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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
    FORM 10-Q (Mark One)  ý            QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES
EXCHANGE ACT OF 1934 For the quarterly period ended July 3, 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.(Exact Name of Registrant as Specified in Its Charter)
 Delaware
    
    
    
    04-2985553(State or Other Jurisdiction of
Incorporation or Organization)
    
    
    
    (I.R.S. Employer
Identification No.)
 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. YES   ý         NO    ̈ Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). YES   ý         NO    ̈ The Registrant had 20,435,663 shares of Common Stock, $0.01 par value per
share, outstanding as of August 3, 2004.




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC. TABLE OF CONTENTS PagePART I
    
    FINANCIAL INFORMATION
    
    
    1Item 1.
    
    Financial Statements (Unaudited)
    
    
    1Consolidated Balance Sheets as of July 3, 2004 and December 31, 2003
    
    
    1Consolidated Statements of Operations for the Three and Six Months Ended
July 3, 2004 and June 28, 2003
    
    
    2Consolidated Statements of Cash Flows for the Six Months Ended
July 3, 2004 and June 28, 2003
    
    
    3Notes to Consolidated Financial Statements
    
    
    4Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    31Item 4.
    
    Controls and Procedures
    
    
    32PART II
    
    OTHER INFORMATION
    
    
    33Item 1.
    
    Legal Proceedings
    
    
    33Item 2.
    
    Changes in Securities, Use of Proceeds, and Issuer Purchases of Equity Securities
    
    
    33Item 3.
    
    Defaults Upon Senior Securities
    
    
    33Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    34Item 5.
    
    Other Information
    
    
    34Item 6.
    
    Exhibits and Reports on Form 8-K
    
    
    34SIGNATURE
    
    
    
    
    35EXHIBIT INDEXEX-10.1 Fifth Amendment to Loan AgreementEX-10.2 Exclusive License 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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PART I  FINANCIAL INFORMATION 
 Item 1. Financial Statements. ASPECT MEDICAL SYSTEMS, INC. 
 CONSOLIDATED BALANCE SHEETS July 3,
    
    December 31,2004
    
    2003(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    21,540,348
    
    
    $
    12,343,808Restricted cash
    
    
    200,000
    
    
    
    5,100,000Short-term investments
    
    
    11,749,071
    
    
    
    13,718,727Accounts receivable, net of allowance of $51,000 at
July 3, 2004 and $150,000 at December 31, 2003
    
    
    7,066,168
    
    
    
    5,772,982Current portion of investment in sales-type leases
    
    
    1,795,318
    
    
    
    1,797,044Inventory, net
    
    
    2,034,959
    
    
    
    1,514,682Other current assets
    
    
    1,233,052
    
    
    
    1,146,675Total current assets
    
    
    45,618,916
    
    
    
    41,393,918Property and equipment, net
    
    
    2,748,014
    
    
    
    2,996,272Long-term investments
    
    
    4,753,300
    
    
    
    Long-term investment in sales-type leases
    
    
    2,425,107
    
    
    
    2,613,074Long-term portion of notes receivable from related parties
    
    
    257,083
    
    
    
    736,833Total assets
    
    $
    55,802,420
    
    
    $
    47,740,097LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Current portion of long-term debt
    
    $
    520,772
    
    
    $
    678,554Accounts payable
    
    
    1,491,905
    
    
    
    1,189,198Accrued liabilities
    
    
    5,979,290
    
    
    
    7,871,139Deferred revenue
    
    
    1,428,345
    
    
    
    975,180Total current liabilities
    
    
    9,420,312
    
    
    
    10,714,071Long-term portion of deferred revenue
    
    
    5,139,854
    
    
    
    5,533,375Long-term debt
    
    
    296,076
    
    
    
    525,018Commitments 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, 20,425,663 and 19,502,079 shares issued
and outstanding at July 3, 2004 and December 31, 2003,
respectively
    
    
    204,257
    
    
    
    195,021Additional paid-in capital
    
    
    142,260,152
    
    
    
    131,131,044Notes receivable from employees and directors
    
    
    (34,235
    )
    
    
    (78,335
    )Accumulated other comprehensive loss
    
    
    (36,068
    )
    
    
    (3,731
    )Accumulated deficit
    
    
    (101,447,928
    )
    
    
    (100,276,366
    )Total stockholders equity
    
    
    40,946,178
    
    
    
    30,967,633Total liabilities and stockholders equity
    
    $
    55,802,420
    
    
    $
    47,740,097
 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 Three Months Ended
    
    Six Months EndedJuly 3, 2004
    
    June 28, 2003
    
    July 3, 2004
    
    June 28, 2003(Unaudited)
    
    (Unaudited)
    
    (Unaudited)
    
    (Unaudited)Revenue
    
    $
    13,425,944
    
    
    $
    10,708,844
    
    
    $
    26,223,221
    
    
    $
    20,836,134Costs of revenue
    
    
    3,176,702
    
    
    
    2,716,429
    
    
    
    6,042,236
    
    
    
    5,265,889Gross profit margin
    
    
    10,249,242
    
    
    
    7,992,415
    
    
    
    20,180,985
    
    
    
    15,570,245Operating expenses:Research and development
    
    
    1,801,655
    
    
    
    1,863,797
    
    
    
    3,747,056
    
    
    
    3,744,753Sales and marketing
    
    
    6,748,001
    
    
    
    5,925,118
    
    
    
