This Annual Report on Form 10-K contains forward-looking statements, including statements about new product introductions, expectations as to future sales of the products of Vision-Sciences, Inc. (the “Company”, “we”, “our”, “us”), the availability of supplies, the sufficiency of our capital resources to meet anticipated capital requirements, our sales distribution channels and our expectations as to future expenditures, including research and development expenditures. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words “believes”, “anticipates”, “plans”, “expects”, and similar expressions are intended to identify forward-looking statements. These forward-looking statements involve risks and uncertainties, and our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, the availability of capital resources, the availability of third-party reimbursement, government regulation, commercialization and technological difficulties, general economic conditions and other risks detailed below. See “Risk Factors.”

This Business section should be read in conjunction with our Consolidated Financial Statements attached hereto as Appendix A, including the notes thereto.

We design, develop, manufacture and market products for endoscopy, the science of using an instrument, known as an endoscope, to provide minimally invasive access to areas not readily visible to the human eye. We operate in three reportable segments: medical, industrial and corporate.

The medical segment designs, manufactures and sells our Slide-On ®  EndoSheath ®  System (“EndoSheath” or “Slide-On EndoSheath”), a single-use device that slides on to the insertion tube of a flexible endoscope. The insertion tube is the part of an endoscope that enters the patient’s body. The use of an EndoSheath gives health-care providers economic advantages because it allows them to avoid the burdensome cleaning required of endoscopes, reduces repair costs to endoscopes caused by the harsh chemicals used in the cleaning process and allows health-care providers to avoid investing in multiple endoscopes. Our EndoSheaths that have channels help to improve the practice efficiency of health-care providers by allowing them to perform procedures in their offices that otherwise they would have to perform in hospitals using special endoscopes that have channels. Often, the reimbursement rates are higher for physicians when they perform procedures in their offices. In addition, the EndoSheath is a sterile device that provides patients with a contaminant-free insertion tube for each procedure. There is a risk to patients of cross-contamination from the reuse of conventional flexible endoscopes that health-care providers are unable to effectively sterilize.

The industrial segment manufactures and repairs flexible endoscopes for the medical segment. These include our conventional nasopharyngolaryngo endoscopes, the ENT-2000, ENT-1000 and ENT-3000, for the Ear-Nose-Throat (“ENT”) market. In addition, the industrial segment manufactures and repairs our trans-nasal diagnostic esophagoscope (“TNE D scope”), our trans-nasal therapeutic esophagoscope (“TNE Bx scope”), our cystoscope (“CST-2000”), our sigmoidoscope and our bronchoscope. We expect the industrial segment will be manufacturing our other endoscopes after they complete the product development cycle. In addition, the industrial segment designs, manufactures and markets flexible endoscopes, called borescopes, for industrial markets, primarily aircraft maintenance, jet engine manufacturing, specialized industries and defense.

The corporate segment consists of certain administrative activities applicable to all segments.

We were incorporated in Delaware in 1987 under the name Machida Incorporated. Since that time, we have acquired by merger Cyberex Corporation (in October 1988) and Vascu-Care, Inc. (in March 1989), and acquired pursuant to a share exchange Opielab, Inc. (in September 1990). We changed

our name to Vision-Sciences, Inc. in December 1990. Our principal executive offices are located at 9 Strathmore Road, Natick, Massachusetts 01760. Our telephone number is (508) 650-9971.

Endoscopy

Background

Endoscopy is a minimally invasive technique that is being used with increased frequency in a growing number of medical applications. Endoscopes are used for a variety of screening and diagnostic procedures and are also used therapeutically as an alternative to more traditional surgical procedures. Endoscopic therapeutic procedures, unlike more traditional “open” surgical procedures, can be performed without a major incision, in most cases without general anesthesia, and are, therefore, safer and less expensive than traditional surgical procedures. In addition, endoscopic procedures are typically performed on an outpatient basis, generally involving less recovery time and patient discomfort than traditional surgery. The patient benefits and cost savings associated with endoscopy have caused many governmental reimbursement programs and private health insurance plans to encourage the use of endoscopic procedures in a number of medical applications. In many instances, the use of endoscopes allow physicians to receive higher reimbursement for performing procedures in their offices, compared to performing them in hospitals, due to the insurance plan not having to reimburse for the hospital cost component.

