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

FORM 10-Q

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

For the quarterly period ended September 30, 2006.

OR

o                                 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the transition period from                                          to

Commission File Number: 1-11388

PLC SYSTEMS INC.
(Exact Name of Registrant as Specified in Its Charter)

 

Registrant’s telephone number, including area code: (508) 541-8800

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x   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):

 

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

PLC SYSTEMS INC.

Index

Part I.		Financial Information:
		Item 1.	Financial Statements
			Condensed Consolidated Balance Sheets (unaudited)		3
			Condensed Consolidated Statements of Operations (unaudited)		4
			Condensed Consolidated Statements of Cash Flows (unaudited)		5
			Notes to Condensed Consolidated Financial Statements (unaudited)		6
		Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		14
		Item 3.	Quantitative and Qualitative Disclosures about Market Risk		24
		Item 4.	Controls and Procedures		25
Part II.		Other Information:
		Item 1A.	Risk Factors		25
		Item 6.	Exhibits		37

 

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Part I.         Financial Information

Item 1.        Financial Statements

PLC SYSTEMS INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited)

		September 30, 2006			December 31, 2005
ASSETS
Current assets:
Cash and cash equivalents		$	4,744		$	2,560
Short-term investments		5,500			6,900
Accounts receivable — Edwards		945			634
Accounts receivable — other, net of allowance of $121 and $96 as of September 30, 2006 and December 31, 2005, respectively		90			153
Inventories, net		1,164			963
Prepaid expenses and other current assets		714			798
Total current assets		13,157			12,008
Equipment, furniture and leasehold improvements, net		152			235
Other assets		212			224
Total assets		$	13,521		$	12,467
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	403		$	352
Accrued compensation		664			677
Accrued other		286			334
Deferred revenue — Edwards		1,784			1,621
Deferred revenue — other		73			60
Total current liabilities		3,210			3,044
Deferred revenue — Edwards		3,108			3,692
Deferred revenue — other		188			188
Total long-term liabilities		3,296			3,880
Commitments and contingencies
Stockholders’ equity:
Preferred stock, no par value, unlimited shares authorized, none issued and outstanding		—			—
Common stock, no par value, unlimited shares authorized, 30,237 and 30,080 shares issued and outstanding as of September 30, 2006 and December 31, 2005, respectively		93,845			93,737
Additional paid in capital		68			—
Accumulated deficit		(86,567		)	(87,850		)
Accumulated other comprehensive loss		(331		)	(344		)
Total stockholders’ equity		7,015			5,543
Total liabilities and stockholders’ equity		$	13,521		$	12,467

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

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PLC SYSTEMS INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)

		Three Months Ended September 30,						Nine Months Ended September 30,
		2006			2005			2006			2005
Revenues:
Product sales — Edwards		$	1,115		$	1,352		$	3,717		$	4,198
Product sales — other		90			183			545			462
Service fees — Edwards		337			313			1,034			984
Service fees — other		25			52			103			181
Total revenues		1,567			1,900			5,399			5,825
Cost of revenues:
Product sales — Edwards		344			564			1,172			1,580
Product sales — other		78			68			315			204
Service fees — Edwards		133			153			405			435
Service fees — other		35			30			111			114
Total cost of revenues		590			815			2,003			2,333
Gross profit		977			1,085			3,396			3,492
Operating expenses:
Selling, general and administrative		786			739			2,470			2,516
Research and development		394			810			1,385			2,030
Total operating expenses		1,180			1,549			3,855			4,546
Gain on the sale of manufacturing rights		—			—			1,432			—
Income (loss) from operations		(203		)	(464		)	973			(1,054		)
Other income, net		123			67			310			183
Net income (loss)		$	(80	)	$	(397	)	$	1,283		$	(871	)
Basic income (loss) per share		$	(0.00	)	$	(0.01	)	$	0.04		$	(0.03	)
Diluted income (loss) per share		$	(0.00	)	$	(0.01	)	$	0.04		$	(0.03	)
Average shares outstanding:
Basic		30,237			30,079			30,080			30,073
Diluted		30,237			30,079			30,518			30,073

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

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PLC SYSTEMS INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

		Nine Months Ended September 30,
		2006			2005
Operating activities:
Net income (loss)		$	1,283		$	(871	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		87			96
Loss on retirement of equipment		77			—
Compensation expense from stock options		68			—
Change in assets and liabilities:
Accounts receivable — Edwards		(311		)	227
Accounts receivable — other		63			117
Inventories		(201		)	126
Prepaid expenses and other assets		84			(147		)
Accounts payable		51			33
Deferred revenue — Edwards		(421		)	263
Deferred revenue — other		11			2
Accrued liabilities		(61		)	267
Net cash provided by operating activities		730			113
Investing activities:
Purchase of investments		(4,000		)	(8,400		)
Maturity of investments		5,400			1,500
Purchase of equipment		(69		)	(32		)
Net cash provided by (used for) investing activities		1,331			(6,932		)
Financing activities:
Net proceeds from sales of common shares		108			6
Net cash provided by financing activities		108			6
Effect of exchange rate changes on cash and cash equivalents		15			(48		)
Net increase (decrease) in cash and cash equivalents		2,184			(6,861		)
Cash and cash equivalents at beginning of period		2,560			9,678
Cash and cash equivalents at end of period		$	4,744		$	2,817

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

5

 

PLC SYSTEMS INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2006

1.             Nature of Business

PLC Systems Inc. (“PLC” or the “Company”) is a medical device company specializing in innovative technologies for the cardiac and vascular markets.  The Company currently manufactures two lasers that are used in the treatment of cardiovascular disease.  PLC pioneered the CO2 Heart Laser System (“The Heart Laser System”) that cardiac surgeons use to perform carbon dioxide (CO2) transmyocardial revascularization (“TMR”) to alleviate symptoms of severe angina.  The Company’s exclusive distributor for TMR products in the United States is Edwards Lifesciences LLC (“Edwards”).  In addition, the Company manufactures the Optiwave 980 laser (“Optiwave 980”) under a supply agreement with Edwards.  The Optiwave 980 is expected to be utilized by surgeons to ablate cardiac tissue as a means to treat certain heart arrhythmias.  As a result of these exclusive distributor and supply arrangements, Edwards is the Company’s largest customer, accounting for 93% and 88% of the Company’s total sales in the three and nine months ended September 30, 2006, respectively. Edwards is also the Company’s largest shareholder, owning approximately 18% of its outstanding stock as of September 30, 2006.

In a move to broaden its market beyond its current products, the Company recently announced its intention to initiate clinical studies for its RenalGuardÔ Therapy and RenalGuardÔ System (collectively, “RenalGuard”). RenalGuard Therapy is designed to reduce the toxic effects that contrast media can have on the kidneys.  This therapy is based on the theory that creating and maintaining a high urine output is beneficial to patients undergoing imaging procedures where contrast agents are used.  The real-time measurement and matched fluid replacement design of the RenalGuard System is intended to ensure that a high urine flow is maintained before, during and after these procedures, thus allowing the body to rapidly eliminate contrast, reducing its toxic effects. The RenalGuard System, with its matched fluid replacement capability, is intended to minimize the risk of over or under hydration.

The Company initiated its first human clinical trial utilizing its RenalGuard System and Therapy in November 2006 after receiving a conditional investigational device exemption from the FDA in October 2006. This 40 patient pilot clinical trial is designed to evaluate the safety of the RenalGuard System and its ability to accurately measure and balance fluid inputs and outputs on patients undergoing a catheterization imaging procedure where contrast media will be administered.

The Company hopes to be able to demonstrate through future clinical trials that its RenalGuard System and Therapy are also safe and effective in preventing contrast-induced nephropathy, a form of acute renal failure caused by exposure to contrast media for patients undergoing imaging procedures.

2.             Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with generally accepted accounting principles 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 generally

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accepted accounting principles for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.  Operating results for the three and nine months ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.  These financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

3.             Edwards Transaction

In February 2004, the Company signed an agreement with Edwards to assume development and manufacturing of the Optiwave 980 and related system disposables. In March 2006, the Company and Edwards terminated this agreement and entered into a new agreement. The Company received $1,500,000 in consideration for selling its Optiwave 980 system related disposable manufacturing and development rights to Edwards.  The Company will continue to be the exclusive manufacturer of the current generation of Optiwave 980 laser console for Edwards and will have certain rights of first refusal related to the development and manufacture of any next generation laser.  Separately, Edwards pays the Company a royalty on all future Optiwave 980 system related disposable sales until such time that cumulative royalty payments from Edwards reach $1,700,000.  For each of the three and nine months ended September 30, 2006, the Company recorded $4,000 and $12,000, respectively, of royalty revenue, which is included in the accompanying Condensed Consolidated Statements of Operations.

In conjunction with the sale of the Optiwave 980 disposable manufacturing rights, the Company wrote off certain inventory and capital assets acquired to manufacture the Optiwave 980 disposables.  The Company recorded a gain of $1,432,000 on the sale of its manufacturing rights in its statement of operations during the first quarter of 2006.  A summary of the components of this gain are as follows:

 

4.             Earnings (Loss) per Share

For the three months ended September 30, 2006 and for the three and nine months ended September 30, 2005, basic and diluted loss per share have been computed using only the weighted average number of common shares outstanding during the period without giving effect to any potential future issuances of common stock related to stock option programs or warrants, since their inclusion would be antidilutive.

