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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------

For the quarterly period ended September 30, 2007

OR



| ̈ | 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: 000-20997



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SRI/Surgical Express, Inc.

(Exact name of registrant as specified in its charter)



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|                         |  |                                     
|------------------------ |  | ------------------------------------
|Florida                  |  | 59-3252632                          
|(State of Incorporation) |  | (I.R.S. Employer Identification No.)

12425 Race Track Road

Tampa, Florida 33626

(Address of Principal Executive Offices)

(813) 891-9550

(Registrants Telephone Number)



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Indicate by check 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  x    No ̈

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2
of the Exchange Act (Check One):

Large accelerated filer ̈Accelerated filer ̈Non-accelerated filer  x

Indicate by check mark whether the registrant is a
shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ̈No  x

Number of outstanding shares of each class of registrants common stock as of October 29, 2007:

Common Stock, par value $.001  6,470,978



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##### Table of Contents

INDEX



|           |  |                                                                                                             |  |     
|---------- |  | ----------------------------------------------------------------------------------------------------------- |  | ----
|           |  |                                                                                                             |  | Page
|PART I     |  | FINANCIAL INFORMATION                                                                                       |  |     
|           |  |                                                                                                            
|Item 1     |  | Financial Statements                                                                                        |  |     
|           |  |                                                                                                            
|           |  | Balance Sheets as of September 30, 2007 (unaudited) and December 31, 2006                                   |  | 1   
|           |  |                                                                                                            
|           |  | Statements of Operations (unaudited) for the three months and nine months ended September 30, 2007 and 2006 |  | 2   
|           |  |                                                                                                            
|           |  | Statements of Cash Flows (unaudited) for the nine months ended September 30, 2007 and 2006                  |  | 3   
|           |  |                                                                                                            
|           |  | Notes to Financial Statements (unaudited)                                                                   |  | 4   
|           |  |                                                                                                            
|Item 2     |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                       |  | 12  
|           |  |                                                                                                            
|Item 3     |  | Quantitative and Qualitative Disclosures About Market Risk                                                  |  | 18  
|           |  |                                                                                                            
|Item 4     |  | Controls and Procedures                                                                                     |  | 20  
|           |  |                                                                                                            
|PART II    |  | OTHER INFORMATION                                                                                           |  |     
|           |  |                                                                                                            
|Item 1     |  | Legal Proceedings                                                                                           |  | 22  
|           |  |                                                                                                            
|Item 1A    |  | Risk Factors                                                                                                |  | 22  
|           |  |                                                                                                            
|Item 6     |  | Exhibits and Reports on Form 8-K                                                                            |  | 22  
|           | 
|SIGNATURES |  | 24                                                                                                         



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##### Table of Contents

PART I  FINANCIAL INFORMATION



|Item 1. | Financial Statements
|------- | --------------------

SRI/SURGICAL EXPRESS, INC.

BALANCE SHEETS

(In thousands)



|                                                                                                                                                          |  |                    |        |                  |   |       
|--------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ------ | ---------------- | - | ------
|                                                                                                                                                          |  | September 30, 2007 |        | December 31,2006
|                                                                                                                                                          |  | (unaudited)        |        |                 
|ASSETS                                                                                                                                                    |  |                    |        |                  |   |       
|Cash and cash equivalents                                                                                                                                 |  | $                  | 434    |                  | $ | 283   
|Accounts receivable, net                                                                                                                                  |  |                    | 12,785 |                  |   | 11,390
|Inventories, net                                                                                                                                          |  |                    | 7,202  |                  |   | 6,715 
|Prepaid expenses and other assets, net                                                                                                                    |  |                    | 3,506  |                  |   | 2,641 
|Reusable surgical products, net                                                                                                                           |  |                    | 20,397 |                  |   | 20,954
|Property, plant and equipment, net                                                                                                                        |  |                    | 31,334 |                  |   | 32,371
|                                                                                                                                                          |  |                    |        |                  |   |       
|Total assets                                                                                                                                              |  | $                  | 75,658 |                  | $ | 74,354
|                                                                                                                                                          |  |                    |        |                  |   |       
|                                                                                                                                                          |  |                   
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                                                                      |  |                    |        |                  |   |       
|Liabilities:                                                                                                                                              |  |                    |        |                  |   |       
|Notes payable                                                                                                                                             |  | $                  | 3,639  |                  | $ | 2,497 
|Accounts payable                                                                                                                                          |  |                    | 8,056  |                  |   | 6,863 
|Employee-related accrued expenses                                                                                                                         |  |                    | 1,489  |                  |   | 1,562 
|Other accrued expenses                                                                                                                                    |  |                    | 3,723  |                  |   | 2,764 
|Mortgage payable                                                                                                                                          |  |                    | 4,346  |                  |   | 4,524 
|Bonds payable                                                                                                                                             |  |                    | 7,225  |                  |   | 7,720 
|Deferred tax liability, net                                                                                                                               |  |                    | 1,209  |                  |   | 1,706 
|                                                                                                                                                          |  |                    |        |                  |   |       
|Total liabilities                                                                                                                                         |  |                    | 29,687 |                  |   | 27,636
|                                                                                                                                                          |  |                    |        |                  |   |       
|Shareholders equity:                                                                                                                                     |  |                    |        |                  |   |       
|Preferred stock-authorized 5,000,000 shares of $0.001 par value; no shares issued and outstanding at September 30, 2007 and
December 31, 2006.            |  |                    |       |                  |   |      
|Common stock-authorized 30,000,000 shares of $0.001 par value; issued and outstanding 6,470,978 at September 30, 2007 and 6,459,021 at
December 31, 2006. |  |                    | 6      |                  |   | 6     
|Additional paid-in capital                                                                                                                                |  |                    | 31,181 |                  |   | 30,353
|Retained earnings                                                                                                                                         |  |                    | 14,784 |                  |   | 16,359
|                                                                                                                                                          |  |                    |        |                  |   |       
|Total shareholders equity                                                                                                                                |  |                    | 45,971 |                  |   | 46,718
|                                                                                                                                                          |  |                    |        |                  |   |       
|Total liabilities and shareholders equity                                                                                                                |  | $                  | 75,658 |                  | $ | 74,354
|                                                                                                                                                          |  |                    |        |                  |   |       

The accompanying notes are an integral part of these financial statements.



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##### Table of Contents

SRI/SURGICAL EXPRESS, INC.

STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(unaudited)



|                                            |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                            |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                            |  | 2007                            |        |   | 2006                           |   |        | 2007 |  |   | 2006   |  
|Revenues                                    |  | $                               | 23,151 |   |                                | $ | 23,111 |      |  | $ | 70,245 |   |  | $ | 70,034 |  
|Cost of revenues                            |  |                                 | 18,606 |   |                                |   | 17,780 |      |  |   | 54,731 |   |  |   | 53,610 |  
|                                            |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Gross profit                                |  |                                 | 4,545  |   |                                |   | 5,331  |      |  |   | 15,514 |   |  |   | 16,424 |  
|Distribution expenses                       |  |                                 | 1,554  |   |                                |   | 1,464  |      |  |   | 4,695  |   |  |   | 4,553  |  
|Selling and administrative expenses         |  |                                 | 3,745  |   |                                |   | 4,079  |      |  |   | 12,397 |   |  |   | 12,893 |  
|                                            |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Loss from operations                        |  |                                 | (754   | ) |                                |   | (212   | )    |  |   | (1,578 | ) |  |   | (1,022 | )
|Interest expense                            |  |                                 | 331    |   |                                |   | 340    |      |  |   | 1,067  |   |  |   | 914    |  
|Other income                                |  |                                 | (128   | ) |                                |   |       |      |  |   | (250   | ) |  |   |       |  
|                                            |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Loss before income taxes                    |  |                                 | (957   | ) |                                |   | (552   | )    |  |   | (2,395 | ) |  |   | (1,936 | )
|Income tax benefit                          |  |                                 | (312   | ) |                                |   | (313   | )    |  |   | (820   | ) |  |   | (617   | )
|                                            |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Net loss                                    |  | $                               | (645   | ) |                                | $ | (239   | )    |  | $ | (1,575 | ) |  | $ | (1,319 | )
|                                            |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Loss per share:                             |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Basic                                       |  | $                               | (0.10  | ) |                                | $ | (0.04  | )    |  | $ | (0.25  | ) |  | $ | (0.21  | )
|                                            |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Diluted                                     |  | $                               | (0.10  | ) |                                | $ | (0.04  | )    |  | $ | (0.25  | ) |  | $ | (0.21  | )
|                                            |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Weighted average common shares outstanding: |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Basic                                       |  |                                 | 6,420  |   |                                |   | 6,339  |      |  |   | 6,390  |   |  |   | 6,338  |  
|                                            |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Diluted                                     |  |                                 | 6,420  |   |                                |   | 6,339  |      |  |   | 6,390  |   |  |   | 6,338  |  
|                                            |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |        |  

The accompanying notes are an integral part of these financial statements.



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SRI/SURGICAL EXPRESS, INC.

STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)



|                                                                                |  |                   |         |   |                   |   |        |  
|------------------------------------------------------------------------------- |  | ----------------- | ------- | - | ----------------- | - | ------ | -
|                                                                                |  | Nine Months Ended |        
|                                                                                |  | September 30,2007 |         |   | September 30,2006 |  
|Cash flows from operating activities:                                           |  |                   |         |   |                   |   |        |  
|Net loss                                                                        |  | $                 | (1,575  | ) |                   | $ | (1,319 | )
|Adjustments to reconcile net loss to net cash provided by operating activities: |  |                   |         |   |                   |   |        |  
|Depreciation and amortization                                                   |  |                   | 2,461   |   |                   |   | 2,563  |  
|Amortization of reusable surgical products                                      |  |                   | 3,939   |   |                   |   | 3,530  |  
|Gain on sale of property, plant and equipment                                   |  |                   | (44     | ) |                   |   |       |  
|Stock-based compensation expense                                                |  |                   | 510     |   |                   |   | 478    |  
|Provision for doubtful accounts                                                 |  |                   | 168     |   |                   |   |       |  
|Provision for slow moving inventory                                             |  |                   | 331     |   |                   |   |       |  
|Provision for slow moving reusable surgical products and shrinkage              |  |                   | 385     |   |                   |   | 965    |  
|Deferred income taxes                                                           |  |                   | (497    | ) |                   |   | (460   | )
|Change in operating assets and liabilities:                                     |  |                   |         |   |                   |   |        |  
|(Increase) decrease in accounts receivable                                      |  |                   | (1,563  | ) |                   |   | 996    |  
|Increase in inventories                                                         |  |                   | (818    | ) |                   |   | (110   | )
|Decrease (increase) in prepaid expenses and other assets, net                   |  |                   | 66      |   |                   |   | (684   | )
|Increase in accounts payable                                                    |  |                   | 1,193   |   |                   |   | 318    |  
|Increase in employee-related and other accrued expenses                         |  |                   | 835     |   |                   |   | 112    |  
|                                                                                |  |                   |         |   |                   |   |        |  
|Net cash provided by operating activities                                       |  |                   | 5,391   |   |                   |   | 6,389  |  
|                                                                                |  |                   |         |   |                   |   |        |  
|Cash flows from investing activities:                                           |  |                   |         |   |                   |   |        |  
|Purchases of property, plant and equipment                                      |  |                   | (1,411  | ) |                   |   | (1,430 | )
|Purchases of reusable surgical products                                         |  |                   | (3,767  | ) |                   |   | (3,710 | )
|Proceeds from sale of property, plant and equipment                             |  |                   | 87      |   |                   |   |       |  
|                                                                                |  |                   |         |   |                   |   |        |  
|Net cash used in investing activities                                           |  |                   | (5,091  | ) |                   |   | (5,140 | )
|                                                                                |  |                   |         |   |                   |   |        |  
|Cash flows from financing activities:                                           |  |                   |         |   |                   |   |        |  
|Borrowings on notes payable                                                     |  |                   | 26,425  |   |                   |   |       |  
|Repayments on notes payable                                                     |  |                   | (26,213 | ) |                   |   | (729   | )
|Repayments on mortgage payable                                                  |  |                   | (179    | ) |                   |   | (179   | )
|Repayments of bonds payable                                                     |  |                   | (495    | ) |                   |   | (495   | )
|Proceeds from exercise of stock options                                         |  |                   | 318     |   |                   |   | 16     |  
|Payments on obligation under capital lease                                      |  |                   | (5      | ) |                   |   | (6     | )
|                                                                                |  |                   |         |   |                   |   |        |  
|Net cash used in financing activities                                           |  |                   | (149    | ) |                   |   | (1,393 | )
|                                                                                |  |                   |         |   |                   |   |        |  
|Increase (decrease) in cash and cash equivalents                                |  |                   | 151     |   |                   |   | (144   | )
|Cash and cash equivalents at beginning of period                                |  |                   | 283     |   |                   |   | 653    |  
|                                                                                |  |                   |         |   |                   |   |        |  
|Cash and cash equivalents at end of period                                      |  | $                 | 434     |   |                   | $ | 509    |  
|                                                                                |  |                   |         |   |                   |   |        |  
|Supplemental cash flow information:                                             |  |                   |         |   |                   |   |        |  
|Cash paid for interest                                                          |  | $                 | 1,053   |   |                   | $ | 877    |  
|                                                                                |  |                   |         |   |                   |   |        |  
|Cash (received) paid for income taxes                                           |  | $                 | (385    | ) |                   | $ | 475    |  
|                                                                                |  |                   |         |   |                   |   |        |  
|Noncash insurance financing                                                     |  | $                 | 931     |   |                   | $ |       |  
|                                                                                |  |                   |         |   |                   |   |        |  

The accompanying notes are an integral part of these financial statements.



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SRI/SURGICAL EXPRESS, INC.

NOTES TO FINANCIAL STATEMENTS

(unaudited)

NOTE A  BASIS OF PRESENTATION

The accompanying unaudited financial statements of SRI/Surgical Express, Inc. (the Company) have been prepared in
accordance with accounting principles generally accepted in the United States of America for interim financial information and with the Securities and Exchange Commissions (the SEC) instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they omit or condense footnotes and certain other information normally included in complete financial statements prepared in accordance with accounting principles generally accepted in the United States of America. In
the opinion of management, all adjustments of a normal recurring nature that are necessary to present fairly the financial information for the interim periods reported have been made. The accompanying unaudited financial statements should be read in
conjunction with the financial statements and notes included in the Companys Form 10-K for the year ended December 31, 2006, filed with the SEC. The results of operations for the three and nine months ended September 30, 2007, are
not necessarily indicative of the results that can be expected for the entire year ending December 31, 2007.

The Company presents an
unclassified balance sheet as a result of the extended amortization period (predominantly three to six years) of its reusable surgical products. The Company provides reusable surgical products to its customers on a per use basis similar to a rental
arrangement.

The Company operates on a 52-53 week fiscal year ending the Sunday nearest December 31. The prior year unaudited
financial statements are reflected as of September 30, 2006 for presentation purposes only. The actual end of the prior year period was October 1, 2006. There are 39 weeks included for each of the nine-month periods ended
September 30, 2007 and 2006. There are 13 weeks included for each of the three-month periods ended September 30, 2007 and 2006.

NOTE B 
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Use of Estimates

Management is required to make estimates and assumptions during the preparation of financial statements and accompanying notes in conformity with accounting principles generally accepted in the United States of
America. These estimates and assumptions affect the amounts reported in the financial statements and accompanying notes. Actual results could differ materially from those estimates and assumptions.

Accounts Receivable, net

The Company has accounts
receivable from hospitals and surgery centers. The Company does not believe that there are substantial credit risks associated with those receivables and does not require any form of collateral from its customers. The allowance for doubtful accounts
as of September 30, 2007, and December 31, 2006, was approximately $260,000 and $235,000, respectively. The allowance for doubtful accounts relates to accounts receivable not expected to be collected and is based on managements
assessment of specific customer balances, the overall aging of the balances, and the financial stability of the customers. The Companys write-offs for uncollectible accounts (determined based on specific account evaluations) are insignificant
to its results of operations. The Company does not customarily charge interest on accounts receivable.

Inventories, net

Inventories consist of raw materials, principally consumables, supplies, and disposable surgical products; work in progress; and finished goods consisting
of company-assembled packs of various combinations of raw materials and reusable surgical products. Inventories are valued at the lower of cost or market, with cost being determined on the first-in, first-out method. As of September 30, 2007
and December 31, 2006, inventory consists of the following:



|                        |  |                    |       |   |                   |   |       |  
|----------------------- |  | ------------------ | ----- | - | ----------------- | - | ----- | -
|                        |  | September 30, 2007 |       |   | December 31, 2006 |  
|                        |  | (in 000s)         |      
|Raw materials           |  | $                  | 4,023 |   |                   | $ | 3,830 |  
|Work in progress        |  |                    | 196   |   |                   |   | 114   |  
|Finished goods          |  |                    | 3,714 |   |                   |   | 3,171 |  
|                        |  |                    |       |   |                   |   |       |  
|                        |  |                    | 7,933 |   |                   |   | 7,115 |  
|Less: Inventory reserve |  |                    | (731  | ) |                   |   | (400  | )
|                        |  |                    |       |   |                   |   |       |  
|                        |  | $                  | 7,202 |   |                   | $ | 6,715 |  
|                        |  |                    |       |   |                   |   |       |  



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Reusable Surgical Products, net

The Companys reusable surgical products, consisting principally of linens (gowns, towels, drapes), basins (stainless steel medicine cups, carafes, trays, basins), and surgical instruments, are stated at cost.
Amortization of linens and basins is computed on a basis similar to the units of production method. Estimated useful lives for each product are based on the estimated total number of available uses for each product. The expected total available
usage for its linen products using the three principal fabrics (accounting for approximately 82% of the reusable surgical products) is 75, 100, and 125 uses, based on several factors, including the Companys actual historical experience with
these products. The Company believes Radio Frequency Identification (RFID) technology enables it to evaluate the useful lives of linen products more efficiently. Basins are amortized over their estimated useful life, which ranges from 25
to 200 uses. Owned surgical instruments are amortized straight-line over a period of four years. Accumulated amortization as of September 30, 2007, and December 31, 2006, was approximately $13.0 million and $11.9 million, respectively.

As of September 30, 2007, and December 31, 2006, the Company had reserves for shrinkage, obsolescence, and scrap related to
reusable surgical products of approximately $1.4 million and $1.6 million, respectively.

Revenue Recognition

Revenues are recognized as the agreed upon products and services are delivered, generally daily. Packing slips signed and dated by the customer evidence
delivery of product. The Companys contractual relationships with its customers are primarily evidenced by purchase orders or service agreements with terms varying from one to five years, which are generally cancelable by either party.