    13,313,298
    
    
    
    12,241,736General and administrative
    
    
    2,268,064
    
    
    
    2,182,600
    
    
    
    4,664,883
    
    
    
    4,281,388Total operating
expenses
    
    
    10,817,720
    
    
    
    9,971,515
    
    
    
    21,725,237
    
    
    
    20,267,877Loss from operations
    
    
    (568,478
    )
    
    
    (1,979,100
    )
    
    
    (1,544,252
    )
    
    
    (4,697,632
    )Interest income
    
    
    220,951
    
    
    
    236,359
    
    
    
    430,199
    
    
    
    486,345Interest expense
    
    
    (28,131
    )
    
    
    (52,456
    )
    
    
    (57,509
    )
    
    
    (107,586
    )Net loss
    
    $
    (375,658
    )
    
    $
    (1,795,197
    )
    
    $
    (1,171,562
    )
    
    $
    (4,318,873
    )Net loss per share:Basic and diluted
    
    $
    (0.02
    )
    
    $
    (0.09
    )
    
    $
    (0.06
    )
    
    $
    (0.22
    )Weighted average shares used
in computing net loss per
share:Basic and diluted
    
    
    19,914,194
    
    
    
    19,394,827
    
    
    
    19,752,456
    
    
    
    19,387,987
 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 Six Months EndedJuly 3,
    
    June 28,2004
    
    2003(Unaudited)
    
    (Unaudited)Cash flows from operating activities:Net loss
    
    $
    (1,171,562
    )
    
    $
    (4,318,873
    )Adjustments to reconcile net loss to net cash used for
operating activities Depreciation and amortization
    
    
    787,607
    
    
    
    1,098,666Provision for doubtful accounts
    
    
    (50,000
    )
    
    
    (100,000
    )Compensation expense related to stock options
    
    
    33,755
    
    
    
    13,537Changes in assets and liabilities Increase in accounts receivable
    
    
    (1,243,186
    )
    
    
    (954,573
    )(Increase) decrease in inventory
    
    
    (520,277
    )
    
    
    595,060Increase in other assets
    
    
    (104,899
    )
    
    
    (428,421
    )Decrease (increase) in investment in sales-type leases
    
    
    189,693
    
    
    
    (24,781
    )Increase in accounts payable
    
    
    302,707
    
    
    
    54,373Decrease in accrued liabilities
    
    
    (1,891,849
    )
    
    
    (188,304
    )Increase (decrease) in deferred revenue
    
    
    59,644
    
    
    
    (473,763
    )Net cash used for operating activities
    
    
    (3,608,367
    )
    
    
    (4,727,079
    )Cash flows from investing activities:Payments on loans to related parties
    
    
    498,272
    
    
    
    118,419Acquisition of property and equipment
    
    
    (539,349
    )
    
    
    (260,097
    )Decrease in restricted cash
    
    
    4,900,000
    
    
    
    Purchases of marketable securities
    
    
    (15,100,981
    )
    
    
    (4,900,000
    )Proceeds from sales and maturities of marketable securities
    
    
    12,285,000
    
    
    
    11,223,086Net cash provided by investing activities
    
    
    2,042,942
    
    
    
    6,181,408Cash flows from financing activities:Proceeds from sale of investment in sales-type leases
    
    
    
    
    
    
    265,730Principal payments on debt related to investment in
sales-type leases
    
    
    (386,724
    )
    
    
    (504,415
    )Proceeds from issuance of common stock
    
    
    11,104,589
    
    
    
    143,023Payments received on notes receivable from employees and
directors
    
    
    44,100
    
    
    
    143,900Net cash provided by financing activities
    
    
    10,761,965
    
    
    
    48,238Net increase in cash and cash equivalents
    
    
    9,196,540
    
    
    
    1,502,567Cash and cash equivalents, beginning of period
    
    
    12,343,808
    
    
    
    11,542,833Cash and cash equivalents, end of period
    
    $
    21,540,348
    
    
    $
    13,045,400Supplemental disclosure of cash flow information:Interest paid
    
    $
    56,640
    
    
    $
    107,586
 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
(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 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 material 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
July 3, 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 other
comprehensive income (loss). Investments which 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
(Unaudited) The Company recognizes revenue from product sales when earned in
accordance with Staff Accounting Bulletin (SAB) No. 104, Revenue
Recognitionand 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 July 3, 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.
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
(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 the
Companys 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 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 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 six
months ended July 3, 2004 and June 28, 2003 and accrued warranty cost,
included in accrued liabilities in the consolidated balance sheet at July 3,
2004, was as follows: Three Months Ended
    
    Six Months EndedJuly 3, 2004
    
    June 28, 2003
    
    July 3, 2004
    
    June 28, 2003Beginning balance
    
    $
    151,617
    
    
    $
    169,907
    
    
    $
    147,313
    
    
    $
    367,798Warranty expense
    
    
    25,287
    
    
    
    8,222
    
    
    
    50,404
    
    
    
    (175,505
    )Deductions and other
    
    
    (21,062
    )
    
    
    (15,613
    )
    
    
    (41,875
    )
    
