory. The Company has experienced
shortages and delays in obtaining certain components of its products in the
past. The Company may experience similar shortages and delays in the future.
The disruption or termination of the supply of components or a significant
increase in the costs of these components from these sources could have a
material adverse effect on the Companys business, financial position and
results of operations. Net Income (Loss) Per Share In accordance with SFAS No. 128, Earnings Per Share, basic and diluted
net income (loss) per share amounts for the three and nine months ended
October 2, 2004 and September 27, 2003, were computed by dividing the net
income (loss) available to common stockholders by the weighted average number
of common shares outstanding during those periods. For
the nine months ended October 2, 2004, the Company has excluded
from the calculation of the Companys diluted net loss per share
approximately 2,049,000 shares of common stock issuable pursuant
to the exercise of stock options because the inclusion of these
shares would have been antidilutive as a result of the Companys net
loss position. For the three and nine months ended September 27,
2003, the Company has excluded from the calculation of the
Companys diluted net loss per share approximately 1,226,000 and
839,000 shares of common stock issuable pursuant to the exercise
of stock options and warrants because the inclusion of these shares
would have been antidilutive. 7




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands except per share amounts)
(Unaudited) Basic and diluted net income (loss) per share for the three and nine
months ended October 2, 2004 and September 27, 2003 were determined as
follows: Three Months Ended October 2, 2004
    
    Three Months Ended September 27, 2003Per Share
    
    
    
    
    
    
    
    
    
    Per ShareNet Income
    
    Shares
    
    Amount
    
    Net Loss
    
    Shares
    
    AmountBasic net income (loss)
per share
    
    $
    520
    
    
    
    20,461
    
    
    $
    0.03
    
    
    $
    (1,387
    )
    
    
    19,421
    
    
    $
    (0.07
    )Effect of dilutive
options
    
    
    
    
    
    
    1,972
    
    
    
    (0.01
    )
    
    
    
    
    
    
    
    
    
    
    Diluted net income
(loss) per share
    
    $
    520
    
    
    
    22,433
    
    
    $
    0.02
    
    
    $
    (1,387
    )
    
    
    19,421
    
    
    $
    (0.07
    )
 Nine Months Ended October 2, 2004
    
    Nine Months Ended September 27, 2003Per Share
    
    
    
    
    
    
    
    
    
    Per ShareNet Loss
    
    Shares
    
    Amount
    
    Net Loss
    
    Shares
    
    AmountBasic net loss per share
    
    $
    (652
    )
    
    
    19,986
    
    
    $
    (0.03
    )
    
    $
    (5,706
    )
    
    
    19,399
    
    
    $
    (0.29
    )Effect of dilutive
options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Diluted net loss per
share
    
    $
    (652
    )
    
    
    19,986
    
    
    $
    (0.03
    )
    
    $
    (5,706
    )
    
    
    19,399
    
    
    $
    (0.29
    )
 Comprehensive Income (Loss) Comprehensive income (loss) is defined as the change in equity of a
business enterprise during a period from transactions and other events and
circumstances from non-owner sources. Other than the Companys net income
(loss), the only other element of comprehensive income (loss) impacting the
Company is the unrealized gains (losses) on its investments for all periods
presented. Stock-Based Compensation SFAS No. 123, Accounting for Stock-Based Compensation, requires the
measurement of the fair value of stock options or warrants to be included in
the statement of income or disclosed in the notes to financial statements.
The Company accounts for stock-based compensation for employees using the
intrinsic value method under APB Opinion No. 25 and has adopted the fair
value disclosure-only alternative under SFAS No. 148, Accounting for
Stock-Based Compensation  Transition and Disclosure. The Company has
computed the weighted-average fair value of options granted in the three and
nine months ended October 2, 2004 and September 27, 2003 using the
Black-Scholes option-pricing model pursuant to SFAS No. 123. The following
table shows the weighted average assumptions used in the applicable periods
and the weighted average fair market value of the options granted in each
period. Three Months Ended
    
    Nine Months EndedOctober 2,
    
    September 27,
    
    October 2,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Risk-free interest rate
    

3.63%
    
2.63%
    

3.21%
    
2.96%Expected dividend yield
    

    
    
    

    
Expected life of options
    
    5 years
    
    5 years
    
    5 years
    
    5 yearsExpected volatility
    
55%
    
57%
    
55%
    
57%Weighted average fair
market value of options
granted
    
$8.21
    
$4.26
    
$8.92
    
$2.40
 8




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands except per share amounts)
(Unaudited) If the Company had recognized compensation cost for these awards
consistent with SFAS No. 123, the Companys net income (loss) and pro forma
net loss per common share would have been changed to the following pro forma
amounts: Three Months Ended
    
    Nine Months EndedOctober 2,
    
    September 27,
    
    October 2,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Net income (loss):Net income (loss) as reported
    
    $
    520
    
    
    $
    (1,387
    )
    
    $
    (652
    )
    
    $
    (5,706
    )Add: Stock-based employee
compensation expense
included in reported net
income (loss)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Deduct: Stock-based
employee compensation
expense determined under
fair value based method
for all awards
    
    
    (1,478
    )
    
    
    (1,767
    )
    
    
    (5,402
    )
    
    
    (5,474
    )Pro forma net loss
    
    $
    (958
    )
    
    $
    (3,154
    )
    
    $
    (6,054
    )
    
    $
    (11,180
    )Net income (loss) per share:Basic  as reported
    
    $
    0.03
    
    
    $
    (0.07
    )
    
    $
    (0.03
    )
    
    $
    (0.29
    )Basic  pro forma
    
    $
    (0.05
    )
    
    $
    (0.16
    )
    
    $
    (0.30
    )
    
    $
    (0.58
    )Diluted  as reported
    
    $
    0.02
    
    
    $
    (0.07
    )
    
    $
    (0.03
    )
    
    $
    (0.29
    )Diluted  pro forma
    
    $
    (0.05
    )
    
    $
    (0.16
    )
    
    $
    (0.30
    )
    
    $
    (0.58
    )
 The Black-Scholes option-pricing model was developed for use in estimating
the fair value of traded options, which have no vesting restrictions and are
fully transferable. In addition, option-pricing models require the input of
highly subjective assumptions, including expected stock price volatility.
Because the Companys employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in
managements opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options. Also, because
options vest over several years and the Company expects to grant options in
future years, the above pro forma results of applying the provisions of SFAS
No. 123 are not necessarily representative of the pro forma results in future
years. Use of Estimates The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates. Fair Value of Financial Instruments The estimated fair market values of the Companys financial instruments,
which include cash equivalents, investments, accounts receivable, investment in
sales-type leases, accounts payable and long-term debt, approximate their
carrying values. Reclassifications Certain amounts in the prior years financial statements have been
reclassified to conform with the current-year presentation. 9




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands except per share amounts)
(Unaudited) (3) Comprehensive Income (Loss) The Companys total comprehensive income (loss) is as follows: Three Months Ended
    
    Nine Months EndedOctober 2,
    
    September 27,
    
    October 2,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Net income (loss)
    
    $
    520
    
    
    $
    (1,387
    )
    
    $
    (652
    )
    
    $
    (5,706
    )Other comprehensive income (loss):Unrealized gain (loss) on
investments
    
    
    1
    
    
    
    (19
    )
    
    
    (31
    )
    
    
    (18
    )Comprehensive income (loss)
    
    $
    521
    
    
    $
    (1,406
    )
    
    $
    (683
    )
    
    $
    (5,724
    )
 (4) Investment in Sales-Type Leases The components of the Companys net investment in sales-type leases are
as follows: October 2,
    
    December 31,2004
    
    2003(Unaudited)Total minimum lease payments receivable
    
    $
    5,958
    
    
    $
    6,493Less:Unearned interest income
    
    
    856
    
    
    
    985Allowance for lease payments
    
    
    1,006
    
    
    
    1,098Net investment in sales-type leases
    
    
    4,096
    
    
    
    4,410Less  current portion
    
    
    1,736
    
    
    
    1,797Long-term investment in sales-type
leases
    
    $
    2,360
    
    
    $
    2,613
 (5) Inventory Inventory consists of the following: October 2,
    
    December 31,2004
    
    2003(Unaudited)Raw materials
    
    $
    1,061
    
    
    $
    739Work-in-progress
    
    
    36
    
    
    
    62Finished goods
    
    
    900
    
    
    
    714Inventory, net
    
    $
    1,997
    
    
    $
    1,515
 10




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands except per share amounts)
(Unaudited) (6) Segment Information and Enterprise Reporting The Company operates in one reportable segment as it markets and sells
one product line of anesthesia monitoring systems. The Company does not
disaggregate financial information by product or geographically, other than
export sales by region and sales by product, for management purposes.
Substantially all of the Companys assets are located within the United
States. All of the Companys products are manufactured in the United States. Revenue by geographic destination and as a percentage of total revenue
is as follows: Three Months Ended
    
    Nine Months EndedOctober 2,
    
    September 27,
    
    October 2,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Geographic Area by DestinationDomestic
    
    $
    10,477
    
    
    $
    9,220
    
    
    $
    31,299
    
    
    $
    25,838International
    
    
    3,148
    
    
    
    1,969
    
    
    
    8,549
    
    
    
    6,187Total
    
    $
    13,625
    
    
    $
    11,189
    
    
    $
    39,848
    
    
    $
    32,025
 Three Months Ended
    
    Nine Months EndedOctober 2,
    
    September 27,
    
    October 2,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Geographic Area by DestinationDomestic
    
    
    77
    %
    
    
    82
    %
    
    
    79
    %
    
    
    81
    %International
    
    
    23
    
    
    
    18
    
    
    
    21
    
    
    
    19Total
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
 The Company did not have sales in any individual country, other than the
United States, that accounted for more than 10% of the Companys total
revenue for the three and nine months ended October 2, 2004 and September 27,
2003, respectively. (7) Related Party Transactions Through May 2002, the Company loaned, on a full recourse basis, an
aggregate of $1,491,000, to certain officers, employees and a consultant of
the Company. All loans are evidenced by promissory notes bearing interest
with rates ranging from 5.00% to 8.00% per annum. The loans are payable over
periods ranging from one to five years and in each case are secured by
certain assets of the borrower, including shares of the Companys common
stock owned by the borrower. At October 2, 2004 and December 31, 2003, the
aggregate outstanding balance on these loans was approximately $280,000 and
$781,000, respectively. The long-term portion of the loans is included in
long-term notes receivable from related parties, and the short-term portion
of approximately $24,000 and $44,000 at October 2, 2004 and December 31,
2003, respectively, is included in other current assets in the accompanying
consolidated balance sheets. In January 2002, the Company entered into a consulting agreement with
one of its directors to provide consulting, advisory and neuroscience
business planning services to the Company. Effective April 11, 2003, this
director resigned from the Companys Board of Directors. Through April 11,
2003, the Company had paid approximately $9,000 to this director under his
consulting agreement. From April 11, 2003 through October 2, 2004, the
Company paid approximately $12,000 to this individual under this consulting
agreement. 11