The Company owns substantially all of the reusable surgical products provided to customers except the surgical instruments. A third party
provides most of the surgical instruments that are included in the Companys comprehensive surgical procedure-based delivery and retrieval service. The Company pays a fee to the third party for the use of the surgical instruments. In accordance
with Emerging Issues Task Force (EITF) No. 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent, the Company acts as a principal in this arrangement and has reported the revenue gross for the comprehensive
surgical procedure-based delivery and retrieval service. The third party agent fee charged to the Company is included in cost of revenues in the statements of operations.

Stock-Based Compensation

Effective January 1, 2006, the Company adopted the provisions of
Statement of Financial Accounting Standard No. 123R, Share-Based Payments, (SFAS 123R) for its stock-based compensation plans. Under SFAS 123R, all stock-based compensation cost is measured at the grant date, based on the
fair value of the award, and is recognized as an expense over the requisite service period. The cost for all stock-based awards granted subsequent to December 31, 2005, represents the grant-date fair value that was estimated in



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accordance with the provisions of SFAS 123R, utilizing the binomial (Lattice) model. Stock-based compensation expense was $186,000 and $151,000, or $131,000
and $123,000, net of income tax, for the three month periods ended September 30, 2007 and 2006, respectively, which contributed to a $0.02 reduction in basic and diluted earnings per share for each of the three month periods ended
September 30, 2007 and 2006. Stock-based compensation expense was $510,000 and $151,000, or $375,000 and $412,000, net of income tax, which contributed to a $0.06 and $0.07 reduction in basic and diluted earnings per share for the nine month
periods ended September 30, 2007 and 2006, respectively.

The proceeds from stock option exercises under all stock-based payment
arrangements for each of the three month and nine month periods ended September 30, 2007 were $69,000 and $319,000, respectively. The proceeds from stock option exercises under all stock-based payment arrangements for each of the three month
and nine month periods ended September 30, 2006 were $0 and $16,000, respectively. There were no capitalized stock-based compensation costs at September 30, 2007 or 2006.

Stock Option Plans

The 1995 Stock Option Plan

The 1995 Stock Option Plan is designed to provide employees with incentive or non-qualified options to purchase up to 700,000 shares of common
stock. The options vest ratably over four to five years from the date of the grant. All outstanding options vest upon a change in control of the Company. Options granted under this Plan expire no later than ten years after the date granted or sooner
in the event of death, disability, retirement or termination of employment. As of September 30, 2007 and 2006, options to purchase 119,600 and 178,400 shares, respectively, were outstanding. The 1995 Stock Option Plan terminated on
December 21, 2005, although that termination does not adversely affect any options outstanding under the Plan.

The 1996 Non-Employee Director
Plan

As amended on May 16, 2001, the Non-Employee Director Plan is designed to provide for the grant of non-qualified stock options to
purchase up to 200,000 shares of common stock to members of the Board of Directors who are not employees of the Company. At the completion of the Companys initial public offering, each non-employee director was granted options to purchase
4,000 shares of common stock for each full remaining year of the directors term. Thereafter, on the date on which a new non-employee director was first elected or appointed, he or she was automatically granted options to purchase 4,000 shares
of common stock for each year of his or her initial term, and was granted options to purchase 4,000 shares of common stock for each year of any subsequent term to which he or she was elected. As of March 2006, the equity component of the director
compensation plan was restructured, so that each non-employee director will receive an annual grant of options to purchase 7,500 shares of common stock as of the date of the Annual Shareholder Meeting, beginning with the 2006 Annual Meeting. All
options vest ratably over a three year term and have an exercise price equal to the fair market value of the common stock on the date of grant. As of September 30, 2007 and 2006, options to purchase 120,000 and 182,000 shares, respectively,
were outstanding, and no options were available to be granted under this Plan. The 1996 Non-Employee Director Plan terminated on July 14, 2006, although that termination does not adversely affect any options outstanding under the Plan.

The 1998 Stock Option Plan

As amended on
May 16, 2001, the 1998 Stock Option Plan is designed to provide employees with incentive or non-qualified options to purchase up to 600,000 shares of common stock. The options vest ratably over four to five years from the date of the grant. All
outstanding options vest upon a change in control of the Company. Options granted under this Plan expire no later than ten years after the date granted or sooner in the event of death, disability, retirement, or termination of employment. As of
September 30, 2007 and 2006, options to purchase 355,500 and 337,500 shares, respectively, were outstanding, and 163,127 and 243,084 options, respectively, were available to be granted under this Plan.



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The 2004 Stock Compensation Plan

The 2004 Stock Compensation Plan is designed to further the interests of the Company and its shareholders by providing incentives in the form of incentive or non-qualified stock options or restricted stock grants to
key employees and non-employee directors who contribute materially to the success and profitability of the Company. Under this Plan, restricted stock grants are not considered outstanding options upon grant but are considered issued and outstanding
stock. When restricted stock awards are forfeited they are considered as available for grant. The equity awards typically vest ratably over five years from the date of the grant. All outstanding grants vest upon a change in control of the Company.
Options granted under this Plan expire no later than ten years after the date granted or sooner in the event of death, disability, retirement, or termination of employment. At the Companys annual meeting of shareholders on May 24, 2007,
the shareholders approved an amendment to the 2004 Stock Compensation Plan to authorize an additional 500,000 shares under the Plan. As of September 30, 2007 and 2006, options to purchase 277,000 and 355,200 shares respectively, were
outstanding, and 652,200 and 144,000 shares, respectively, were available to be granted as options or restricted stock under this Plan.

The following table summarizes option and restricted stock grant activity from January 1, 2007 through September 30, 2007:



|                                          |  |                          |   |  |                    |   |  |                               |       |                                         |     
|----------------------------------------- |  | ------------------------ | - |  | ------------------ | - |  | ----------------------------- | ----- | --------------------------------------- | ----
|                                          |  | SharesAvailablefor Grant |   |  | OptionsOutstanding |   |  | WeightedAverage ExercisePrice |       | WeightedAverageRemainingContractualLife
|Balance at December 31, 2006              |  | 413,284                  |   |  | 819,100            |   |  | $                             | 8.21  |                                         | 5.90
|Options authorized                        |  | 500,000                  |   |  |                   |   |  |                               |      |                                         |     
|Options expired                           |  | 43,043                   |   |  | (76,043            | ) |  |                               | 10.88 |                                         |     
|Options granted                           |  | (278,000                 | ) |  | 278,000            |   |  |                               | 4.84  |                                         |     
|Options and restricted stock cancelled    |  | 137,000                  |   |  | (87,000            | ) |  |                               | 5.24  |                                         |     
|Options exercised                         |  |                         |   |  | (61,957            | ) |  |                               | 5.15  |                                         |     
|                                          |  |                          |   |  |                    |   |  |                               |       |                                         |     
|Balance at September 30, 2007             |  | 815,327                  |   |  | 872,100            |   |  | $                             | 7.41  |                                         | 6.86
|                                          |  |                          |   |  |                    |   |  |                               |       |                                         |     
|Options exercisable at September 30, 2007 |  |                         |   |  | 401,686            |   |  | $                             | 10.38 |                                         | 4.51
|                                          |  |                          |   |  |                    |   |  |                               |       |                                         |     

The weighted-average grant date fair value of options granted during the nine months ended
September 30, 2007 and 2006 was $3.06 and $4.72, respectively. The total intrinsic value of options exercised in the nine months ended September 30, 2007 and 2006 was $12,800 and $10,000, respectively. As of September 30, 2007, there
was $887,000 of unrecognized compensation cost related to non-vested options that is expected to be recognized over a weighted average period of 1.3 years. The total fair value of options vested during the three months ended September 30, 2007
and 2006 was $167,000 and $114,000, respectively. The total fair value of options vested during the nine months ended September 30, 2007 and 2006 was $452,000 and $379,000, respectively.

The Company consistently used the binomial model for estimating the fair value of options granted in the nine month periods ended September 30, 2007
and 2006. The Company used historical data to estimate the option exercise and employee departure behavior used in the binomial valuation model. The expected term of options granted is derived from the output of the option pricing model and
represents the period of time that options granted are expected to be outstanding. The risk-free rates for periods within the contractual term of the options are based on the U.S. Treasury stripped coupon interest in effect at the end of the
quarter. Because the binomial valuation model accommodates multiple input values, the risk free interest rates and expected term rates used in calculating the fair value of the options, are expressed in ranges.

Following are the weighted-average and range assumptions, where applicable, used for each respective period:



|                                     |  |                    |   |  |                   |   |  |                    |   |  |                   |  
|------------------------------------ |  | ------------------ | - |  | ----------------- | - |  | ------------------ | - |  | ----------------- | -
|                                     |  | Three Months Ended |   |  | Nine Months Ended |  
|                                     |  | September 30, 2007 |   |  | September 30,2006 |   |  | September 30, 2007 |   |  | September 30,2006 |  
|                                     |  | (Binomial)         |   |  | (Binomial)        |  
|Expected dividend yield              |  | 0.0                | % |  | 0.0               | % |  | 0.0                | % |  | 0.0               | %
|Risk-free interest rate              |  | 4.09 to 4.78       | % |  | 4.46 to 4.68      | % |  | 4.09 to 5.12       | % |  | 4.46 to 5.19      | %
|Weighted-average expected volatility |  | 59.4               | % |  | 60.9              | % |  | 59.1 to 60.7       | % |  | 60.9              | %
|Expected term                        |  | 1.82 to 9.36 years |   |  | 1.8 to 9.0 years  |   |  | 1.82 to 9.36 years |   |  | 1.8 to 10.0 years |  
|Respective service period            |  | 5 years            |   |  | 3 to 5 years      |   |  | 5 years            |   |  | 3 to 5 years      |  



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Restricted Stock Awards

In 2006, the Company granted unvested common stock awards (restricted stock) to certain key employees pursuant to the 2004 Stock Compensation Plan. The shares will vest ratably over five years.