Flexible endoscopes are tubular instruments that enter the body through a natural orifice and enable physicians to view the interior of a body organ or cavity remotely and perform various screening, diagnostic and therapeutic procedures. Flexible endoscopes generally utilize fiberoptic bundles or video camera technology for image production. The physician can steer the distal portion of a flexible endoscope with control knobs on the endoscope’s operator body. By maneuvering the tip of the endoscope, the physician can access body regions through lengthy and twisted passageways, and perform a variety of procedures. The typical ENT endoscope does not contain channels whereas most conventional flexible endoscopes for gastroenterology (“GI”), pulmonary, urology procedures and special ENT endoscopes do contain one or more channels that run the length of the endoscope for delivery of air, water, suction and accessory devices, such as biopsy forceps and cutting instruments.

Rigid endoscopes generally utilize a stainless steel tube encasing a series of high resolution lenses to transmit the optical image. Most rigid endoscopes do not contain the channels that are characteristic of flexible endoscopes. Rigid endoscopes are currently utilized for diagnostic and surgical procedures such as arthroscopy, laparoscopy, urological and gynecological procedures. While rigid endoscopes for other medical applications, such as bronchoscopes, sigmoidoscopes and nasopharyngo-laryngoscopes are still marketed, they have largely been supplanted by flexible endoscopes, which offer improved patient comfort and better handling capabilities. We do not currently plan to manufacture endoscopes for the rigid endoscope market.

Applications

Flexible endoscopes are widely used in hospitals, clinics and physicians’ offices, primarily on an outpatient basis. Our flexible endoscopes are designed primarily for screening, diagnostic and therapeutic procedures in fields such as otolaryngology (ear-nose-throat medicine, or “ENT”), urology, gastroenterology, pulmonary medicine, primary care and surgery. We estimate, based on various industry sources, that approximately 20 million flexible endoscopic procedures in these fields are performed in the United States annually.

ENT Endoscopes.    These endoscopes, typically without channels, are used for viewing the ears, nose, throat and larynx for diagnostic purposes, such as testing for throat cancer or sleep apnea. We estimate that based on industry sources, approximately 4 million such procedures are performed in the United States annually, generally by otolaryngologists and allergists in hospitals, clinics and physicians’ offices. In

addition, there are ENT endoscopes with a channel, which are typically used in hospitals to perform procedures such as biopsies, removal of polyps in sinus cavities, tests for swallowing disorders and other procedures. These endoscopes require a significantly larger investment to acquire than flexible endoscopes without a channel.

Urology Endoscopes.    Cystoscopes allow the urologist to view the inside of the bladder and urethra and are commonly used to diagnose and take biopsies of bladder tumors, identify obstruction of the bladder and to install and remove stents as part of surgical procedures. We estimate that based upon industry sources, over 440,000 flexible cystoscopies are performed annually in the United States, of which 79% are done in an outpatient setting. Sterile equipment is highly desired for cystoscopy, but today, most cystoscopes are disinfected, not sterilized.

Gastrointestinal Endoscopes.    Based on industry sources, we estimate that over 12 million flexible endoscopic procedures involving the screening, diagnosis or treatment of the colon, esophagus, stomach and duodenum are performed in the United States annually. Continued growth in such procedures is expected to result from an increase in procedures performed for the purpose of detecting cancer of the descending colon, as well as the increased medical needs associated with an aging population. The American Cancer Society has recommended that every adult over the age of 50 (currently approximately 77 million Americans) receive a screening sigmoidoscopy every three to five years, or a colonoscopy every ten years. The most common flexible endoscopes used in GI endoscopy are sigmoidoscopes, colonoscopes, gastroscopes and duodenoscopes.

Pulmonary Endoscopes.    A bronchoscope and an intubation endoscope are flexible endoscopes used for viewing the trachea, bronchi and lungs for diagnostic and therapeutic purposes, generally by pulmonary specialists and anesthesiologists in a clinic or hospital setting. We estimate that based on industry sources, approximately 500,000 procedures using flexible bronchoscopes are performed in the United States annually. Because pneumonia is common in persons infected with the HIV virus, and because bronchoscopy is often used to make this diagnosis, there has been increased usage of bronchoscopes for this purpose, as well as greater recognition of the need to perform bronchoscopies in a contamination-free manner to protect both the HIV positive patients, who have weakened immune systems, and subsequent patients on whom the bronchoscope is used.