For the nine months ended September 30, 2006, basic earnings per share have been computed using only the weighted average number of common shares outstanding during the period, while diluted earnings per share have been computed using the weighted average number of common shares outstanding during the period plus the effect of outstanding dilutive stock options using the treasury stock method.

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In calculating diluted earnings per share, the dilutive effect of stock options is computed using the average market price for the respective period.  For the three months ended September 30, 2006 and 2005, 5,036,410 and 4,718,422 shares, respectively, and for the nine months ended September 30, 2006 and 2005, 5,036,410 and 4,718,422 shares, respectively, attributable to outstanding stock options were excluded from the calculation of diluted earnings (loss) per share because the effect was antidilutive.  For each of the three and nine months ended September 30, 2005, 1,100,000 shares attributable to outstanding common stock warrants were also excluded from the calculation of diluted loss per share because the effect was antidilutive.  The following table sets forth the computation of basic and diluted earnings (loss) per share.

		Three Months Ended September 30,						Nine Months Ended September 30,
		2006			2005			2006			2005
		(In thousands, except per share data)
Basic:
Net income (loss)		$	(80	)	$	(397	)	$	1,283		$	(871	)
Weighted average shares outstanding		30,237			30,079			30,080			30,073
Earnings (loss) per share		$	(0.00	)	$	(0.01	)	$	0.04		$	(0.03	)
Diluted:
Net income (loss)		$	(80	)	$	(397	)	$	1,283		$	(871	)
Weighted average shares outstanding		30,237			30,079			30,080			30,073
Assumed impact of the exercise of outstanding dilutive stock options using the treasury stock method		—			—			438			—
Weighted average common and common equivalent shares		30,237			30,079			30,518			30,073
Earnings (loss) per share		$	(0.00	)	$	(0.01	)	$	0.04		$	(0.03	)

 

5.             Stock-Based Compensation

Stock Option and Stock Purchase Plans

In May 2005, the Company adopted the 2005 Stock Incentive Plan (the “2005 Plan”).  The 2005 Plan has replaced the 1997 Executive Stock Option Plan, 2000 Equity Incentive Plan, 2000 Non-Statutory Stock Option Plan and 2000 Non-Qualified Performance and Retention Equity Plan (the “Previous Plans”), under which no further awards can be granted.

The number of stock options that may be granted under the 2005 Plan is equal to 2,156,175 shares of common stock (subject to adjustment in the event of stock splits and other similar events), plus such number of shares as may become available under the Previous Plans after the date of the adoption of the 2005 Plan because any award previously granted under any such plan expires or is terminated, surrendered or cancelled without having been fully exercised or is forfeited in whole or in part or results in any common stock not being issued, provided that such number of additional shares may not exceed 2,535,492.  Incentive stock options are issuable only to employees of the Company, while non-qualified options may be issued to non-employee directors, consultants, and others, as well as to employees. The options granted under the

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Previous Plans and the 2005 Plan become exercisable either immediately, or ratably over one to four years from the date of grant, and expire ten years from the date of grant.

The Company grants stock options to its non-employee directors. Generally, new non-employee directors receive an initial grant of an option to purchase 30,000 shares of the Company’s common stock that vests in installments over three years.  Once the initial grant has fully vested, non-employee directors other than the Chairman of the Board receive an annual grant of an option to purchase 15,000 shares of the Company’s common stock that generally vests either immediately or in four equal quarterly installments. The Chairman of the Board receives an annual grant of an option to purchase 30,000 shares of the Company’s common stock that vests either immediately or in four equal quarterly installments in the same manner as the options granted annually to the other non-employee directors. All such options have an exercise price equal to the fair market value of the common stock on the date of grant.

The per share exercise price of an incentive stock option may not be less than the fair market value of the common stock on the date the option is granted. The Company must grant non-qualified options at an exercise price of at least 85% of the fair market value of the common stock.

The Company has a 2000 Employee Stock Purchase Plan (the “Purchase Plan”) for all eligible employees.  Prior to December 1, 2005, shares of the Company’s common stock could be purchased at six-month intervals at 85% of the lower of the fair market value on the first or the last day of each six-month period.  On November 30, 2005, the Company adopted an amendment to the Purchase Plan which provides that the purchase price for each share of the Company’s common stock purchased under the Plan will be 95% of the closing price of the Company’s common stock on the last business day of the relevant plan period.  The change in the purchase price was effective beginning with the plan period commencing on December 1, 2005. Employees may purchase shares having a value not exceeding 10% of their gross compensation during an offering period, subject to certain additional limitations. Under the Purchase Plan, employees of the Company purchased 631 shares of common stock in 2006, 12,044 shares of common stock in 2005, and 13,390 shares of common stock in 2004 at average prices of $0.62, $0.51 and $0.70 per share, respectively.  At September 30, 2006, 321,856 shares were reserved for future issuance under the Purchase Plan.

Adoption of SFAS 123(R)

Effective January 1, 2006, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment (“SFAS 123(R)”), using the modified-prospective transition method, which did not require restatement of prior period results. Under this transition method, compensation expense totaling $35,000 and $68,000, respectively, was recognized in the accompanying statement of operations for the three and nine months ended September 30, 2006. The compensation expense recorded includes (a) $22,000 of compensation cost in the nine months ended September 30, 2006 for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value calculated in accordance with the original provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-based Compensation (“SFAS 123”), and (b) $46,000 of compensation cost in the nine months ended September 30, 2006 for all share-based payments granted subsequent to December 31, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). The Company estimates an

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expected forfeiture rate based on its historical forfeiture activity.  Actual results, and future changes in estimates, may differ substantially from the Company’s current estimates.  As of September 30, 2006, the Company had $246,000 of total unrecognized compensation cost related to its unvested options, which is expected to be recognized over a weighted average period of 2.3 years.

The weighted average fair value of options issued during the three and nine months ended September 30, 2006 were estimated using the Black-Scholes model.

 

The expected life is calculated using the simplified method. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of the grant for the expected term period.  Expected volatility is based exclusively on historical volatility data of the Company’s common stock.

Options Outstanding

The following table summarizes stock option activity during the nine months ended September 30, 2006:

		Number of Options		Weighted Average Exercise Price			Weighted Average Remaining Contractual Term (Years)		Aggregate Intrinsic Value
		(in thousands, except per option data)
Outstanding, December 31, 2005		4,688		$	1.19
Granted		596		0.69
Exercised		(157	)	0.68
Canceled		(40	)	0.88
Cancellation upon termination of expired option plans		(51	)	4.90
Outstanding, September 30, 2006		5,036		1.11			6.35		$	1,139
Exercisable, September 30, 2006		4,483		1.16			5.95		1,032

 

The aggregate intrinsic value amounts in the table above represent the difference between the closing price of the Company’s common stock on September 30, 2006 and the exercise price, multiplied by the in-the-money stock options as of the same date.  There were no stock options exercised during the three months ended September 30, 2006.

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Options granted during 2006 will vest ratably annually over a three year period for employees and ratably quarterly over a one year period for non-employee directors. Options granted during 2005 to both employees and non-employee directors vested immediately upon granting.

The following table summarizes unvested share activity during the nine months ended September 30, 2006:

 

Pro Forma Information for Period Prior to SFAS 123(R) Adoption

The Company has historically granted stock options for a fixed number of shares to employees and certain other individuals with exercise prices equal to the fair value of the shares at the dates of grant. Through December 31, 2005, the Company adopted the disclosure only provisions of SFAS 123, and accounted for its stock option plans in accordance with the provisions of Accounting Principles Board Opinion 25, Accounting for Stock Issued to Employees (“APB Opinion No. 25”).  Under APB Opinion No. 25, compensation expense with respect to such awards is not recognized if on the date the awards were granted the exercise price was equal to or greater than the fair market value of the underlying common shares.

The following table illustrates the effect on net loss and basic loss per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation during the three and nine month periods ended September 30, 2005.  For purposes of this pro forma disclosure, the value of the options is estimated using the Black-Scholes option-pricing model and is being amortized to expense over the options’ vesting periods.

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		Three Months Ended  September 30, 2005			Nine Months Ended September 30, 2005
		(In thousands, except per share data)
Net loss attributable to common stockholders—As reported		$	(397	)	$	(871	)
Deduct total stock-based compensation expense determined under fair value based method for all stock option awards		(10		)	(176		)
Net loss attributable to common stockholders—Pro forma		$	(407	)	$	(1,047	)
Loss per basic and diluted share attributable to common stockholders—As reported		$	(0.01	)	$	(0.03	)
Loss per basic and diluted share attributable to common stockholders—Pro forma		$	(0.01	)	$	(0.03	)

 

The fair value of issued options at the date of grant was estimated using the Black-Scholes model with the following weighted average assumptions:

 

6.             Comprehensive Income (Loss)

Total comprehensive loss for the three months ended September 30, 2006 was $78,000 and total comprehensive income for the nine months ended September 30, 2006 was $1,296,000.  Total comprehensive loss for the three and nine months ended September 30, 2005 was $400,000 and $905,000, respectively. Comprehensive income (loss) is comprised of net income (loss) plus the increase/decrease in currency translation adjustment.

7.             Inventories

Inventories are stated at the lower of cost (computed on a first-in, first-out method) or market value and include allocations of labor and overhead.  As of September 30, 2006 and December 31, 2005, inventories consisted of the following (in thousands):

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At September 30, 2006 and December 31, 2005, inventories are stated net of a reserve of $528,000 and $533,000, respectively, for potentially excess and obsolete inventory.

