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 June 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		23
Item 4.		Controls and Procedures		23
Part II.   Other Information:
Item 1A.		Risk Factors		24
Item 4.		Submission of Matters to a Vote of Security Holders		33
Item 6.		Exhibits		33

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Part I.     Financial Information

Item 1.                          Financial Statements

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

		June 30, 2006			December 31, 2005
ASSETS
Current assets:
Cash and cash equivalents		$	4,896		$	2,560
Short-term investments		5,500			6,900
Accounts receivable — Edwards		1,168			634
Accounts receivable — other, net of allowance of $97 and $96 as of June 30, 2006 and December 31, 2005, respectively		134			153
Inventories, net		986			963
Prepaid expenses and other current assets		742			798
Total current assets		13,426			12,008
Equipment, furniture and leasehold improvements, net		137			235
Other assets		216			224
Total assets		$	13,779		$	12,467
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	447		$	352
Accrued compensation		543			677
Accrued other		316			334
Deferred revenue — Edwards		1,830			1,621
Deferred revenue — other		56			60
Total current liabilities		3,192			3,044
Deferred revenue — Edwards		3,341			3,692
Deferred revenue — other		188			188
Total long-term liabilities		3,529			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 June 30, 2006 and December 31, 2005, respectively		93,845			93,737
Additional paid in capital		33			—
Accumulated deficit		(86,487		)	(87,850		)
Accumulated other comprehensive loss		(333		)	(344		)
Total stockholders’ equity		7,058			5,543
Total liabilities and stockholders’ equity		$	13,779		$	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 June 30,						Six Months Ended June 30,
		2006			2005			2006			2005
Revenues:
Product sales — Edwards		$	1,426		$	1,438		$	2,602		$	2,846
Product sales — other		151			129			455			279
Service fees — Edwards		333			360			697			671
Service fees — other		33			55			78			129
Total revenues		1,943			1,982			3,832			3,925
Cost of revenues:
Product sales — Edwards		464			531			827			1,016
Product sales — other		90			69			238			136
Service fees — Edwards		129			144			271			282
Service fees — other		39			46			77			84
Total cost of revenues		722			790			1,413			1,518
Gross profit		1,221			1,192			2,419			2,407
Operating expenses:
Selling, general and administrative		804			897			1,684			1,777
Research and development		458			649			991			1,220
Total operating expenses		1,262			1,546			2,675			2,997
Gain on the sale of manufacturing rights		—			—			1,432			—
Income (loss) from operations		(41		)	(354		)	1,176			(590		)
Other income, net		113			64			187			116
Net income (loss)		$	72		$	(290	)	$	1,363		$	(474	)
Basic income (loss) per share		$	0.00		$	(0.01	)	$	0.05		$	(0.02	)
Diluted income (loss) per share		$	0.00		$	(0.01	)	$	0.04		$	(0.02	)
Average shares outstanding:
Basic		30,092			30,071			30,086			30,070
Diluted		30,731			30,071			30,657			30,070

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)

		Six Months Ended June 30,
		2006			2005
Operating activities:
Net income (loss)		$	1,363		$	(474	)
Adjustments to reconcile net loss to net cash provided by (used for) operating activities:		63			68
Depreciation and amortization
Loss on retirement of equipment		77			—
Compensation expense from stock options		33			—
Change in assets and liabilities:
Accounts receivable — Edwards		(535		)	44
Accounts receivable — other		19			64
Inventories		(23		)	(35		)
Prepaid expenses and other assets		56			(276		)
Accounts payable		95			65
Deferred revenue — Edwards		(142		)	364
Deferred revenue — other		(6		)	(1		)
Accrued liabilities		(152		)	121
Net cash provided by (used for) operating activities		848			(60		)
Investing activities:
Purchase of investments		(4,000		)	(6,900		)
Maturity of investments		5,400			—
Purchase of equipment		(34		)	(30		)
Net cash provided by (used for) investing activities		1,366			(6,930		)
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		14			(49		)
Net increase (decrease) in cash and cash equivalents		2,336			(7,033		)
Cash and cash equivalents at beginning of period		2,560			9,678
Cash and cash equivalents at end of period		$	4,896		$	2,645

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

5

PLC SYSTEMS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 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 91% and 86% of the Company’s total sales in the three and six months ended June 30, 2006, respectively. Edwards is also the Company’s largest shareholder, owning approximately 18% of its outstanding stock as of June 30, 2006.