Problems with Conventional Flexible Endoscopes

While endoscopy represents a significant advance in the field of clinical medicine, flexible endoscopes without EndoSheaths present a number of health risks and problems to both patients and medical personnel. Flexible endoscopes are intended for repeated use in hundreds of procedures and, with each use, come in contact with some combination of the patient’s blood, tissue, mucus, saliva, urine or stool. Therefore, flexible endoscopes without EndoSheaths must be meticulously manually cleaned and disinfected after each procedure. However, the design of flexible endoscopes makes it impossible to sterilize them, and even difficult to attain high-level disinfection after cleaning. As a result, the repeated use of flexible endoscopes without EndoSheaths and the difficulty of thoroughly cleaning and disinfecting them after each use create the following problems:

·        Patients, and to a lesser degree the physicians using the flexible endoscopes without EndoSheaths and the nurse assistants cleaning them, are exposed to the risk of infection from contaminated endoscopes that results from their repeated use.

·        The nurses or other medical personnel who clean endoscopes used without EndoSheaths face health risks from exposure to toxic disinfecting agents used in the cleaning process.

·        The proper cleaning of a flexible endoscope used without an EndoSheath is relatively expensive, time-consuming and arduous.

·        The repeated cleaning of a flexible endoscope used without an EndoSheath subjects it to wear and tear, reduces its useful life and impairs the quality of its optics; in addition, improper cleaning can cause blocked channels, which require expensive endoscope repairs.

·        The time needed to clean a flexible endoscope used without an EndoSheath after each use results in a period of “down time” during which the endoscope cannot be used and may require users to buy and maintain multiple endoscopes.

Difficulty of Proper Cleaning.    The problems associated with cleaning flexible endoscopes used without EndoSheaths can be better understood by examining the cleaning procedures they require. The cleaning of these endoscopes is generally the responsibility of the nurse or endoscopic assistant. The Society of Gastroenterology Nurses and Associates, Inc., in 1990 published Recommended Guidelines for Infection Control in Gastrointestinal Endoscopy Settings (the “SGNA Guidelines”). Although cleaning procedures for endoscopes vary widely, the following is a summary of the principal steps in the cleaning procedures that are called for by the SGNA Guidelines:

·        Inspection—Endoscopes should be tested for leaks and inspected for damage. Even small leaks can lead to costly fiberoptic or video component damage or contamination of the endoscope.

·        Cleaning—After gross cleaning to remove patient material, endoscopes should be thoroughly rinsed, the detachable parts should be removed and cleaned and exteriors should be sponge-cleaned. All internal channels that are accessible should be scrubbed with brushes, while unreachable air and water channels should be rinsed clear of residual patient organic matter, as the presence of such matter diminishes the effectiveness of the disinfecting agents used. The endoscope should then be washed in a detergent and enzyme solution, with such cleaning agents drawn through internal channels. The endoscope should then be rinsed, with excess water removed, since residual water can dilute disinfectants.

·        Disinfection—Endoscopes should be disinfected using recommended chemical agents or an automated cleaner. Disinfectants must also be drawn through internal channels during this process. Although certain sterilization methods are available for flexible endoscopes, conventional heat sterilization will destroy flexible endoscopes.

·        Rinsing—To ensure that patients are not exposed to toxic disinfectants, endoscopes should be thoroughly rinsed using either tap water or sterile water, followed by a final rinse in an alcohol solution.

·        Drying—Endoscopes and channels should be dried using forced air, flushed with an alcohol solution and dried again, prior to storage.

·        Storage—Endoscopes should be hung vertically in well-ventilated cabinets to prevent recontamination or damage between uses.