    
    (29,777
    )Ending balance
    
    $
    155,842
    
    
    $
    162,516
    
    
    $
    155,842
    
    
    $
    162,516
 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 $337,000 at July 3, 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
(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 on a straight-line
basis 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 Loss Per Share In accordance with SFAS No. 128, Earnings Per Share, basic and diluted
net loss per share amounts for the three and six months ended July 3, 2004
and June 28, 2003, were computed by dividing the net loss available to common
stockholders by the weighted average number of common shares outstanding
during those periods. All shares of restricted common stock that are subject to repurchase and
common stock issuable pursuant to the exercise of stock options and warrants
have been excluded from the calculation of diluted net loss per share since
the inclusion of such amounts would be antidilutive. 7




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ASPECT MEDICAL SYSTEMS, INC. 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) 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 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
six months ended July 3, 2004 and June 28, 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
    
    Six Months EndedJuly 3, 2004
    
    June 28, 2003
    
    July 3, 2004
    
    June 28, 2003Risk-free interest rate
    
    
    3.71
    %
    
    
    2.82
    %
    
    
    3.17
    %
    
    
    2.99
    %Expected dividend yield
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Expected life of options
    
    5 years
    
    5 years
    
    5 years
    
    5 yearsExpected volatility
    
    
    53
    %
    
    
    57
    %
    
    
    56
    %
    
    
    57
    %Weighted average fair
market value of options
granted
    
    $
    6.82
    
    
    $
    2.89
    
    
    $
    9.00
    
    
    $
    2.26
 If the Company had recognized compensation cost for these awards
consistent with SFAS No. 123, the Companys net loss and pro forma net loss
per common share would have been increased to the following pro forma
amounts: Three Months Ended
    
    Six Months EndedJuly 3, 2004
    
    June 28, 2003
    
    July 3, 2004
    
    June 28, 2003Net loss:Net loss as reported
    
    $
    (375,658
    )
    
    $
    (1,795,197
    )
    
    $
    (1,171,562
    )
    
    $
    (4,318,873
    )Add: Stock-based
employee
compensation
expense included
in reported net
loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Deduct:Stock-based
employee
compensation
expense
determined under
fair value based
method for all
awards
    
    
    (2,038,329
    )
    
    
    (1,880,390
    )
    
    
    (3,912,643
    )
    
    
    (3,706,971
    )Pro forma net loss
    
    $
    (2,413,987
    )
    
    $
    (3,675,587
    )
    
    $
    (5,084,205
    )
    
    $
    (8,025,844
    )Net loss per share:Basic and diluted
net loss per
common share:As reported
    
    $
    (0.02
    )
    
    $
    (0.09
    )
    
    $
    (0.06
    )
    
    $
    (0.22
    )Pro forma
    
    $
    (0.12
    )
    
    $
    (0.19
    )
    
    $
    (0.26
    )
    
    $
    (0.41
    )
 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. 8




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ASPECT MEDICAL SYSTEMS, INC. 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) 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. (3) Comprehensive Income (Loss) The Companys total comprehensive income (loss) is as follows: Three Months Ended
    
    Six Months EndedJuly 3, 2004
    
    June 28, 2003
    
    July 3, 2004
    
    June 28, 2003(Unaudited)
    
    (Unaudited)
    
    (Unaudited)
    
    (Unaudited)Net loss
    
    $
    (375,658
    )
    
    $
    (1,795,197
    )
    
    $
    (1,171,562
    )
    
    $
    (4,318,873
    )Other comprehensive income (loss):Unrealized (loss) gain on
marketable securities
    
    
    (31,851
    )
    
    
    (9,827
    )
    
    
    (32,337
    )
    
    
    833Comprehensive loss
    
    $
    (407,509
    )
    
    $
    (1,805,024
    )
    
    $
    (1,203,899
    )
    
    $
    (4,318,040
    )
 (4) Investment in Sales-Type Leases The components of the Companys net investment in sales-type leases are
as follows: July 3,
    
    December 31,2004
    
    2003(Unaudited)Total minimum lease payments receivable
    
    $
    6,176,529
    
    
    $
    6,492,607Less:Unearned interest income
    
    
    889,380
    
    
    
    984,751Allowance for lease payments
    
    
    1,066,724
    
    
    
    1,097,738Net investment in sales-type leases
    
    
    4,220,425
    
    
    
    4,410,118Less  current portion
    
    
    1,795,318
    
    
    
    1,797,044$
    2,425,107
    
    
    $
    2,613,074
 9




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ASPECT MEDICAL SYSTEMS, INC. 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) (5) Inventory Inventory consists of the following: July 3,
    
    December 31,2004
    
    2003(Unaudited)Raw materials
    
    $
    1,034,676
    
    
    $
    739,331Work-in-progress
    
    
    45,032
    
    
    
    61,763Finished goods
    
    
    955,251
    
    
    
    713,588$
    2,034,959
    
    
    $
    1,514,682
 (6) Segment Information and Enterprise Reporting The Company operates in one reportable segment as it markets and sells
one family 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
    
    Six Months EndedJuly 3, 2004
    
    June 28, 2003
    
    July 3, 2004
    
    June 28, 2003(Unaudited)
    
    (Unaudited)
    
    (Unaudited)
    
    (Unaudited)Geographic Area by DestinationDomestic
    
    $
    10,442,155
    
    
    $
    8,678,204
    
    
    $
    20,821,813
    
    
    $
    16,618,538International
    
    
    2,983,789
    
    
    
    2,030,640
    
    
    
    5,401,408
    
    
    