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 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 six months ended June 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 six months ended June 30, 2006, the Company recorded $8,000 of royalty revenue, which is included in the accompanying Condensed Consolidated Statements of Operations.

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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 and six months ended June 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.

For the three and six months ended June 30, 2005, basic and diluted earnings 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.

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 June 30, 2006 and 2005, 1,759,075 and 4,718,422 shares, respectively, and for the six months ended June 30, 2006 and 2005, 1,759,075 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 the three and six months ended June 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.

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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 from the Previous Plans after the adoption of the 2005 Plan.

The number of 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 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

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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 the common stock subject to 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 June 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 $23,000 and $33,000, respectively, was recognized in the accompanying statement of operations for the three and six months ended June 30, 2006. The compensation expense recorded includes (a) $18,000 of compensation cost 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) $15,000 of compensation cost 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 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 June 30, 2006, the Company had $256,000 of total unrecognized compensation cost related to its unvested options, which is expected to be recognized over a weighted average period of nineteen months.

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

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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 six months ended June 30, 2006:

 

 

The aggregate intrinsic value amounts in the table above represent the difference between the closing price of the Company’s common stock on June 30, 2006 and the exercise price, multiplied by the in-the-money stock options as of the same date.  The total intrinsic value of options exercised during the three months ended June 30, 2006 was $39,000.

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 six months ended June 30, 2006:

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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 six month periods ended June 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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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 income for the three and six month periods ended June 30, 2006 amounted to $80,000 and $1,374,000, respectively, as compared to a comprehensive loss of $307,000 and $505,000, respectively, for the three and six month periods ended June 30, 2005.  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 June 30, 2006 and December 31, 2005, inventories consisted of the following (in thousands):

 

At June 30, 2006 and December 31, 2005, inventories are stated net of a reserve of $473,000 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

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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 six months ended June 30, 2006 the Company recorded amortization of $170,000 and $325,000, respectively, as compared to $98,000 and $174,000, respectively, for the three and six months ended June 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.

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.

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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.

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.

Edwards is our exclusive distributor for TMR products in the United States and our largest customer, accounting for approximately 91% and 86%, respectively, of our total sales in the three and six months ended June 30, 2006 and 89% in the year ended December 31, 2005.  We expect this sales trend to continue for the near future.

Approximately 95% and 96%, respectively, of our revenues in the three and six months ended June 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 5% and increased approximately 2%, respectively, in the three and six months ended June 30, 2006 compared to the three and six months ended June 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 information obtained from supplier audits.

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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 six months ended June 30, 2006, we recorded amortization of $170,000 and $325,000, respectively, as compared to $98,000 and $174,000, respectively, for the three and six months ended June 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 $23,000 and $33,000, respectively, was recognized in our statement of operations for the three and six months ended June 30, 2006. The compensation expense recorded includes (a) $18,000 of compensation cost 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) $15,000 of compensation cost 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 June 30, 2006, we had $256,000 of total unrecognized compensation cost related to our unvested options, which is expected to be recognized over a weighted average period of nineteen months.