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands except per share amounts)
(Unaudited) (8) Loan Agreements In May 2001, the Company entered into an agreement with a commercial
bank for a revolving line of credit. The Company is entitled to borrow up to
$5,000,000 under the revolving line of credit, which expires in May 2005 and,
subject to annual review by the commercial bank, may be extended at the
discretion of the commercial bank. Interest on any borrowings under the
revolving line of credit is, at the election of the Company, either the prime
rate or at LIBOR plus 2.25%. Up to $1,500,000 of the $5,000,000 revolving
line of credit is available for standby letters of credit. At October 2,
2004, the Company had outstanding standby letters of credit with the
commercial bank of approximately $80,000. At October 2, 2004, there was no
outstanding balance under this revolving line of credit. The revolving line of credit agreement contains restrictive covenants
that require the Company to maintain liquidity and net worth ratios and is
secured by certain investments of the Company, which are shown as restricted
cash in the accompanying consolidated balance sheets. In connection with the
extension of the revolving line of credit in May 2004, the Company is
required to maintain restricted cash in an amount equal to 102% of the
outstanding amounts under the revolving line of credit agreement. Prior to
the amendment in May 2004, the Company was required to maintain restricted
cash in an amount equal to 102% of the $5,000,000 commitment, or $5,100,000.
At October 2, 2004, the Company was in compliance with all covenants
contained in the revolving line of credit agreement. At October 2, 2004, the
interest rate on the revolving line of credit was 4.75%. In August 2002, the Company entered into an agreement for a $5,000,000
revolving line of credit with BSC in connection with a strategic alliance
(see Note 9). (9) Strategic Alliance with Boston Scientific Corporation On August 7, 2002, the Company formed a strategic alliance with BSC. In
connection with this strategic alliance, the Company sold 1,428,572 shares of
the Companys common stock at a purchase price per share of $7.00 to BSC
pursuant to a stock purchase agreement. Gross cash proceeds from this sale
of common stock were $10,000,004. In addition, the Company granted BSC an
option under an OEM product development and distribution agreement to
distribute newly developed technology for monitoring patients under sedation
in a range of less-invasive medical specialties. The Company allocated the
fair market value between the common stock and the option to be the exclusive
distributor. The excess of $4.41 per share paid by BSC over the closing
price of the Companys common stock on August 7, 2002, or approximately
$6,300,000 in total, was attributed to the value of the rights provided to
BSC under the OEM product development and distribution agreement. Approximately $5,071,000 of the aggregate purchase price is recorded as
deferred revenue in the accompanying consolidated balance sheet at October 2,
2004, which represents the unamortized portion of the purchase price in
excess of the closing price of the Companys common stock on August 7, 2002.
The deferred revenue is being recognized ratably over the term of the OEM
product development and distribution agreement, which represents the
Companys best estimate of its period of significant continuing obligation to
provide BSC exclusive distribution rights to newly developed technology. The
term of the agreement continues until such time that BSC is no longer
distributing the Companys products, but in no event will extend beyond
December 31, 2012. Approximately $154,000 was recognized as revenue for the
three months ended October 2, 2004 and September 27, 2003 and approximately
$461,000 was recognized as revenue in the nine months ended October 2, 2004
and September 27, 2003. As part of the strategic alliance with BSC, the Company also entered
into an agreement pursuant to which BSC has agreed to provide the Company a
$5,000,000 revolving line of credit, which expires in August 2007 and may be
extended at the discretion of BSC. Interest on any borrowings under this
revolving line of credit is at a rate equal to the LIBOR rate at which BSC,
under its own revolving credit facility, is entitled to borrow funds, plus
any additional amounts payable thereon by BSC under such revolving credit
facility, plus eighty basis points. The Companys revolving line of credit
with BSC is secured by the Companys inventory and certain of the Companys
accounts receivable and contains certain restrictive covenants covering the
collateral. At October 2, 2004, there was no outstanding balance under this
revolving line of credit, and the Company was in compliance with all
covenants contained in the revolving line of credit agreement. 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) On April 7, 2004, the Company entered into an agreement with BSC to
issue and sell 500,000 shares of the Companys common stock to BSC pursuant
to a stock purchase agreement. The Company completed the sale on June 8,
2004. The purchase price per share was $16.21 and the aggregate gross
proceeds from the transaction were $8,105,000. In connection with this sale
of common stock, the Company has granted BSC the right to require the Company
to register these shares for resale under the Securities Act of 1933. 13




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##### Table of Contents



Item 2.
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This Quarterly Report onForm 10-Qcontains, in addition to historical
information, forward-looking statements within the meaning of Section 21E of
the Securities Exchange Act of 1934. 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. 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. See the
important factors in the cautionary statements below under the heading Factors
Affecting Future Operating Results that we believe could cause our actual
results to differ materially from the forward-looking statements we make. Overview We develop, manufacture and market an anesthesia monitoring system that we
call the BIS® system. The BIS system is based on our patented core technology,
the Bispectral Index, which we refer to as the BIS index. The BIS system
provides information that allows clinicians to better assess and manage a
patients level of consciousness in the operating room and intensive care
settings and administer the precise amount of anesthesia needed by each
patient. Our proprietary BIS system includes our BIS monitor, or our BIS
Module Kit, which allows original equipment manufacturers to incorporate the
BIS index into their monitoring products, and our single-use disposable BIS
Sensors. We collectively refer to our various types of disposable sensors as
BIS Sensors. Our latest generation monitor, the A-2000® BIS Monitor, was cleared for
marketing by the United States Food and Drug Administration, or the FDA, in
February 1998. Our latest version of the BIS system, the BIS XP system, was
cleared for marketing by the FDA in June 2001. In addition to our A-2000 BIS
Monitor, we offer original equipment manufacturers our BIS Module Kit for
integration into equipment sold by the original equipment manufacturers. In
February 2004, our BISx system was cleared for marketing by the FDA. The BISx
system is our latest BIS monitoring system for integration into the equipment
sold by original equipment manufacturers. The BISx system provides the BIS
XP functionality in a single device the size of a hockey puck, simplifying the
incorporation of BIS XP into third-party patient monitoring systems. We derive our revenue primarily from sales of BIS monitors, BIS Module
Kits and related accessories, which we collectively refer to as Equipment, and
sales of BIS Sensors. For management purposes, we segregate our revenue by
sales by region and sales by product group as shown in the following table: Three Months Ended
    
    Nine Months EndedOctober 2,
    
    September 27,
    
    October 2,
    
    September 27,2004
    
    2003
    
    2004
    
    2003(in thousands)Domestic revenue
    
    $
    10,477
    
    
    $
    9,220
    
    
    $
    31,299
    
    
    $
    25,838Percent of total revenue
    
    
    77
    %
    
    
    82
    %
    
    
    79
    %
    
    
    81
    %International revenue
    
    $
    3,148
    
    
    $
    1,969
    
    
    $
    8,549
    
    
    $
    6,187Percent of total revenue
    
    
    23
    %
    
    
    18
    %
    
    
    21
    %
    
    
    19
    %Total revenue
    
    $
    13,625
    
    
    $
    11,189
    
    
    $
    39,848
    
    
    $
    32,025BIS Sensor revenue
    
    $
    9,835
    
    
    $
    7,520
    
    
    $
    28,681
    
    
    $
    21,736Percent of total revenue
    
    
    72
    %
    
    
    67
    %
    
    
    72
    %
    
    
    68
    %Equipment revenue
    
    $
    3,790
    
    
    $
    3,669
    
    
    $
    11,167
    
    
    $
    10,289Percent of total revenue
    
    
    28
    %
    
    
    33
    %
    
    
    28
    %
    
    
    32
    %Total revenue
    
    $
    13,625
    
    
    $
    11,189
    
    
    $
    39,848
    
    
    $
    32,025
 At October 2, 2004, we had cash, cash equivalents, restricted cash and
investments of approximately $40.5 million and working capital of approximately
$33.7 million. We follow a system of fiscal quarters as opposed to calendar quarters.
Under this system, the first three quarters of each fiscal year end on the
Saturday closest to the end of the calendar quarter and the last quarter of the
fiscal year always ends on December 31. 14