    4,217,596$
    13,425,944
    
    
    $
    10,708,844
    
    
    $
    26,223,221
    
    
    $
    20,836,134
 Three Months Ended
    
    Six Months EndedJuly 3, 2004
    
    June 28, 2003
    
    July 3, 2004
    
    June 28, 2003(Unaudited)
    
    (Unaudited)
    
    (Unaudited)
    
    (Unaudited)Geographic Area by DestinationDomestic
    
    
    78
    %
    
    
    81
    %
    
    
    79
    %
    
    
    80
    %International
    
    
    22
    
    
    
    19
    
    
    
    21
    
    
    
    20100
    %
    
    
    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 six months ended July 3, 2004 and June 28, 2003. 10




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ASPECT MEDICAL SYSTEMS, INC. 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) (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 assets
of the borrower, including shares of the Companys common stock owned by the
borrower. The long-term portion of the loans is included in long-term notes
receivable from related parties, and the short-term portion of approximately
$26,000 and $44,000 at July 3, 2004 and December 31, 2003, respectively, is
included in other current assets in the accompanying consolidated balance
sheets. The aggregate outstanding balance on these loans at July 3, 2004 and
December 31, 2003 was approximately $283,000 and $781,000, respectively. 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 July 3, 2004, the Company
paid approximately $12,000 to this individual under this consulting
agreement. (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 July 3, 2004,
the Company had outstanding standby letters of credit with the commercial
bank of approximately $165,000. 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 extension 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 July 3, 2004, the Company was in compliance with all covenants contained
in the revolving line of credit agreement. At July 3, 2004, the interest
rate on the revolving line of credit was 4.25%. 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, or approximately $6,300,000 in total,
was attributed to the value of the rights provided to BSC under the OEM
Product Development Agreement. Approximately $5,224,000 of the aggregate purchase price is recorded as
deferred revenue in the accompanying consolidated balance sheet at July 3,
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 11




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ASPECT MEDICAL SYSTEMS, INC. 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) 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 July 3, 2004 and June 28, 2003 and approximately $307,000
was recognized as revenue in the six months ended July 3, 2004 and June 28,
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 July 3, 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. 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. 12




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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 the 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
export sales by region and sales by products as shown in the following table: Three Months Ended
    
    Six Months EndedJuly 3,
    
    June 28,
    
    July 3,
    
    June 28,2004
    
    2003
    
    2004
    
    2003(in thousands)Domestic revenue
    
    $
    10,442
    
    
    $
    8,678
    
    
    $
    20,822
    
    
    $
    16,619Percent of total revenue
    
    
    78
    %
    
    
    81
    %
    
    
    79
    %
    
    
    80
    %International revenue
    
    $
    2,984
    
    
    $
    2,031
    
    
    $
    5,401
    
    
    $
    4,217Percent of total revenue
    
    
    22
    %
    
    
    19
    %
    
    
    21
    %
    
    
    20
    %BIS Sensor revenue
    
    $
    9,640
    
    
    $
    7,432
    
    
    $
    18,846
    
    
    $
    14,217Percent of total revenue
    
    
    72
    %
    
    
    69
    %
    
    
    72
    %
    
    
    68
    %Equipment revenue
    
    $
    3,786
    
    
    $
    3,277
    
    
    $
    7,377
    
    
    $
    6,619Percent of total revenue
    
    
    28
    %
    
    
    31
    %
    
    
    28
    %
    
    
    32
    %
 At July 3, 2004, we had cash, cash equivalents, restricted cash and
investments of approximately $38.2 million and working capital of approximately
$36.2 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. 13




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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 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. Placements by our original
equipment manufacturers comprised
approximately 52% of the growth in our installed base from the
second quarter of 2003 to the second quarter of 2004. We believe that maintaining our gross profit margin and controlling the
growth of our operating expenses are important factors in achieving
profitability. To maintain our gross profit margin we believe we must continue
to focus on maintaining our average unit 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. The transition from BIS monitor placements to BIS module placements has
adversely impacted our gross profit margin on Equipment as BIS Module Kits have
a lower gross margin than the BIS monitors. However, we believe that this
transition should, over time, improve our total gross profit margin as we
expect BIS module placements to be a contributing factor to increasing revenue
from the sale of our BIS Sensors. For those healthcare organizations desiring to purchase our BIS monitors,
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%
and 4% of total revenue in the three months ended July 3, 2004 and June 28,
2003, respectively, and approximately 2% and 3% of total revenue in the six
months ended July 3, 2004 and June 28, 2003, respectively. 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 26% and
20%, respectively, of international revenue for the three and six months ended
July 3, 2004 and approximately 10% and 13% of international revenue in the
three and six months ended June 28, 2003, respectively. 14




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##### Table of Contents



Various factors may adversely affect our quarterly operating results
through the third fiscal quarter of 2004 and the year ending December 31, 2004.
These factors include 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. 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. 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 Recognitionand 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. 15




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##### Table of Contents



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. 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 increased warranty claim
activity or increased costs associated with servicing those claims, our
warranty expenses will increase, and we would experience decreased gross profit
margin and cash flow. 16




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##### Table of Contents



Results of Operations The following tables present, for the three and six month periods ended
July 3, 2004 and June 28, 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
    
    Six Months EndedJuly 3, 2004
    
    June 28, 2003
    
    July 3, 2004
    
    June 28, 2003Revenue
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Costs of revenue
    
    
    24
    
    
    
    25
    
    
    
    23
    
    
    
    25Gross profit margin
    
    
    76
    
    
    