The restricted stock awards granted in 2006 were accounted for using the measurement and recognition principles of SFAS 123R. Compensation for
restricted stock awards is measured at fair value on the date of grant based on the number of shares expected to vest and the quoted market price of the Companys common stock. Compensation cost for all awards will be recognized in earnings,
net of estimated forfeitures, on a straight-line basis over the requisite service period.

The Company recorded $18,000 and $36,000,
respectively, in compensation expense related to the restricted stock that vested during the three month periods ended September 30, 2007 and 2006, respectively. The Company recorded $58,000 and $101,000 in compensation expense related to the
restricted stock that vested during the nine month periods ended September 30, 2007 and 2006, respectively. As of September 30, 2007, there was $241,000 of total unrecognized compensation cost related to restricted stock awards granted
under the Plan. That cost is expected to be recognized over a period of 3.25 years.

Uncertain Tax Positions

In July 2006, the Financial Accounting Standards Board (the FASB) issued Interpretation No. 48 (FIN 48), Accounting for
Uncertainty in Income Taxesan interpretation of FASB Statement No. 109, which clarifies the accounting for and disclosure of uncertainty in tax positions. FIN 48 prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and
transition associated with tax positions. The provisions of FIN 48 were effective January 1, 2007. The Company completed an assessment of FIN 48 and determined that FIN 48 did not have a material impact on its financial statements.

On May 2, 2007, the FASB issued FASB Staff Position No. FIN 48-1, Definition of Settlement in FASB Interpretation No. 48(FIN
48-1), to provide guidance about how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. Under FIN 48-1, a tax position is considered effectively
settled if the taxing authority completed its examination, the company does not plan to appeal, and it is remote that the taxing authority would reexamine the tax position in the future.

Recently Issued Financial Accounting Standards

In September 2006, the FASB issued Statement of
Financial Accounting Standards No. 157 (SFAS 157), Fair Value Measurements. SFAS 157 defines fair value, establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements. SFAS
157 creates a fair value hierarchy, which prioritizes the inputs to be used in determining fair value. Companies are required to disclose relevant fair value information in their financial statements that allows users to assess inputs used to
measure fair value, and the effect of those measurements on earnings for the periods presented. Companies are also required to separately reconcile the beginning and ending balances for each major category of assets and



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liabilities. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those
fiscal years. The Company believes that the adoption of SFAS 157 will not have a material impact on its financial statements.

In April
2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS 159 permits an entity to measure certain financial assets and financial liabilities at fair value where entities will report
unrealized gains and losses in earnings at each subsequent reporting date. The standard allows entities to elect fair value application on an instrument-by-instrument basis with certain exceptions. The fair value option election is irrevocable in
most cases. The new standard establishes presentation and disclosure requirements and assets and liabilities that are measured at fair value must be displayed on the face of the balance sheet. SFAS 159 is effective for fiscal years beginning after
November 15, 2007. The Company believes that the adoption of SFAS 159 will not have a material impact on its financial statements.

NOTE C 
NOTES PAYABLE

On June 20, 2005, the Company entered into a three-year $30 million revolving credit facility with two financial
institutions. The credit facility is secured by substantially all of the Companys assets and has an interest rate that varies between 200 and 300 basis points over LIBOR (5.12% as of September 30, 2007) depending on the quarterly results
under the Companys consolidated leverage ratio covenant. The credit facility agreement was amended in June 2007 to revise the funds flow coverage ratio. The available credit under the facility is subject to limitation based upon the
consolidated leverage ratio of the Company. The amended credit facility requires the Company to maintain (a) a quarterly consolidated leverage ratio of not more than 2.50 to 1.00 for fiscal quarters ending June 30, 2006 and thereafter;
(b) a funds flow coverage ratio of not less than 1.75 to 1.00 for the fiscal quarter ended June 30, 2007, and 2.00 to 1.00 for the fiscal quarter ending September 30, 2007 and thereafter; and (c) a tangible net worth at the end
of each fiscal quarter beginning June 30, 2005, of at least $45 million plus 75% of cumulative net positive income generated after March 31, 2005. In addition, the interest and the unused fee will be the high end of the ranges allowed
under the facility (300 basis points over LIBOR and 0.35%, respectively) until the funds flow coverage ratio returns to not less than 2.25 to 1.00 for two consecutive quarters. The credit facility places a number of restrictions on the Company,
including without limitation: the paying of dividends, incurring additional indebtedness, making loans and investments, encumbering its assets, entering into a new business, and entering into certain merger, consolidation or liquidation
transactions. The Company is in compliance with all the financial and non-financial covenants under the amended credit facility as of September 30, 2007.

Based on the Companys current projections, there may be a need to request additional waivers of the minimum funds flow coverage ratio in future quarters. There can be no assurance that the Companys lenders
will issue a waiver or grant an amendment in those future periods.

As of September 30, 2007, the Company had the ability to borrow an
additional $19.4 million under the facility, which takes into consideration the amounts already outstanding under the credit facility and certain letters of credit principally associated with the Companys bonds payable.

The credit facility allows the Company to repurchase its common stock through open market purchases at prevailing market prices. During the first nine
months of 2007 and in fiscal year 2006, the Company did not repurchase any shares of its common stock.

The credit facility expires in June
2008. There is no assurance that the Companys lenders will renew or extend the credit agreement.

On August 20, 2007, the
Company entered into a short-term agreement with AIG to finance the annual premiums under certain of its insurance contracts. The amount outstanding under the agreement was $931,000 at September 30, 2007. The agreement calls for equal monthly
payments of principal and interest over a term of nine months, with the final payment due on May 1, 2008. The stated interest rate under the agreement is 5.63%.



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NOTE D  LOSS PER SHARE

The following table sets forth the Companys computation of basic and diluted loss per share:



|                                                       |  |                                                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |        |  
|------------------------------------------------------ |  | ------------------------------------------------- | ----- | - | ----------------- | - | ----- | ----------------- |  | - | ----------------- | - |  | - | ------ | -
|                                                       |  | Three Months Ended                                |       |   | Nine Months Ended |  
|                                                       |  | September 30,2007                                 |       |   | September 30,2006 |   |       | September 30,2007 |  |   | September 30,2006 |  
|                                                       |  | (In thousands, except per share data) (unaudited) |      
|Basic                                                  |  |                                                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |        |  
|Numerator:                                             |  |                                                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |        |  
|Net loss                                               |  | $                                                 | (645  | ) |                   | $ | (239  | )                 |  | $ | (1,575            | ) |  | $ | (1,319 | )
|                                                       |  |                                                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |        |  
|Denominator:                                           |  |                                                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |        |  
|Weighted average shares outstanding                    |  |                                                   | 6,420 |   |                   |   | 6,339 |                   |  |   | 6,390             |   |  |   | 6,338  |  
|                                                       |  |                                                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |        |  
|Loss per common share, basic                           |  | $                                                 | (0.10 | ) |                   | $ | (0.04 | )                 |  | $ | (0.25             | ) |  | $ | (0.21  | )
|                                                       |  |                                                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |        |  
|Diluted                                                |  |                                                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |        |  
|Numerator:                                             |  |                                                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |        |  
|Net loss                                               |  | $                                                 | (645  | ) |                   | $ | (239  | )                 |  | $ | (1,575            | ) |  | $ | (1,319 | )
|                                                       |  |                                                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |        |  
|Denominator:                                           |  |                                                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |        |  
|Weighted average shares outstanding                    |  |                                                   | 6,420 |   |                   |   | 6,339 |                   |  |   | 6,390             |   |  |   | 6,338  |  
|Effect of dilutive securities - employee stock options |  |                                                   |      |   |                   |   |      |                   |  |   |                  |   |  |   |       |  
|                                                       |  |                                                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |        |  
|                                                       |  |                                                   | 6,420 |   |                   |   | 6,339 |                   |  |   | 6,390             |   |  |   | 6,338  |  
|                                                       |  |                                                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |        |  
|Loss per common share, diluted                         |  | $                                                 | (0.10 | ) |                   | $ | (0.04 | )                 |  | $ | (0.25             | ) |  | $ | (0.21  | )
|                                                       |  |                                                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |        |  

Options to purchase 846,956 and 814,277 shares of common stock for the three and nine month
periods ended September 30, 2007, respectively, were not included in the computation of diluted earnings per common share, because the assumed proceeds per share were greater than the average market price, and therefore, were antidilutive.
Options to purchase 721,100 and 488,800 shares of common stock for the three and nine-month periods ended September 30, 2006, respectively, were not included in the computation of diluted earnings per common share, because the options
exercise prices were greater than the average market price of the common shares, and therefore, were anti-dilutive. The dilutive effect of 27,000 and 49,913 options with assumed proceeds per share less than the average market price, were not
included for the three and nine month periods ended September 30, 2007, respectively, because the effect would be anti-dilutive due to the Companys net loss for the period. The dilutive effect of 332,000 and 664,500 options with an
exercise price less than the average market price of the common shares were not included for the three and nine month periods ended September 30, 2006, respectively, because the effect would be anti-dilutive due to the Companys net loss
for the period.

