NeuroMetrix, Inc. - Quarter Report: 2007 September (Form 10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

Commission file number:    000-50856

NEUROMETRIX, INC.
(Exact name of registrant as specified in its charter)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve (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 ninety (90) days.

Yes ý        No o

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 o          Accelerated filer ý          Non-accelerated filer o

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

Yes o          No ý

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:
12,624,545 shares of common stock, par value $0.0001 per share, were outstanding as of November 2, 2007.

NEUROMETRIX, INC.
FORM 10-Q
INDEX

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PART I
FINANCIAL INFORMATION

Item 1.    Condensed Financial Statements

NeuroMetrix, Inc.

Balance Sheets

(Unaudited)

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

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NeuroMetrix, Inc.

Statements of Operations

(Unaudited)

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

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NeuroMetrix, Inc.

Statements of Cash Flows

(Unaudited)

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

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NeuroMetrix, Inc.
Notes to Unaudited Financial Statements

1.    Business and Basis of Presentation

Business

        NeuroMetrix, Inc. (the "Company"), a Delaware corporation, was formed in June 1996. The Company designs, develops and sells proprietary medical devices used to help physicians diagnose neuropathies and neurovascular diseases. Neuropathies are diseases of the peripheral nerves and parts of the spine that frequently are caused by or associated with diabetes, low back pain and carpal tunnel syndrome, as well as other clinical disorders. The Company markets and sells the NC-stat System, an internally-developed product, to physician practice groups for the diagnosis of neuropathies. Diabetic retinopathy is a neurovascular disease affecting the vision of patients with diabetes. The Company has an exclusive sales and marketing license with EyeTel Imaging, Inc. ("EyeTel") to market the DigiScope®, a product designed to detect diabetic retinopathy. The Company operates in one business segment.

        In October 2006, the Company entered into an exclusive seven year licensing agreement with EyeTel. The agreement grants the Company an exclusive license to market, brand, and sell EyeTel's DigiScope throughout the primary care physician and endocrinologist market in the United States. The DigiScope, developed by EyeTel in collaboration with the Wilmer Eye Institute at Johns Hopkins, is a United States Food and Drug Administration ("FDA") cleared diagnostic device that primary care physicians and endocrinologists can use for the early detection of diabetic retinopathy. Revenues from the DigiScope, for which we initiated sales and marketing efforts during the first quarter of 2007, are derived through: (a) eye scan fees, (b) monthly rental fees and (c) installation and training fees. Eye scan fees using the DigiScope are recognized at the time of the patient examination. Installation and training fees are deferred and recognized on a straight line basis over the non-cancelable term of the customer contract, currently one year, and rental fees are recognized on a monthly basis.

        The accompanying unaudited balance sheet as of September 30, 2007, unaudited statements of operations for the three and nine month periods ended September 30, 2007 and 2006 and the unaudited statements of cash flows for the nine month periods ended September 30, 2007 and 2006 have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair statement of the results of operations have been included. Operating results for the nine month period ended September 30, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007 or any other period. These financial statements and notes should be read in conjunction with the financial statements for the year ended December 31, 2006 included in the Company's Annual Report on Form 10-K (File No. 000-50856). The accompanying balance sheet as of December 31, 2006 has been derived from audited financial statements prepared at that date, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

Use of Estimates

        The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at

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the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Recent Accounting Pronouncements

        In February 2007, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115." ("SFAS No. 159") SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS No. 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company does not believe that the adoption of SFAS No. 159 will have a material impact on its financial position, results of operations or cash flows.

        In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" ("SFAS No. 157"). SFAS No. 157 defines fair value in numerous accounting pronouncements, establishes a framework for measuring fair value in generally accepted accounting principles ("GAAP") and expands disclosures related to the use of fair value measures in financial statements. SFAS No. 157 does not expand the use of fair value measures in financial statements, but standardizes its definition and guidance in GAAP. SFAS No. 157 emphasizes that fair value is a market-based measurement and not an entity-specific measurement based on an exchange transaction in which the entity sells an asset or transfers a liability (exit price). SFAS No. 157 establishes a fair value hierarchy from observable market data as the highest level to fair value based on an entity's own fair value assumptions as the lowest level. SFAS No. 157 is effective for our financial statements issued in 2008; however, earlier application is encouraged. The Company has not yet determined the impact that the adoption of SFAS No. 157 will have on its financial position, results of operations or its cash flows.

        In June 2006, the FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109" ("FIN No. 48"), which clarifies the accounting and disclosure for uncertainty in tax positions, as defined. FIN No. 48 requires that management recognize in the Company's financial statements the impact of the tax position if that position is more likely than not of being sustained upon examination, based on the technical merits of the position. The Company adopted the provisions of FIN No. 48 effective January 1, 2007 and such adoption did not have a material effect on the financial statements. See Note 7—Income Taxes—Adoption of FIN No. 48.