8.             Revenue Recognition

The Company records revenue from the sale of TMR kits and the Optiwave 980 at the time of shipment to Edwards.  TMR kit revenues include the amount invoiced to Edwards for kits shipped pursuant to purchase orders received, as well as an amortized portion of deferred revenue related to a payment of $4,533,333 received from Edwards in February 2004.  This payment was made by Edwards in exchange for a reduction in the prospective purchase price the Company receives from Edwards upon a sale of the kits.  The Company is amortizing this payment from Edwards into its Consolidated Statement of Operations as revenue over a seven year period (culminating in 2010) under the units-of-revenue method as prescribed by Emerging Issues Task Force (EITF) 88-18, Sales of Future Revenue.  Management determined that a seven year timeframe was the most appropriate amortization period based on a valuation model they used to assess the economic fairness of the payment. Factors management considered in developing this valuation model included the estimated foregone revenues over a seven year period resulting from the reduction in the prospective purchase price payable to the Company by Edwards, a discount rate deemed appropriate to this transaction and an estimate of the remaining economic useful life of the current TMR kit design, without any benefit being given to potential future product improvements the Company may make.  Management reviews annually, and adjusts if necessary, the prospective revenue amortization rate for kits based on its best estimate of the total number of kits likely remaining to be shipped to hospital customers by Edwards through 2010.  Based on this, for the three and nine months ended September 30, 2006 the Company recorded amortization of $158,000 and $483,000, respectively, as compared to $89,000 and $263,000, respectively, for the three and nine months ended September 30, 2005.  These amounts are included in revenues in the Consolidated Statements of Operations for the respective periods.

TMR lasers are billed to Edwards in accordance with purchase orders that the Company receives.  Invoiced TMR lasers are recorded as other current assets and deferred revenue on the Company’s Consolidated Balance Sheet until such time as the laser is shipped to a hospital, at which time the Company records revenue and cost of revenue.

Under the terms of the Edwards TMR distribution agreement, once Edwards has recovered a prescribed amount of revenue from a hospital for the use or purchase of a TMR laser, any additional revenues earned by Edwards are shared with the Company pursuant to a formula established in the distribution agreement. The Company only records its share of such additional revenue, if any, at the time the revenue is earned.

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The Company records revenue from the sale of TMR kits and TMR lasers to international distributors or hospitals at the time of shipment.

Revenues from service and maintenance contracts are recognized ratably over the life of the contract.

Installation revenues related to a TMR laser transaction are recorded as a component of service fees when the laser is installed.

9.             Warranty and Preventative Maintenance Costs

The Company warranties its products against manufacturing defects under normal use and service during the warranty period.  The Company obtains similar warranties from a majority of its suppliers, including those who supply critical Heart Laser System components.  In addition, under the terms of its TMR distribution agreement with Edwards, the Company is able to bill Edwards for actual warranty costs, including preventative maintenance services, up to a specified amount during the warranty period.

The Company evaluates the estimated future unrecoverable costs of warranty and preventative maintenance services for its installed base of lasers on a quarterly basis and adjusts its warranty reserve accordingly.  The Company considers all available evidence, including historical experience and information obtained from supplier audits.

Changes in the warranty accrual were as follows (in thousands):

 

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

This quarterly report (including certain information incorporated herein by reference) contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Statements containing terms such as “believes”, “plans”, “expects”, “anticipates”, “intends”, “estimates” and similar expressions reflect uncertainty and are forward-looking statements. Forward-looking statements are based on current plans and expectations and involve known and unknown important risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. Such important factors and uncertainties include, but are not limited to, those set forth below in Part II, Item 1A. “Risk Factors”, and elsewhere in this quarterly report.

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Overview

We are a medical device company specializing in innovative technologies for the cardiac and vascular markets.  We currently manufacture two lasers that are used in the treatment of cardiovascular disease.  Our Heart Laser Systems are used to treat patients with severe angina and the Optiwave 980 is used to ablate cardiac tissue as a means to treat certain heart arrhythmias.

In a move to broaden our market beyond our current products, we recently announced our intention to initiate clinical studies for our RenalGuardÔ Therapy and RenalGuardÔ System. RenalGuard Therapy is designed to reduce the toxic effects that contrast media can have on the kidneys.  This therapy is based on the theory that creating and maintaining a high urine output is beneficial to patients undergoing imaging procedures where contrast agents are used.  The real-time measurement and matched fluid replacement design of our RenalGuard System is intended to ensure that a high urine flow is maintained before, during and after these procedures, thus allowing the body to rapidly eliminate contrast, reducing its toxic effects. The RenalGuard System, with its matched fluid replacement capability, is intended to minimize the risk of over or under hydration.

We initiated our first human clinical trial utilizing our RenalGuard System and Therapy in November 2006 after receiving a conditional investigational device exemption from the FDA in October 2006. This 40 patient pilot clinical trial is designed to evaluate the safety of the RenalGuard System and its ability to accurately measure and balance fluid inputs and outputs on patients undergoing a catheterization imaging procedure where contrast media will be administered.

We hope to be able to demonstrate through future clinical trials that our RenalGuard System and Therapy are also safe and effective in preventing contrast-induced nephropathy, a form of acute renal failure caused by exposure to contrast media for patients undergoing imaging procedures.

Edwards is our exclusive distributor for TMR products in the United States and our largest customer. In addition, we manufacture the Optiwave 980 for Edwards under a supply agreement. As a result of these exclusive distributor and supply arrangements, Edwards accounted for approximately 93% and 88%, respectively, of our total sales in the three and nine months ended September 30, 2006 and 89% in the year ended December 31, 2005.  We expect this sales trend to continue for the near future.  We do not expect in the future to market RenalGuard through Edwards.

Approximately 95% and 96%, respectively, of our revenues in the three and nine months ended September 30, 2006 and 89% in the year ended December 31, 2005 came from the sale and service of TMR lasers and related disposable kits. Although not a direct measure, we believe a leading indicator of the adoption rate of TMR as a treatment for severe angina is TMR kit shipments to U.S. hospitals. TMR kit shipments to U.S. hospitals through Edwards decreased approximately 2% and increased approximately 1%, respectively, in the three and nine months ended September 30, 2006 compared to the three and nine months ended September 30, 2005. We remain largely dependent on the success of Edwards’ sales and marketing efforts to increase our installed base of TMR lasers and increase TMR procedure volumes and revenues.

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Our management reviews a number of key performance indicators to assist them in determining how to allocate resources and run our day to day operations. These indicators include (1) actual prior quarterly sales trends, (2) projected TMR laser and kit sales for the next four quarters, as provided by Edwards in a rolling twelve month sales forecast, (3) research and development progress as measured against internal project plan objectives, (4) budget to actual financial expenditure results, (5) inventory levels (both our own and Edwards’) and (6) short term and long term projected cash flows of the business.

Critical Accounting Policies and Estimates

Our financial statements are based on the application of significant accounting policies, many of which require us to make significant estimates and assumptions (see Note 2 to the Consolidated Financial Statements).  We believe that the following are some of the more material judgment areas in the application of our accounting policies that currently affect our financial condition and results of operations.

Inventories

Inventories are stated at the lower of cost (computed on a first-in, first-out method) or market value and include allocations of labor and overhead.  A specific obsolescence allowance is provided for slow moving, excess and obsolete inventory based on our best estimate of the net realizable value of inventory on hand taking into consideration factors such as (1) actual trailing twelve month sales, (2) expected future product line demand, based in part on sales forecast input received from Edwards, and (3) service part stocking levels which, in management’s best judgment, are advisable to maintain in order to meet warranty, service contract and time and material spare part demands.  Historically, we have found our reserves to be adequate.

Allowance for Doubtful Accounts

For our accounts receivable, we continuously monitor collections from customers, our principal customer being Edwards, and we maintain a provision for estimated credit losses based upon historical experience and any specific customer collection issues that we have identified.  Historically, we have not experienced significant losses related to our accounts receivable.  Collateral is not generally required. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Warranty and Preventative Maintenance Costs

We warranty our products against manufacturing defects under normal use and service during the warranty period.  We obtain similar warranties from a majority of our suppliers, including those who supply critical Heart Laser System and Optiwave 980 components.  In addition, under the terms of our TMR distribution agreement with Edwards, we are able to bill Edwards for actual warranty costs, including preventative maintenance services, up to a specified amount during the warranty period.

We evaluate the estimated future unrecoverable costs of warranty and preventative maintenance services for our installed base of lasers on a quarterly basis and adjust our warranty reserve accordingly.  We consider all available evidence, including historical experience and

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information obtained from supplier audits.