NOTE E  LEASE AGREEMENT

Effective March 1, 2007, the Company entered into an agreement to lease to a third party a portion of its corporate headquarters under the terms of a non-cancelable operating lease. The lease calls for an initial term of five
(5) years with a tenant option to renew for one extension period of five years. The lease agreement provides for escalating rental payments over its term. Under the agreement, the tenant pays an allocated share of the increase over the base
year of certain costs, including utilities, maintenance costs and property taxes.

Future minimum lease payments expected to be received as
of September 30, 2007 are as follows (in 000s):



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|                        |  |   |      
|----------------------- |  | - | -----
|Year ending December 31 |  |   |      
|2007                    |  | $ | 87   
|2008                    |  |   | 354  
|2009                    |  |   | 364  
|2010                    |  |   | 375  
|2011                    |  |   | 387  
|Thereafter              |  |   | 97   
|                        |  |   |      
|                        |  | $ | 1,664
|                        |  |   |      

Rental income, which is included in other income in the statements of operations, was
approximately $90,000 and $212,000 for the three and nine months ended September 30, 2007, respectively.



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|Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations
|------- | -------------------------------------------------------------------------------------

The following discussion and analysis should be read with our financial statements and the notes thereto included elsewhere in this report. This
discussion and analysis contains trend analysis and might contain forward-looking statements. These statements are based on current expectations, and actual results might differ materially. Among the factors that could cause actual results to vary
are those described in Critical Accounting Policies and Certain Considerations included in this report and Risk Factors included in this report and our 2006 Annual Report on Form 10-K, filed with the Securities
and Exchange Commission.

Overview

We provide daily processing, assembly and delivery of reusable and disposable products and instruments required for surgery through our state-of-the-art, FDA-regulated service centers. Our integrated closed-loop process starts
with daily delivery of reusable and disposable surgical supplies and instruments to the healthcare provider. After use, we pick up the reusable textiles, basins and instruments used in surgery and return them to our processing facility. Used
products arriving at our processing facility are sorted, cleaned, inspected, packaged, sterilized, and subsequently, shipped back to the healthcare providers. In addition, we manage the instrumentation and supply chain of hospitals and surgery
centers, including their central sterilization facilities.

We believe our facilities are strategically situated to capitalize on future
market opportunities. These facilities have significant available capacity to access more of the national market.

We derive our revenues
from the sale and servicing of reusable and disposable surgical products and instruments and the management of our customers supply chain. Reusable products include linens (gowns, towels and drapes) and basins (stainless steel cups, carafes,
trays and basins). Disposable accessory packs supplement the reusable products with highly customizable components. We sell our products and services through a direct sales force strategically located throughout the United States. Our revenue growth
is primarily determined by the number of customers, the number and type of surgical procedures that we service for each customer, and pricing for our various types of surgical packs and procedures. Revenues are recognized as the agreed upon products
and services are delivered, generally daily.We incur most of our cost of revenues from processing the reusable surgical products and instruments at our processing facilities.

Most of our surgical instrument supply arrangements with customers utilize instruments owned by Aesculap, Inc. (Aesculap), which receives an
agreed upon fee for each procedure based on the number and kinds of procedures performed with its instruments and the number and combination of instruments used for each procedure. This arrangement allows us to limit our cost of capital for
instrument programs. In addition to the Aesculap-owned instruments, we purchase surgical instruments from other vendors to service customers that have requirements that Aesculap cannot fulfill.

Our profitability is primarily determined by our revenues, the efficiency with which we deliver
products and services to customers, and our ability to control our costs. We incurred operating and net losses for our three-month and nine-month periods ended September 30, 2007 and for our fiscal year ended December 31, 2006. Although
sales to customers who predominantly purchase reusable textiles declined, we continue to see growth in other products sold with our ReadyCaseSMcase cart
management system (combining instruments, reusable textiles and disposable products). We are encountering compressed margins, primarily as a result of pricing pressures. During the current fiscal year, we also incurred increased product and
production labor costs, severance, and management consulting fees for the business assessment and planning described below.

Our principal strategic opportunity to improve our operating results is to capitalize on our
service capabilities and considerable infrastructure by leveraging our current relationships with existing customers and adding new customers. We continue to focus on introducing current and potential new customers to our physician-specific
ReadyCaseSMcase cart management system, which has been our principal source of new sales.

In the fourth quarter of 2006, we engaged a global management consulting firm to conduct an in-depth business assessment and develop specific plans to
optimize our performance and growth. During the second



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quarter of 2007, we paid the management consulting firm $470,000 to assist us in developing a plan for improving the effectiveness of our sales and service
organizations which involves reorganizing and retraining our sales force, developing a customer service and sales training function, and implementing a technology platform to support our sales force and customer service initiatives. We expect to
incur significant costs over the remainder of 2007 and then additional costs on a continuing basis to implement the plan. We expect that the costs will relate primarily to compensation, training, travel and technology expenses associated with this
reorganization as well as the implementation of technology. We expect these changes will generate revenue growth and, in the longer run, improve our financial performance. See Certain Considerations  Our restructuring of our sales,
service and operations might disrupt our business.

Critical Accounting Policies

The preparation of our financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of
America requires management to make judgments, assumptions, and estimates that affect the amounts reported in our financial statements and accompanying notes. On an on-going basis, we evaluate our estimates and assumptions based upon historical
experience and various other factors and circumstances. We believe that these estimates and assumptions are reasonable under the circumstances; however, actual results may vary from these estimates and assumptions. We identified the following
critical accounting policies that affect the more significant judgments, assumptions and estimates used in preparing our financial statements:

Allowance for Doubtful Accounts.Our allowance for doubtful accounts is based on our assessment of the collectibility of specific customer accounts, the overall aging of the balances, and the financial stability of the customer. The
use of different estimates or assumptions could produce different allowance balances. If a major customers creditworthiness deteriorates or customer defaults run at a rate higher than historical experience, we would be required to increase
this allowance, which could adversely affect our results of operations.

Reserves for Shrinkage, Obsolescence, and Scrap for Reusable
Surgical Products and Instruments.We determine our reserves for shrinkage and obsolescence of our reusable surgical products and instruments based on historical experience. Any linen products not scanned by our RFID system for a 210-day period
are considered lost and written off. We determine our reserve for scrap based upon quality assurance standards and historical evidence. We periodically verify the quantity of other reusable surgical products by counting and by applying observed turn
rates. A third party, Aesculap, owns most of the surgical instruments that we use. We base our reserve for owned surgical instrument losses on our assessment of our historical loss experience, including periodic physical counts. Using different
estimates or assumptions could produce different reserve balances for our reusable products and instruments. We review this reserve quarterly. If actual shrinkage, obsolescence or scrap differs from our estimates, our reserve would increase or
decrease accordingly, which could adversely affect our results of operations.

Reserves for Shrinkage and Obsolescence for
Inventories. We determine our reserves for shrinkage and obsolescence of our inventories based on historical data, including the results of cycle counts performed during the year and the evaluation of the aging of reusable and disposable
surgical products and instruments. Using different estimates or assumptions could produce different reserve balances. We review this reserve quarterly. If actual losses differ from our estimates, our reserve would increase or decrease accordingly,
which could adversely affect our results of operations.

Amortization of Reusable Surgical Products and Instruments.Our reusable
surgical products are stated at cost. We amortize linens and basins on a basis similar to the units of production method. Estimated useful lives for each product are based on the estimated total number of available uses for each product. The
expected total available usage for our linen products using the three principal fabrics (accounting for approximately 82% of the reusable surgical products) is 75, 100, and 125 uses, based on several factors, including our actual historical
experience with these products. We believe our RFID technology enables us to evaluate the useful lives of linen products more often. Basins are amortized over their estimated useful life, which ranges from 25 to 200 uses. We amortize owned surgical
instruments on the straight-line method based on a four-year useful life. If our actual use experience with these products is shorter than these assumptions, our amortization rates for reusable products and instruments would increase, which could
adversely affect our results of operations.



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Health Insurance Reserves. We offer employee benefit programs including health insurance to
eligible employees. We retain a liability up to $85,000 annually for each health insurance claim. Our policy has an estimated annual aggregate liability limit of $3.2 million. We accrue health insurance costs using estimates to approximate the
liability for reported claims and claims incurred but not reported. Using different estimates or assumptions could produce different reserve balances. If actual claim results exceed our estimates, our health insurance reserve would increase, which
could adversely affect our results of operations.

Workers Compensation Insurance Reserve. Our workers compensation
insurance program is a large dollar deductible, self-funded plan. We retain a liability of $250,000 for each claim occurrence. Our policy has an annual aggregate liability limit of $1.25 million. We base our reserve on historical claims experience
and reported claims. We accrue workers compensation insurance costs using estimates to approximate the liability for reported claims and claims incurred but not reported. We review this reserve quarterly. If actual claims differ from our
estimates, the reserve would increase or decrease accordingly, which could adversely affect our results of operations.

Income
Taxes. Our effective tax rate is based on expected income and statutory tax rates in the various jurisdictions in which we operate. Significant judgment is required in determining our effective tax rate and evaluating our tax positions. Our
effective tax rate depends upon our forecast of results for the fiscal year. Each quarter, we evaluate our forecasted fiscal year results and adjust our tax provision to reflect the effective tax rate on a cumulative basis. This rate is applied to
our quarterly operating results. Income taxes have been provided using the liability method in accordance with Statement of Financial Accounting Standards Statement No. 109, Accounting for Income Taxes(SFAS 109). In
accordance with SFAS 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and
liabilities of a change in the tax rate is recognized in operations in the period that includes the enactment date of the rate change. The tax benefits must be reduced by a valuation allowance in certain circumstances. Realization of the deferred
tax benefits is dependent on generating sufficient taxable income prior to expiration of any net operating loss carry-forwards. We periodically review deferred tax assets for recoverability, and provide valuation allowances as necessary.