2.    Restatement

        As previously disclosed in Note 2—Restatement of the Notes to Financial Statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2006, the Company has restated its financial statements for the three and nine months ended September 30, 2006 to correct an error in accounting for sales tax liabilities. The error arose from the Company's failure in certain states within the United States to charge sales tax to customers as required by state law and subsequently file and remit such collections to the state tax authorities. The Company has computed the error as the total of the sales tax due, based on historical sales in those states where sales tax should have been collected, and the resulting interest and penalties in accordance with the applicable state laws.

        The impact of correcting this error resulted in an increase in general and administrative expenses of $309,000 and a reduction of net income of $309,000 for the quarter ended September 30, 2006 and an increase in general and administrative expenses of $856,000 and a reduction of net income of $856,000 for the nine months ended September 30, 2006.

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        The following table presents the impact of the restatement:

        As applicable, the footnotes contained elsewhere within these financial statements have also been restated to correct this error.

3.    Net Income (Loss) Per Common Share

        The Company accounts for and discloses net income (loss) per common share in accordance with SFAS No. 128, "Earnings Per Share". Basic net income (loss) per common share is computed by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding. Diluted net income (loss) per common share is computed by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares

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and dilutive potential common share equivalents then outstanding. Potential common shares consist of shares issuable upon the exercise of stock options using the treasury stock method.

        The following potentially dilutive common shares were excluded from the calculation of diluted net income (loss) per common share because their effect was antidilutive for each of the periods presented:

4.    Inventories

        Inventories consist of the following:

        Included in inventories are amounts related to the Company's third-generation neurodiagnostic system, the ADVANCE^TM System. Finished goods include $2.2 million and $262,900 related to the ADVANCE System at September 30, 2007 and December 31, 2006, respectively. Purchased components include $680,300 related to the ADVANCE System at September 30, 2007. There were no purchased components related to the ADVANCE System at December 31, 2006. The Company remains in the process of seeking 510(k) regulatory clearance from the FDA in order to begin selling this product.

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5.    Other Balance Sheet Items

        Other accrued expenses consist of the following:

        At September 30, 2007, the decrease in state sales tax liability reflects a reversal of $1.7 million in previously accrued expenses resulting from the receipt of amnesty and other forms of relief from a number of states in the form of a limited look back period and waiver of penalties. This reversal was recorded as a reduction of general and administrative expenses in the second quarter of 2007.

Product Warranty Costs

        The Company accrues estimated product warranty costs at the time of sale which are included in cost of revenues in the statements of operations. The amount of the accrued warranty liability is based on historical information such as past experience, product failure rates, number of units repaired and estimated cost of material and labor. The liability for product warranty costs is included in accrued expenses in the balance sheet.

        The following is a rollforward of the Company's accrued warranty liability for the three and nine month periods ended September 30, 2007 and 2006:

6.    Shareholder Rights Plan

        On March 7, 2007, the Company's Board of Directors adopted a Shareholder Rights Plan and declared a dividend distribution of one preferred stock purchase right for each outstanding share of the Company's common stock to shareholders of record as of the close of business on March 8, 2007. Initially, these rights will not be exercisable and will trade with the shares of the Company's common stock. Under the Shareholder Rights Plan, the rights generally will become exercisable if a person becomes an "acquiring person" by acquiring 15% or more of the common stock of the Company or if a person commences a tender offer that could result in that person owning 15% or more of the common stock of the Company. If a person becomes an acquiring person, each holder of a right (other than the acquiring person) would be entitled to purchase, at the then-current exercise price of the right, such number of shares of preferred stock which are equivalent to shares of the Company's common stock having a value of twice the exercise price of the right. If the Company is acquired in a merger or other business combination transaction after any such event, each holder of a right would then be entitled to purchase, at the then-current exercise price of the right, shares of the acquiring company's common stock having a value of twice the exercise price of the right.

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7.    Income Taxes—Adoption of FIN No. 48

        On January 1, 2007, the Company adopted the provisions of FIN No. 48. FIN No. 48 requires that the impact of tax positions be recognized in the financial statements if they are more likely than not of being sustained based on the technical merits of the position. As disclosed in the financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2006, the Company has a valuation allowance against the full amount of its net deferred taxes. The Company currently provides a valuation allowance against deferred taxes when it is more likely than not that some portion, or all, of its deferred tax assets will not be realized.

        As a result of the implementation of FIN No. 48, the Company reduced its deferred tax assets and the associated valuation allowance for gross unrecognized tax affected benefits by approximately $120,000. There was no adjustment to the Company's accumulated deficit as a result of these unrecognized tax benefits since there was a full valuation allowance against the related deferred tax assets. If these unrecognized tax benefits are ultimately recognized, they would have no impact on the effective tax rate to the extent the Company continues to maintain a valuation allowance.