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##### Table of Contents



We believe our ability to grow our revenue is directly related to our
ability to sell our Equipment to healthcare organizations and influence our
customers after they purchase our Equipment to continue to purchase and use our
BIS Sensors. We believe the increase in our installed base of Equipment
resulting from the sale of BIS monitors and the sale of original equipment
manufacturers equipment incorporating our BIS Module Kit have been the primary
reasons for the growth in revenue from the sale of BIS Sensors. In order to
successfully grow our revenue, we need to continue to focus on both selling our
Equipment and improving our per monitor and per module sensor utilization rate.
To achieve this growth, we continue to implement new sales and marketing
programs. We expect that as we grow our business, revenue from the sale of BIS
Sensors should contribute an increasing percentage of total revenue.
Additionally, we believe that, over time, revenue from the sale of BIS Module
Kits and our BISx system will increase as a percentage of total Equipment
revenue as healthcare organizations purchase our technology as part of an
integrated solution offered by our original equipment manufacturers. We believe that maintaining our gross profit margin and controlling the
growth of our operating expenses are important factors in sustaining
profitability. To maintain our gross profit margin we believe we must continue
to focus on maintaining our average unit sales prices for both BIS monitors and
BIS Sensors, increasing revenue from the sale of BIS Sensors as a percentage of
total revenue, as BIS Sensors have a higher gross profit margin than Equipment,
and continuing to reduce the costs of manufacturing our products. For
those healthcare organizations desiring to purchase our BIS monitors
directly from us,
we offer two options. Our customers have the option either to
purchase BIS monitors outright or to acquire BIS monitors pursuant to a
sales-type lease agreement whereby the customer contractually commits to
purchase a minimum number of BIS Sensors per BIS monitor per year. Under our
sales-type leases, customers purchase BIS Sensors and the BIS monitor for the
purchase price of the BIS Sensors plus an additional charge per BIS Sensor to
pay for the purchase price of the BIS monitor and related financing costs over
the term of the agreement. We also grant these customers an option to purchase
the BIS monitors at the end of the term of the agreement, which is typically
three to five years. We recognize Equipment revenue under sales-type lease
agreements either at shipment or delivery in accordance with the agreed upon
contract terms with interest income recognized over the life of the sales-type
lease. The cost of the BIS monitor acquired by the customer is recorded as
costs of revenue in the same period. Sales-type leases accounted for
approximately 2% of total revenue in both the three and nine months ended
October 2, 2004, and approximately 3% of total revenue in both
the three and nine months ended September 27, 2003. Under certain limited circumstances, we also offer customers the
opportunity to use the BIS monitors under our Equipment Placement program,
which we refer to as the EP program. Under the EP program, the customer is
granted the right to use the BIS monitors for a mutually agreed upon period of
time. During this period, the customer purchases BIS Sensors at a price that
includes a premium above the list price of the BIS Sensors to cover the rental
of the equipment, but without any minimum purchase commitments. At the end of
the agreed upon period, the customer has the option of purchasing the BIS
monitors, continuing to use them under the EP program or returning them to us. We have subsidiaries in The Netherlands and the United Kingdom to
facilitate the sale of our products into the international market. We are
continuing to develop our international sales and distribution program through
a combination of distributors and marketing partners, including companies with
which we have entered into original equipment manufacturer relationships. In January 1998, we entered into a distribution agreement with Nihon
Kohden Corporation to distribute BIS monitors in Japan. In March 2000, Nihon
Kohden received approval from the Japanese Ministry of Health, Labor and
Welfare for marketing in Japan our A-1050 EEG Monitor with BIS and in May 2001,
received approval for marketing in Japan our A-2000 BIS Monitor. Nihon Kohden
has requested, but has not yet received, approval to market the BIS XP system
in Japan. In January 2002, the Japanese Ministry of Health, Labor and Welfare
granted reimbursement approval for use of our BIS monitors. With this
approval, healthcare providers in Japan are eligible to receive partial
reimbursement of 1,000 Yen each time BIS monitoring is used. In July 2002, the
Japanese Ministry of Health, Labor and Welfare approved our BIS module for
marketing in Japan. Sales to Nihon Kohden represented approximately 21% of
international revenue for both the three and nine months ended October 2, 2004
and approximately 12% and 13% of international revenue in the three and nine
months ended September 27, 2003, respectively. Various factors may adversely affect our quarterly operating results
through the fourth fiscal quarter of 2004 and beyond. These factors may have a
potentially adverse effect on Equipment revenue and gross profit margin on
Equipment as we continue to shift the focus of our placements from BIS monitors
to BIS modules and BISx systems. In addition, in Japan, Nihon Kohden is
awaiting approval of the BIS XP system, and we believe customers may continue
to delay purchases of our products or may choose not to purchase our products
pending this approval. 15




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##### Table of Contents



Critical Accounting Policies and Estimates Managements discussion and analysis of the financial condition and
results of operations is based upon the consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. Note 2 of the Notes to Consolidated Financial
Statements included elsewhere in this Quarterly Report on Form 10-Q includes a
summary of our significant accounting policies and methods used in the
preparation of our financial statements. In preparing these financial
statements, we have made estimates and judgments in determining certain amounts
included in the financial statements. The application of these accounting
policies involves the exercise of judgment and use of assumptions as to future
uncertainties and, as a result, actual results could differ from these
estimates. We do not believe there is a significant likelihood that materially
different amounts would be reported under different conditions or using
different assumptions. We believe that our critical accounting policies and
estimates are as follows: Revenue Recognition We sell our BIS monitors primarily through a combination of a direct sales
force and distributors. Our BIS Module Kits are sold to original equipment
manufacturers who in turn sell them to the end-user. BIS Sensors are sold
through a combination of a direct sales force, distributors and original
equipment manufacturers. Direct product sales are structured as sales,
sales-type lease arrangements or sales under our EP program. We recognize
revenue from product sales when earned in accordance with Staff Accounting
Bulletin, or SAB, No. 104, Revenue Recognition,and Emerging Issues Task Force,
or EITF, 00-21, Revenue Arrangements with Multiple Deliverables. Revenue is
recognized when persuasive evidence of an arrangement exists, product delivery
has occurred or services have been rendered, the price is fixed or determinable
and collectibility is reasonably assured. For product sales, revenue is not
recognized until title and risk of loss have transferred to the customer. We also recognize revenue from prepaid license and royalty fees. This
revenue is deferred until product shipment or delivery in accordance with the
terms of the agreement and license and royalty fees are earned in accordance
with the terms of the respective agreements. In August 2002, we recorded
approximately $6,300,000 of deferred revenue related to an OEM product
development and distribution agreement with Boston Scientific Corporation. The
deferred revenue is being recognized ratably over the term of the OEM product
development and distribution agreement, which represents our best estimate of
our period of significant continuing obligation to provide Boston Scientific
Corporation exclusive distribution rights to newly developed technology. If our
estimate of the period of significant continuing obligation is revised, this
may have an impact on our revenue recognition of the deferred revenue related
to the Boston Scientific Corporation agreement. We follow Statement of Financial Accounting Standards, or SFAS, No. 13,
Accounting For Leases, for our sales-type lease agreements. Under our
sales-type leases, customers purchase BIS Sensors and the BIS monitor for the
purchase price of the BIS Sensors plus an additional charge per BIS Sensor to
pay for the purchase price of the BIS monitor and related financing costs over
the term of the agreement. The minimum lease payment, consisting of the
additional charge per BIS Sensor, less the unearned interest income, which is
computed at the interest rate implicit in the lease, is recorded as the net
investment in sales-type leases. We recognize Equipment revenue under
sales-type lease agreements either at shipment or delivery in accordance with
the agreed upon contract terms with interest income recognized over the life of
the sales-type lease. The cost of the BIS monitor acquired by the customer is
recorded as costs of revenue in the same period. We review and assess the net
realizability of our investment in sales-type leases at each reporting period.
This review includes determining, on a customer specific basis, if a customer
is significantly underperforming relative to the customers cumulative level of
committed BIS Sensor purchases as required by the sales-type lease agreement.
If a customer is underperforming, we record an allowance for lease payments as
a charge to revenue to reflect the lower estimate of the net realizable
investment in sales-type lease balance. We recognize revenue either at shipment or delivery in accordance with the
agreed upon contract terms with distributors and original equipment
manufacturers in accordance with SAB No. 104. Sales to distributors and
original equipment manufacturers include a clause in the contracts that
indicates that customer acceptance is limited to confirmation that our products
function in accordance with our applicable product specifications in effect at
the time of delivery. Formal acceptance by the distributor or original
equipment manufacturer is not necessary to recognize revenue provided that we
objectively demonstrate that the criteria specified in the acceptance
provisions are satisfied. Each product is tested prior to shipment to ensure
that it meets the applicable product specifications in effect at the time of
delivery. Additionally, we have historically had a minimal number of defective
products shipped to distributors and original equipment manufacturers and any
defective products are subject to repair or replacement under warranty as
distributors and original equipment manufacturers do not have a right of
return. 16




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##### Table of Contents



Accounts Receivable We determine our allowance for doubtful accounts by using estimates based
on our historical collections experience, current trends, historical write-offs
of our receivables, credit policy and a percentage of our accounts receivable
by aging category. We also review the credit quality of our customer base as
well as changes in our credit policies. We continuously monitor collections and
payments from our customers. While credit losses have historically been within
our expectations and the provisions established, our credit loss rates in the
future may not be consistent with our historical experience. To the extent we
experience a deterioration in our historical collections experience or
increased credit losses, bad debt expense would likely increase in future
periods. Inventories We value inventory at the lower of cost or estimated market, and determine
cost on a first-in, first-out basis. We regularly review inventory quantities
on hand and record a provision for excess or obsolete inventory primarily based
on production history and on our estimated forecast of product demand. The
medical industry in which we market our products is characterized by rapid
product development and technological advances that could result in
obsolescence of inventory. Additionally, our estimates of future product demand
may prove to be inaccurate, in which case we would need to change our estimate
of the provision required for excess or obsolete inventory. If revisions are
deemed necessary, we would recognize the adjustments in the form of a charge to
costs of revenue at the time of the determination. Therefore, although we
continually update our forecasts of future product demand, any significant
unanticipated declines in demand or technological developments, such as the
introduction of new products by our competitors, could have a significant
negative impact on the value of our inventory, results of operations and cash
flows in future periods. Warranty Equipment that we sell generally is covered by a warranty period of one
year. We accrue a warranty reserve for estimated costs to provide warranty
services. Our estimate of costs to service our warranty obligations is based on
our historical experience and expectation of future conditions. While our
warranty costs have historically been within our expectations and the
provisions established, to the extent we experience an increased number of
warranty claims or increased costs associated with servicing those claims, our
warranty expenses will increase, and we may experience decreased gross profit
margin and cash flow. Results of Operations The following tables present, for the three and nine month periods ended
October 2, 2004 and September 27, 2003, information expressed as a percentage
of revenue and a summary of our total revenue. This information has been
derived from our consolidated statements of operations included elsewhere in
this Quarterly Report on Form 10-Q. You should not draw any conclusions about
our future results from the results of operations for any period. Three Months Ended
    
    Nine Months EndedOctober 2,
    
    September 27,
    
    October 2,
    
    September 27,2004
    
    2003
    
    2004
    
    2003Revenue
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Costs of revenue
    
    
    24
    
    
    
    25
    
    
    
    23
    
    
    
    25Gross profit margin
    
    
    76
    
    
    
    75
    
    
    
    77
    
    
    
    75Operating expenses:Research and development
    
    
    13
    
    
    
    14
    
    
    
    14
    
    
    
    17Sales and marketing
    
    
    45
    
    
    
    56
    
    
    
    49
    
    
    
    58General and administrative
    
    
    16
    
    
    
    19
    
    
    
    17
    
    
    
    20Total operating expenses
    
    
    74
    
    
    
    89
    
    
    
    80
    
    
    
    95Income (loss) from operations
    
    
    2
    
    
    
    (14
    )
    
    
    (3
    )
    
    
    (20
    )Interest income, net
    
    
    2
    
    
    
    2
    
    
    
    1
    
    
    
    2Net income (loss)
    
    
    4
    %
    
    
    (12
    )%
    
    
    (2
    )%
    
    
    (18
    )%
 17




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##### Table of Contents



Three and Nine Months Ended October 2, 2004 Compared with Three and Nine Months
Ended September 27, 2003 Three Months Ended
    