Revenue Recognition

We record revenue from the sale of TMR kits and the Optiwave 980 at the time of shipment to Edwards.  TMR kit revenues include the amount invoiced to Edwards for kits shipped pursuant to purchase orders received, as well as an amortized portion of deferred revenue related to Edwards’ payment to us of $4,533,333 in February 2004. This payment was made by Edwards in exchange for a reduction in the prospective purchase price we receive from Edwards upon a sale of the kits. We are amortizing this payment from Edwards into our Consolidated Statement of Operations as revenue over a seven year period (culminating in 2010) under the units-of-revenue method as prescribed by Emerging Issues Task Force (EITF) 88-18, Sales of Future Revenue. We determined that a seven year timeframe was the most appropriate amortization period based on a valuation model we used to assess the economic fairness of the payment. Factors we considered in developing this valuation model included the estimated foregone revenues over a seven year period resulting from the reduction in the prospective purchase price payable to us by Edwards, a discount rate deemed appropriate to this transaction and an estimate of the remaining economic useful life of the current TMR kit design, without any benefit being given to potential future product improvements we may make.  Management reviews annually, and adjusts if necessary, the prospective revenue amortization rate for kits based on its best estimate of the total number of kits likely remaining to be shipped to hospital customers by Edwards through 2010.  Based on this, for the three and nine months ended September 30, 2006, we recorded amortization of $158,000 and $483,000, respectively, as compared to $89,000 and $263,000, respectively, for the three and nine months ended September 30, 2005. These amounts are included in revenues in our Consolidated Statements of Operations for the respective periods.

TMR lasers are billed to Edwards in accordance with purchase orders that we receive.  Invoiced TMR lasers are recorded as other current assets and deferred revenue on our Consolidated Balance Sheet until such time as the laser is shipped to a hospital, at which time we record revenue and cost of revenue.

Under the terms of the Edwards TMR distribution agreement, once Edwards has recovered a prescribed amount of revenue from a hospital for the use or purchase of a TMR laser, any additional revenues earned by Edwards are shared with us pursuant to a formula established in the distribution agreement. We only record our share of such additional revenue, if any, at the time the revenue is earned.

We record revenue from the sale of TMR kits and TMR lasers to international distributors or hospitals at the time of shipment.

Revenues from service and maintenance contracts are recognized ratably over the life of the contract.

Installation revenues related to a TMR laser transaction are recorded as a component of service fees when the laser is installed.

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Stock Based Compensation

Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS 123(R) using the modified-prospective transition method, which did not require restatement of prior period results. Under this transition method, compensation expense totaling $35,000 and $68,000, respectively, was recognized in our statement of operations for the three and nine months ended September 30, 2006. The compensation expense recorded includes (a) $22,000 of compensation cost in the nine months ended September 30, 2006 for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value calculated in accordance with the original provisions SFAS 123, and (b) $46,000 of compensation cost in the nine months ended September 30, 2006 for all share-based payments granted subsequent to December 31, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). As of September 30, 2006, we had $246,000 of total unrecognized compensation cost related to our unvested options, which is expected to be recognized over a weighted average period of 2.3 years.

The valuation of employee stock options is an inherently subjective process, since market values are generally not available for long-term, non-transferable employee stock options. Accordingly, an option pricing model is utilized to derive an estimated fair value. In calculating the estimated fair value of our stock options, we used the Black-Scholes pricing model which requires the consideration of six variables for purposes of estimating fair value which include the stock option exercise price, the grant date price of our common stock, the expected life of the option, the risk free interest rate for the expected option life, the expected volatility of our common stock and the expected dividends on our common stock.  The expected life is calculated using the simplified method.  The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of the grant for the expected term period.  Expected volatility is based exclusively on historical volatility data on our common stock. The dividend yield percentage is zero because we do not currently pay dividends nor intend to do so during the expected option life.

Results of Operations

Results for the three and nine months ended September 30, 2006 and 2005 and the related percent of revenues were as follows:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2006				2005				2006				2005
		$		%		$		%		$		%		$		%
		(dollars in thousands)
Total revenues		1,567		100		1,900		100		5,399		100		5,825		100
Total cost of revenues		590		38		815		43		2,003		37		2,333		40
Gross profit		977		62		1,085		57		3,396		63		3,492		60
Selling, general & administrative		786		50		739		39		2,470		46		2,516		43
Research & development		394		25		810		43		1,385		26		2,030		35
Total operating expenses		1,180		75		1,549		82		3,855		71		4,546		78
Gain on sale of manufacturing assets		—		—		—		—		1,432		27		—		—
Income (loss) from operations		(203	)	(13	)	(464	)	(24	)	973		18		(1,054	)	(18	)
Other income		123		8		67		4		310		6		183		3
Net income (loss)		(80	)	(5	)	(397	)	(21	)	1,283		24		(871	)	(15	)

 

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		Three Months Ended September 30,								Nine Months Ended September 30,
		2006		2005		Increase (decrease) over 2005				2006		2005		Increase (decrease) over 2005
		$		$		$		%		$		$		$		%
		(dollars in thousands)
Product sales		1,205		1,535		(330	)	(21	)	4,262		4,660		(398	)	(9	)
Service fees		362		365		(3	)	(1	)	1,137		1,165		(28	)	(2	)
Total revenues		1,567		1,900		(333	)	(18	)	5,399		5,825		(426	)	(7	)
Product cost of sales		422		632		(210	)	(33	)	1,487		1,784		(297	)	(17	)
Service fees cost of sales		168		183		(15	)	(8	)	516		549		(33	)	(6	)
Total cost of revenues		590		815		(225	)	(28	)	2,003		2,333		(330	)	(14	)
Gross profit		977		1,085		(108	)	(10	)	3,396		3,492		(96	)	(3	)
Selling, general & administrative expenses		786		739		47		6		2,470		2,516		(46	)	(2	)
Research & development expenses		394		810		(416	)	(51	)	1,385		2,030		(645	)	(32	)
Total operating expenses		1,180		1,549		(369	)	(24	)	3,855		4,546		(691	)	(15	)
Gain on sale of manufacturing assets		—		—		—		—		1,432		—		1,432		100
Income (loss) from operations		(203	)	(464	)	261		56		973		(1,054	)	2,027		192
Other income		123		67		56		84		310		183		127		69
Net income (loss)		(80	)	(397	)	317		80		1,283		(871	)	2,154		247

 

Product Sales

TMR laser revenues, the largest component of product sales in the three months ended September 30, 2006, decreased by $438,000, or 52%, as compared to the three months ended September 30, 2005.  Domestic TMR laser revenues decreased $388,000, or 49%, as a result of a decrease in the number of new TMR lasers sold by Edwards, as well as decreased revenue sharing earned under the TMR distribution agreement with Edwards.  International TMR laser revenues decreased $50,000, from $50,000 to $0, due to the sale of a single used laser to an international customer in the three months ended September 30, 2005.

In the nine months ended September 30, 2006, TMR laser revenues decreased by $302,000, or 14%, as compared to the nine months ended September 30, 2005.  Domestic TMR laser revenues decreased $510,000, or 24%, as a result of a decrease in the number of new TMR lasers sold by Edwards, as well as decreased revenue sharing earned under the TMR distribution agreement with Edwards.  International TMR laser revenues increased $208,000, from $60,000 to $278,000, due to one additional laser sale to international customers in the nine months ended September 30, 2006.

Disposable TMR kit revenues, the second largest component of product sales, increased by $156,000, or 28%, in the three months ended September 30, 2006 as compared to the three months ended September 30, 2005.  Domestic TMR kit revenues increased $129,000, or 23%, as

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a result of (1) a $69,000 increase in deferred revenue amortization related to the $4,533,333 payment by Edwards in 2004 and (2) a higher volume of kit shipments to Edwards. International disposable TMR kit revenues increased $27,000 as a result of a sale to one customer in the three months ended September 30, 2006.

In the nine months ended September 30, 2006, disposable TMR kit revenues increased by $350,000, or 20%, as compared to the nine months ended September 30, 2005.  Domestic TMR kit revenues increased $368,000, or 22%, as a result of (1) a $220,000 increase in deferred revenue amortization related to the $4,533,333 payment by Edwards and (2) a higher volume of kit shipments to Edwards.  International disposable TMR kit revenues decreased $18,000, or 18%, as a result of a lower volume of kit shipments to international customers.

Optiwave 980 revenues to Edwards were $20,000 in the three months ended September 30, 2006 as compared to $0 in the three months ended September 30, 2005, as no Optiwave 980 units were sold to Edwards in the three months ended September 30, 2005. Optiwave 980 revenues to Edwards decreased $325,000, or 94%, in the nine months ended September 30, 2006 as compared to the nine months ended September 30, 2005, due to a lower volume of Optiwave 980 units shipped to Edwards in the nine months ended September 30, 2006.  Under our new supply agreement with Edwards that we entered into in March 2006, Edwards has agreed to purchase any additional units of the current generation of Optiwave 980 exclusively from us.  We believe that our future revenues from sales of this current generation laser will not exceed $980,000 and may be less, depending in part on demand for that product and when, if ever, Edwards chooses to introduce its next generation laser to the market.  We have a right of first refusal to develop and manufacture any next generation laser for Edwards; however, at this time we have not had discussions with Edwards regarding any such successor product.

Other product sales, relating to sales of new and refurbished general purpose surgical laser tubes, decreased $68,000, or 54%, and 121,000, or 36%, respectively, in the three and nine months ended September 30, 2006 as compared to the three and nine months ended September 30, 2005.

Service Fee Revenues

Service fee revenues decreased $3,000, or 1%, in the three months ended September 30, 2006 as compared to the three months ended September 30, 2005.  Domestic service fees increased $25,000, or 8%, due to increased billings to Edwards for service related calls and increased revenues generated from service contracts. International service fees decreased $28,000, or 53%, due to a decrease in billings to a single international customer whose HL2 laser was removed.