Stock-Based Compensation. In accordance with the Statements of Financial Accounting Standards Statement No. 123R, Share-Based
Payments, (SFAS 123R) and the Security and Exchange Commission Staff Accounting Bulletin No. 107 (SAB 107), we began recognizing stock-based compensation expense in our statement of operations on January 1,
2006. We have elected to use the binomial model to determine the fair value of our issued options. Option pricing models require the input of subjective assumptions, including the expected life of the option, the price volatility of the underlying
stock, expected interest rates and forfeitures. If actual results differ significantly from our assumptions, stock-based compensation could increase or decrease. For further discussion of our stock-based compensation, see Note B-Summary of
Significant Accounting PoliciesStock-Based Compensation to the financial statements.

Recently Issued Financial Accounting Standards

In September 2006, the Financial Accounting Standards Board (the FASB) issued SFAS No. 157 (SFAS
157), Fair Value Measurements. SFAS 157 defines fair value, establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements. SFAS 157 creates a fair value hierarchy, which prioritizes the
inputs to be used in determining fair value. Companies are required to disclose relevant fair value information in their financial statements that allows users to assess inputs used to measure fair value, and the effect of those measurements on
earnings for the periods presented. Companies are also required to separately reconcile the beginning and ending balances for each major category of assets and liabilities. SFAS 157 is effective for financial statements issued for fiscal years
beginning after November 15, 2007, and interim periods within those fiscal years. We believe that the adoption of SFAS 157 will not have a material impact on our financial statements.



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In April 2007, the FASB issued SFAS 159, The Fair Value Option for Financial Assets and Financial
Liabilities. SFAS 159 permits an entity to measure certain financial assets and financial liabilities at fair value where entities will report unrealized gains and losses in earnings at each subsequent reporting date. The standard allows
entities to elect fair value application on an instrument-by-instrument basis with certain exceptions. The fair value option election is irrevocable in most cases. The new standard establishes presentation and disclosure requirements and assets and
liabilities that are measured at fair value must be displayed on the face of the balance sheet. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We believe that the adoption of SFAS 159 will not have a material impact
on our financial statements.

Results of Operations

We operate on a 52-53 week fiscal year ending the Sunday nearest December 31. The prior year unaudited financial statements are reflected as of September 30, 2006 for presentation purposes only. The actual
end of the prior year period was October 1, 2006. There are 39 weeks included for each of the nine month periods ended September 30, 2007 and 2006. There are 13 weeks included for each of the three month periods ended September 30,
2007 and 2006.

The following table sets forth for the periods shown the percentage of revenues represented by certain items reflected in
our statements of income:



|                                    |  |                                 |    |  |                                |    |  |       |    |  |       |   
|----------------------------------- |  | ------------------------------- | -- |  | ------------------------------ | -- |  | ----- | -- |  | ----- | --
|                                    |  | Three Months EndedSeptember 30, |    |  | Nine Months EndedSeptember 30, |   
|                                    |  | 2007                            |    |  | 2006                           |    |  | 2007  |    |  | 2006  |   
|Revenues                            |  | 100.0                           | %  |  | 100.0                          | %  |  | 100.0 | %  |  | 100.0 | % 
|Cost of revenues                    |  | 80.4                            |    |  | 76.9                           |    |  | 77.9  |    |  | 76.5  |   
|                                    |  |                                 |    |  |                                |    |  |       |    |  |       |   
|Gross profit                        |  | 19.6                            |    |  | 23.1                           |    |  | 22.1  |    |  | 23.5  |   
|Distribution expenses               |  | 6.7                             |    |  | 6.3                            |    |  | 6.7   |    |  | 6.5   |   
|Selling and administrative expenses |  | 16.2                            |    |  | 17.7                           |    |  | 17.6  |    |  | 18.5  |   
|                                    |  |                                 |    |  |                                |    |  |       |    |  |       |   
|Loss from operations                |  | (3.3                            | )  |  | (0.9                           | )  |  | (2.2  | )  |  | (1.5  | ) 
|Interest expense                    |  | 1.4                             |    |  | 1.5                            |    |  | 1.5   |    |  | 1.3   |   
|Other income                        |  | (0.6                            | )  |  |                               |    |  | (0.3  | )  |  |      |   
|                                    |  |                                 |    |  |                                |    |  |       |    |  |       |   
|Loss before income taxes            |  | (4.1                            | )  |  | (2.4                           | )  |  | (3.4  | )  |  | (2.8  | ) 
|Income tax benefit                  |  | (1.3                            | )  |  | (1.4                           | )  |  | (1.2  | )  |  | (0.9  | ) 
|                                    |  |                                 |    |  |                                |    |  |       |    |  |       |   
|Net loss                            |  | (2.8                            | )% |  | (1.0                           | )% |  | (2.2  | )% |  | (1.9  | )%
|                                    |  |                                 |    |  |                                |    |  |       |    |  |       |   

Three and Nine Months Ended September 30, 2007 Compared to Three and Nine Months Ended September 30,
2006

Revenues. Revenues increased $40,000, or 0.2%, to $23.2
million for the three months ended September 30, 2007, compared to $23.1 million for the three months ended September 30, 2006. For the nine months ended September 30, 2007, revenues increased $211,000, or 0.3%, to $70.2 million
compared to $70.0 million for the nine months ended September 30, 2006. The increase in revenues in the three month and nine month periods ended September 30, 2007 is primarily attributable to an increase in the growth of our
ReadyCaseSMdelivery system partially offset by pricing pressures from our competitors and a decline in sales to customers who predominately purchase
reusable textiles.

Gross Profit. Gross profit decreased $786,000 and $910,000 for the three-month and nine-month
periods ended September 30, 2007, respectively, as compared to the same periods in the prior year. As a



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percentage of revenues, gross profit decreased by 3.5 percentage points and 1.4 percentage points for the three-month and nine-month periods ended
September 30, 2007, respectively, as compared to the same periods in the prior year. For both the three and nine months ended September 30, 2007, the decrease in gross profit was primarily due to continued pricing pressures from
competitors, higher material costs from disposable products, higher workers compensation expenses, higher laundry and instrument labor costs, partially offset by lower amortization of reusable products and lower facility overhead costs.

Distribution Expenses. Distribution expenses for the three-month period ended September 30, 2007 were $1.6 million
(6.7% of revenues) compared to $1.5 million (6.3% of revenues) for the three-month period ended September 30, 2006. The increase in distribution expenses for the three months ended September 30, 2007 when compared to the prior year is due
to a fuel surcharge offset to fuel expense recorded in the three months ended September 30, 2006. Distribution expenses for the nine-month period ended September 30, 2006 were $4.7 million (6.7% of revenues) remained essentially unchanged
when compared to the same period in the prior year.

Selling and Administrative Expenses. Selling and administrative expenses
decreased $334,000, or 8.2%, to $3.7 million for the three months ended September 30, 2007 compared to $4.1 million for the same period in the prior year. Selling and administrative expenses for the three-month period ended September 30,
2007 were lower than the prior year primarily as a result of lower compensation costs and lower advertising costs, partially offset by higher professional service fees. Selling and administrative expenses decreased $496,000, or 3.8%, to $12.4
million for the nine-month period ended September 30, 2007 compared to $12.9 million for the same period in the prior year. Selling and administrative expenses for the nine-month period ended September 30, 2007 were lower than prior year
primarily as a result of lower compensation costs of $1.1 million, lower convention related expenses of $190,000 and lower advertising expenses of $100,000 partially offset by severance expenses for our former President and CEO, $470,000 of expenses
paid to the global management consulting firm engaged to assist us in developing a plan to improve our sales and service effectiveness, Sarbanes-Oxley compliance and internal audit related consulting fees of $182,000, and bad debt expense of
$167,000.

Interest Expense. Interest expense for the three-month period ended September 30, 2007 was $331,000 and
remained essentially unchanged when compared to the prior year. For the nine months ended September 30, 2007, interest expense increased $154,000, or 16.8%, to $1.1 million compared to the same period in the prior year. The higher expense when
compared to last year is due primarily to higher average outstanding balances earlier in the year under our line of credit agreement and higher interest rates.

Other Income. Other income was $128,000 and $250,000 for the three-month and nine-month periods ended September 30, 2007, respectively, primarily as a result of rental income. Effective
March 1, 2007, we entered into an agreement to lease to a third party a portion of our corporate headquarters under the terms of a non-cancelable operating lease.

Income Tax Benefit.Our effective tax rate is based on expected income and statutory tax rates in the various jurisdictions in which we operate. Income taxes are a function of our net income (loss) and
effective tax rate. The effective tax rate for the three months ended September 30, 2007 was 32.4% compared to 56.7% for the three months ended September 30, 2006. For the nine months ended September 30, 2007, the effective tax rate
was 34.2% compared to 31.8% for the nine months ended September 30, 2006. The primary reason for the higher effective tax rate in the three-month period ended September 30, 2006 when compared to the three-month period ended
September 30, 2007 is due to adjusting the forecast for taxable income or loss for the year ended December 31, 2006. The primary reason for the lower effective tax rate in the nine months ended September 30, 2007 and 2006 was the
effect of permanent differences on our taxable loss. Our effective tax rate depends upon our forecast of tax expense or benefit based upon the expected results for the fiscal year. Each quarter, we evaluate our forecasted fiscal year results and
adjust our tax provision to reflect the effective tax rate on a cumulative basis. Our effective tax rate may increase or decrease during the remainder of 2007 depending upon actual results of operations.