    Nine Months EndedPercentage
    
    
    
    
    
    
    
    
    
    PercentageOctober 2,
    
    September 27,
    
    Increase
    
    October 2,
    
    September 27,
    
    Increase2004
    
    2003
    
    (Decrease)
    
    2004
    
    2003
    
    (Decrease)(in thousands, except
    
    
    
    
    
    (in thousands, exceptunit amounts)
    
    
    
    
    
    unit amounts)Revenue  WorldwideBIS Sensor
    
    $
    9,835
    
    
    $
    7,520
    
    
    
    31
    %
    
    $
    28,681
    
    
    $
    21,736
    
    
    
    32
    %BIS monitor
    
    
    2,145
    
    
    
    1,741
    
    
    
    23
    %
    
    
    6,523
    
    
    
    5,013
    
    
    
    30
    %BIS Module Kit
    
    
    748
    
    
    
    1,056
    
    
    
    (29
    )%
    
    
    2,094
    
    
    
    2,592
    
    
    
    (19
    )%Other equipment and
accessories
    
    
    897
    
    
    
    872
    
    
    
    3
    %
    
    
    2,550
    
    
    
    2,684
    
    
    
    (5
    )%Total Equipment
    
    
    3,790
    
    
    
    3,669
    
    
    
    3
    %
    
    
    11,167
    
    
    
    10,289
    
    
    
    9
    %Total revenue
    
    $
    13,625
    
    
    $
    11,189
    
    
    
    22
    %
    
    $
    39,848
    
    
    $
    32,025
    
    
    
    24
    %Unit Analysis  WorldwideBIS Sensors
    
    
    702,000
    
    
    
    543,000
    
    
    
    29
    %
    
    
    2,048,000
    
    
    
    1,609,000
    
    
    
    27
    %BIS monitors
    
    
    436
    
    
    
    342
    
    
    
    27
    %
    
    
    1,312
    
    
    
    993
    
    
    
    32
    %Original equipment
manufacturer BIS modules
    
    
    562
    
    
    
    740
    
    
    
    (24
    )%
    
    
    1,456
    
    
    
    1,758
    
    
    
    (17
    )%Installed base
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    22,395
    
    
    
    18,652
    
    
    
    20
    %
 Revenue.The 31% increase in revenue from the sale of BIS Sensors in the
three months ended October 2, 2004 compared with the three months ended
September 27, 2003 was primarily attributable to an increase of approximately
29% in the number of BIS Sensors sold as a result of growth in the installed
base of BIS monitors and BIS modules, plus a slight increase of approximately
1% in the average selling price of BIS Sensors. For the nine months ended October 2, 2004 compared with the nine months
ended September 27, 2003, revenue from the sale of BIS Sensors increased
approximately 32% primarily related to an increase of approximately 27% in the
number of BIS Sensors sold and an increase of approximately 4% in the average
selling price of BIS Sensors. Our installed base of BIS monitors and BIS
modules increased approximately 20% to 22,395 units at October 2, 2004 compared
with 18,652 units at September 27, 2003. The increase in revenue from the sale of Equipment in the three months
ended October 2, 2004 compared with the three months ended September 27, 2003
was primarily the result of an increase of approximately 23% in BIS monitor
revenue, which resulted from an increase in unit sales volume of approximately
27% as we shipped 436 BIS monitors in the third quarter of 2004 compared with
342 BIS monitors in the third quarter of 2003. The 27% increase in unit volume
relates primarily to BIS monitor shipments to Japan. In the three months ended October
2, 2004, we shipped 100 BIS monitors to Japan compared with no shipments in the
three months ended September 27, 2003. The shipments to our distributor in
Japan during the third quarter of 2004 were in response to increased demand for our BIS
technology as Nihon Kohden continues to await approval from the Japanese
Ministry of Health, Labor and Welfare to market the BIS XP system in Japan.
The increase in BIS monitor revenue was also accompanied by an increase of
approximately 3% in other equipment revenue. The increase in BIS monitor
revenue and other equipment revenue was offset by a decrease of approximately
29% in BIS Module Kit revenue. The number of BIS Module Kits shipped to our
original equipment manufacturers decreased approximately 24%, from 740 BIS
Module Kits shipped in the third quarter of 2003 to 562 BIS Module Kits shipped
in the third quarter of 2004. We believe that this decrease is largely the
result of our original equipment manufacturers purchasing fewer BIS Module Kits
as they begin to equip their patient monitoring systems to interface with our
new BISx system. For the nine months ended October 2, 2004 compared with the nine months
ended September 27, 2003, revenue from the sale of Equipment increased
approximately 9%, which was primarily attributable to an increase in BIS
monitor revenue of approximately 30%. This was a result of an increase of
approximately 32% in unit volume, as we shipped 1,312 BIS monitors in the nine
months ended October 2, 2004 compared with 993 BIS monitors shipped in the nine
months ended September 27, 2003, primarily related to shipments of BIS monitors
to Japan. In the nine months ended October 2, 2004, we shipped 250 BIS
monitors to Japan in response to increased demand for our BIS technology compared
with no shipments in the nine months ended September 27, 2003. The increase in
BIS monitor revenue was offset by a decrease in BIS Module Kit revenue of
approximately 19%, which was a result of a decrease in the number of BIS Module
Kits shipped to our original equipment manufacturers. In the nine months ended
September 27, 2003, we shipped 1,758 BIS Module Kits to our original equipment
manufacturers compared with 1,456 BIS Module Kits shipped in the nine months
ended October 2, 2004. The decrease in the number of BIS Module Kits shipped
was related to high levels of shipments to Japan and South America in 18




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##### Table of Contents



the first quarter of 2003. We expect revenue in the fourth quarter of
2004 to increase compared with the third quarter of 2004. Our gross profit margin was approximately 76% and 77% of revenue in the
three and nine months ended October 2, 2004, respectively, compared with a
gross profit margin of approximately 75% in both the three and nine months
ended September 27, 2003. The increase in the gross profit margin in the three
and nine months ended October 2, 2004 compared with the three and nine months
ended September 27, 2003 was primarily attributable to increased sales of our
BIS Sensors as a percentage of total revenue. BIS Sensors have a higher gross
profit margin than Equipment. BIS Sensors accounted for approximately 72% of
our total revenue in both the three and nine months ended October 2, 2004
compared with approximately 67% and 68%, respectively, of revenue in the three
and nine months ended September 27, 2003. The increased unit volume of BIS
Sensors, combined with an increase in the BIS Sensor average unit selling price
contributed to the increase in our gross profit margin for the three and nine
months ended October 2, 2004. The increase in the average unit selling price
of our BIS Sensors resulted primarily from increased sales of our BIS XP family of
sensors as our BIS XP technology continues to represent a growing percentage of our
installed base. Expense Overview Three Months Ended
    
    
    
    
    
    Nine Months EndedPercentage
    
    
    
    
    
    
    
    
    
    PercentageOctober 2,
    
    September 27,
    
    Increase
    
    October 2,
    
    September 27,
    
    Increase2004
    
    2003
    
    (Decrease)
    
    2004
    
    2003
    
    (Decrease)(in thousands)
    
    
    
    
    
    (in thousands)ExpensesResearch and development
    
    $
    1,748
    
    
    $
    1,626
    
    
    
    8
    %
    
    $
    5,495
    
    
    $
    5,370
    
    
    
    2
    %Sales and marketing
    
    $
    6,129
    
    
    $
    6,286
    
    
    
    (3
    )%
    
    $
    19,443
    
    
    $
    18,528
    
    
    
    5
    %General and administrative
    
    $
    2,241
    
    
    $
    2,070
    
    
    
    8
    %
    
    $
    6,905
    
    
    $
    6,352
    
    
    
    9
    %
 Research and Development.The increase in research and development
expenses in the three months ended October 2, 2004 compared with the three
months ended September 27, 2003 was primarily attributable to an increase in
patent related expenses of approximately $57,000 as we strengthen our
intellectual property rights with respect to certain products in the countries in which we distribute our
products, an increase in compensation and benefits expense of approximately
$53,000 related to increased headcount and an increase in clinical study
expenses of approximately $45,000. For the nine months ended October 2, 2004 compared with the nine months
ended September 27, 2003, the increase in research and development expenses
resulted from an increase of approximately $160,000 in compensation and
benefits as a result of increased headcount, an increase of approximately
$52,000 in travel and entertainment expenses and an increase in clinical study
expenses of approximately $77,000. These increases were offset by a decrease
in consulting expenses of approximately $152,000 for various ongoing projects.
We expect research and development expenses to increase in the fourth quarter
of 2004 compared with the third quarter of 2004 as we continue to invest in
product development, clinical studies and expand applications for our
technology, including our initiatives into neuroscience. Sales and Marketing.The decrease in sales and marketing expenses in the
three months ended October 2, 2004 compared with the three months ended
September 27, 2003 was attributable to a decrease of approximately $211,000 in
expenses related to advertising, public relations and tradeshows resulting from
a reduction in discretionary spending, a decrease of approximately $86,000 in
commissions payable to group purchasing organizations, a decrease of approximately
$80,000 in meeting expenses, a decrease of approximately $68,000 in
clinical education initiatives and a decrease of approximately $51,000 in travel
and entertainment expenses. The decreases in sales and marketing
expenses were partially
offset by an increase in the operating expenses associated with our
international subsidiaries of approximately $468,000. The $468,000 increase in
our international operating expenses was the result of an increase of
approximately $304,000 in compensation and benefits which was a result of
increased headcount and sales levels. For the nine months ended October 2, 2004 compared with the nine months
ended September 27, 2003, the increase in sales and marketing expenses was
attributable to an increase in our operating expenses associated with our
international subsidiaries of approximately $1.4 million. The increase in the
operating expenses of our international subsidiaries was driven by an increase
in compensation and benefits of approximately $822,000 and an increase of
approximately $190,000 in travel and entertainment expenses resulting from an
increase in headcount. This increase was offset by a decrease of approximately
$326,000 in expenses related to advertising, public relations and tradeshows
and a decrease of approximately $289,000 in commissions payable to group
purchasing organizations. We expect sales and marketing expenses to increase
in the fourth quarter of 2004 compared with the third quarter of 2004. 19