Proper cleaning of flexible endoscopes used without EndoSheaths, even when done in compliance with the SGNA Guidelines, is difficult to achieve for a number of reasons. Firstly, the design of these flexible endoscopes, which includes channels, joints and crevices, makes it difficult to reach and clean all parts of the endoscope. As the SGNA Guidelines state, an endoscope’s “complex and fragile structure presents problems in cleaning/disinfecting/sterilizing”. Secondly, we believe the most important step in the cleaning process is the manual removal of organic material, and therefore, the opportunity for human error is always present, even if optimal cleaning procedures are followed. Finally, there are questions concerning the efficiency of some disinfecting agents used in the endoscope cleaning process. For example, in 1991 the federal Food & Drug Administration (“FDA”) recommended that the medical profession cease the use of Sporicidin, a widely-used endoscope disinfectant, based upon the FDA’s conclusion that this disinfectant does not work. The FDA has also required that the manufacturers of 2.4%

glutaraldehyde-based disinfectants change the recommended soak time on their instructions for use from 20 minutes to 45 minutes, and increase the temperature from 20 degrees Celsius to 25 degrees Celsius. This longer soak time means slower turnaround on conventional scopes, and the increased temperature of the glutaraldehyde is hazardous due to increased caustic vapors released during heating.

Health Risks.    Because flexible endoscopes used without EndoSheaths are difficult to clean properly, sterilization (the complete elimination of microbial life) is virtually impossible to achieve. Therefore, “high-level disinfection” (the elimination of all microbial life other than the most highly resistant spores) is the standard currently recommended by the Centers for Disease Control (“CDC”) for cleaning flexible endoscopes. However, studies indicate that high-level disinfection is often not attained and that cross-contamination remains a risk to patients and medical personnel.

Numerous infectious agents, including pseudomonas, tuberculosis and salmonella, have been reported in the medical literature as having been transmitted through the use of contaminated endoscopes. Concern about the risk of endoscopic cross-contamination has also been heightened by the increasing prevalence of the HIV and hepatitis viruses.

The cleaning procedures required for endoscopes also subject patients and medical personnel to health risks (such as severe eye, nose and throat irritation, nausea, headaches, asthma and skin rashes) from exposure to toxic disinfecting agents. The Occupational Safety and Health Administration has classified glutaraldehyde, a key ingredient in many endoscope disinfecting agents, as a highly toxic material and requires hospitals, clinics and physicians’ offices to reduce the level of emissions to 0.2 parts per million wherever glutaraldehyde is used. In addition, toxic disinfectants must be disposed of in compliance with applicable environmental laws.

Other Problems.    In addition to the health problems posed by the use and cleaning of conventional flexible endoscopes, the required cleaning of these products is relatively expensive, time-consuming and arduous. We estimate, based upon our own experience that the cleaning and disinfection procedure required following each use of a flexible endoscope without an EndoSheath, if done in compliance with the FDA recommendations, would take approximately 60 minutes. The repeated cleaning in harsh chemical disinfectants also subjects a flexible endoscope to wear and tear, reducing its useful life and impairing the quality of its optics. Moreover, the failure to clean all organic materials from a flexible endoscope’s channels is a common cause of blocked channels, which require expensive endoscope repairs as well as a back-up inventory of endoscopes. In addition, the need to properly clean a flexible endoscope after each use requires that each doctor performing endoscopies must either have access to a number of endoscopes or be forced to wait an estimated 60 minutes between each endoscopic procedure (assuming the endoscope is cleaned in compliance with FDA Guidelines).

Company Strategy

Our business strategy is to design, develop, manufacture and market flexible endoscopes with Slide-On EndoSheath Systems as devices that provide physicians with tools to increase their practice efficiency and also protect patients by providing a sterile insertion tube for each procedure. To implement this strategy, we developed a variety of flexible endoscopes with Slide-On EndoSheath Systems described below. We market our ENT products domestically primarily through an exclusive distribution agreement (the “Medtronic Agreement”) with Medtronic ENT (“MENT”, formerly known as “Medtronic Xomed”). From December 2004 to May 1, 2006, we marketed our urology products domestically through a separate exclusive agreement (the “MGU Agreement”) with Medtronic USA, Inc. (the Medtronic Gastroenterology/Urology business, or “MGU”). On May 1, 2006, we and MGU terminated the MGU Agreement, and we plan to market and sell our urology products through our own network of independent sales representatives. We market our other products domestically through our own network of independent sales representatives. We market all our products internationally through our network of independent international distributors. We manufacture EndoSheaths in our Natick, MA facility, and endoscopes in our Orangeburg, NY facility.