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Liquidity and Capital Resources

Our principal sources of capital have been cash flows from operations and borrowings under our revolving credit facility. As of September 30, 2007,
we had approximately $434,000 in cash and cash equivalents, compared to approximately $283,000 as of December 31, 2006. In addition, as of September 30, 2007, we had $19.4 million available under our credit facility. Net cash provided by
operating activities for the nine-month period ended September 30, 2007 was $5.4 million, compared to $6.4 million for the comparable period in 2006. Net cash from operations during the period ended September 30, 2007 is primarily
attributable to depreciation and amortization expense of $2.5 million, reusable surgical products amortization of $3.9 million, an increase in our accounts payable of $1.2 million and an increase in employee-related and other accrued expenses of
$835,000, partially offset by higher accounts receivable of $1.6 million, higher inventory levels of $818,000, and a net loss of $1.6 million.

Net cash used in investing activities during the nine months ended September 30, 2007 was $5.1 million the same as in the prior year period. Cash used in investing activities this year primarily related to purchases of property, plant
and equipment and reusable surgical products. We estimate that our expenditures in 2007 for property, plant and equipment will be approximately $2.5 million. We estimate that our expenditures in 2007 for reusable surgical products will be
approximately $5.5 million, an amount that may fluctuate depending on the growth of our business.

Net cash used in financing activities in
the nine months ended September 30, 2007 was $149,000 compared to $1.4 million in 2006. Cash used was primarily a result of the repayment on our notes payable, mortgage payable and bonds payable offset by our borrowings on our notes payable and
proceeds from the exercise of stock options.

We plan to reorganize and retrain our sales force, develop a customer service and sales
training function, and implement a technology platform to support our sales force and customer service initiatives. As a result, we expect to incur significant additional costs over the remainder of 2007 and then more added costs on a continuing
basis to implement the plan. We expect these changes will accelerate our growth and, in the longer run, improve our financial performance. We expect that these costs will be primarily related to compensation, training, travel and technology expenses
associated with the reorganization, as well as the implementation of technology.

We have a three-year $30 million revolving credit
facility with two financial institutions, which is scheduled to mature in June 2008, of which $2.7 million was outstanding at September 30, 2007. The amount available under the revolving credit facility is limited by letters of credit
principally associated with our bonds payable described below. The facility was amended in June 2007 to revise the funds flow coverage ratio. We are in compliance with all the financial and non-financial covenants under the amended credit facility
as of September 30, 2007. Based on our current projections, we may need to request a waiver or an amendment to the minimum funds flow coverage ratio in future quarters. There can be no assurance that our lenders will issue a waiver or grant an
amendment in those future periods. As of September 30, 2007, we had the ability to borrow an additional $19.4 million under the facility, which takes into consideration the amounts already outstanding under the credit facility and certain
letters of credit principally associated with the bonds payable.

The credit facility is secured by substantially all of our assets and has
an interest rate that varies between 200 and 300 basis points over LIBOR (5.12% as of September 30, 2007) depending on the quarterly results under our consolidated leverage ratio covenant, as well as an unused availability fee. The available
credit under the facility is subject to limitation based upon our consolidated leverage ratio. The amended credit facility requires us to maintain (a) a quarterly consolidated leverage ratio of not more than 2.50 to 1.00 for fiscal quarters
ending June 30, 2006 and thereafter; (b) a funds flow coverage ratio of not less than 1.75 to 1.00 for the fiscal quarter ended June 30, 2007, and 2.00 to 1.00 for the fiscal quarter ending September 30, 2007 and thereafter; and
(c) a tangible net worth at the end of each fiscal quarter beginning June 30, 2005, of at least $45 million plus 75% of cumulative net positive income generated after March 31, 2005. The credit facility places a number of restrictions
on us, including without limitation: the paying of dividends, incurring additional indebtedness, making loans and investments, encumbering our assets, entering into a new business, and entering into certain merger, consolidation or liquidation
transactions. The credit facility expires in June 2008. There can be no assurance that our lenders will renew or extend the credit agreement.



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We are also obligated under a mortgage from our primary lenders for approximately $4.3 million, which we
incurred to finance the purchase of our corporate headquarters. The mortgage has a term of five years and an amortization schedule based on 20 years, with a balloon payment of $3.6 million in 2010. The mortgage bears an interest rate of 250 basis
points over LIBOR.

We have outstanding public bonds that we issued to fund the construction of two of our reusable processing facilities.
Interest expense on these bonds adjusts based on rates that approximate LIBOR (5.3% at September 30, 2007). Starting in 2004, we began amortizing the bonds through quarterly payments of $165,000. Balloon principal payments of $3.1 million are
due on the bonds in 2014. The bonds are secured by the two reusable processing facilities and backed by letters of credit issued by a financial institution. We paid a commitment fee of approximately $111,000 (125 basis points) for the letters of
credit for 2007. The letters of credit must be renewed in January of each year through maturity in 2014. We expect that our banks will renew the letters of credit in January 2008 only through June 2008, the scheduled expiration of the credit
agreement. We believe we will be able to extend the credit agreement for another year after June 2008; however, there is no assurance that the credit facility will be renewed or extended after June 2008.

On August 20, 2007, we entered into a short-term agreement with AIG to finance the annual premiums uncertain of our insurance contracts. The amount
outstanding under the agreement was $931,000 at September 30, 2007. The agreement calls for equal monthly payments of principal and interest over a term of nine months, with the final payment due on May 1, 2008. The stated interest rate
under the agreement is 5.63%.

We believe that our existing cash and cash equivalents together with expected cash provided by operations
and the revolving credit facility will be adequate to finance our operations. Although it is difficult for us to predict our future liquidity needs with certainty. Our ability to continue accessing the credit facility might depend on our ability to
comply with or satisfactorily restructure the funds flow coverage financial covenant term and our lenders willingness to renew our credit facility.



|Item 3. | Quantitative and Qualitative Disclosures About Market Risk
|------- | ----------------------------------------------------------

Our principal exposure to market risk is change in interest rates under our various debt instruments and borrowings. The outstanding balance under our revolving credit facility was approximately $2.7 million as of
September 30, 2007. The credit facilitys interest rate varies between 200 and 300 basis points over LIBOR (5.12% as of September 30, 2007), depending on our leverage ratio (earnings coverage of debt). We are subject to changes in our
interest expense on this facility based on fluctuations in interest rates. Assuming an outstanding balance of this facility of $2.7 million, if LIBOR were to increase (decrease) by 100 basis points, our interest payments would increase (decrease) by
$6,750 per quarter.

The outstanding balance under our real estate mortgage was approximately $4.3 million as of September 30, 2007.
The mortgage bears an interest rate of 250 basis points over LIBOR. Assuming an outstanding balance of this facility of $4.3 million, if LIBOR were to increase (decrease) by 100 basis points, our interest payments would increase (decrease) by
$10,750 per quarter.

Interest on our bonds that financed two of our facilities is at a rate that approximates LIBOR. We are subject to
changes in our interest expense on these bonds based on fluctuations in interest rates. Assuming an outstanding balance of these bonds of $7.2 million, if LIBOR were to increase (decrease) by 100 basis points, our interest payments would increase
(decrease) by $18,000 per quarter.

We do not have any other material market risk sensitive instruments.



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Certain Considerations

This report, other documents that we publicly disseminate, and oral statements that we make contain or might contain both statements of historical fact and forward-looking statements. Examples of forward-looking
statements include: (a) projections of revenue, earnings, capital structure, and other financial items, (b) statements of our plans and objectives, (c) statements of future economic performance, and (d) assumptions underlying
statements regarding us or our business. The statements set forth below discuss important factors that could cause actual results to differ materially from any forward-looking statements. We assume no obligation to update these forward-looking
statements.

Our future growth is dependent on the sales process and market acceptance of our products and services. Our
future performance depends on our ability to maintain and increase revenues from new and existing customers. Our sales process to acquire new customers is typically extended in duration, because of industry factors such as the approval process in
hospitals for purchases from new suppliers, the duration of existing supply contracts, and implementation delays pending termination of a hospitals previous supply relationships. Our future performance also depends on the market accepting our
product and service offerings, which emphasize the supply of reusable surgical products to a market that predominantly uses disposable products. We are also regularly developing new instrument processing programs. We are subject to a risk that the
market will not broadly accept these product offerings, which would adversely affect our revenues and operating results.

Our
restructuring of our sales, service and operations might disrupt our business.Over the next several months, we expect to continue implementing recommendations of our management consulting firm for a reorganization of our sales, service and
operations. See Managements Discussion and Analysis of Financial Condition and Results of Operations  Overview. We are subject to risks that the reorganization might not be successful, and might result in business
disruption and higher costs than anticipated.

We might need additional capital in the future, which might not be available;
potential impact of covenant default.Our business is capital intensive and requires annual capital expenditures for additional surgical products. Should we need or otherwise decide to raise additional funds, we may not be able to obtain
additional financing on favorable terms, if at all. If we cannot raise funds, if needed, on acceptable terms, we may not be able to develop or enhance our products, take advantage of future opportunities, respond to competitive pressures or
unanticipated requirements or otherwise support our operations. Based on our current projections, we may need to request a waiver or an amendment to the minimum funds flow coverage ratio in future quarters, which might not be available. Our bank
credit facility expires in June 2008. We may not be able to renew or extend the agreement. If we are unable to extend or renew the credit agreement the letter of credit supporting the industrial revenue bonds may not be renewed. See
Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and Capital Resources.