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General and Administrative.The increase in general and administrative
expenses in the three months ended October 2, 2004 compared with the three
months ended September 27, 2003 was primarily attributable to an increase in
compensation and benefits of approximately $126,000. The increase in general and administrative expenses in the nine months
ended October 2, 2004 compared with the nine months ended September 27, 2003
was attributable to an increase professional and consulting expenses of
approximately $222,000 and an increase in compensation and benefits of
approximately $175,000. We expect general and administrative expenses in the
fourth quarter of 2004 to increase from the third quarter of 2004. Interest Income.Interest income increased to approximately $285,000 in
the three months ended October 2, 2004 from approximately $215,000 in the three
months ended September 27, 2003, an increase of approximately 32%. Interest
income increased slightly to approximately $715,000 in the nine months ended
October 2, 2004 from approximately $702,000 in the nine months ended September
27, 2003, an increase of approximately 2%. The increase in interest income in
the three and nine months ended October 2, 2004 was primarily attributable to
higher cash and investment balances for this period resulting from gross cash
proceeds of approximately $8.1 million from the sale of our common stock to
Boston Scientific Corporation in June of this year. We expect interest income
to increase in the fourth quarter of 2004 compared with the third quarter of
2004 due to the increase in our cash and investment balances and expected
increases in interest rates. Interest expense.Interest expense decreased to approximately $27,000 in
the three months ended October 2, 2004 from approximately $48,000 in the three
months ended September 27, 2003, a decrease of approximately 43%. Interest
expense decreased to approximately $85,000 in the nine months ended October 2,
2004 from approximately $156,000 in the nine months ended September 27, 2003, a
decrease of approximately 45%. The decrease in interest expense in the three
and nine months ended October 2, 2004 was a result of lower average outstanding
debt obligations. We expect interest expense to decrease slightly in the
fourth quarter of 2004 compared with the third quarter of 2004 as a result of
continuing lower average outstanding debt obligations. Net Income (loss).As a result of the factors discussed above, for the
three months ended October 2, 2004, we had net income of approximately $520,000
and for the nine months ended October 2, 2004 we had a net loss of
approximately $652,000, compared with a net loss of approximately $1.4 million
and $5.7 million for the three and nine months ended September 27, 2003,
respectively. We did not record a provision for income taxes for the three and
nine months ended October 2, 2004 as we have significant deferred tax assets
available to offset any income tax liabilities and expenses. At October 2,
2004, we had a full valuation allowance against these gross deferred tax
assets as we have determined that it is more likely than not that
some portion or all of the deferred tax assets will not be realized. Liquidity and Capital Resources Our liquidity requirements have historically consisted of research and
development expenses, sales and marketing expenses, capital expenditures,
working capital and general corporate expenses. From our inception through
January 2000, we financed our operations primarily from the sale of convertible
preferred stock. Through October 2, 2004, we raised approximately $85.7
million from private equity financings, have received approximately $3.4
million in equipment financing and have received approximately $5.1 million of
financing related to our investment in sales-type leases. We also received
approximately $2.8 million of financing under a term loan in December 1999.
The outstanding principal on the equipment and term loans was paid in May 2001.
In February 2000, we completed our initial public offering of an aggregate of
4,025,000 shares of common stock and received net proceeds of approximately
$54.6 million. In May 2001, we entered into an agreement with Fleet National Bank, or
Fleet, for a $5.0 million revolving line of credit, which expires in May 2005.
The revolving line of credit with Fleet contains restrictive covenants that
require us to maintain liquidity and net worth ratios and is secured by certain
investments, which are shown as restricted cash on our consolidated balance
sheets. In connection with the extension of our revolving line of credit
agreement in May 2004, we are now required to maintain restricted cash in an
amount equal to 102% of the outstanding amounts under the revolving line of
credit. Prior to the extension in May 2004, we were required to maintain
restricted cash in an amount equal to 102% of the $5.0 million commitment. At
October 2, 2004, we were in compliance with all covenants contained in
the revolving line of credit agreement. Interest on any borrowings under the
revolving line of credit with Fleet is, at our election, either the prime rate
or at LIBOR plus 2.25%. At October 2, 2004, the interest rate on the line of
credit with Fleet was 4.75%. Up to $1.5 million of the $5.0 million revolving
line of credit is available for standby letters of credit. At October 2, 2004,
there was no amount outstanding under this line of credit and we had standby
letters of credit outstanding with Fleet in the amount of $80,000. 20




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In August 2002, we entered into a strategic alliance with Boston
Scientific Corporation whereby we sold 1,428,572 shares of our common stock at
a purchase price per share of $7.00 to Boston Scientific Corporation. Gross
cash proceeds from this sale of common stock were approximately $10.0 million.
Note 9 of our Notes to Consolidated Financial Statements included elsewhere in
this Quarterly Report on Form 10-Q includes additional information relating to
the strategic alliance with Boston Scientific Corporation. In connection with our strategic alliance with Boston Scientific
Corporation, we also entered into an agreement with Boston Scientific
Corporation for a revolving line of credit under which we are entitled to
borrow up to $5.0 million. The revolving line of credit expires in August 2007
and may be extended at the discretion of Boston Scientific Corporation.
Interest on any borrowings under this revolving line of credit is at a rate
equal to the LIBOR rate at which Boston Scientific Corporation, under its own
revolving credit facility, is entitled to borrow funds, plus any additional
amounts payable thereon by Boston Scientific Corporation under such revolving
credit facility, plus eighty basis points. Our revolving line of credit with
Boston Scientific Corporation is secured by our inventory and certain of our
accounts receivable and contains certain restrictive covenants covering the
collateral. At October 2, 2004, there was no outstanding balance under this
revolving line of credit and we were in compliance with all covenants
contained in the revolving line of credit agreement. On April 7, 2004, in order to raise cash for working capital and other
general corporate purposes, we entered into a stock purchase agreement with
Boston Scientific Corporation to issue and sell to Boston Scientific
Corporation an aggregate of 500,000 shares of our common stock. We completed
the sale on June 8, 2004. Gross cash proceeds from this sale of common stock
were approximately $8.1 million. We expect to meet our short-term liquidity needs through the use of cash
and short-term investments on hand at October 2, 2004. We believe that the
financial resources available to us, including our current working capital, our
long-term investments and available revolving lines of credit will be
sufficient to finance our planned operations and capital expenditures through
at least the end of 2005. However, our future liquidity and capital
requirements will depend upon numerous factors, including the resources
required to further develop our marketing and sales organization domestically
and internationally, to finance our research and development programs, to
implement new marketing programs, to finance our sales-type lease program and
to meet market demand for our products. Working capital at October 2, 2004 was approximately $33.7 million
compared to approximately $30.7 million at December 31, 2003. The increase in
working capital from December 31, 2003 to October 2, 2004 was primarily
attributable to an increase in our short-term investments which resulted from
the sale of common stock to Boston Scientific Corporation in June 2004 and an
increase in our accounts receivable. Cash from Operations.We used approximately $1.4 million of cash for
operations in the nine months ended October 2, 2004 compared with approximately
$4.9 million in the nine months ended September 27, 2003. Cash used for
operations in the nine months ended October 2, 2004 was
primarily driven by operating losses, an
increase in accounts receivable of approximately $724,000, an increase in
inventory of approximately $482,000 and a decrease in deferred revenue of
approximately $528,000. These were offset by a decrease in our investment in
sales-type leases of approximately $314,000. Cash used for operations in the
nine months ended September 27, 2003 was primarily driven by operating losses,
an increase in accounts receivable of approximately $505,000, an increase in
other assets of approximately $226,000 and a decrease in deferred revenue of
approximately $698,000, offset by a decrease in inventory of approximately
$699,000. Cash from Investing Activities.We used approximately $9.8 million of
cash for investing activities in the nine months ended October 2, 2004 compared
with approximately $3.6 million of cash provided by investing activities in the
nine months ended September 27, 2003. The cash used for investing activities
in the nine months ended October 2, 2004 was the result of net purchases of investments of approximately $14.5 million
offset by a decrease in restricted cash of approximately $5.0 million. The
reduction in restricted cash resulted from the amendment of our revolving line
of credit with Fleet in May 2004. In the nine months ended September 27, 2003,
we received approximately $4.0 million, net, of proceeds from sales and
maturities of marketable securities and invested approximately $492,000
primarily for the purchase of manufacturing equipment, computer hardware and
third-party software. Cash from Financing Activities.We received approximately $11.1 million
of cash from financing activities in the nine months ended October 2, 2004
primarily as a result of proceeds from the issuance of our common stock to
Boston Scientific Corporation of approximately $8.1 million and proceeds from
the issuance of our common stock upon the exercise of stock options granted
under our stock option plans, offset by payments of principal on debt related
to our investment in sales-type leases of approximately $574,000. In the nine
months ended September 27, 2003, we used approximately $163,000 of cash from
financing activities primarily as a result of payments of principal on debt
related to our investment in sales-type leases of approximately $738,000,
offset by proceeds from the sale of our investment in sales-type leases of
approximately 21




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$266,000, proceeds from payments on notes receivable from employees and
directors of approximately $154,000 and proceeds from the issuance of our
common stock upon the exercise of stock options granted under our stock option
plans of approximately $155,000. We guarantee certain operating lease obligations of our subsidiaries of
approximately $287,000 for the lease of automobiles. In July 1999, we entered into an agreement under which we can sell a
portion of our existing and future investment in sales-type leases to Americorp
Financial, Inc. Through October 2, 2004, we sold approximately $5.1 million of
our investment in sales-type leases under this agreement. In accordance with
SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities  A replacement of FASB Statement No. 125, the
proceeds from these sales are classified as debt. Payments on the outstanding
principal under this debt match the timing of the payments due on the
underlying investment in sales-type leases. At October 2, 2004, approximately
$629,000 is recorded as debt on our consolidated balance sheet. We had capital expenditures of approximately $258,000 and approximately
$796,000 for the three and nine months ended October 2, 2004, respectively,
which related primarily to the purchase of manufacturing equipment for use in
the production of our BIS Sensors and the purchase of computer hardware and
third-party software. At October 2, 2004, we anticipate that we
will spend approximately $200,000 to complete the purchase of manufacturing equipment for use in the production of our
BIS Sensors. We anticipate that the level of capital expenditures in the
fourth quarter of 2004 will increase from the level of capital expenditures
during the third quarter of 2004, mostly as a result of the expected purchase
of this additional manufacturing equipment. We have summarized below our contractual cash obligations as of October 2,
2004: Payments Due By Period(in thousands)Less Than
    