        The Company files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. The Company has not been audited by the Internal Revenue Service ("IRS") or any states in connection with income taxes. The periods from 1996 - 2006 remain open to examination by the IRS and state jurisdictions.

        The Company's policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. As of the date of adoption of FIN No. 48, the Company did not have any accrued interest or penalties associated with any unrecognized tax benefits, nor was any interest expense recognized during the quarter. The Company's effective tax rate differs from the federal statutory rate primarily due to non-deductible expenses and is offset somewhat by state tax credits.

        Under Internal Revenue Code Section 382, cumulative ownership changes by material shareholders exceeding 50% during a 3-year period can potentially limit a company's future use of its net operating losses. The Company has performed a Section 382 study and, under current tax rules, the limitations are not expected to significantly impact the recorded value or timing of utilization of the Company's net operating losses. However, ownership changes since the completion of the study and in future periods may further limit the utilization of net operating losses and tax credit carryforwards.

8.    Commitments and Contingencies

        In the second quarter of 2006, the Company received a subpoena from the Office of Inspector General ("OIG"), of the Department of Health and Human Services requesting documents in connection with an investigation of potential violations of the federal anti-kickback statute and False Claims Act. In addition, on June 21, 2007, the Company received a subpoena from the U.S. Attorney's Office for the District of Massachusetts requesting documents in connection with an investigation by the U.S. Department of Justice ("DOJ"). It is believed that the DOJ is investigating various aspects of the Company's sales and marketing practices relating to the NC-stat System. The Company is cooperating with both investigations. The likelihood or magnitude of any potential liabilities arising out of these investigations cannot be reasonably estimated and therefore no loss contingency has been accrued as of September 30, 2007.

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Item 2.    Management's Discussion and Analysis of Financial Condition and Results of Operations

        You should read the following discussion of our financial condition and results of operations in conjunction with our condensed financial statements and the accompanying notes to those financial statements included elsewhere in this Quarterly Report on Form 10-Q. This discussion contains forward-looking statements that involve risks and uncertainties. For a description of factors that may cause our actual results to differ materially from those anticipated in these forward looking statements, please refer to the section of this Quarterly Report on Form 10-Q titled "Cautionary Note Regarding Forward-Looking Statements."

        We have restated our financial statements as of and for the three and nine months ended September 30, 2006 to correct an error in accounting for sales taxes, as discussed in Note 2—Restatement of the Notes to Unaudited Financial Statements included elsewhere in this Quarterly Report on Form 10-Q. Additional information about this restatement may be found in Note 2—Restatement of the Notes to Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2006.

Overview

        NeuroMetrix was founded in June 1996. We design, develop and sell proprietary medical devices used to help physicians diagnose neuropathies and neurovascular disease. Our proprietary technology provides physicians with an in-office diagnostic system, the NC-stat System, which enables physicians to make rapid and accurate diagnoses of neuropathies, including carpal tunnel syndrome, low back and leg pain and diabetic peripheral neuropathy. The NC-stat System is comprised of: (a) disposable single use NC-stat biosensors that are placed on the patient's body; (b) the NC-stat monitor and related components; and (c) the NC-stat docking station, an optional device that enables the physician's office to transmit data to our onCall Information System. Each component of the NC-stat System is also sold separately. The sensitivity of the nervous system to metabolic and mechanical damage, compounded by its limited regenerative ability, creates a market opportunity for a medical device that can assist in point-of-service diagnoses of neuropathies in a manner that is cost-effective for the patient and third-party payer. We believe the accuracy and convenience provided by the NC-stat System position it to become a standard of care for the assessment of neuropathies at the point-of-service.

        Neurovascular disease includes conditions such as retinopathy, an eye disease prevalent in patients with diabetes. We hold an exclusive sales and marketing license to a product known as the DigiScope®, which allows primary care and specialist physicians to diagnose diabetic retinopathy and refer patients to an eye specialist for treatment if deemed necessary based on the results. It is recommended by the American Diabetes Association, or ADA, that all patients with diabetes receive an annual dilated eye examination to monitor vision. There are approximately 21 million people in the United States with diabetes, according to the ADA, and only approximately 50% comply with the recommendation to have an annual eye examination. We believe that a product such as the DigiScope in primary care physicians' and endocrinologists' offices could potentially lead to an increase in the level of testing and result in the earlier detection of eye diseases in patients with diabetes.

        We derive the majority of our revenues from the sale of NC-stat biosensors, monitors and docking stations directly to end users, which are generally physician practice groups. Our NC-stat biosensors are disposable products that are used once and inactivated after use. The NC-stat monitor is an electronic instrument that is used with the NC-stat biosensors to perform nerve conduction studies for the purpose of diagnosing neuropathies. The NC-stat monitor displays the pertinent results of nerve conduction studies on a LCD screen immediately at the conclusion of each study. The NC-stat docking station is an optional device that is used to transmit to the onCall Information System data generated by the nerve conduction study performed with the NC-stat monitor. The onCall Information System

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formulates the data it receives for each test into a detailed report that is provided to the customer through facsimile or e-mail.