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 six months ended June 30, 2006 and 2005 and the related percent of revenues were as follows:

		Three Months Ended June 30,								Six Months Ended June 30,
		2006				2005				2006				2005
		$		%		$		%		$		%		$		%
		(dollars in thousands)
Total revenues		1,943		100		1,982		100		3,832		100		3,925		100
Total cost of revenues		722		37		790		40		1,413		37		1,518		39
Gross profit		1,221		63		1,192		60		2,419		63		2,407		61
Selling, general & administrative		804		41		897		45		1,684		44		1,777		45
Research & development		458		24		649		33		991		26		1,220		31
Total operating expenses		1,262		65		1,546		78		2,675		70		2,997		76
Gain on sale of manufacturing assets		—		—		—		—		1,432		37		—		—
Income (loss) from operations		(41	)	(2	)	(354	)	(18	)	1,176		31		(590	)	(15	)
Other income		113		6		64		3		187		5		116		3
Net income (loss)		72		4		(290	)	(15	)	1,363		36		(474	)	(12	)

 

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		Three Months Ended June 30,								Six Months Ended June 30,
		2006		2005		Increase (decrease) over 2005				2006		2005		Increase (decrease) over 2005
		$		$		$		%		$		$		$		%
		(dollars in thousands)
Product sales		1,577		1,567		10		1		3,057		3,125		(68	)	(2	)
Service fees		366		415		(49	)	(12	)	775		800		(25	)	(3	)
Total revenues		1,943		1,982		(39	)	(2	)	3,832		3,925		(93	)	(2	)
Product cost of sales		554		600		(46	)	(8	)	1,065		1,152		(87	)	(8	)
Service fees cost of sales		168		190		(22	)	(12	)	348		366		(18	)	(5	)
Total cost of revenues		722		790		(68	)	(9	)	1,413		1,518		(105	)	(7	)
Gross profit		1,221		1,192		29		2		2,419		2,407		12		-
Selling, general & administrative expenses		804		897		(93	)	(10	)	1,684		1,777		(93	)	(5	)
Research & development expenses		458		649		(191	)	(29	)	991		1,220		(229	)	(19	)
Total operating expenses		1,262		1,546		(284	)	(18	)	2,675		2,997		(322	)	(11	)
Gain on sale of manufacturing assets		—		—		—		—		1,432		—		1,432		100
Income (loss) from operations		(41	)	(354	)	313		88		1,176		(590	)	1,766		299
Other income		113		64		49		77		187		116		71		61
Net income (loss)		72		(290	)	362		125		1,363		(474	)	1,837		388

 

Product Sales

TMR laser revenues, the largest component of product sales in the three months ended June 30, 2006, increased by $61,000, or 9%, as compared to the three months ended June 30, 2005. International TMR laser revenues increased $53,000, from $5,000 to $58,000, due to the sale of a single laser to an international customer in the three months ended June 30, 2006. Domestic TMR laser revenues increased $8,000, or 1%, as a result of an increase in the number of new TMR lasers sold by Edwards, offset by decreased revenue sharing earned under the TMR distribution agreement with Edwards.

In the six months ended June 30, 2006, TMR laser revenues increased by $136,000, or 10%, as compared to the six months ended June 30, 2005.  International TMR laser revenues increased $258,000, from $20,000 to $278,000, due to the sale of two lasers to international customers in the six months ended June 30, 2006.  Domestic TMR laser revenues decreased $122,000, or 9%, as a result of decreased revenue sharing earned under the TMR distribution agreement with Edwards.

Disposable TMR kit revenues, the second largest component of product sales, increased by $164,000, or 29%, in the three months ended June 30, 2006 as compared to the three months ended June 30, 2005. Domestic TMR kit revenues increased $158,000, or 28%, as a result of (1) a higher volume of kit shipments to Edwards and (2) a $72,000 increase in deferred revenue amortization related to the $4,533,333 payment by Edwards in 2004. International disposable TMR kit revenues increased $6,000, or 46%, as a result of a higher volume of kit shipments to international customers.

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In the six months ended June 30, 2006, disposable TMR kit revenues increased by $194,000, or 16%, as compared to the six months ended June 30, 2005. Domestic TMR kit revenues increased $239,000, or 22% as a result of (1) a $151,000 increase in deferred revenue amortization related to the $4,533,333 payment by Edwards and (2) an 8% higher volume of kit shipments to Edwards. International disposable TMR kit revenues decreased $45,000, or 49%, as a result of a lower volume of kit shipments to international customers.