Products and Product Development Programs

In the medical segment, our primary products include a family of flexible endoscopes with Slide-On EndoSheath Systems for applications in the ENT, urology, GI and pulmonary markets. In addition, through our industrial segment we currently manufacture and sell borescopes, which are endoscope devices for industrial applications, and related products.

Medical Segment

ENT EndoSheaths and Endoscopes

We have developed a family of Slide-On ENT EndoSheaths for use with our own ENT-2000 conventional endoscope, our ENT-1000 small diameter endoscope, our ENT-3000 portable endoscope with battery-powered LED light source and with ENT endoscopes manufactured by other companies. Slide-On EndoSheaths are made with materials using our own proprietary process that makes them slippery, allowing the health-care provider to easily slide the EndoSheath onto the insertion tube of an ENT endoscope. The user stretches the Slide-On EndoSheaths slightly until the proximal connector attaches to the strain relief of the ENT endoscope, allowing a snug fit. In addition, Slide-On ENT EndoSheaths have an optically clear window that fits securely over the ENT endoscope tip, preventing glare. After the procedure is completed, the health-care provider slides the EndoSheath off the endoscope and disposes of it. In general, ENT endoscopes do not contain air, water, suction or accessory channels, unlike endoscopes designed for use in urology, gastroenterology or pulmonology. Therefore, our standard Slide-On ENT EndoSheaths (“ENT SOS”), designed to be the only component that comes into contact with the patient, do not contain channels. Other of our ENT EndoSheaths, our TNE EndoSheaths and our EndoSheaths for urology, gastroenterology and pulmonology do contain channels. We have also developed our own ENT endoscopes, with state-of-the-art fiberoptic bundles, designed so that any necessary repairs are inexpensive and with other features that we believe make them competitive with ENT endoscopes of other major manufacturers.

As part of the Slide-On family of ENT EndoSheaths, we manufacture and sell a Slide-On ENT Channeled EndoSheath and a Slide-On ENT Sensory EndoSheath, both for our own flexible ENT-2000 endoscope and for ENT endoscopes manufactured by other companies. These EndoSheaths allow physicians to perform procedures in their offices using their conventional ENT endoscopes that otherwise they would have to perform using special ENT endoscopes that contain a channel. These special ENT endoscopes are expensive, and typically are found at hospitals.

The Slide-On ENT Channeled EndoSheath contains a 2.1mm channel within the Slide-On EndoSheath that the physician can use to perform biopsies or other therapeutic procedures. The Slide-On ENT Sensory EndoSheath is designed to provide ENT physicians the opportunity to perform Flexible Endoscopic Evaluation of Swallowing with Sensory Testing (“FEESST”) using their conventional endoscopes. FEESST, an alternative emerging procedure to modified barium swallow studies, is performed by the ENT physician using the Slide-On ENT Sensory EndoSheath that contains a channel through which air is pulsed to the larynx to elicit an airway protective reflex. The ENT physician, by observing the reaction to the air pulse, is able to diagnose, treat and manage patients with swallowing disorders with an emphasis on decreasing the risk of choking, coughing and aspirating food and liquids that can lead to aspiration pneumonia. Both of these EndoSheaths enhance the practice efficiency of physicians, as they enable the physicians to use their conventional ENT endoscope to perform tests in their offices, compared to traveling to a hospital to perform them with a special ENT endoscope. Often, by performing the tests in their offices, the ENT physician receives a higher reimbursement, compared to the reimbursement received when the test is performed in a hospital.

We manufacture and sell a TNE D scope with Slide-On EndoSheath System that is designed to allow ENT and GI physicians to view the esophagus transnasally, i.e. through the nose, compared to viewing it

transorally, i.e. through the mouth, as with a conventional gastroscope. Conventional gastroscopes require patients to be consciously sedated to counteract the gag reflex encountered when a gastroscope is inserted transorally. Our TNE D scope with Slide-On EndoSheath System, with its narrow diameter allowing transnasal passage, enables physicians to perform examinations in their office of a patient’s throat and esophagus for manifestations of gastroesophageal reflux disease (“GERD”) and other disorders. Millions of people in the United States suffer from some form of GERD affecting their vocal chords, esophagus or stomach.