        In October 2006, we entered into an exclusive seven year licensing agreement with EyeTel Imaging, Inc., or EyeTel. The agreement grants us an exclusive license to market, brand and sell EyeTel's DigiScope throughout the primary care physician and endocrinologist market in the United States. Revenues associated with the DigiScope are derived through: (a) eye scan fees; (b) monthly rental fees and (c) installation and training fees. Under the terms of agreement, we are required to remit a percentage of the revenues related to the DigiScope to EyeTel.

        Our revenues declined to $11.3 million for the three months ended September 30, 2007, compared to $15.3 million for the same period a year ago, and declined to $34.5 million for the nine months ended September 30, 2007, compared to $41.1 million for the same period a year ago. Additionally, we incurred a net loss of $3.6 million for the three months ended September 30, 2007, compared to net income of $2.1 million for the same period a year ago, and incurred a net loss of $6.2 million for the nine months ended September 30, 2007, compared to net income of $3.2 million for the same period a year ago. The third quarter of 2007 represents our third consecutive quarter of net losses and declining revenues following our first profitable year in 2006 and a period of significant growth in our revenues extending back through 2002. We believe that the decline in our revenues has been caused primarily by adverse developments over the last several quarters relating to the reimbursement by third-party payers of nerve conduction studies performed using the NC-stat System, and we expect that our revenues will continue to be adversely affected by the uncertainty regarding reimbursement. One important development that may resolve some of the uncertainty, as described in more detail below, occurred when the American Medical Association, or AMA, formed a committee to examine reimbursement coding of nerve conduction studies. We believe this committee may issue recommendations, which may or may not be beneficial to us, for consideration by the AMA CPT Editorial Panel in early 2008. Other significant developments relating to our financial condition and results of operations include:

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the launch of our sales and marketing efforts relating to the DigiScope in the first quarter of 2007, which contributed approximately $270,000 to our revenues in the third quarter of 2007 and is expected to continue to contribute to our revenues going forward;



•

our decision to terminate our relationships with all independent sales agencies following the end of the second quarter of 2007, which may adversely impact future revenues, but is likely to reduce future sales and marketing expenses;



•

the delay of our expected launch of our third-generation neurodiagnostic system, the ADVANCE™ System, for which we have invested $2.8 million in inventories as of September 30, 2007 and remain in the process of seeking 510(k) regulatory clearance from the U.S. Food and Drug Administration, or FDA;



•

our receipt of amnesty and other forms of relief from a number of states related to state sales tax liability that we had previously accrued, which resulted in a reversal of $1.7 million of state sales tax liability in the second quarter of 2007; and



•

the governmental investigations by the Office of Inspector General, or OIG, of the Department of Health and Human Services and the U.S. Department of Justice, or DOJ, that we are subject to, which resulted in increased legal expenses during the three and nine months ended September 30, 2007, respectively.

In addition, we continued to make progress with our research and development efforts, particularly with a minimally invasive neurotherapeutic product. These developments are discussed in greater detail below and elsewhere in this Quarterly Report on Form 10-Q.

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        Reimbursement from third-party payers is an important element of success for medical products companies. As our presence in the market expands and the use of the NC-stat System increases, we have experienced and are likely to continue to experience an increased focus from third-party payers and governmental agencies regarding the reimbursement of nerve conduction studies performed using the NC-stat System and an increased focus from these organizations regarding the professional requirements for performing nerve conduction studies in general. A number of third-party payers, including commercial payers, have taken and may continue to take the position of not reimbursing our customers for their use of the NC-stat System. We do not have complete or timely access to all of the reimbursement policies issued by third-party payers. These policies may vary by provider agreement and by patient health plan. The policies may change frequently and they may contain exceptions and exemptions. As a result, the information we have on payer policies specifically relating to reimbursement for the NC-stat System is incomplete and may be outdated. Our customers are responsible for monitoring and understanding the specific payer policies relevant to their practice since they are submitting claims for reimbursement directly to these third-party payers.