Optiwave 980 revenues to Edwards decreased $192,000, or 100%, and $345,000, or 100%, respectively in the three and six months ended June 30, 2006 as compared to the three and six months ended June 30, 2005, as no Optiwave 980 units were sold to Edwards in the first or second quarters of 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 $1,000,000 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 $23,000, or 21%, and 53,000, or 26%, respectively, in the three and six months ended June 30, 2006 as compared to the three and six months ended June 30, 2005.

Service Fee Revenues

Service fee revenues decreased $49,000, or 12%, in the three months ended June 30, 2006 as compared to the three months ended June 30, 2005.  Domestic service fees decreased $27,000, or 8%, due to decreased billings to Edwards for service related calls, offset in part by increased revenues generated from service contracts. International service fees decreased $22,000, or 40%, due to a decrease in billings to a single international customer whose HL2 laser was removed.

Service fee revenues decreased $25,000, or 3%, in the six months ended June 30, 2006 as compared to the six months ended June 30, 2005.  Domestic service fees increased $25,000, or 4%, due to increased revenues generated from service contracts, offset in part by decreased billings to Edwards for service related calls. International service fees decreased $50,000, or 39%, due to a decrease in billings to a single international customer whose HL2 laser was removed.

Gross Profit

Total gross profit was $1,221,000, or 63% of total revenues, for the three months ended June 30, 2006 as compared with gross profit of $1,192,000, or 60% of total revenues, for the three months ended June 30, 2005.  The increase in gross profit dollars is due to (1) higher disposable TMR kit revenues, (2) an increase in the number of new domestic TMR lasers sold and (3) higher international TMR laser sales.  These increases were offset in part by (1) a decrease in additional revenue sharing on lasers earned under the TMR distribution agreement with Edwards and (2) a decrease in Optiwave 980 revenues.

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Total gross profit was $2,419,000, or 63% of total revenues, for the six months ended June 30, 2006 as compared with gross profit of $2,407,000, or 61% of total revenues, for the six months ended June 30, 2005.  The increase in gross profit dollars is due to (1) higher disposable TMR kit revenues and (2) higher international TMR laser sales.  These increases were offset in part by (1) a decrease in Optiwave 980 revenues and (2) a decrease in additional revenue sharing earned under the TMR distribution agreement with Edwards.

Selling, General and Administrative Expenses

Selling, general and administrative expenses decreased 10% and 5%, respectively, in the three and six months ended June 30, 2006 as compared to the three and six months ended June 30, 2005.  The decreases for both 2006 periods are a result of lower legal expenses as well as lower incentive compensation.

Research and Development Expenses

Research and development expenditures decreased 29% and 19%, respectively, in the three and six months ended June 30, 2006 as compared to the three and six months ended June 30, 2005.  There was a decrease in expenditures in connection with the Optiwave 980 and our new product development.

We expect to continue to incur significant new research and development expenditures in 2006 and future years in pursuit of our business strategy to broaden and diversify our product portfolio beyond our current TMR offerings.

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 $49,000, or 77%, and $71,000, or 61%, respectively, in the three and six months ended June 30, 2006 as compared to the three and six months ended June 30, 2005 due to higher interest rates earned on our cash, cash equivalents and short-term investments and higher investable balances.

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Net Income (Loss)

In the three months ended June 30, 2006, we recorded net income of $72,000 as compared to a net loss of $290,000 in the three months ended June 30, 2005.  This increase is primarily a result of lower operating expenses and higher other income in the three months ended June 30, 2006 as compared to the three months ended June 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 six months ended June 30, 2006 of $1,363,000, as compared to a net loss of $474,000 for the six months ended June 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:

		Three Months Ended June 30,						Six Months Ended June 30,
		2006		2005		% Increase over 2005		2006		2005		% Increase over 2005
Domestic		537		566		(5	)	1,028		1,005		2
International		10		5		100		25		55		(55	)
Total		547		571		(4	)	1,053		1,060		(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 $10,396,000 as of June 30, 2006, an increase of $936,000 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 six months ended June 30, 2006 was $848,000 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

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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 $14,000.  We used $34,000 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 and Optiwave 980 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 either the Heart Laser Systems or the Optiwave 980, or that we will be able to operate profitably in the future on a consistent basis, if at all.