The inability of a key supplier to perform may leave us without a source of supplies and could adversely affect our operating results.We rely on Aesculap, Inc. (Aesculap) as our major source of supply of
instruments for our instrument processing programs. Any failure of Aesculap to furnish instruments for any reason would materially and adversely affect our ability to service these programs until we secured one or more alternative suppliers. We also
have a procurement agreement with Standard Textile Co., Inc. (Standard Textile) as our supply source for our reusable surgical products through August 2008. If Standard Textile were unable to perform under this agreement, we would be
materially and adversely affected until we secured alternative suppliers.

The loss of a significant customer or purchasing
organization could adversely affect our operating results.During the nine-month period ended September 30, 2007, hospitals belonging to three group purchasing organizations (GPOs), Novation, LLC,
HealthTrust Purchasing Group, L.P. and MedAssets, Inc. accounted for approximately 61% of our sales. No single healthcare provider accounts for more than 8% of our sales. Our business with these GPOs is pursuant to short-term agreements, which are
subject to renewal from time to time through competitive processes. Although each GPO member hospital currently makes its purchasing decisions on an individual basis, the loss of a substantial portion of the GPO hospitals business would
adversely affect our revenues and results of operations.



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Intense competition in the markets in which we operate could adversely affect
us. Our business is highly competitive. Competitors include a number of distributors and manufacturers, as well as the in-house reprocessing operations of hospitals. Certain of our existing and potential competitors possess
substantially greater resources than we possess. Some of our competitors, including Allegiance Corporation (a subsidiary of Cardinal Health, Inc.) and Medline Industries, Inc., serve as the sole supplier of a wide assortment of products to a
significant number of hospitals. While we have a substantial array of surgical products, many of our competitors have a greater number of products for the entire hospital, which in some instances is a competitive disadvantage for us. There is no
assurance that we will be able to compete effectively with existing or potential competitors.

The loss of key executives and
employees could adversely affect us. Our success depends upon the contributions of executives and key employees. The loss of executives and certain key employees in sales, operations and marketing could have a significant adverse effect on
our ability to penetrate our markets, operate efficiently, and develop and sell new products and services. In February 2007, our President and Chief Executive Officer resigned. We have engaged a search firm to assist us in locating a successor. We
also believe our success will depend in large part upon our ability to attract and retain additional highly skilled personnel.

Our ability to effectively grow depends on our ability to improve our operational systems.We have expanded our operations since inception and may continue to expand to pursue existing and
potential market opportunities. This growth places a significant demand on management, financial and operational resources. To manage growth effectively, we must implement and improve our operational systems, procedures and controls on a timely
basis and continue to invest in the operational infrastructure of our business.

Our product liability insurance may not be
sufficient to cover all claims.The use of medical devices such as surgical instruments entails an inherent risk of product liability or other claims initiated by patients or hospitals. Any of those claims in excess of our insurance coverage
or not covered by insurance could adversely affect our results of operations.

Changes in federal or state regulations could
materially adversely affect us.Significant aspects of our businesses are subject to federal, state and local statutes and regulations governing, among other things, medical waste-disposal and workplace health and safety. In addition, most
of the products furnished or sold by us are subject to regulation as medical devices by the U.S. Food and Drug Administration (FDA), as well as by other federal, state and local agencies. Our facilities are subject to quality systems
inspections by FDA officials. The FDA has the power to enjoin future violations, seize adulterated or misbranded devices, and require the manufacturer to remove products from the market, and publicize relevant facts. Federal, state or local
governments might impose additional restrictions or adopt interpretations of existing laws that could materially adversely affect us.



|Item 4. | Controls and Procedures
|------- | -----------------------

Under the
supervision and with the participation of our management, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of our most recent fiscal quarter. Based on that evaluation, we
concluded that our disclosure controls and procedures are effective in timely alerting us to material information required to be included in our filings with the SEC.

We have also evaluated our internal controls for financial reporting, and there have been no changes that occurred during our most recent fiscal quarter that have materially affected, or are reasonably likely to
materially affect, our internal controls over financial reporting.

Any system of disclosure controls and internal controls, even if well
conceived, is inherently limited in detecting and preventing all errors and fraud and provides reasonable, not absolute, assurance that its objectives are met. The design of a control system must reflect resource constraints. Inherent limitations
include the potential for faulty judgments in decision-making, breakdowns because of simple errors or mistakes, and circumvention of controls by individual acts, collusion of two or more people, or management override of the controls.



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We included certifications of our Sr. Vice President of Strategic Sourcing and Sr. Vice President and
Chief Financial Officer as exhibits to this report as required by Section 302 of the Sarbanes-Oxley Act of 2002. The foregoing information concerning our evaluation of disclosure controls referenced in the Section 302 certifications should
be read with the Section 302 certifications to more completely understand them.



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PART II  OTHER INFORMATION



|Item 1. | Legal Proceedings
|------- | -----------------

We are subject to matters that
arise in the ordinary course of our business, none of which we expect to be material.



|Item 1A. | Risk Factors
|-------- | ------------

We have not materially amended our
risk factors from those stated in our Annual Report on Form 10-K filed with the SEC on March 23, 2007. See Certain Considerations above.



|Item 6. | Exhibits and Reports on Form 8-K
|------- | --------------------------------



|              |  |                                                                                                                                                                                                                                                                                                          
|------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Exhibit Description                                                                                                                                                                                                                                                                                      
|3.1(1)        |  | Restated Articles of Incorporation of the Company.                                                                                                                                                                                                                                                       
|              | 
|3.2(2)        |  | Amended and Restated Bylaws of the Company.                                                                                                                                                                                                                                                              
|              | 
|3.3(3)        |  | First Amendment to Restated Articles of Incorporation dated as of August 31, 1998, of the Company (for Series A Preferred Stock).                                                                                                                                                                        
|              | 
|31            |  | Certifications by the Sr. Vice President (SVP) of Strategic Sourcing and Sr. Vice President (SVP) and Chief Financial Officer (CFO) of the Company pursuant to Rule 13a-14 under the Securities
Exchange Act of 1934 (the Exchange Act) in accordance with Section 302 of the Sarbanes-Oxley Act of 2002.
|              | 
|32            |  | Certifications by the SVP of Strategic Sourcing and SVP and CFO of the Company pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (Not deemed to be filed with the Securities
and Exchange Commission).                                                                                        

Reports on Form 8-K

We filed a report on Form 8-K dated August 6, 2007 to furnish information related to our announcement of our operating results for our second quarter period ended June 30, 2007 (pursuant to Item 2.02 of
Form 8-K).

---

|(1) | Incorporated by reference to the Registration Statement on Form S-1 filed by the Registrant on May 15, 1996.
|--- | ------------------------------------------------------------------------------------------------------------

|(2) | Incorporated by reference to the Annual Report on Form 10-K for 2006 filed by the Registrant on March 23, 2007.
|--- | ---------------------------------------------------------------------------------------------------------------

|(3) | Incorporated by reference to the Current Report on Form 8-K dated August 31, 1998, and filed by the Registrant on September 9, 1998.
|--- | ------------------------------------------------------------------------------------------------------------------------------------



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EXHIBIT INDEX



|              |  |                                                                                                                                                                                                                                                                                                         
|------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Exhibit Description                                                                                                                                                                                                                                                                                     
|3.1(1)        |  | Restated Articles of Incorporation of the Company.                                                                                                                                                                                                                                                      
|              | 
|3.2(2)        |  | Amended and Restated Bylaws of the Company.                                                                                                                                                                                                                                                             
|              | 
|3.3(3)        |  | First Amendment to Restated Articles of Incorporation dated as of August 31, 1998, of the Company (for Series A Preferred Stock).                                                                                                                                                                       
|              | 
|31            |  | Certifications by the Sr. Vice President (SVP) of Strategic Sourcing and Sr.Vice President (SVP) and Chief Financial Officer (CFO) of the Company pursuant to Rule 13a-14 under the Securities
Exchange Act of 1934 (the Exchange Act) in accordance with Section 302 of the Sarbanes-Oxley Act of 2002.
|              | 
|32            |  | Certifications by the SVP of Strategic Sourcing and CFO of the Company pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (Not deemed to be filed with the Securities and
Exchange Commission).                                                                                               

---

|(1) | Incorporated by reference to the Registration Statement on Form S-1 filed by the Registrant on May 15, 1996.
|--- | ------------------------------------------------------------------------------------------------------------

|(2) | Incorporated by reference to the Annual Report on Form 10-K for 2006 filed by the Registrant on March 23, 2007.
|--- | ---------------------------------------------------------------------------------------------------------------

|(3) | Incorporated by reference to the Current Report on Form 8-K dated August 31, 1998, and filed by the Registrant on September 9, 1998.
|--- | ------------------------------------------------------------------------------------------------------------------------------------



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SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



|                       |  |                            |  |                                               
|---------------------- |  | -------------------------- |  | ----------------------------------------------
|                       |  | SRI/SURGICAL EXPRESS, INC.
|                       |  |                           
|Date: November 5, 2007 |  | By:                        |  | /s/ Wallace D. Ruiz                           
|                       |  |                            |  | Sr. Vice President and Chief Financial Officer



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