        During the second half of 2006 and in 2007, several local Medicare carriers issued draft local coverage decisions, or LCDs, final LCDs or coding articles particularly addressing coverage and reimbursement policies under Medicare for nerve conduction studies performed using the NC-stat System. Several of these carriers indicated that they will not reimburse physicians under Medicare for nerve conduction studies performed using the NC-stat System under the three existing Current Procedural Terminology, or CPT, codes for conventional nerve conduction studies (95900, 95903 and 95904), which provide for levels of reimbursement fixed by the Center for Medicaid and Medicare Services, or CMS, but rather that physicians must submit claims for reimbursement for these procedures under a miscellaneous CPT code (95999), in which case the local carriers may determine the level of reimbursement to be paid, if any. Currently, there are three local Medicare carriers with final LCDs, one local Medicare carrier with a draft LCD, and one local Medicare carrier with a coding article which addresses coverage and reimbursement policies under Medicare for nerve conduction studies performed using the NC-stat System. One additional Medicare carrier, which had previously issued a final LCD, reversed their position effective June 30, 2007. In certain regions impacted by these reimbursement decisions, our customers have experienced lower levels of reimbursement and higher levels of claims denials. If physicians do not receive adequate reimbursement under the miscellaneous CPT code from those local carriers, our existing customers may continue to limit or curtail their use of the NC-stat System and we may be unable to obtain new customers, both of which could materially and adversely impact our revenues and profitability. The AMA formed a committee in early 2007 to examine the reimbursement coding of nerve conduction studies and nerve conduction equipment, including the NC-stat System. The findings of this committee, which are expected to be presented to the AMA CPT Editorial Panel, may affect which CPT codes Medicare carriers and commercial payers will require physicians who perform nerve conduction studies to use. We believe that the three most likely outcomes of the AMA CPT Editorial Panel review are as follows:

•

The existing Category I CPT codes are determined to be applicable to nerve conduction studies performed using FDA cleared equipment such as the NC-stat System;



•

A new series of Category I CPT codes is established for nerve conduction studies performed using the NC-stat System; or



•

A new series of Category III CPT codes, designated for emerging technologies, is established for nerve conduction studies performed using the NC-stat System.

        The assignment of a new series of CPT I codes by the AMA CPT Editorial Panel could potentially result in less favorable reimbursement rates compared with existing CPT codes for nerve conduction studies. The assignment of a new series of Category III codes is likely to result in limited

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reimbursement since there is the potential that no specified reimbursement values would be assigned to these codes.

        The LCDs and coding articles issued by local Medicare carriers have also addressed a number of other issues, including (a) the background and training of physicians supervising or performing nerve conduction studies; (b) the level of training requirements for technicians performing a nerve conduction study; (c) whether nerve conduction tests should be required to be performed concomitantly with a needle electromyography procedure; and (d) whether the NC-stat System is comparable to conventional nerve conduction testing equipment. We do not believe that these LCDs prohibit physicians from receiving reimbursement under Medicare for medically necessary nerve conduction studies performed using the NC-stat System. However, these LCDs do appear to be targeted at limiting access to perform and/or reimbursement for nerve conduction studies. In certain cases, these LCDs are being interpreted or implemented in a manner that impacts the ability of physicians to receive reimbursement under Medicare, including lower levels of reimbursement and an increase in the number of claims being denied, for nerve conduction studies performed using the NC-stat System, which are having an adverse impact on our revenues.

        Additionally, a growing number of commercial payers, including the majority of regional Blue Cross Blue Shield carriers, and other major private payers have adopted policies indicating that they will not provide reimbursement for the use of the NC-stat System. These commercial payers have cited various reasons for their reimbursement policies, including, among others, that the NC-stat System is experimental and investigational. We are in the process of communicating with these payers, directly, through our customers or through our network of reimbursement consultants, to attempt to address their concerns. Third-party payers may also impose requirements on physicians to submit additional paperwork supporting the medical necessity of nerve conduction studies performed using the NC-stat System. We believe these requirements are negatively impacting the use of the NC-stat System by existing customers and our sales to new customers, both of which are having an adverse impact on our revenues.

        Additional third-party payers, including local Medicare carriers and commercial payers, could potentially take a position that could reduce or eliminate the reimbursement for the NC-stat System and could have the impact of deterring usage by our customers.

        We believe that eye scans performed using the DigiScope are being reimbursed by the majority of third-party payers. Many commercial payers have policies in place providing for reimbursement for the use of the DigiScope and many of these payers have published favorable articles about the DigiScope in their newsletters. However, several Medicare carriers have issued draft LCDs and coding articles that require a diagnosis of pre-existing retinal disease and/or will only reimburse for fundus photography, a highly specialized form of medical imaging, when performed in conjunction with an eye examination performed by an eye specialist. There are no assurances that other Medicare carriers will not issue similar draft LCDs, final LCDs or coding articles restricting the reimbursement for the use of the DigiScope. We believe that eye examinations performed on patients covered by Medicare represented less than 25% of our DigiScope revenues in the third quarter of 2007. However, the restrictions on reimbursement by Medicare carriers could have an adverse impact on our ability to grow our DigiScope revenues in future periods.