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 TMR offerings, by developing or acquiring new and innovative medical devices to address cardiac and vascular related markets. We believe this strategy will result in our incurring losses for at least the next 18-30 months as we increase our research and development spending.  We cannot be certain that we will be successful in implementing our business strategy or that future sales, if any, from these planned 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.

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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 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 6% and 11%, respectively, of our consolidated sales in the three and six months ended June 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 June 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 June 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 June 30, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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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.

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

Although we have been profitable during the first two quarters of 2006, we expect to incur net losses in future quarters as we increase our research and development spending on an internal R&D initiative.  Moreover, as we continue to pursue our business strategy of acquiring or developing new medical devices to address cardiac and vascular related markets, we may continue to incur expenses that exceed the revenues we generate.  We cannot provide any assurance that we will be successful with our business strategy, that any new products under development will be successful 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 91% and 86%, respectively, of our total revenues in the three and six months ended June 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 six months ended June 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.

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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 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, 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 June 30, 2006, we had cash, cash equivalents and short-term investments totaling $10,396,000. 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

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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;

·                  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 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,

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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 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 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.

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.

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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.

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.

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Changes in third party reimbursement for either TMR or cardiac tissue ablation procedures 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.

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.

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.

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.

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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.

We will soon have to comply with internal controls evaluations and attestation requirements.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we will be required, beginning with our fiscal year ending December 31, 2007, to perform an evaluation of our internal controls over financial reporting and have our independent registered public accounting firm attest to such evaluation.  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, or if our independent registered public accounting firm cannot timely attest to our evaluation, we could be

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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.

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.

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Item 4.            Submission of Matters to a Vote of Security Holders

On May 17, 2006, the Company held its 2006 Annual Meeting of Shareholders (the “Shareholders Meeting”).  At the Shareholders Meeting, the following matters were approved by the vote specified below:

1.                                       Benjamin L. Holmes, Alan H. Magazine and Edward H. Pendergast were elected as Class II directors and will hold office until the annual meeting of shareholders in 2009 or until their successors are duly elected and qualified.  Mr. Holmes received 26,217,802 shares of common stock voting in favor of his election and 506,787 shares of common stock were withheld.  Mr. Magazine received 26,217,428 shares of common stock voting in favor of his election and 507,161 shares of common stock were withheld.  Mr. Pendergast received 26,217,428 shares of common stock voting in favor of his election and 507,161 shares of common stock were withheld.  The remaining terms of Kevin J. Dunn, Brent Norton, M.D., Robert I. Rudko, Ph.D. and Mark R. Tauscher continued after the Shareholders Meeting.

2.                                       The selection of Vitale, Caturano & Company, Ltd. as the Company’s independent registered public accounting firm for the year ending December 31, 2006 and the authorization of the Audit Committee of the Board of Directors to fix the remuneration to be paid to the auditors were approved.  The votes were cast as follows: 26,324,481 shares of common stock were voted for the approval, 375,527 shares of common stock were voted against the approval and 24,581 shares of common stock abstained from the vote.

Item 6.          Exhibits

10.1		Second Amendment to Shareholders Agreement, dated April 6, 2006, by and among the Registrant and Edwards Lifesciences Corporation, incorporated by reference to the Registrant’s quarterly report on Form 10-Q for the quarter ended March 31, 2006, as previously filed with the Securities and Exchange Commission.
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: August 9, 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
10.1		Second Amendment to Shareholders Agreement, dated April 6, 2006, by and among the Registrant and Edwards Lifesciences Corporation, incorporated by reference to the Registrant’s quarterly report on Form 10-Q for the quarter ended March 31, 2006, as previously filed with the Securities and Exchange Commission.
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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