Service fee revenues decreased $28,000, or 2%, in the nine months ended September 30, 2006 as compared to the nine months ended September 30, 2005.  Domestic service fees increased $50,000, or 5%, due to increased billings to Edwards for service related calls and increased revenues generated from service contracts. International service fees decreased $78,000, or 43%, due to a decrease in billings to a single international customer whose HL2 laser was removed.

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Gross Profit

Total gross profit was $977,000, or 62% of total revenues, for the three months ended September 30, 2006 as compared with gross profit of $1,085,000, or 57% of total revenues, for the three months ended September 30, 2005.  The improved gross profit percentage is the result of a better overall sales mix of our products, most notably higher TMR kit revenues.  The decrease in gross profit dollars is due to (1) a decrease in additional revenue sharing on lasers earned under the TMR distribution agreement with Edwards, (2) a decrease in the number of new domestic TMR lasers sold, (3) lower revenues from new and refurbished general purpose surgical tubes, (4) an increase in the inventory obsolescence reserve and (5) lower international TMR laser revenues.  These decreases were offset in part by (1) higher disposable TMR kit revenues, (2) reduced service costs and (3) an increase in Optiwave 980 revenues.

Total gross profit was $3,396,000, or 63% of total revenues, for the nine months ended September 30, 2006 as compared with gross profit of $3,492,000, or 60% of total revenues, for the nine months ended September 30, 2005.  The improved gross profit percentage is the result of a better overall sales mix of our products, most notably higher TMR kit revenues.  The decrease in gross profit dollars is due to (1) a decrease in additional revenue sharing earned under the TMR distribution agreement with Edwards, (2) lower revenues from new and refurbished general purpose surgical tubes, (3) a decrease in Optiwave 980 revenues, (4) a decrease in the number of new domestic TMR lasers sold and (5) an increase in the inventory obsolescence reserve.  These decreases were offset in part by (1) higher disposable TMR kit revenues, (2) reduced service costs and (3) higher international TMR laser sales.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 6% and decreased 2%, respectively, in the three and nine months ended September 30, 2006 as compared to the three and nine months ended September 30, 2005.  The increase in the three months ended September 30, 2006 is related to increased incentive compensation and bad debt expense offset in part by lower legal expenses and corporate expenditures.  The decrease in the nine months ended September 30, 2006 is related to lower corporate, legal and incentive compensation offset in part by increased consulting and bad debt expenses.

Research and Development Expenses

Research and development expenditures decreased 51% and 32%, respectively, in the three and nine months ended September 30, 2006 as compared to the three and nine months ended September 30, 2005.  There was a decrease in expenditures in connection with both the Optiwave 980 and RenalGuard projects.

We expect to continue to incur significant new research and development expenditures for the remainder of 2006 and future years in pursuit of our business strategy to broaden and diversify our product portfolio beyond our current product offerings. Our current and near term development efforts in pursuit of this business strategy are focused on performing clinical trials of our newest product, RenalGuard, which should result in increased research and development expenditures through 2008.

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Gain on Sale of Manufacturing Rights

In March 2006, we received $1,500,000 related to the sale of our Optiwave 980 System disposable manufacturing and development rights to Edwards (See Note 3 to the consolidated financial statements). In conjunction with this transaction, we wrote off certain inventory and capital assets acquired to manufacture the Optiwave 980 disposables, and we recorded a gain of $1,432,000 on the sale of our manufacturing rights in our statement of operations during the first quarter of 2006.  A summary of the components of this gain are outlined below:

 

Other Income

The largest component of other income is interest income earned on our cash, cash equivalents and short-term investments. Interest income increased $56,000, or 84%, and $127,000, or 69%, respectively, in the three and nine months ended September 30, 2006 as compared to the three and nine months ended September 30, 2005 due to higher interest rates earned on our cash, cash equivalents and short-term investments and higher investable balances.

Net Income (Loss)

In the three months ended September 30, 2006, we recorded net loss of $80,000 as compared to a net loss of $397,000 in the three months ended September 30, 2005.  This decrease in the net loss is primarily a result of lower operating expenses and higher other income in the three months ended September 30, 2006 as compared to the three months ended September 30, 2005.

In the first quarter, we recorded a gain of $1,432,000 from the sale of our Optiwave 980 disposable manufacturing rights to Edwards.  This non-recurring gain resulted in our recording net income for the nine months ended September 30, 2006 of $1,283,000, as compared to a net loss of $871,000 for the nine months ended September 30, 2005.

Kit Shipments

We view disposable kit shipments to end users as an important metric in evaluating our business.  We believe that kit shipments (particularly kit shipments to U.S. hospitals), although not a direct measure, are a reasonable indicator for the adoption of TMR as a therapy in the marketplace.  Disposable kit shipments to end users are as follows:

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		Three Months Ended September 30,						Nine Months Ended September 30,
		2006		2005		% Increase (Decrease) over 2005		2006		2005		% Increase (Decrease) over 2005
Domestic		502		513		(2	)	1,530		1,518		1
International		13		15		(13	)	38		70		(46	)
Total		515		528		(2	)	1,568		1,588		(1	)

 

We believe the overall limited growth in TMR kit shipments in recent years may be partly attributable to what we believe may be an ongoing downward trend in the number of heart bypass surgeries being performed. We believe the proliferation in the number of interventional cardiac procedures being performed, particularly with the recent advent of drug eluting stents, is causing a delay in the number of patients being referred to cardiac surgeons for treatment of their cardiovascular disease. Because a significant number of the total TMR procedures performed each year by cardiac surgeons are done in combination with bypass surgery, we believe the growth in the number of TMR procedures may be being adversely impacted by this reduction in the number of bypass surgeries being performed.

Liquidity and Capital Resources

Cash, cash equivalents and short-term investments totaled $10,244,000 as of September 30, 2006, an increase of $784,000 from $9,460,000 as of December 31, 2005.  Our short-term investments consist of monies invested in bank certificates of deposit.  We have no debt obligations. We believe that our existing cash resources will meet our working capital requirements through at least the next 12 months.

Cash provided by operating activities in the nine months ended September 30, 2006 was $730,000 due to our net income (including from the sale of the Optiwave 980 manufacturing rights) and non-cash depreciation, amortization, loss on retirement of equipment and compensation expense related to stock options, partially offset by overall unfavorable working capital changes. Additional cash was provided by net proceeds from the sales of common shares of $108,000 and the effect of foreign exchange rate changes totaling $15,000.  We used $69,000 for the purchase of equipment.

We are largely dependent on the success of Edwards’ sales and marketing efforts in the U.S. to continue to increase the installed base of HL2 lasers and to substantially increase TMR procedural volumes and revenues. Should the installed base of HL2 lasers or TMR procedural volume not increase sufficiently, our liquidity and capital resources will be negatively impacted.  Additionally, other unanticipated decreases in operating revenues or increases in expenses or changes or delays in third-party reimbursement to healthcare providers using our products may adversely impact our cash position and require further cost reductions or the need to obtain additional financing.  It is not certain that we, working with Edwards and our international distributors, will be successful in achieving broad commercial acceptance of the Heart Laser Systems, or that we will be able to operate profitably in the future on a consistent basis, if at all.

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Some hospital customers prefer to acquire the Heart Laser Systems on a usage basis rather than as a capital equipment purchase.  We believe this is the result of limitations many hospitals currently have on acquiring expensive capital equipment as well as competitive pressures in the marketplace.  A usage business model will result in a longer recovery period for Edwards to recoup its investment in lasers it purchases from us.  This results in (1) a delay in our ability to receive additional shared revenue, if any, that we otherwise are entitled to receive under the terms of our distribution agreement with Edwards (see “Critical Accounting Policies and Estimates — Revenue Recognition”) and (2) a delay in the purchase of new lasers by Edwards if its installed base of lasers placed under usage contracts are under-performing and it chooses to re-deploy these lasers to other hospital sites in lieu of purchasing a new laser from us.  Our cash position and our need for additional financing to fund operations will be dependent in part upon the number of hospitals that acquire Heart Laser Systems from Edwards on a usage basis and the number and frequency of TMR procedures performed by these hospitals.

Furthermore, we have undertaken a new business strategy that involves broadening and diversifying our product portfolio beyond our current offerings, by developing or acquiring new and innovative medical devices to address cardiac and vascular related markets. Our current and near term development efforts in pursuit of this business strategy are focused on performing clinical trials of our newest product, RenalGuard.  We believe this strategy will result in our incurring losses at least through 2008 as we increase our research and development spending in order to conduct the clinical trials we believe are necessary to successfully market RenalGuard.  We cannot be certain that we will be successful in implementing our business strategy or that future sales, if any, of RenalGuard or other potential new products will recover the investments we plan to make. If we are unsuccessful in implementing our business strategy, or if the diversification of our product portfolio takes longer or costs more than anticipated, our liquidity and capital resources will be adversely affected and we may need to obtain additional financing.

There can be no assurance that, should we require additional financing, such financing will be available on terms and conditions acceptable to us, if at all.  Should additional financing not be available on terms and conditions acceptable to us, additional actions may be required that could adversely impact our ability to continue to realize assets and satisfy liabilities in the normal course of business.  The consolidated financial statements set forth in this report do not include any adjustments to reflect the possible future effects of these uncertainties.

Off-Balance Sheet Arrangements

None.