    75
    
    
    
    77
    
    
    
    75Operating expenses:Research and development
    
    
    13
    
    
    
    18
    
    
    
    14
    
    
    
    18Sales and marketing
    
    
    50
    
    
    
    55
    
    
    
    51
    
    
    
    59General and administrative
    
    
    17
    
    
    
    20
    
    
    
    18
    
    
    
    21Total operating expenses
    
    
    80
    
    
    
    93
    
    
    
    83
    
    
    
    98Loss from operations
    
    
    (4
    )
    
    
    (18
    )
    
    
    (6
    )
    
    
    (23
    )Interest income, net
    
    
    1
    
    
    
    1
    
    
    
    1
    
    
    
    2Net loss
    
    
    (3
    )%
    
    
    (17
    )%
    
    
    (5
    )%
    
    
    (21
    )%
 Three and Six Months Ended July 3, 2004 Compared to Three and Six Months Ended
June 28, 2003 Three Months Ended
    

    Six Months EndedPercentage
    
    
    
    
    
    
    
    
    
    PercentageJuly 3,
    
    June 28,
    
    Increase
    
    July 3,
    
    June 28,
    
    Increase2004
    
    2003
    
    (Decrease)
    
    2004
    
    2003
    
    (Decrease)(in thousands, exceptunit amounts)
    
    
    
    
    
    (in thousands, exceptunit amounts)Revenue  WorldwideBIS Sensor
    
    $
    9,640
    
    
    $
    7,432
    
    
    
    30
    %
    
    $
    18,846
    
    
    $
    14,217
    
    
    
    33
    %BIS monitor
    
    
    2,185
    
    
    
    1,685
    
    
    
    30
    %
    
    
    4,378
    
    
    
    3,273
    
    
    
    34
    %BIS Module Kit
    
    
    804
    
    
    
    600
    
    
    
    34
    %
    
    
    1,346
    
    
    
    1,535
    
    
    
    (12
    )%Other equipment and accessories
    
    
    797
    
    
    
    992
    
    
    
    (20
    )%
    
    
    1,653
    
    
    
    1,811
    
    
    
    (9
    )%Total Equipment
    
    
    3,786
    
    
    
    3,277
    
    
    
    15
    %
    
    
    7,377
    
    
    
    6,619
    
    
    
    11
    %Total revenue
    
    $
    13,426
    
    
    $
    10,709
    
    
    
    25
    %
    
    $
    26,223
    
    
    $
    20,836
    
    
    
    26
    %Unit Analysis  WorldwideBIS Sensors
    
    
    695,000
    
    
    
    563,000
    
    
    
    23
    %
    
    
    1,346,000
    
    
    
    1,066,000
    
    
    
    26
    %BIS monitors
    
    
    460
    
    
    
    280
    
    
    
    64
    %
    
    
    876
    
    
    
    651
    
    
    
    35
    %Original equipment manufacturerBIS modules
    
    
    517
    
    
    
    466
    
    
    
    11
    %
    
    
    894
    
    
    
    1,018
    
    
    
    (12
    )%Installed base
    
    
    21,411
    
    
    
    17,831
    
    
    
    20
    %
    
    
    21,411
    
    
    
    17,831
    
    
    
    20
    %
 Revenue.The 30% increase in revenue from the sale of BIS Sensors in the
three months ended July 3, 2004 compared with the three months ended June 28,
2003 was primarily attributable to an increase of approximately 23% in the
number of BIS Sensors sold as a result of growth in the installed base of BIS
monitors and BIS modules, plus an increase in the average selling price of BIS
Sensors of approximately 5%. For the six months ended July 3, 2004 compared with the six months ended
June 28, 2003, revenue from the sale of BIS Sensors increased approximately 33%
primarily related to an increase of approximately 26% in the number of BIS
Sensors sold and an increase in the average selling price of BIS Sensors of
approximately 5%. Our installed base of BIS monitors and BIS modules increased
approximately 20% to 21,411 units at July 3, 2004 compared with 17,831 units at
June 28, 2003. 17




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##### Table of Contents



The increase in revenue from the sale of Equipment in the three months
ended July 3, 2004 compared with the three months ended June 28, 2003 was the
result of two factors. First, there was an increase of approximately 34% in
BIS Module Kit revenue. This was a result of an increase in the number of BIS
Module Kits shipped to our original equipment manufacturers, from 466 BIS
Module Kits in the second quarter of 2003 to 517 BIS Module Kits in the second
quarter of 2004. Second, BIS monitor revenue increased by approximately 30%.
The increase in BIS monitor revenue resulted from an increase in unit volume of
approximately 64% as we shipped 460 BIS monitors in the second quarter of 2004
compared with 280 BIS monitors in the second quarter of 2003. For the six months ended July 3, 2004 compared with the six months ended
June 28, 2003, revenue from the sale of Equipment increased approximately 11%
which was primarily attributable to an increase in BIS monitor revenue of
approximately 34%. This was a result of an increase of approximately 35% in
unit volume, as we shipped 876 BIS monitors in the six months ended July 3,
2004 compared with 651 BIS monitors shipped in the six months ended June 28,
2003. The increase in BIS monitor revenue was offset by a decrease in BIS
Module Kit revenue of approximately 12%. The decrease in BIS Module Kit
revenue was a result of a decrease in the number of BIS Module Kits shipped to
our original equipment manufacturers. In the six months ended June 28, 2003,
we shipped 1,018 BIS Module Kits to our original equipment manufacturers
compared with 894 BIS Module Kits shipped in the six months ended July 3, 2004.
The decrease in the number of BIS Module Kits shipped was related to high
levels of shipments to Japan and South America in the first quarter of 2003. Our gross profit margin was approximately 76% and 77% of revenue in the
three and six months ended July 3, 2004 compared with a gross profit margin of
approximately 75% in both the three and six months ended June 28, 2003. The
increase in the gross profit margin in the three and six months ended July 3,
2004 compared with the three and six months ended June 28, 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 six months ended July 3, 2004 compared with approximately 69% and 68%,
respectively, of revenue in the three and six months ended June 28, 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 six months ended July 3, 2004. Expense Overview Three Months Ended
    