    One to Three
    
    Three to Five
    
    After FiveContractual Obligations
    
    Total
    
    One Year
    
    Years
    
    Years
    
    YearsOperating leases
    
    $
    2,912
    
    
    $
    1,234
    
    
    $
    1,560
    
    
    $
    118
    
    
    $
    Debt related to the sale of investment in sales type leases
    
    
    629
    
    
    
    404
    
    
    
    217
    
    
    
    8
    
    
    
    Total contractual cash obligations
    
    $
    3,541
    
    
    $
    1,638
    
    
    $
    1,777
    
    
    $
    126
    
    
    $
    
 Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements or relationships with
unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, which are
typically established for the purpose of facilitating off-balance sheet
arrangements or other contractually narrow or limited purposes. Income Taxes We have net operating loss and research and development tax credit
carryforwards for federal income tax purposes that began expiring in 2002 and
will continue to expire through 2023 if not utilized. The net operating loss and research and development tax credit
carryforwards are subject to review by the Internal Revenue Service. Ownership
changes, as defined under Sections 382 and 383 in the Internal Revenue Code,
may limit the amount of these tax attributes that can be utilized annually to
offset future taxable income or tax liabilities. The amount of the annual
limitation is determined based on our value immediately prior to the ownership
change. Subsequent ownership changes may further affect the limitation in
future years. We have substantial net operating loss carryforwards
that have generated significant deferred tax assets. We have provided
a full valuation allowance against these deferred tax assets as we
have determined that it is more likely than not that we will not be
able to fully utilize these net operating loss carryforwards. Effects of Inflation We believe that inflation and changing prices over the past year have not
had a significant impact on our revenue or on our results of operations. 22




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FACTORS AFFECTING FUTURE OPERATING RESULTS This Quarterly Report on Form 10-Q includes forward-looking statements,
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, BIS Module Kits 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, 2004. The
following important factors represent some of the current challenges to us that
create risk and uncertainty. Failure to adequately overcome any of the
following challenges could have a material adverse effect on our results of
operations, business or financial condition. We will not continue to be profitable if hospitals and anesthesia providers do
not buy and use our BIS system in sufficient quantities. Our customers may determine that the cost of the BIS system exceeds cost
savings in drugs, personnel and post-anesthesia care recovery resulting from
use of the BIS system. In addition, hospitals and anesthesia providers may not
accept the BIS system as an accurate means of assessing a patients level of
consciousness during surgery or in the intensive care unit. If extensive or
frequent malfunctions occur, healthcare providers may also conclude that the
BIS system is unreliable. If hospitals and anesthesia providers do not accept
the BIS system as cost-effective, accurate and reliable, they will not buy and
use the BIS system in sufficient quantities to enable us to continue to be
profitable. The success of our business also depends in a large part on continued use
of the BIS system by our customers and, accordingly, sales by us of BIS
Sensors. We expect that over time sales of BIS Sensors will increase as a
percentage of our revenue as compared to sales of Equipment as we build our
installed base of monitors and modules. If use of our BIS system, and
accordingly, sales of our BIS Sensors, do not increase, it could adversely
affect our ability to grow our revenue. 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. We began selling our current BIS system in early 1998 and introduced the
latest version, the BIS XP system, at the end of the third fiscal quarter of
2001. In 2002, we introduced commercially the BIS Extend Sensor for patients
who are monitored over an extended period of time, such as in intensive care
unit settings. To date, we have not achieved widespread market acceptance of
the BIS system for use in the operating room or in the intensive care unit from
healthcare providers or the professional organizations that influence market
behavior. Because we depend on our BIS system for substantially all of our
revenue and we have no other significant products, if we fail to achieve
widespread market acceptance for the BIS system, we will not be able to sustain
or grow our product revenue. Various factors may adversely affect our quarterly operating results through
the fourth fiscal quarter of 2004. In addition to the other factors identified in this Form 10-Q, various
factors may adversely affect our quarterly operating results through the fourth
fiscal quarter of 2004. First, we continue to shift the focus of our placements
from BIS monitors to BIS modules which may lead to a reduction in Equipment
revenue and gross margin on Equipment. Second, in Japan, Nihon Kohden is
awaiting approval of the BIS XP system from the Japanese Ministry of Health,
Labor and Welfare which may cause delays in purchasing decisions by customers
in Japan, or these potential customers may choose not to purchase our products.
The continuation of difficult worldwide economic conditions, reductions in
hospital purchasing programs and the cost of transitioning our installed base
to the BIS XP system may also adversely impact our revenue and operating
results through the fourth fiscal quarter of 2004. Additionally, on October 7,
2004, the Joint Commission on Accreditation of Healthcare Organizations, or
JCAHO, issued a Sentinel Event Alert aimed at preventing and managing the
impact of anesthesia awareness. While we believe this report is favorable to
our business, industry organizations and others in the anesthesia community may
not agree with the position taken in the Alert and, accordingly, potential
benefits to our business that could have resulted from this Alert may not be
realized. 23




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Fluctuations in our quarterly operating results could cause our stock price to
decrease. Our operating results have fluctuated significantly from quarter to
quarter in the past and are likely to vary in the future. These fluctuations
are due to several factors relating to the sale of our products, including:  
    
    the timing and volume of customer orders for our BIS system,  
    
    implementation of, and our subsequent reduction on the focus of, our EP program,  
    
    use of and demand for our BIS Sensors,  
    
    transition of sales focus from BIS monitors to BIS Module Kits,  
    
    customer cancellations,  
    
    introduction of competitive products,  
    
    regulatory approvals,  
    
    changes in management,  
    
    turnover in our direct sales force,  
    
    effectiveness of new marketing and sales programs,  
    
    reductions in orders by our distributors and original equipment manufacturers, and  
    
    the timing and amount of our expenses. Because of these fluctuations, it is likely that in some future quarter or
quarters our operating results could fall below the expectations of securities
analysts or investors. If our quarterly operating results are below
expectations in the future, the market price of our common stock would likely decrease. In addition, because we do not have a backlog of customer
orders for our BIS system, revenue in any quarter depends on orders received in
that quarter. Our quarterly results may also be adversely affected because some
customers may have inadequate financial resources to purchase our products or
may fail to pay for our products after receiving them. In particular, hospitals
continue to experience financial constraints, consolidations and
reorganizations as a result of cost containment measures and declining
third-party reimbursement for services, which may result in decreased product
orders or an increase in bad debt allowances in any quarter. 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. Our financial statements have been prepared in accordance with accounting
principles generally accepted in the United States. The preparation of these
financial statements requires us to make estimates and judgments that affect
the reported amounts of our assets, liabilities, revenues and expenses, the
amounts of charges accrued by us and related disclosure of contingent assets
and liabilities. We base our estimates on historical experience and on various
other assumptions that we believe to be reasonable under the circumstances.
There can be no assurance, however, that our estimates, or the assumptions
underlying them, will be correct. 24




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We believe that we currently have adequate internal controls but we are still
exposed to potential risks resulting from new requirements under Section 404 of
the Sarbanes-Oxley Act of 2002. We are evaluating our internal controls in order to allow management to
report on, and our independent auditors to attest to, our internal controls
over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act
of 2002. We may encounter unexpected delays in implementing the requirements
relating to internal controls, therefore we cannot be certain about the timing
of completion of our evaluation, testing and remediation actions or the impact
that these activities will have on our operations since there is no precedent
available by which to measure the adequacy of our compliance. We also expect to
incur additional expenses and management will be required to spend more time
performing the system and process evaluation, testing and remediation required
in order to comply with the ongoing management certification and auditor
attestation requirements. If we are not able to implement the requirements of
Section 404 in a timely manner or with adequate compliance, we might be subject
to sanctions or investigation by regulatory authorities. Any such action could
adversely affect our business, financial results or cause us to fail to meet
our reporting obligations. If approval of our BIS XP system is not obtained in Japan, our revenue and
operating results could be adversely affected. In Japan, Nihon Kohden is awaiting approval of the BIS XP system from the
Japanese Ministry of Health, Labor and Welfare. Until approval is obtained,
customers in Japan may delay their purchasing decisions with respect to our
products or may decide not to purchase our products at all. As a result, if
approval for this product is not obtained in Japan in the near future, or at
all, it could limit the growth of our international revenue. 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. We believe that the financial resources available to us, including our
current working capital and available revolving lines of credit, will be
sufficient to finance our planned operations and capital expenditures through
at least the end of 2005. If we are unable to increase our revenue and maintain
positive cash flow, we will need to raise additional funds. We may also need
additional financing if:  
    
    we need additional cash to fund research and development costs of products currently under development,  
    
    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. We can provide no assurance that we will be able to raise additional funds
on terms acceptable to us, if at all. If future financing is not available or
is not available on acceptable terms, we may not be able to fund our future
operations which would significantly limit our ability to implement our
business plan. In addition, we may have to issue securities that may have
rights, preferences and privileges senior to our common stock. 25




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Cases of awareness with recall during monitoring with the BIS system could
limit market acceptance of BIS systems and could expose us to product liability
claims. Clinicians have reported to us cases of possible awareness with recall
during surgical procedures monitored with the BIS system. In most of the cases
that were reported to us, when BIS index values were recorded at the time of
awareness, high BIS index values were noted, indicating that the BIS index
correctly identified the increased risk of awareness with recall in these
patients. However, in a small number of these reported cases, awareness with
recall may not have been detected by monitoring with the BIS system. We have
not systematically solicited reports of awareness with recall. It is possible
that additional cases of awareness with recall during surgical procedures
monitored with the BIS system have not been reported to us. Anesthesia
providers and hospitals may elect not to purchase and use BIS systems if there
is adverse publicity resulting from the report of cases of awareness with
recall that were not detected during procedures monitored with the BIS system.
If anesthesia providers and hospitals do not purchase and use the BIS system,
then we may not sustain or grow our product revenue. Although our multi-center,
multinational clinical studies have demonstrated that the use of BIS monitoring
to help guide anesthetic administration may be associated with the reduction of
the incidence of awareness with recall in adults using general anesthesia and
sedation, we may be subject to product liability claims for cases of awareness
with recall during surgical procedures monitored with the BIS system. These
claims could require us to spend significant time and money in litigation or to
pay significant damages. Moreover, if the patient safety benefits of BIS
monitoring are not persuasive enough to lead to wider adoption of our BIS
technology, our business could be adversely affected. 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. The
medical device industry in which we market our products is characterized by
rapid product development and technological advances. Our competitors have
introduced commercially anesthesia monitoring products which have been cleared
by the United States Food and Drug Administration, or FDA. If we do not compete
effectively with these monitoring products, our revenue will be adversely
affected. Our current or planned products are at risk of obsolescence from:  
    