Item 3.        Quantitative and Qualitative Disclosures about Market Risk

A portion of our operations consists of sales activities in foreign jurisdictions.  We manufacture our products exclusively in the U.S. and sell our products in the U.S. and abroad. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the foreign markets in which we distribute our products.  Our operating results are exposed to changes in exchange rates between the U.S. dollar and foreign currencies, especially the Euro. When the U.S. dollar strengthens against the Euro, the value of foreign sales decreases. When the U.S. dollar weakens, the value of foreign sales increases. No assurance can be given that foreign currency fluctuations in the future will not adversely affect

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our business, financial condition and results of operations, although at present we do not believe that our exposure is significant, as international sales represented only 4% and 9%, respectively, of our consolidated sales in the three and nine months ended September 30, 2006 and 6% in the year ended December 31, 2005. We do not hedge any balance sheet exposures and intercompany balances against future movements in foreign exchange rates.

Our interest income and expense are sensitive to changes in the general level of U.S. and foreign interest rates. In this regard, changes in U.S. and foreign interest rates affect the interest earned on our cash and cash equivalents.  We do not believe that a 10% change to the applicable interest rates would have a material impact on our future results of operations or cash flows.

Item 4.        Controls and Procedures

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2006. The term “disclosure controls and procedures”, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.  Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.  Based on the evaluation of our disclosure controls and procedures as of September 30, 2006, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended September 30, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Part II.  Other Information

Item 1A.         Risk Factors

Certain Factors that May Affect our Future Results

The risks and uncertainties described below are not the only risks we face.  Additional risks and uncertainties not presently known to us or currently deemed immaterial may also impair our business operations.  If any of the following risks actually occur, our financial condition and operating results could be materially adversely affected.

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We expect to incur significant operating losses in the near future.

We incurred a net loss in the quarter ended September 30, 2006 and we expect to continue to incur net losses in future quarters, at least through 2008, as we increase our research and development spending on clinical studies of RenalGuard. We cannot provide any assurance that we will be successful with our business strategy, that RenalGuard will receive FDA approval or commercial acceptance, or that we will ever return to profitability.

Our company is currently dependent on one principal customer.

Pursuant to the terms of our TMR distribution agreement with Edwards, Edwards is our exclusive distributor for our HL2 TMR laser and TMR kits in the United States.  In addition, we are the exclusive manufacturer of the current version of the Optiwave 980 laser console for Edwards.  As a result of these exclusive arrangements, Edwards accounted for 93% and 88%, respectively, of our total revenues in the three and nine months ended September 30, 2006 and 89% in the year ended December 31, 2005, and we expect Edwards to account for the significant majority of our revenue in the near future.  If our relationship with Edwards does not progress as anticipated, or if Edwards’ sales and marketing strategies fail to generate sales of our products in the future, our revenue will decrease significantly and our business, financial condition and results of operations will be seriously harmed.

Our company is currently dependent on one principal product line to generate revenues.

We currently sell one principal product line, which consists of two patented high-powered carbon dioxide lasers and related TMR disposable kits known as the Heart Laser Systems, which account for the majority of our total revenue.  Approximately 95% and 96%, respectively, of our revenues in the three and nine months ended September 30, 2006 and 89% in the year ended December 31, 2005, were derived from the sales and service of our Heart Laser Systems.  This absence of a diversified product line means that we are directly and materially impacted by changes in the market for Heart Laser Systems.

Our ability to realize future revenues from the Optiwave 980 is dependent upon Edwards successfully launching this new product into an existing market with a new sales team.

Edwards has only recently completed its marketing evaluations of the Optiwave 980 System and, as a result, has a limited amount of experience selling this new product into the U.S. market.  Edwards must effectively train a new sales team to market the Optiwave 980 System and faces significant competition from several other companies that have been selling competitive non-laser based technologies for several years.  We cannot assure you that Edwards will successfully commercialize the Optiwave 980 System or that we will ever receive any or all of the royalty revenue we negotiated to receive from the sale of disposable products under our royalty agreement with Edwards.

Our company is dependent on certain suppliers.

Some of the components for our Heart Laser Systems, most notably the power supply and certain optics and fabricated parts for the HL2, and certain components for the Optiwave 980

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System, are only available from one supplier, and we have no assurance that we will be able to source any of our sole-sourced components from additional suppliers.  We are dependent upon our sole suppliers to perform their obligations in a timely manner.  In the past, we have experienced delays in product delivery from our sole suppliers and, because we do not have an alternative supplier to produce these products for us, we have little leverage to enforce timely delivery. Any delay in product delivery or other interruption in supply from these suppliers could prevent us from meeting our commercial demands for our products, which could have a material adverse effect on our business, financial condition and results of operations.  Furthermore, we do not require significant quantities of any components because we produce a limited number of our products each year.  Our low-quantity needs may not generate substantial revenue for our suppliers.  Therefore, it may be difficult for us to continue our relationships with our current suppliers or establish relationships with additional suppliers on commercially reasonable terms, if at all, and such difficulties may seriously harm our business, financial condition and results of operations.

We are dependent upon our key personnel and will need to hire additional key personnel in the near future.

Our ability to operate our business successfully depends in significant part upon the retention and motivation of certain key technical, regulatory, clinical, marketing, production and managerial personnel and consultants and our ongoing ability to hire and retain additional qualified personnel in these areas. Competition for such personnel is intense, particularly in the Greater Boston area. We cannot be certain that we will be able to attract such personnel and the loss of any of our current key employees or consultants could have a significant adverse impact on our business.

Our company may be unable to raise needed funds.

As of September 30, 2006, we had cash, cash equivalents and short-term investments totaling $10,244,000. Based on our current operating plan, we anticipate that our existing capital resources should be sufficient to meet our working capital requirements for at least the next 12 months.  However, if our business does not progress in accordance with our current business plan, we may need to raise additional funds in the future.  We may not be able to raise additional capital upon satisfactory terms, or at all, and our business, financial condition and results of operations could be materially and adversely affected.  To the extent that we raise additional capital by issuing equity or convertible securities, ownership dilution to our shareholders will result.  To the extent that we raise additional capital through the incurrence of debt, our activities may be restricted by the repayment obligations and other restrictive covenants related to the debt.

In order to compete effectively, our current and future products need to gain commercial acceptance.

TMR and surgical ablation for cardiac arrhythmias are still both novel technologies.  Our current and planned future products may never achieve widespread commercial acceptance.  To be successful, we and Edwards need to:

·                  demonstrate to the medical community in general, and to heart surgeons and cardiologists in particular, that TMR and surgical tissue ablation for cardiac arrhythmias are procedures that are effective, relatively safe and cost effective;

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·                  support third-party efforts to document the medical processes by which TMR procedures relieve angina and surgical tissue ablation cures cardiac arrhythmias;

·                  have more heart surgeons trained to perform TMR procedures using the Heart Laser Systems and surgical tissue ablation procedures using the Optiwave 980 System; and

·                  maintain and expand third-party reimbursement for the TMR procedure.

To date, only a limited number of heart surgeons have been trained in the use of TMR using the Heart Laser Systems and cardiac tissue ablation procedures using the Optiwave 980 System.  We are dependent on Edwards to expand related marketing and training efforts in the U.S. for the use of our products.

The Heart Laser Systems have not yet received widespread commercial acceptance.  We believe that concerns over the lack of a consensus view on the reason or reasons why a TMR procedure relieves angina in patients who undergo the procedure has limited demand for and use of the Heart Laser Systems. Until there is consensus, if ever, of the medical processes by which TMR procedures relieve angina, we believe some hospitals may delay the implementation of a TMR program.

If we are unable to achieve widespread commercial acceptance of the Heart Laser Systems or the Optiwave 980 System, our business, financial condition and results of operations will be materially and adversely affected.

Our newest product, RenalGuard, is still undergoing development and we have only recently begun to test it in a clinical setting as part of our initial pilot clinical study.

We have only recently completed the first generation product design for our RenalGuard System and we have just begun testing the device in a clinical hospital setting as part of our pilot human clinical study. We may need to make substantial modifications to the design, features or functions of our device in order for it to obtain FDA approval or meet customer expectations. These changes may not be able to be completed in a timely fashion, if at all. Should any such modifications prove to be significantly more costly or time consuming to engineer than we estimate, our ability to bring this product to market may be severely and negatively impacted.

Our planned future clinical trials to study the safety and effectiveness of RenalGuard in preventing contrast-induced nephropathy will take us a significant amount of time to complete, if we can complete them at all, and the results of these clinical trials may not show sufficient safety and efficacy for us to either obtain FDA approval or otherwise be able to successfully market and sell the product.

Our business strategy to grow our revenues and profitability is largely dependent on our success in timely completing our planned future clinical trials of RenalGuard. We hope to be able to demonstrate through clinical trials that RenalGuard is safe and effective in preventing contrast-induced nephropathy (“CIN”), a form of acute renal failure caused by exposure to contrast media for patients undergoing imaging procedures.

We can provide no assurance that when studied in humans RenalGuard will be shown to be safe or effective in preventing CIN, or that the degree of any positive safety and efficacy

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results will be sufficient to either obtain FDA approval or otherwise successfully market our product. Furthermore, the completion of our planned clinical trials is dependent upon many factors, some of which are not entirely within our control, including, but not limited to, our ability to successfully recruit investigators, the availability of patients meeting the inclusion criteria of our clinical study, the competition for these particular study patients amongst other clinical trials being conducted by other companies at these same study sites, the ability of the sites participating in our study to successfully enroll patients in our trial, and proper data gathering on the part of the investigating sites.