        One of the primary challenges we face in our business is successfully expanding the market for nerve conduction studies. A successful market expansion will depend upon, in part, our targeting of primary care and specialist physicians who traditionally have not been targeted by companies selling equipment used to perform nerve conduction studies and our ability to alter physicians' practices relating to the diagnosis of neuropathies. Our strategy had been to sell the NC-stat System through a combination of independent sales agencies and a direct sales force of experienced sales representatives. The independent sales agencies, including small to medium sized regional firms and larger national

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firms, had primarily been responsible for generating sales leads and our direct sales force had been responsible for bringing these sales leads to closure. These independent sales agencies typically had not served in a traditional distribution role and therefore had not been responsible for maintaining inventories, for making shipments to customers or for billing and collection functions.

        Our strategy of utilizing independent sales agencies had been effective historically, but we experienced a significant decline in the percentage of new customers being sourced through our independent sales agency network in the first half of 2007. As a result, consistent with our long term business objectives, in the third quarter of 2007, we made a decision to terminate our relationships with all independent sales agencies and focus our selling efforts exclusively through our direct sales force, which, as of September 30, 2007, was comprised of 51 regional sales managers, 5 sales directors and 1 national sales director.

        We expect that our direct sales force will expand their role in generating new customer sales leads, and we plan to increase efforts to generate sales leads through various marketing activities including mailings and tradeshows. However, we experienced a decline in the number of new customers added in the third quarter of 2007 along with a decline in sales to our existing customers. We believe the decision to terminate the independent sales agency relationships may have contributed to these declines and could potentially have an adverse impact on our revenues and our ability to secure new customers in future periods as well.

        Our long-term financial objectives are to grow our business through the sale of the NC-stat System and the DigiScope and additional products that may be commercialized for the diagnosis and treatment of neuropathies and to achieve sustainable profitability. However, during the remainder of 2007 our revenues are likely to continue to decline and we are likely to continue to incur losses as a result of the reimbursement and other issues we are currently facing. Our efforts during the remainder of 2007 will focus on (a) sales of the NC-stat System; (b) sales and marketing of the DigiScope for the detection of diabetic retinopathy; (c) seeking regulatory clearance from the FDA for our third-generation neurodiagnostic system, the ADVANCE System, in order to launch this product; (d) efforts to manage the reimbursement challenges posed by third-party payers for the NC-stat System; (e) cooperating with, and working to resolve, the government investigations of which we are subject; and (f) our ongoing research and development programs.

        Our launch of the ADVANCE System will depend upon our receipt of regulatory clearance from the FDA. We submitted our initial 510(k) filing for the ADVANCE System in the first quarter of 2007, subsequently submitted a response to a request for additional information from the FDA and have received an additional request for further information from the FDA, including a request for additional data relating to the ADVANCE System. During the fourth quarter of 2006, we submitted a 510(k) filing for an updated version of the onCall Information System, and we have submitted a response to a request for additional information from the FDA related to this filing. We recently received an additional request for information from the FDA in connection with the 510(k) submission for the onCall Information System. If the onCall 510(k) clearance is not obtained, it may require additional product development and potential changes in the configuration of our products.

        With respect to our research and development programs, during the remainder of 2007, we expect to continue efforts to develop new biosensors, on the development of the ADVANCE System and its accessories, on the development of a product for the minimally invasive pain control and treatment of neuropathies. During 2007, we initiated testing of our minimally invasive neurotherapeutic product for pain control and treatment of neuropathies.

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Results of Operations

        The following table presents certain statement of operations information stated as a percentage of total revenues:

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Comparison of Three Months Ended September 30, 2007 and September 30, 2006

Revenues

        The following tables present a breakdown of our customers, biosensor units used and revenues:

        Diagnostic device revenues were $925,300 and $2.2 million for the three months ended September 30, 2007 and 2006, respectively, a decrease of $1.3 million or 58.0%. This decrease is primarily attributable to a lower number of units sold, which we believe resulted primarily from uncertainty and adverse developments relating to the reimbursement for procedures performed with the NC-stat System. Diagnostic device revenues accounted for 8.2% and 14.4% of our total revenues for the three months ended September 30, 2007 and 2006, respectively.

        Biosensor revenues were $10.1 million and $13.1 million for the three months ended September 30, 2007 and 2006, respectively, a decrease of $3.0 million, or 22.7%. Biosensor revenues accounted for 89.4% and 85.6% of our total revenues for the three months ended September 30, 2007 and 2006, respectively. This decrease is attributable to lower sales of biosensors, which we believe resulted primarily from uncertainty and adverse developments relating to the reimbursement for procedures performed with our product.

        Our customers used 257,900 biosensors in the three months ended September 30, 2007, compared to 302,200 biosensors for the same period in 2006, a decrease of 44,300 or 14.7%. This decrease in biosensor usage is primarily the result of a decline in average usage per customer partially offset by an increase in our customer base. During the 12-month period ended September 30, 2007, a total of 5,523 customers used the NC-stat System compared to 4,518 customers for the same period in 2006. The average quarterly usage per account declined to 47 biosensors for the quarter ended September 30, 2007 from 67 biosensors for the same period in 2006.