    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. We may not be able to improve our products or develop new products or
technologies quickly enough to maintain a competitive position in our markets
and continue to grow our business. If we do not successfully develop and introduce enhanced or new products we
could lose revenue opportunities and customers. As the market for our BIS system matures, we need to develop and introduce
new products for anesthesia monitoring or other applications. In 2002, we
introduced commercially the BIS Extend Sensor for patients who are typically
monitored for an extended period of time, such as in intensive care unit
settings. We do not know whether the use of the BIS system in the intensive
care unit will achieve market acceptance. In addition, we have begun to
research the use of BIS monitoring to diagnose and track neurological diseases,
and face at least the following two related risks:  
    
    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. 26




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If we do not successfully adapt the BIS system for new products and
applications both within and outside the field of anesthesia monitoring, or if
such products and applications are developed but not successfully
commercialized, then we could lose revenue opportunities and customers. If we do not develop and implement a successful sales and marketing strategy,
we will not expand our business. In the past, we have experienced high turnover in our direct sales force.
It is possible that high turnover may occur in the future. If new sales
representatives do not acquire the technological skills to sell our products in
a timely and successful manner or we experience high turnover in our direct
sales force, we may not be able to sustain and grow our product revenue. In
addition, in order to increase our sales, we need to continue to strengthen our
relationships with our international distributors and continue to add
international distributors. Also, we need to continue to strengthen our
relationships with our original equipment manufacturers and other sales
channels and increase sales through these channels. On an ongoing basis, we
develop and introduce new sales and marketing programs and clinical education
programs to promote the use of the BIS system by our customers. If we do not
implement these new sales and marketing programs in a timely and successful
manner, we may not be able to achieve the level of market awareness and sales
required to expand our business. We have only limited sales and marketing
experience both in the United States and internationally and may not be
successful in developing and implementing our strategy. Among other things, we
need to:  
    
    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 marketing and sales 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. 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. Sales through distributors could be less profitable than direct sales.
Sales of our products through multiple channels could also confuse customers
and cause the sale of our products to decline. We do not control our original
equipment manufacturers and distribution partners. Our partners could sell
competing products, may not incorporate our technology into their products in a
timely manner and may devote insufficient sales efforts to our products. In
addition, our partners are generally not required to purchase minimum
quantities. As a result, even if we are dissatisfied with the performance of
our partners, we may be unable to terminate our agreements with these partners
or enter into alternative arrangements. 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. A component of our growth strategy is to expand our presence in foreign
markets. We conduct international business primarily in Europe and Japan and we
are attempting to increase the number of countries in which we do business. It
is costly to establish international facilities and operations and to promote
the BIS system in international markets. We have encountered barriers to the
sale of our BIS system outside the United States, including less acceptance by
anesthesia providers for use of disposable products, such as BIS Sensors,
delays in regulatory approvals outside of the United States, particularly in
Japan, and difficulties selling through indirect sales channels. In addition,
we have little experience in marketing and distributing products in these
markets. Revenue from international activities may not offset the expense of
establishing and maintaining these foreign operations. 27




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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. We are increasingly subject to a number of challenges which specifically
relate to our international business activities. These challenges include:  
    
    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 similar to the 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. If we are unable to meet and overcome these challenges, our international
operations may not be successful which would limit the growth of our business
and could adversely impact our results of operations. We may experience customer dissatisfaction and our reputation could suffer if
we fail to manufacture enough products to meet our customers demands. We rely on third-party manufacturers to assemble and manufacture the
components of our BIS monitors, BIS Module Kits and a portion of our BIS
Sensors. We manufacture substantially all BIS Sensors in our own manufacturing
facility. We have only one manufacturing facility. If we fail to produce enough
products at our own manufacturing facility or at a third-party manufacturing
facility or experience a termination or modification of any manufacturing
arrangement with a third party, we may be unable to deliver products to our
customers on a timely basis. Our failure to deliver products on a timely basis
could lead to customer dissatisfaction and damage our reputation. 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. Some of the components that are necessary for the assembly of our BIS
system, including some of the components used in our BIS Sensors, are currently
provided to us by sole-source suppliers or a limited group of suppliers. We
purchase components through purchase orders rather than long-term supply
agreements and generally do not maintain large volumes of inventory. We have
experienced shortages and delays in obtaining some of the components of our BIS
systems in the past, and we may experience similar shortages or delays in the
future. The disruption or termination of the supply of components could cause a
significant increase in the costs of these components, which could affect our
profitability. A disruption or termination in the supply of components could
also result in our inability to meet demand for our products, which could lead
to customer dissatisfaction and damage our reputation. If a supplier is no
longer willing or able to manufacture components that we purchase and integrate
into the BIS system, we may attempt to design replacement components ourselves
that would be compatible with our existing technology. In doing so, we would
incur additional research and development expenses, and there can be no
assurance that we would be successful in designing or manufacturing any
replacement components. Furthermore, if we are required to change the
manufacturer of a key component of the BIS system, we may be required to verify
that the new manufacturer maintains facilities and procedures that comply with
quality standards and with all applicable regulations and guidelines. The
delays associated with the verification of a new manufacturer could delay our
ability to manufacture BIS systems in a timely manner or within budget. 28




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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. We believe that the success of our business depends, in part, on obtaining
patent protection for our products, defending our patents once obtained and
preserving our trade secrets. We rely on a combination of contractual
provisions, confidentiality procedures and patent, trademark and trade secret
laws to protect the proprietary aspects of our technology. These legal measures
afford only limited protection, and competitors may gain access to our
intellectual property and proprietary information. Litigation may be necessary
to enforce our intellectual property rights, to protect our trade secrets and
to determine the validity and scope of our proprietary rights. Any litigation
could result in substantial expense and diversion of our attention from the
growth of the business and may not be adequate to protect our intellectual
property rights. 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. We may be exposed to litigation by third parties based on claims that our
products infringe the intellectual property rights of others. This risk is
exacerbated by the fact that the validity and breadth of claims covered in
medical technology patents involve complex legal and factual questions for
which important legal principles are unresolved. Any litigation or claims
against us, whether or not valid, could result in substantial costs, could
place a significant strain on our financial resources and could harm our
reputation. In addition, intellectual property litigation or claims could force
us to do one or more of the following:  
    
    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 and time-consuming. 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. The manufacture and sale of our products expose us to product liability
claims and product recalls, including those which may arise from misuse or
malfunction of, or design flaws in, our products or use of our products with
components or systems not manufactured or sold by us. Product liability claims
or product recalls, regardless of their ultimate outcome, could require us to
spend significant time and money in litigation or to pay significant damages.
We currently maintain product liability insurance; however, it may not cover
the costs of any product liability claims made against us. Furthermore, we may
not be able to obtain insurance in the future at satisfactory rates or in
adequate amounts. In addition, publicity pertaining to the misuse or
malfunction of, or design flaws in, our products could impair our ability to
successfully market and sell our products. 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. The underwriters of our initial public offering are named as defendants in
several class action complaints which have been filed allegedly on behalf of
certain persons who purchased shares of our common stock between January 28,
2000 and December 6, 2000. These complaints allege violations of the Securities
Act of 1933 and the Securities Exchange Act of 1934. Primarily they allege that
there was undisclosed compensation received by our underwriters in connection
with our initial public offering. While we and our officers and directors have
not been named as defendants in these suits, based on comparable lawsuits filed
against other companies, there can be no assurance that we and our officers and
directors will not be named in similar complaints in the future. In addition,
the underwriters may assert that we are liable for some or all of any liability
that they are found to have to the plaintiffs, pursuant to the indemnification
provisions of the underwriting agreement we entered into as part of the initial
public offering, or otherwise. 29




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We can provide no assurance as to the outcome of these complaints or any
potential suit against us or our officers and directors. Any conclusion of
these matters in a manner adverse to us could have a material adverse affect on
our financial position and results of operations. In addition, the costs to us
of defending any litigation or other proceeding, even if resolved in our favor,
could be substantial. Such litigation could also substantially divert the
attention of our management and our resources in general. Even if we are not
named as defendants in these lawsuits, we may also be required to incur
significant costs and our management may be distracted by being required to
provide information, documents or testimony in connection with the actions
against our underwriters. Uncertainties resulting from the initiation and
continuation of any litigation or other proceedings and the negative publicity
associated with this litigation could harm our ability to compete in the
marketplace. Boston Scientific Corporation may be able to impact corporate actions requiring
stockholder approval because it owns a significant amount of our common stock,
and, if our strategic alliance with Boston Scientific Corporation is not
successful, our operating results could be adversely affected. As of November 1, 2004, Boston Scientific Corporation owned approximately
24% of our outstanding common stock, which includes 500,000 shares of our
common stock that we sold to Boston Scientific Corporation on June 8, 2004. We
also have an agreement with Boston Scientific Corporation, pursuant to which
Boston Scientific Corporation has agreed not to acquire any shares of our
common stock in excess of 25% of the outstanding shares of our common stock
prior to December 31, 2004 without our prior approval. If Boston Scientific
Corporation maintains or increases its ownership of our outstanding common
stock, it may have the ability to impact corporate actions requiring
stockholder approval. In addition, on August 7, 2002, we formed a strategic
alliance with Boston Scientific Corporation. In connection with this strategic
alliance, we entered into an agreement pursuant to which we granted Boston
Scientific Corporation an option to distribute newly developed technology for
monitoring patients under sedation in a range of less-invasive medical
specialties. If such products are not successfully developed, marketed and sold
under the agreement in a manner consistent with our expectations, the growth of
our business and our operating results will be adversely affected. Even if we
successfully develop new sedation management technology for less-invasive
medical procedures, Aspect and Boston Scientific Corporation may not
successfully market and sell this new technology. We may not reserve amounts adequate to cover product obsolescence, claims and
returns, which could result in unanticipated expenses and fluctuations in
operating results. Depending on factors such as the timing of our introduction of new
products which utilize our BIS technology, as well as warranty claims and
product returns, we may need to reserve amounts in excess of those currently
reserved for product obsolescence, excess inventory, warranty claims and
product returns. These reserves may not be adequate to cover all costs
associated with these items. If these reserves are inadequate, we would be
required to incur unanticipated expenses which could result in unexpected
fluctuations in quarterly operating results. We may not be able to compete effectively, which could result in price
reductions and decreased demand for our products. We are facing increased competition in the domestic level of consciousness
monitoring market as a result of a number of competitors monitoring systems
which have been cleared by the FDA. These products are marketed by
well-established medical products companies with significant resources. We may
not be able to compete effectively with these and other potential competitors.
We may also face substantial competition from companies which may develop
sensor products that compete with our proprietary BIS Sensors for use with our
BIS monitors or with third-party monitoring systems or anesthesia delivery
systems that incorporate the BIS index. We also expect to face competition from
companies currently marketing conventional electroencephalogram, or EEG,
monitors using standard and novel signal-processing techniques. Other companies
may develop anesthesia-monitoring systems that perform better than the BIS
system and/or sell for less. In addition, one or more of our competitors may
develop products that are substantially equivalent to our FDA-approved
products, in which case they may be able to use our products as predicate
devices to more quickly obtain FDA approval of their competing products.
Medical device companies developing these and other competitive products may
have greater financial, technical, marketing and other resources than we do.
Competition in the sale of anesthesia-monitoring systems could result in price
reductions, fewer orders, reduced gross margins and loss of market share. 30