Should our clinical trials take longer than we expect, our competitive position relative to existing preventative measures, or relative to new devices, drugs or therapies that may be developed, could be seriously harmed and our ability to successfully fund the completion of the trials and bring RenalGuard to market may be adversely affected.

We will need to build a direct sales and marketing organization or otherwise enter into one or more distribution arrangements in order to market our RenalGuard System if and when it is approved for sale.

We currently do not have a direct sales force. Instead, we market our existing products primarily through Edwards in the United States and through independent distributors outside the U.S.  We do not plan to use Edwards to market our RenalGuard product if and when it becomes commercially available to customers. We will need to either build an internal direct sales and marketing organization or find distribution partners in order to successfully market our RenalGuard System.

If we choose to build a direct sales force, we may not be able to attract qualified individuals with the requisite training or experience to sell our product. In addition, we would need to devote substantial management time instituting policies, procedures and controls to oversee and effectively manage this new part of our organization, which could adversely impact our daily operations and would require us to invest significant financial resources, the cost of which could be prohibitive.

If we instead choose to pursue an indirect distribution strategy, we may not be able to identify suitable distribution partners with sufficient industry experience, brand recognition, sales capacity and willingness/ability to maximize sales. Further, we may not be able to negotiate distribution agreements with terms and conditions that are acceptable to us, including ensuring that our product receives adequate sales force focus and attention.

Our primary competitor in TMR may obtain FDA approval to market a new device, the impact of which is uncertain on the future adoption rate of TMR.

Our primary TMR competitor, CardioGenesis, is attempting to obtain FDA approval to market their “percutaneous” method of performing myocardial revascularization, previously known as PMR, and recently rebranded as PMC (percutaneous myocardial channeling), which would provide a less invasive method of creating channels in the heart.  If PMC can be shown to be safe and effective and is approved by the FDA, it would eliminate the need in certain patients to make an incision in the chest, reducing costs and speeding recovery.  It is unclear what impact, if any, an approval of a PMC device would have on the future adoption rate for TMR procedures. If PMC is approved, it could erode the potential TMR market which would have a material

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adverse effect on our business, financial condition and results of operations.

Rapid technological changes in our industry could make our products obsolete.

Our industry is characterized by rapid technological change and intense competition.  New technologies and products and new industry standards will develop at a rapid pace, which could make our current and future planned products obsolete. The advent of new devices and procedures and advances in new drugs and genetic engineering are especially concerning competitive threats.  Our future success will depend upon our ability to develop and introduce product enhancements to address the needs of our customers.  Material delays in introducing product enhancements may cause customers to forego purchases of our products and purchase those of our competitors.

Many potential competitors have substantially greater financial resources and are in a better financial position to exploit marketing and research and development opportunities.  In addition, we are aware that other companies are developing or already have developed proprietary systems for the treatment of cardiac arrhythmias, and specifically atrial fibrillation (“AF”), that may be safer, clinically more effective, easier and more cost effective to use and, in the case of percutaneous devices, less invasive than the systems we market.

We must receive and maintain government clearances or approvals in order to market our products.

Our products and our manufacturing activities are subject to extensive, rigorous and changing federal and state regulation in the U.S. and to similar regulatory requirements in other major international markets, including the European Union and Japan.  These regulations and regulatory requirements are broad in scope and govern, among other things:

·                  product design and development;

·                  product testing;

·                  product labeling;

·                  product storage;

·                  premarket clearance and approval;

·                  advertising and promotion; and

·                  product sales and distribution.

Furthermore, regulatory authorities subject a marketed product, its manufacturer and the manufacturing facilities to continual review and periodic inspections.  We are subject to ongoing FDA requirements, including required submissions of safety and other post-market information and reports, registration requirements, Quality Systems regulations, and recordkeeping requirements. The FDA’s Quality Systems regulations include requirements relating to quality control and quality assurance, as well as the corresponding maintenance of records and documentation.  Edwards, our distributor, depending on its activities, is also subject to certain requirements under the Federal Food, Drug, and Cosmetic Act and the regulations promulgated thereunder, and state laws and registration requirements covering the distribution of our products. Regulatory agencies may change existing requirements or adopt new requirements or policies that could affect our regulatory responsibilities or the regulatory responsibilities of a distributor like Edwards.  We may be slow to adapt or may not be able to adapt to these changes or new requirements.

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Later discovery of previously unknown problems with our products, manufacturing processes, or our failure to comply with applicable regulatory requirements may result in enforcement actions by the FDA and other international regulatory authorities, including, but not limited to:

·                  warning letters;

·                  patient or physician notification;

·                  restrictions on our products or manufacturing processes;

·                  voluntary or mandatory recalls;

·                  product seizures;

·                  refusal to approve pending applications or supplements to approved applications that we submit;

·                  refusal to permit the import or export of our products;

·                  fines;

·                  injunctions;

·                  suspension or withdrawal of marketing approvals or clearances; and

·                  civil and criminal penalties.

Should any of these enforcement actions occur, our business, financial condition and results of operations could be materially and adversely affected.

To date, the following regulatory approvals have been obtained for our products:

Heart Laser Systems

United States — We received FDA approval to market the HL1 Heart Laser System in August 1998 and the HL2 Heart Laser System in January 2001.  However, although we have received FDA approval, the FDA:

·                  has restricted the use of the Heart Laser Systems by not allowing us to market these products to treat patients whose condition is amenable to conventional treatments, such as heart bypass surgery, stenting and angioplasty; and

·                  could impose additional restrictions or reverse its ruling and prohibit use of the Heart Laser Systems at any time.

In addition, as a condition of our original FDA approval for our TMR products, we were required by the FDA to perform a postmarket surveillance study. The FDA has recently requested us to submit a Premarket Approval (“PMA”) Postapproval Study report summarizing this postmarket surveillance study. As part of this report, the FDA has requested that we analyze and discuss the adverse event and mortality rates seen in the postmarket study and compare these results to the premarket study which was presented as part of our initial FDA PMA application. Because of the significant safety information collected in the postapproval study, and as the FDA has indicated it plans to do in other product areas, the FDA plans to present the results at a future meeting of the FDA Circulatory System Devices Advisory Panel and thereafter determine what, if any, actions should be taken with respect to our current Heart Laser Systems PMA.

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Europe — We received the CE Mark from the European Union for the HL1 and HL2 in March 1995 and February 2001, respectively.  However:

·                  the European Union could impose additional restrictions or reverse its ruling and prohibit use of the Heart Laser Systems at any time; and

·                  France has prohibited, and other European Union countries could prohibit or restrict, use of the Heart Laser Systems.

Japan — Our HL1 Heart Laser System received marketing approval from the Japanese Ministry of Health, Labor and Welfare (“MHLW”) in May 2006. However, the MHLW could impose restrictions in the future or reverse its ruling and prohibit use of the Heart Laser Systems at any time.

In addition, it is unclear what impact the introduction of the HL2 into the U.S. and other international markets will have on the ability of our Japanese distributor to market our older, first generation HL1 in Japan. Although our Japanese distributor has indicated to us that it plans to seek MHLW approval in the future to market our newer HL2, we can provide no assurance that the distributor will be successful in obtaining the necessary approvals or how long it may take to secure the required approvals.

Optiwave 980 System

United States — The FDA has given clearance to the Optiwave 980 System through the 510(k) premarket notification process with indications for use as a surgical instrument for coagulation of soft tissue, including cardiac tissue, in conjunction with or without endoscopic equipment in the contact or non-contact mode in open or closed surgical procedures.

Although the Optiwave 980 System has received clearance from the FDA only for the indications of use stated above, physicians, under the practice of medicine exception, may use the device in any manner they choose in treating an individual patient, including using the device to treat patients with AF.  However, neither we nor Edwards have conducted any clinical trials designed to obtain data to submit to the FDA for the purpose of obtaining a specific indication for use of the Optiwave 980 System that would allow Edwards to make claims or otherwise market this device for the treatment of AF. We are aware of several other companies that have announced their plans to conduct clinical trials in support of a labeling claim that would allow them to market their devices for the treatment of AF if clearance is obtained from the FDA.

In the event these other competitors are successful in obtaining specific indications of use for their devices in the treatment of AF, the Optiwave 980 System may be at a competitive marketing disadvantage until such time, if ever, that Edwards conducts a clinical trial, submits sufficient data to the FDA by means of a new 510(k) and obtains clearance to market the Optiwave 980 System for the treatment of AF. We cannot provide any assurance that Edwards will ever conduct such a clinical trial or, if they do, that the data they obtain and submit to the FDA will be sufficient for the FDA to expand the current indications of use and provide clearance for the Optiwave 980 System to be marketed for the treatment of AF. Also, we cannot assure you that even if such clearance is obtained, that it will be obtained in a timely enough fashion for our products to remain competitive in the marketplace.

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Europe — The Optiwave 980 System cannot be marketed in the EU until such time as it receives CE Mark approval. Edwards needs to complete and submit the relevant technical documentation to the appropriate certifying body in order to be able to apply the CE Mark to the product.  If approval to apply the CE Mark is granted, the Optiwave 980 System will then be able to be distributed in the EU.

RenalGuard

We presently have no governmental approvals to market our RenalGuard System. We must receive either FDA approval or clearance before we can market our product in the United States. We must also receive CE Mark approval before we can market our product in the EU. Other international countries may require their own approvals prior to our being able to market our product in those countries.