The TNE D endoscope can also be used to evaluate patients with dysphagia, a condition broadly defined as a subjective or objective patient complaint of difficulty swallowing, or of coughing or choking while swallowing or eating. A physician performs this test if an oropharyngeal exam did not fully reveal the cause of the patient’s swallowing problem. Currently this procedure is performed in a hospital setting with conscious sedation and a special endoscope that contains a biopsy channel that doubles as an air-administration channel. The TNE D scope with Slide-On EndoSheath System is designed to allow these tests to be done by ENT and GI physicians in their offices, thus improving practice efficiency and lowering overall costs to the health care system. Both the diagnostic and therapeutic procedures have reimbursement codes, allowing physicians to receive payment for the service, and allowing us to measure the practice efficiencies presented by our products. We completed the development of the TNE D scope with Slide-On EndoSheath System in our fiscal year ended March 31, 2004 (“FY 04”).

In our fiscal year ended March 31, 2005 (“FY 05”), we received clearance from the FDA to market our TNE Bx flexible trans-nasal endoscope with Slide-On EndoSheath System. The TNE Bx is designed to allow ENT and GI physicians to view the esophagus transnasally, and to perform therapeutic procedures, such as biopsies, in an office setting.

Urology Endoscopes and EndoSheaths

We have developed a cystoscope (the “CST-2000”) with Slide-On EndoSheath System for use by urologists. In April 2004, we received clearance from the FDA to market the CST-2000 with Slide-On EndoSheath System. The CST-2000 with Slide-On EndoSheath System consists of two components—a reusable flexible endoscope incorporating our proprietary design, and a proprietary, sterile, disposable EndoSheath—functional when used together. The EndoSheath slides easily onto the insertion tube of the CST-2000, and contains a 2.1 millimeter channel for irrigation, air and suction capabilities. The EndoSheath is the only component that comes into contact with the patient, and is disposed of after each procedure. This allows the physician to avoid using harsh chemicals to reprocess the endoscope after each use. Avoiding these reprocessing steps allows the physician to increase the number of patients who can be examined in a given day. This improves the physician’s practice efficiency, while also ensuring a sterile insertion tube for each patient. In April 2004, CIDEX ®  OPA Solution, a common disinfectant used to reprocess cystoscopes, was contraindicated for the reprocessing of urological instruments that were to be used on patients with a history of bladder cancer. This was due to instances of allergic reactions to that disinfectant by patients who had undergone repeated cystoscopies. Using the EndoSheath also reduces the wear and tear on the CST-2000, further reducing costs of the physician’s practice.

Gastrointestinal and Pulmonary EndoSheath/Endoscope Systems

We have developed a family of proprietary flexible endoscope systems for GI and pulmonary applications consisting of two main components—a reusable flexible endoscope incorporating our proprietary design, and a proprietary, sterile, disposable EndoSheath. The EndoSheaths and endoscopes included in these systems are functional only when used together.

Industrial Segment

Under the Machida name, we design, manufacture and market flexible borescopes, which are similar in design to endoscopes and are used for inspection and quality-control functions in industrial applications, such as the inspection of aircraft engines and nuclear power plants. Through Machida, we were first to offer a flexible borescope with a grinding attachment that allows users to “blend”, or smooth, small cracks in small turbine blades of jet engines without disassembling the engine, which would involve significant expense and delay. We also offer a variety of ancillary products for use with flexible endoscopes and borescopes, such as light sources, cameras, adapters, accessories and imaging systems.

Sales and Marketing

Medical Segment

The end users of our disposable EndoSheaths, flexible endoscopes and related products are otolaryngologists (ENT doctors), urologists, gastroenterologists, pulmonologists and primary care physicians in hospitals, medical clinics and physicians’ offices. As of May 1, 2006, we had five sales and marketing employees. Since September 19, 2003 we have been distributing all of our products for the ENT markets in the U.S.A. and Canada through MENT under the Medtronic Agreement. From December 2004 to May 1, 2006, we distributed all of our products for the urology markets in the U.S.A. and Canada through MGU under the MGU Agreement. As of May 1, 2006 we will be distributing our urology products through our own independent network of sales representatives, and also have a domestic network of independent sales representatives for the GI and pulmonary product lines. We do not expect the termination of the MGU Agreement to have any negative effect on our relationship with MENT. We distribute all our products internationally through 17 independent international distributors in Europe, Australia, the Middle East and the Far East. We periodically evaluate the effectiveness of our sales channels, and may change them if we believe a different method will increase our revenues.