    Percentage
    
    Six Months Ended
    
    PercentageJuly 3,
    
    June 28,
    
    Increase
    
    July 3,
    
    June 28,
    
    Increase2004
    
    2003
    
    (Decrease)
    
    2004
    
    2003
    
    (Decrease)(in thousands)
    
    
    
    
    
    (in thousands)ExpensesResearch and development
    
    $
    1,802
    
    
    $
    1,864
    
    
    
    (3
    )%
    
    $
    3,747
    
    
    $
    3,745
    
    
    
    0
    %Sales and marketing
    
    $
    6,748
    
    
    $
    5,925
    
    
    
    14
    %
    
    $
    13,313
    
    
    $
    12,242
    
    
    
    9
    %General and administrative
    
    $
    2,268
    
    
    $
    2,183
    
    
    
    4
    %
    
    $
    4,665
    
    
    $
    4,281
    
    
    
    9
    %
 Research and Development.The decrease in research and development
expenses in the three months ended July 3, 2004 compared with the three months
ended June 28, 2003 was primarily attributable to a decrease in consulting
expenses of approximately $94,000, offset by an increase in clinical study
expenses of approximately $63,000. Research and development expenses remained
relatively consistent between the six months ended July 3, 2004 and the six
months ended June 28, 2003. In the first six months of 2004 compared with the
first six months of 2003, there was a decrease in consulting expenses of
approximately $129,000 offset by an increase in payroll related expenses of
approximately $124,000. We expect research and development expenses to
increase in the third quarter of 2004 compared with the second 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 increase in sales and marketing expenses in the
three months ended July 3, 2004 compared with the three months ended June 28,
2003 was attributable to an increase of approximately $601,000 in commissions
expense and an increase in the operating expenses associated with our
international subsidiaries of approximately $524,000, offset by a decrease of
approximately $149,000 in expenses related to advertising, public relations and
tradeshows. The $524,000 increase in our international operating expenses was
the result of an increase of approximately $299,000 in payroll related
expenses, an increase of approximately $59,000 in travel and entertainment
related expenses and an increase of approximately $43,000 in consulting
expenses. 18




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##### Table of Contents



For the six months ended July 3, 2004 compared with the six months ended
June 28, 2003, the increase in sales and marketing expenses was attributable to
an increase in our operating expenses associated with our international
subsidiaries of approximately $978,000 and approximately $457,000 in
commissions expense. The increase in the operating expenses of our
international subsidiaries was driven by an increase in payroll related
expenses of approximately $518,000 and an increase in consulting expenses of
approximately $99,000. These increases were offset by a decrease of
approximately $120,000 in expenses related to advertising, public relations and
tradeshows. We expect sales and marketing expenses to decrease in the third
quarter of 2004 compared with the second quarter of 2004 as a result of cost
reductions in various programs and other discretionary spending. General and Administrative.The increase in general and administrative
expenses in the three months ended July 3, 2004 compared with the three months
ended June 28, 2003 was primarily attributable to an increase in professional
and consulting services of approximately $76,000. The increase in general and administrative expenses in the six months
ended July 3, 2004 compared with the six months ended June 28, 2003 was
attributable to an increase in professional and consulting services of
approximately $270,000, offset by a decrease of approximately $41,000 in travel
and entertainment related expenses. We expect general and administrative
expenses in the third quarter of 2004 to remain relatively consistent with the
second quarter of 2004. Interest Income.Interest income decreased to approximately $221,000 in
the three months ended July 3, 2004 from approximately $236,000 in the three
months ended June 28, 2003, a decrease of approximately 7%. Interest income
decreased to approximately $430,000 in the six months ended July 3, 2004 from
approximately $486,000 in the six months ended June 28, 2003, a decrease of
approximately 12%. The decrease in interest income in the three and six months
ended July 3, 2004 was primarily attributable to lower cash and investment
balances for the majority of this period resulting from continued operating
losses and other uses of cash. We expect interest income to increase in the
third quarter of 2004 compared with the second quarter of 2004 due to the
increase in our cash and investment balances resulting from the sale of our
common stock to Boston Scientific Corporation in June which provided us gross
cash proceeds of approximately $8.1 million Interest expense.Interest expense decreased to approximately $28,000 in
the three months ended July 3, 2004 from approximately $52,000 in the three
months ended June 28, 2003, a decrease of approximately 46%. Interest expense
decreased to approximately $58,000 in the six months ended July 3, 2004 from
approximately $108,000 in the six months ended June 28, 2003, a decrease of
approximately 47%. The decrease in interest expense in the three and six
months ended July 3, 2004 was a result of lower average outstanding debt
obligations. We expect interest expense to decrease slightly in the third
quarter of 2004 compared with the second quarter of 2004 as a result of
continuing lower average outstanding debt obligations. Net Loss.As a result of the factors discussed above, for the three and
six months ended July 3, 2004, we had a net loss of approximately $376,000 and
$1.2 million, respectively, compared with a net loss of approximately $1.8
million and $4.3 million for the three and six months ended June 28, 2003. 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 July 3, 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 closed 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.
Interest on any borrowings under the revolving line of credit with Fleet is, at
our election, either the prime rate 19