The process of obtaining and maintaining regulatory approvals and clearances to market a medical device can be costly and time consuming, and we cannot predict when, if ever, such approvals or clearances will be granted. Pursuant to FDA regulations, unless exempt, the FDA permits commercial distribution of a new medical device only after the device has received 510(k) clearance or is the subject of an approved PMA application. The FDA will clear marketing of a medical device through the 510(k) process only if it is demonstrated that the new product is substantially equivalent to other 510(k)-cleared products.

At the present time we are not aware of any clear predicates with substantially the same proposed indications for use which would enable us to conclude that RenalGuard is likely to be cleared by the FDA as a 510(k) device. Therefore, we believe RenalGuard most likely will need to go through the PMA application process.

Because the PMA application process is more costly, lengthy and uncertain than the 510(k) process and must be supported by extensive data, including data from preclinical studies and human clinical trials, we cannot predict when our product may eventually come to market. Should we be unable to obtain FDA or CE Mark approval for RenalGuard, or should the approval process take longer than we anticipate, our future revenue growth prospects could be materially and adversely affected.

Changes in third party reimbursement for either TMR or cardiac tissue ablation procedures and our ability to secure third party reimbursement for RenalGuard could materially affect future demand for our products.

Demand for medical devices is often affected by whether third party reimbursement is available for the devices and related procedures.  Currently Medicare coverage is provided for TMR when it is performed as a sole therapy treatment.  In addition, when two or more medical procedures are performed in combination with each other, Medicare rules generally allow hospitals to bill for whichever of the two procedures carries the higher reimbursement amount. Therefore, in situations where sole therapy TMR reimbursement rates exceed that provided for bypass surgery alone, if hospitals perform a combination procedure where both bypass surgery and adjunctive TMR are performed on a patient, the hospital is able to bill for the higher TMR procedure reimbursement payment. In these instances, the doctor also can bill an additional amount for performing multiple procedures.

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Certain private insurance companies and health maintenance organizations also currently provide reimbursement for TMR procedures performed with our products and physician reimbursement codes have been established for both surgical procedures.

Cardiac tissue ablation procedures, such as those that are expected to be performed using the Optiwave 980 System, are also currently reimbursed by Medicare when performed as a sole therapy.  In instances where a surgeon might perform a cardiac tissue ablation procedure in combination with another heart related procedure, such as a valve replacement or repair, we believe the other procedure will normally carry a higher reimbursement and, therefore, will be the procedure that the hospital bills to Medicare.

No assurance can be given, however, that these payers will continue to reimburse healthcare providers who perform TMR or cardiac tissue ablation procedures using our products now or in the future. Further, no assurance can be given that additional payers will reimburse healthcare providers who perform TMR or cardiac tissue ablation procedures using our products or that reimbursement, if provided, will be timely or adequate.

Should third party insurance reimbursement for either TMR or cardiac tissue ablation procedures be reduced or eliminated in the future, our business, financial condition and results of operations would be materially and adversely affected.

Furthermore, we know of no existing Medicare coverage or other third party reimbursement that would be available to either hospitals or physicians that would help defray the additional cost that would result from the purchase and/or use of our RenalGuard System. We also can provide no assurance that we will ever be able to obtain Medicare coverage or other third party reimbursement for the use of RenalGuard, which could materially and adversely affect the potential future demand for this product.

In addition, the market for our products could be adversely affected by future legislation to reform the nation’s healthcare system or by changes in industry practices regarding reimbursement policies and procedures.

Securing intellectual property rights for our RenalGuard System is critical to our future business plans, but may prove to be difficult or impossible for us to obtain.

We have filed seven patent applications and have one provisional patent application pending at the United States patent office related to our RenalGuard System and other intellectual property in the general field of preventing acute renal failure. Securing patent protection over our intellectual property ideas in this field is, we believe, critical to our plans to successfully differentiate and market our RenalGuard System and grow our future revenues. We can provide no assurance, however, that we will be successful in securing any patent protection for our intellectual property ideas in this chosen field or that our efforts to obtain patent protection will not prove more difficult, and therefore more costly, than we are otherwise expecting. Furthermore, even if we are successful in securing patent protection for some or all of our intellectual property ideas in this field, we cannot predict when in the future any such potential patents may be issued, how strong such patent protection will prove to be, or whether these patents will be issued in a timely enough fashion to afford us any commercially meaningful advantage in marketing our RenalGuard System against other potentially competitive devices.

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Asserting and defending intellectual property rights may impact our results of operations.

In our industry, competitors often assert intellectual property infringement claims against one another and occasionally attempt to challenge, invalidate or circumvent patents that are issued to other parties.  The success of our business depends on our ability to successfully defend our intellectual property.  Future litigation may have a material impact on our financial condition even if we are successful in marketing our products. We may not be successful in defending or asserting our intellectual property rights.

An adverse outcome in any litigation or interference proceeding could subject us to significant liabilities to third parties and require us to cease using the technology that is at issue or to license the technology from third parties.  In addition, a finding that any of our intellectual property is invalid could allow our competitors to more easily and cost-effectively compete with us.  Thus, an unfavorable outcome in any patent litigation or interference proceeding could have a material adverse effect on our business, financial condition or results of operations.

The cost to us of any patent litigation or interference proceeding could be substantial.  Uncertainties resulting from the initiation and continuation of patent litigation or interference proceedings could have a material adverse effect on our ability to compete in the marketplace.  Patent litigation and interference proceedings may also absorb significant management time.

We may be subject to product liability lawsuits; our insurance may not be sufficient to cover damages.

We may be subject to product liability claims.  Such claims may absorb significant management time and could degrade our reputation and the marketability of our products.  If product liability claims are made with respect to our products, we may need to recall the implicated product which could have a material adverse effect on our business, financial condition and results of operations. In addition, although we maintain product liability insurance, we cannot be sure that our insurance will be adequate to cover potential product liability lawsuits. Our insurance is expensive and in the future may not be available on acceptable terms, if at all. If a successful product liability claim or series of claims exceeds our insurance coverage, it could have a material adverse effect on our business, financial condition and results of operations.

We are subject to risks associated with international operations.

A portion of our product sales are generated from operations outside of the U.S.  Establishing, maintaining and expanding international sales can be expensive.  Managing and overseeing foreign operations are difficult and products may not receive market acceptance.  Risks of doing business outside the U.S. include, but are not limited to, the following: agreements may be difficult to enforce and receivables difficult to collect through a foreign country’s legal system; foreign customers may have longer payment cycles; foreign countries may impose additional withholding taxes or otherwise tax our foreign income, impose tariffs or adopt other restrictions on foreign trade; U.S. export licenses may be difficult to obtain; and the protection of intellectual property rights in foreign countries may be more difficult to enforce.  There can be no assurance that our international business will grow or that any of the foregoing risks will not result in a material adverse effect on our business or results of operations.

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We will soon have to comply with requirements regarding internal control over financial reporting.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, beginning with our fiscal year ending December 31, 2007, our management will be required to provide a report on the effectiveness of our internal control over financial reporting.  We are developing a program to perform this evaluation in order to comply with these requirements.  Compliance with these requirements is expected to be expensive and time-consuming.  If we fail to timely complete this evaluation, we could be subject to regulatory action and public confidence in us could be adversely affected and our stock price could decline.  In addition, any failure to implement required new or improved controls, or difficulties encountered in their implementation, could harm our operating results or cause us to fail to meet our reporting obligations.

Because we are incorporated in Canada, you may not be able to enforce judgments against us and our Canadian directors.

Under Canadian law, you may not be able to enforce a judgment issued by courts in the U.S. against us or our Canadian directors. The status of the law in Canada is unclear as to whether a U.S. citizen can enforce a judgment from a U.S. court in Canada for violations of U.S. securities laws. A separate suit may need to be brought directly in Canada.

Our stock price has historically fluctuated and may continue to fluctuate significantly in the future which may result in losses for our investors.

Our stock price has been and may continue to be volatile. Some of the factors that can affect our stock price are:

·                  the announcement of new products, services or technological innovations by us or our competitors;

·                  actual or anticipated quarterly increases or decreases in revenue, gross margin or earnings, and changes in our business, operations or prospects;

·                  speculation or actual news announcements in the media or industry trade journals about our company, our products, the TMR or cardiac ablation procedures or changes in reimbursement policies by Medicare and/or private insurance companies;

·                  announcements relating to strategic relationships or mergers;

·                  conditions or trends in the medical device industry;

·                  changes in the economic performance or market valuations of other medical device companies; and

·                  general market conditions or domestic or international macroeconomic and geopolitical factors unrelated to our performance.

The market price of our stock may fall if shareholders sell their stock.

Certain current shareholders hold large amounts of our stock, which they could sell in the public market from time to time.  Sales of a substantial number of shares of our common stock within a short period of time could cause our stock price to fall.  In addition, the sale of these shares could impair our ability to raise capital through the sale of additional stock.

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We have no intention to pay dividends.

We have never paid any cash dividends on our common stock. We currently intend to retain all future earnings, if any, for use in our business and do not expect to pay any dividends in the foreseeable future.

Item 6.          Exhibits

Exhibit Number		Description of Document
31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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SIGNATURES

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

		PLC SYSTEMS INC.
Date: November 14, 2006		By:	/s/ James G. Thomasch
			James G. Thomasch
			Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer)

 

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EXHIBIT INDEX

Exhibit Number		Description of Document
31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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