        Other revenues are attributable to the DigiScope, for which we obtained an exclusive sales and marketing license from EyeTel in October 2006 and launched our sales and marketing efforts during the first quarter of 2007. Revenues related to the DigiScope were derived from a mix of new customers and customer accounts that existed at the time of our signing of the license agreement with EyeTel and were transferred to us.

        Our total revenues were $11.3 million and $15.3 million for the three months ended September 30, 2007 and 2006, respectively.

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        We anticipate that revenues in the remainder of 2007 will continue to decline. In the third quarter of 2007, we experienced a decline in revenues of 26.0% from the third quarter of 2006, which we believe primarily resulted from the uncertainty created by the issuance of draft LCDs, final LCDs and coding articles by Medicare carriers addressing reimbursement for nerve conduction studies and policies issued by commercial payers intended to deter usage or limit the reimbursement for the NC-stat System. These developments and other future reimbursement decisions could continue to adversely impact reimbursement for procedures performed using the NC-stat System. Our revenues in the remainder of 2007 are likely to be impacted by (a) the level of reimbursement, if any, established for procedures performed using the NC-stat System by these carriers and other third-party payers; (b) whether final LCDs are applied in a manner that places additional restrictions or qualifications on the performance of these procedures; (c) any other reimbursement determinations relating to nerve conduction studies that may be issued by third-party payers; (d) any other events causing uncertainty as to the existence or amount of reimbursement physicians are likely to receive for performing procedures using the NC-stat System or (e) decisions potentially forthcoming from the AMA CPT Editorial Panel regarding reimbursement codes for nerve conduction studies. Separately, we expect revenues to continue to be positively impacted by the initiation of our sales and marketing efforts for the DigiScope. However, continuing revenues derived from the DigiScope may be impacted by EyeTel's ability to raise additional capital to fund their ongoing business requirements. Overall, revenues could be impacted by a variety of factors, including the level of demand for our products, potential for changes in third-party reimbursement for nerve conduction studies, the decision to terminate our relationships with independent sales agencies, the overall economy, competitive factors and the factors described in the section of this Quarterly Report on Form 10-Q titled "Cautionary Note Regarding Forward-Looking Statements."

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Costs and expenses

        The following table presents our costs and expenses and net income (loss):

Gross Margin

        Diagnostic device gross margin percentage decreased to 77.6% for the three months ended September 30, 2007 from 84.6% for the same period in 2006. The decrease in the gross margin percentage is primarily attributable to a decrease in the number of devices sold and lower average selling prices.

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        Biosensor gross margin percentage decreased to 73.9% for the three months ended September 30, 2007 from 74.0% for the same period in 2006. The decrease in the biosensor gross margin percentage is primarily due to the change in the mix of biosensors sold.

        Other gross margin percentage, which related entirely to the DigiScope, was 25.0% for the three months ended September 30, 2007. DigiScope revenues in the third quarter of 2007 included monthly rental fees and eye scan fees associated with customer accounts that existed at the time of our signing the license agreement with EyeTel as well as the amortization of deferred revenues relating to installation and training fees. Under the terms of agreement, we are required to remit a percentage of the revenues related to the DigiScope to EyeTel. The agreement includes a provision for a higher percentage of the scan fees to be remitted to EyeTel for these existing customers for the first nine months of the agreement. Effective October 1, 2007, consistent with the terms of our original agreement with EyeTel, the percentage of revenues we retain from these existing customers will increase from 25% to 50%.

        Our overall gross margin percentage was 73.0% for the three months ended September 30, 2007 compared to 75.5% for the same period in 2006.

        Our gross margins may decline during the remainder of 2007 due to the expected decline in revenues derived from the NC-stat System and due to an expected increase in the percentage of total revenues derived from the DigiScope, which has lower gross margins as compared with our other products.

Research and Development

        Our research and development, or R&D, expenses include expenses associated with our research, product development, clinical, regulatory and quality assurance departments.

        R&D expenses were $1.3 million for the three months ended September 30, 2007 and 2006. As a percentage of revenues, R&D expenses were 11.4% and 8.4% for the three months ended September 30, 2007 and 2006, respectively. While R&D expenses were relatively unchanged in the third quarter of 2007 compared with the same period in 2006, we experienced a decrease of $92,200 related to developmental costs expended on the ADVANCE System, and on new prototype biosensors and we also experienced an increase of $83,200 in stock-based compensation expense.