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##### Table of Contents



or at LIBOR plus 2.25%. At July 3, 2004,
the interest rate on the line of credit with Fleet was 4.25%. Up to $1.5
million of the $5.0 million revolving line of credit is available for standby
letters of credit. At July 3, 2004, we had standby letters of credit
outstanding with Fleet in the amount of approximately $165,000. 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 July 3, 2004, there was no outstanding balance under this
revolving line of credit. 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 July 3, 2004. 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. 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 July 3, 2004 was approximately $36.2 million compared
with approximately $30.7 million at December 31, 2003. The increase in working
capital from December 31, 2003 to July 3, 2004 was primarily attributable to
our sale of common stock to Boston Scientific Corporation. Cash Used for Operations.We used approximately $3.6 million of cash for
operations in the six months ended July 3, 2004 compared with approximately
$4.7 million in the six months ended June 28, 2003. Cash used for operations
in the six months ended July 3, 2004 was primarily driven by operating losses,
a decrease in accrued liabilities of approximately $1.9 million and an increase
in accounts receivable of approximately $1.2 million. These were offset by an
increase in accounts payable of approximately $303,000 and a decrease in our
investment in sales-type leases of approximately $190,000. The decrease in
accrued liabilities of approximately $1.9 million was primarily driven by a
decrease in accrued bonus of approximately $1.1 million as annual bonuses were
paid in the first quarter of 2004. The increase in accounts receivable relates
to increased sales during the second quarter and a slight increase in our days
sales outstanding. Cash from Investing Activities.We received approximately $2.0 million of
cash from investing activities in the six months ended July 3, 2004 compared
with approximately $6.2 million in the six months ended June 28, 2003. The
cash received from investing activities in the six months ended July 3, 2004
was primarily attributable to a reduction in our restricted cash of $4.9
million resulting from the amendment to our revolving line of credit with Fleet
offset by net purchases of investments of approximately $2.8 million. In the
six months ended June 28, 2003, we received approximately $6.3 million, net, of
proceeds from sales and maturities of marketable securities and invested
approximately $260,000 primarily for the purchase of manufacturing equipment,
computer hardware and third-party software. 20




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##### Table of Contents



Cash from Financing Activities.We received approximately $10.8 million
of cash from financing activities in the six months ended July 3, 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 $387,000. In the six
months ended June 28, 2003, we received approximately $48,000 of cash from
financing activities primarily as a result of proceeds from the sale of our
investment in sales-type leases of approximately $266,000, proceeds from
payments on notes receivable from employees and directors of approximately
$144,000 and proceeds from the issuance of our common stock upon the exercise
of stock options granted under our stock option plans of approximately
$143,000. These were offset by payments of principal on debt related to our
investment in sales-type leases of approximately $504,000. We guarantee certain operating lease obligations of our subsidiaries of
approximately $337,000 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 July 3, 2004, we sold approximately $5.1 million of
our investment in sales-type leases. 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 July 3, 2004, approximately $817,000 is recorded as debt
on our consolidated balance sheet. We had capital expenditures of approximately $380,000 and approximately
$539,000 for the three and six months ended July 3, 2004, respectively, which
related primarily to the purchase of manufacturing equipment for use in the
production of our BIS Sensors of approximately $152,000 and the purchase of
computer hardware and third-party software. At July 3, 2004, the
balance of our commitment to purchase additional manufacturing equipment for use in
the production of our BIS Sensors remains outstanding. We anticipate that the level of capital
expenditures in the third quarter of 2004 will increase from the level of
capital expenditures during the second 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 July 3,
2004: Payments Due By PeriodLess Than
    
    One to Three
    
    Three to Five
    
    After FiveContractual Obligations
    
    Total
    
    One Year
    
    Years
    
    Years
    
    YearsOperating leases
    
    $
    3,248,814
    
    
    $
    1,275,809
    
    
    $
    1,817,056
    
    
    $
    155,949
    
    
    $
    
    Debt related to the sale of investment in sales type leases
    
    
    816,848
    
    
    
    520,772
    
    
    
    275,971
    
    
    
    20,105
    
    
    
    
    Total contractual cash obligations
    
    $
    4,065,662
    
    
    $
    1,796,581
    
    
    $
    2,093,027
    
    
    $
    176,054
    
    
    $
    
    
 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 the year
2002 and will continue to expire through the year 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. 21




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##### Table of Contents



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. FACTORS AFFECTING FUTURE OPERATING RESULTS This Quarterly Report on Form 10-Q includes forward-looking statements,
including information relating to our ability to achieve 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 October 2, 2004 and for the
year ending December 31, 2004. The following important factors represent
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 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 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 market factors may adversely affect our quarterly operating results
through the third fiscal quarter of 2004 and for the year ending December 31,
2004. In addition to the other factors identified in this Form 10-Q, various
factors may adversely affect our quarterly operating results through the third
fiscal quarter of 2004 and the year ending December 31, 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. Additionally, 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 third fiscal quarter of 2004 and for the year ending
December 31, 2004. 22