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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. Before we can market new products in the United States, we must obtain
clearance from the FDA. If the FDA concludes that any of our products do not
meet the requirements to obtain clearance of a premarket notification under
Section 510(k) of the Food, Drug and Cosmetic Act, then we would be required to
file a premarket approval application. The approval process for a premarket
approval application is lengthy, expensive and typically requires extensive
preclinical and clinical trial data. We may not obtain clearance of a 510(k)
notification or approval of a premarket approval application with respect to
any of our products on a timely basis, if at all. If we fail to obtain timely
clearance or approval for our products, we will not be able to market and sell
our products, which will limit our ability to generate revenue. We may also be
required to obtain clearance of a 510(k) notification from the FDA before we
can market certain previously marketed products which we modify after they have
been cleared. We have made certain enhancements to our currently marketed
products which we have determined do not necessitate the filing of a new 510(k)
notification. However, if the FDA does not agree with our determination, it
will require us to file a new 510(k) notification for the modification and we
may be prohibited from marketing the modified device until we obtain FDA
clearance. The FDA also requires us to adhere to current Good Manufacturing Practices
regulations, which include production design controls, testing, quality
control, storage and documentation procedures. The FDA may at any time inspect
our facilities to determine whether adequate compliance has been achieved.
Compliance with current Good Manufacturing Practices regulations for medical
devices is difficult and costly. In addition, we may not continue to be
compliant as a result of future changes in, or interpretations of, regulations
by the FDA or other regulatory agencies. If we do not achieve continued
compliance, the FDA may withdraw marketing clearance or require product recall.
When any change or modification is made to a device or its intended use, the
manufacturer may be required to reassess compliance with current Good
Manufacturing Practices regulations, which may cause interruptions or delays in
the marketing and sale of our products. Sales of our products outside the United States are subject to foreign
regulatory requirements that vary from country to country. The time required to
obtain approvals from foreign countries may be longer than that required for
FDA approval, and requirements for foreign licensing may differ from FDA
requirements. The federal, state and foreign laws and regulations regarding the
manufacture and sale of our products are subject to future changes, as are
administrative interpretations of regulatory agencies. If we fail to comply
with applicable federal, state or foreign laws or regulations, we could be
subject to enforcement actions, including product seizures, recalls, withdrawal
of clearances or approvals and civil and criminal penalties. If we do not retain our senior management and other key employees, we may not
be able to successfully implement our business strategy. Our president and chief executive officer, Nassib Chamoun, joined us at
our inception in 1987. Our chairman, J. Breckenridge Eagle, began serving as a
director in 1988. Many other members of our management and key employees have
extensive experience with us and other companies in the medical device
industry. Our success is substantially dependent on the ability, experience and
performance of these members of our senior management and other key employees.
Because of their ability and experience, if we lose one or more of the members
of our senior management or other key employees, our ability to successfully
implement our business strategy could be seriously harmed. If we do not attract and retain skilled personnel, we will not be able to
expand our business. Our products are based on complex signal-processing technology.
Accordingly, we require skilled personnel to develop, manufacture, sell and
support our products. Our future success will depend largely on our ability to
continue to hire, train, retain and motivate additional skilled personnel,
particularly sales representatives who are responsible for customer education
and training and post-installation customer support. Consequently, if we are
not able to attract and retain skilled personnel, we will not be able to expand
our business. 31




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Failure of users of the BIS system to obtain adequate reimbursement from
third-party payors could limit market acceptance of the BIS system, which could
prevent us from sustaining profitability. Anesthesia providers are generally not reimbursed separately for patient
monitoring activities utilizing the BIS system. For hospitals and outpatient
surgical centers, when reimbursement is based on charges or costs, patient
monitoring with the BIS system may reduce reimbursements for surgical
procedures, because charges or costs may decline as a result of monitoring with
the BIS system. Failure by hospitals and other users of the BIS system to
obtain adequate reimbursement from third-party payors, or any reduction in the
reimbursement by third-party payors to hospitals and other users as a result of
using the BIS system could limit market acceptance of the BIS system, which
could prevent us from achieving profitability. 
 Item 3. Quantitative and Qualitative Disclosures About Market Risk. Interest Rate Exposure Our investment portfolio consists primarily of high-grade commercial
paper, high grade corporate bonds and debt obligations of various governmental
agencies. We manage our investment portfolio in accordance with our investment
policy. The primary objectives of our investment policy are to preserve
principal, maintain a high degree of liquidity to meet operating needs, and
obtain competitive returns subject to prevailing market conditions.
Investments are made with an average maturity of 12 months or less and a
maximum maturity of 24 months. These investments are subject to risk of
default, changes in credit rating and changes in market value. These
investments are also subject to interest rate risk and will decrease in value
if market interest rates increase. Due to the conservative nature of our
investments and relatively short effective maturities of the debt instruments,
we believe interest rate risk is mitigated. Our investment policy specifies
the credit quality standards for our investments and limits the amount of
exposure from any single issue, issuer or type of investment. Our investment in sales-type leases, line of credit agreements and
sales-type lease debt agreements are also subject to market risk. The interest
rates implicit in our sales-type leases and on our sales-type lease debt
agreements are fixed and not subject to interest rate risk. The interest rates
on our line of credit agreements are variable and subject to interest rate
risk. The interest rate risk related to the lines of credit is mitigated
primarily by the fact that the lines of credit, when drawn on, are generally
outstanding for short periods of time in order to fund short-term cash
requirements. Foreign Currency Exposure Most of our revenue, expenses and capital spending are transacted in U.S.
dollars. The expenses and capital spending of our two international
subsidiaries are transacted in the respective countrys local currency and
subject to foreign currency exchange rate risk. Our foreign currency
transactions are translated into U.S. dollars at prevailing rates. Gains or
losses resulting from foreign currency transactions are included in current
period income or loss as incurred. Currently, all material transactions are
denominated in U.S. dollars, and we have not entered into any material
transactions that are denominated in foreign currencies. 32




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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 defined in Rules 13a15(e) and 15d-15(e) under
the Securities Exchange Act) as of October 2, 2004. In designing and
evaluating our disclosure controls and procedures, our management
recognized that any controls and procedures, no matter how well designed
and operated, can provide only reasonable assurance of achieving their
objectives, and our management necessarily applied its judgment in
evaluating the cost-benefit relationship of possible controls and
procedures. Based on this evaluation, our chief executive officer and
chief financial officer concluded that, as of October 2, 2004, our
disclosure controls and procedures were (1) designed to ensure that
material information relating to us, including our consolidated
subsidiaries, is made known to our chief executive officer and chief
financial officer by others within those entities, particularly during the
period in which this report was being prepared and (2) effective, in that
they provide reasonable assurance that information required to be
disclosed by us in the reports that we file or submit under the Securities
Exchange Act is recorded, processed, summarized and reported within the
time periods specified in the Securities and Exchange Commissions rules
and forms.(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 Securities Exchange Act) occurred
during the third quarter ended October 2, 2004 that has materially
affected, or is reasonably likely to materially affect, our internal
control over financial reporting. 33




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PART II  OTHER INFORMATION 
 Item 1. Legal Proceedings. We are not a party to any material threatened or pending legal proceedings. 
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. Initial Public Offering and Use of Proceeds from Sales of Registered Securities On February 2, 2000, we sold 3,500,000 shares of our common stock,
at an initial public offering price of $15.00 per share, pursuant to a
Registration Statement on Form S-1 (Registration No. 333-86295), which
was declared effective by the Securities and Exchange Commission on
January 27, 2000. On February 4, 2000, the underwriters exercised in
full their over-allotment option to purchase an additional 525,000
shares of our common stock at $15.00 per share. The managing
underwriters of our initial public offering were Morgan Stanley & Co.
Incorporated, Deutsche Bank Securities Inc. and U.S. Bancorp Piper
Jaffray Inc. The aggregate gross proceeds raised in the offering were
approximately $60.4 million. Our total expenses in connection with the
offering were approximately $5.7 million, of which $4.2 million was for
underwriting discounts and commissions and, based on our reasonable
estimate, approximately $1.5 million was for other expenses. Our net
proceeds from the offering were approximately $54.6 million. From
January 27, 2000 through October 2, 2004, we used approximately $10.4
million of the net proceeds for the acquisition of machinery and
equipment, leasehold improvements, furniture and fixtures,
demonstration and evaluation equipment and new information systems. In
addition, from January 27, 2000 through October 2, 2004, we used
approximately $43.9 million of the net proceeds for general corporate
purposes, including the funding of operating losses, working capital,
product development, increasing our sales and marketing capabilities
and expanding our international operations. As of October 2, 2004, we
had approximately $320,000 of proceeds remaining from the offering, and
pending use of the proceeds, we have invested these funds in both
short-term and long-term, interest-bearing, investment-grade
securities. 
 Item 3. Defaults Upon Senior Securities. None. 
 Item 4. Submission of Matters to a Vote of Security Holders. None. 
 Item 5. Other Information. None. 
 Item 6. Exhibits. The exhibits listed in the Exhibit Index immediately preceding the
exhibits are filed as part of this Quarterly Report on Form 10-Q. 34




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SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. ASPECT MEDICAL SYSTEMS, INC.Date: November 10, 2004
    By:
    /s/ J. Neal ArmstrongJ. Neal ArmstrongVice President and Chief Financial Officer
(Principal Financial and Accounting Officer) 35




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EXHIBIT INDEX EXHIBITNUMBER
    
    EXHIBIT10.1
    
    Sixth Amendment, dated October 8, 2004, to Loan Agreement, dated
May 16, 2001, by and between the Registrant and Fleet National
Bank.31.1
    
    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.