        We expect our spending on R&D will be relatively unchanged during the remainder of 2007. We anticipate that resources devoted to the development of the ADVANCE System may be reallocated to other research and development efforts. This amount may vary, however, depending on the opportunities and challenges that arise during the year and depending on the outcome of the FDA review of our 510(k) submission for the ADVANCE System.

Sales and Marketing

        Our sales and marketing expenses include expenses from the marketing, field sales, sales administration and reimbursement departments.

        Sales and marketing expenses increased $377,700, or 6.7%, to $6.0 million for the three months ended September 30, 2007 from $5.7 million for the same period in 2006. As a percentage of revenues, sales and marketing expenses were 53.5% and 37.1% for the three months ended September 30, 2007 and 2006, respectively. The increase in expenses was primarily due to (a) an increase of $648,800 in employee compensation and benefit costs attributable to the expansion of our sales force; (b) an increase of $184,900 in consulting services, primarily to assist us with the reimbursement challenges we are facing; (c) an increase of $86,700 in stock-based compensation expense; and (d) an increase of $75,300 in expenses attributable to a national sales meeting for which there was no comparable expense during the same period a year ago. These amounts were partially offset by a decrease in third-party

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sales commissions of $697,800, primarily due to decreased revenues. We anticipate that our sales and marketing expenses may decline in the fourth quarter of 2007 as a result of reduced payments to independent sales agencies.

        Our sales force is comprised of 57 employees, including 51 regional sales managers, as of September 30, 2007 compared to 49 employees, including 45 regional sales managers as of September 30, 2006. We plan to continue selling the DigiScope through the same sales force used to sell the NC-stat System and as a result we do not anticipate the need to expand the sales force to support the sales and marketing efforts for the DigiScope.

General and Administrative

        Our general and administrative expenses include expenses from the executive, finance, administrative, customer service and information technology departments.

        General and administrative expenses increased $2.1 million or 73.0%, to $4.9 million for the three months ended September 30, 2007 from $2.8 million for the same period in 2006. As a percentage of revenues, general and administrative expenses were 43.4% and 18.6% for the three months ended September 30, 2007 and 2006, respectively. The increase in expenses is primarily due to an increase of $2.2 million in professional fees for legal services and an increase of $139,600 in consulting services, both primarily related to the government investigations previously disclosed by us and to reimbursement matters. These amounts were offset by a decrease of $217,500 in bad debt expense.

        We believe our general and administrative expenses will be relatively unchanged for the remainder of 2007. However, our general and administrative expenses may be impacted by certain factors including the governmental investigations previously disclosed.

Interest Income

        Interest income was $426,900 and $436,000 during the three months ended September 30, 2007 and 2006, respectively. Interest income was earned from investments in cash equivalents and short-term investments. The decrease in interest income for the quarter ended September 30, 2007, as compared to the same period in 2006, is primarily due to a slight decrease in the average effective portfolio yield attributable to the impact of lower market interest rates in 2007.

Provision for Income Taxes

        We recorded no tax provision for the three months ended September 30, 2007 as a result of the net loss incurred. We recorded a tax provision related to the alternative minimum tax of $66,900 for the three months ended September 30, 2006.

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Comparison of Nine Months Ended September 30, 2007 and September 30, 2006

Revenues

        The following tables present a breakdown of our customers, biosensor units used and revenues:

        Diagnostic device revenues were $3.4 million and $5.7 million for the nine months ended September 30, 2007 and 2006, respectively, a decrease of $2.3 million, or 39.6%. This decrease is primarily attributable to a lower number of units sold, which we believe resulted primarily from uncertainty and adverse developments relating to the reimbursement for procedures performed with our product. Diagnostic device revenues accounted for 9.9% and 13.8% of our total revenues for the nine months ended September 30, 2007 and 2006, respectively.

        Biosensor revenues were $30.4 million and $35.4 million for the nine months ended September 30, 2007 and 2006. Biosensor revenues accounted for 88.1% and 86.2% of our total revenues for the nine months ended September 30, 2007 and 2006, respectively. This decrease is attributable to lower sales of biosensors, which we believe resulted primarily from uncertainty and adverse developments relating to the reimbursement for procedures performed with the NC-stat System.

        Our customers used 827,000 biosensors in the nine months ended September 30, 2007, compared to 845,000 biosensors for the same period in 2006, a decrease of 18,000 or 2.1%. This decrease in biosensor usage is primarily the result of a decline in average usage per customer offset by an increase in our customer base. During the 12-month period ended September 30, 2007, a total of 5,523 customers used the NC-stat System compared to 4,518 customers for the same period in 2006. The average usage per account declined to 150 biosensors for the nine months ended September 30, 2007 from 187 biosensors for the same period in 2006.

        Other revenues are attributable to the DigiScope.

        Our total revenues were $34.5 million and $41.1 million for the nine months ended September 30, 2007 and 2006, respectively.

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Costs and expenses

        The following table presents our costs and expenses and net income (loss):