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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 again 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 also
likely decrease. In addition, because we do not have a significant 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 are increasingly experiencing 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 debts 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 projections and accruals. 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. 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. 23




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We may need additional financing for our future capital needs and may not be
able to raise additional funds on terms acceptable to us, or at all. 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 achieve
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 in the United States 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
needs 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. 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. 24




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We may not be able to compete with new products or alternative techniques
developed by others, which could impair our ability to remain competitive and
achieve future growth. The medical 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. 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. 25




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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. We need to also 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. 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. 26




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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 the same degree of 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. 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. 27




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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 would 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. 28




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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 will be adversely affected. As of August 3, 2004, Boston Scientific Corporation owned approximately
22% 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-cleared
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. 29




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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. 30




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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 achieving 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. 31




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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 July 3, 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 July 3, 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 fiscal quarter ended July 3, 2004 that has materially affected,
or is reasonably likely to materially affect, our internal control over
financial reporting. 32




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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.
    
    Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities.Recent Sales of Unregistered SecuritiesOn June 8, 2004, we issued and sold 500,000 shares of our common
stock to Boston Scientific Corporation at a purchase price of $16.21
per share, for aggregate gross proceeds of $8,105,000. The common
stock was issued in reliance upon the exemptions from registration
under Section 4(2) of the Securities Act of 1933 or Regulation D
promulgated thereunder, relative to sales by an issuer not involving a
public offering.Initial Public Offering and Use of Proceeds from Sales of Registered
SecuritiesOn 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 July 3, 2004, we used approximately $10.1
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 July 3, 2004, we used
approximately $42.8 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 July 3, 2004, we had
approximately $1.7 million 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.
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Item 4.
    
    Submission of Matters to a Vote of Security Holders.On May 25, 2004, we held our 2004 annual meeting of stockholders.
At the meeting, Richard J. Meelia and Donald R. Stanski, M.D. were
elected as Class I Directors of Aspect, to serve until our 2007 annual
meeting of stockholders and until their successors are duly elected and
qualified. The results of the voting were as follows: 18,159,684
shares of common stock were voted in favor of the election of Mr.
Meelia, and 588,791 shares of common stock were withheld. 18,159,934
shares of common stock were voted in favor of the election of
Dr. Stanski, and
588,541 shares of common stock were withheld.The terms of office of the following directors, who were not up
for re-election at our 2004 annual meeting of stockholders, continued
after our 2004 annual meeting of stockholders: Boudewijn L.P.M. Bollen,
J. Breckenridge Eagle, Edwin M. Kania, Nassib G. Chamoun and James J.
Mahoney.Stockholders approved an amendment to increase the number of
shares of our common stock authorized for issuance under our 2001 Stock
Incentive Plan from 2,000,000 shares to 4,000,000 shares by a vote of
10,476,218 in favor, 4,764,114 against, 13,515 abstaining and
3,494,628 broker non-votes.Stockholders approved the issuance and sale of shares of our
common stock to Boston Scientific Corporation pursuant to the
Marketplace Rules of the Nasdaq Stock Market by a vote of 15,234,210 in
favor, 10,362 against, 9,275 abstaining and 3,494,628 broker
non-votes.Stockholders also ratified the selection of Ernst & Young LLP by
our board of directors as our independent auditors for the fiscal year
ending December 31, 2004 by a vote of 12,881,459 in favor, 5,761,106
against and 105,910 abstaining.Item 5.
    
    Other Information.None.Item 6.
    
    Exhibits and Reports on Form 8-K.None.
  (a)
    
    ExhibitsThe exhibits listed in the Exhibit Index immediately preceding the
exhibits are filed as part of this Quarterly Report on Form 10-Q.(b)
    
    Reports on Form 8-KOn April 8, 2004, we filed a Current Report on Form 8-K (Item 5 
Other Events) with the Securities and Exchange Commission reporting
that on April 7, 2004 we had entered into an agreement with Boston
Scientific Corporation for the sale of 500,000 shares of our common
stock to Boston Scientific Corporation subject to a number of
closing conditions.On April 21, 2004, we furnished a Current Report on Form 8-K (Item
12  Results of Operations and Financial Condition) to the
Securities and Exchange Commission announcing our financial results
for the fiscal quarter ended April 3, 2004.On July 21, 200 we furnished a Current Report on Form 8-K (Item 12 
Results of Operations and Financial Condition) to the Securities and
Exchange Commission announcing our financial results for the fiscal
quarter ended July 3, 2004. 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: August 11, 2004
    
    By:
    
    /s/ J. Neal Armstrong
J. Neal Armstrong
Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)
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EXHIBIT INDEX EXHIBITNUMBER
    
    EXHIBIT10.1
    
    Fifth Amendment, dated May 14, 2004, to Loan Agreement, dated as
of May 16, 2001, by and between the Registrant and Fleet National
Bank, together with Deposit Pledge Agreement, dated May 14, 2004,
by and between the Registrant and Fleet National Bank.10.2
    
    Exclusive License Agreement, dated July 1, 2004, by and between
the Registrant and The Regents of the University of California.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.
   
    
    Confidential treatment has been requested as to certain portions of this
Exhibit. Such portions have been omitted and filed separately with the
Securities and Exchange Commission. 36