Although we have no specific plans or commitments in this regard, we may also license to one or more third parties rights to manufacture and sell reusable flexible endoscopes incorporating our proprietary design features, while retaining the rights to manufacture and sell the EndoSheaths used with these endoscopes.

Industrial Segment

Our borescopes are sold both directly by our Machida subsidiary and through independent sales representatives.

International Sales and Sales to Major Customers

Sales to unaffiliated customers outside of the United States were approximately $2,981,000, $3,370,000 and $4,122,000 for FY 04, FY 05 and our fiscal year ended March 31, 2006 (“FY 06”), respectively. In FY 06, sales to foreign customers accounted for approximately 42% of the annual net sales of our medical segment, and 22% of the annual net sales of our industrial segment. In FY 05, sales to foreign customers accounted for approximately 38% of the annual net sales of our medical segment and 19% of net annual sales of our industrial segment. In FY 04, sales to foreign customers accounted for approximately 34% of the annual net sales of our medical segment and 21% of net annual sales of our industrial segment. We expect to sell our medical segment products outside of the United States in the fiscal year ending March 31, 2007 (“FY 07”) in a higher proportion than in FY 06, due primarily to planned higher sales of ENT and urology products to our current distributor network, and to planned expansion of our distributor network to countries where we do not currently have a presence. However, there can be no assurance that we will meet our goals. Finding international distributors with the desired skills, market knowledge and financial capabilities can be a difficult process and take considerable time to

accomplish. We currently sell certain models of our borescopes and repair services outside of the United States.

During FY 04, Medtronic, Inc. and Gyrus International Ltd. accounted for 30% and 10% of net sales, respectively. During FY 05, Medtronic, Inc. accounted for 35% of net sales. During FY 06, Medtronic, Inc. and Gyrus International, Ltd. accounted for 41% and 12% of net sales, respectively.

Backlog

We had an order backlog of approximately $228,000 at March 31, 2006, compared to a backlog of approximately $1,118,000 at March 31, 2005. The backlog in 2006 was comprised of approximately $136,000 and $92,000 for the medical and industrial segments, respectively, compared to approximately $979,000 and $139,000 for those same segments at March 31 2005. The decrease in the medical segment backlog is primarily due to a decrease in endoscopes and EndoSheaths for delivery to MGU. The decrease in the backlog of the industrial segment was due primarily to a decrease in the amount of orders from that segment’s existing customer base. We expect to fill over 75% of our order backlog in FY 07.

Manufacturing and Suppliers

We produce EndoSheaths at our Natick, Massachusetts facility using raw materials, molded parts and components purchased from independent vendors, some of which are manufactured to our specifications. We manufacture our ENT EndoSheaths using proprietary processes that utilize forming and bonding machines that were manufactured to our specifications. In addition, we use molded purchased parts and a worldwide, royalty-free exclusive license, negotiated with a third party, to manufacture optically clear windows. This license is for windows used in our EndoSheaths for ENT and intubation endoscopes. We have also negotiated a non-exclusive license to include the same technology in our EndoSheaths for use in other markets. Currently, we are using this technology in the EndoSheaths for the urology and pulmonary markets.

We assemble the GI and pulmonary EndoSheaths using molded and extruded components purchased from independent vendors, some of which are manufactured to our specifications. Most purchased components are available from multiple sources. With the exception of our supply agreement with Pentax Corporation (“Pentax”), discussed below, we have no long-term agreements with any of our vendors or suppliers, and we purchase our required components and supplies on a purchase-order basis. We contract with third parties for the sterilization of all of our EndoSheaths.

In June 2003, we entered into a Contract Manufacturing Agreement, a Loan Agreement and a Pledge Agreement (collectively, the “3BY Agreements”) with Three BY Ltd., an Israeli company (“3BY”). The purpose of the 3BY Agreements was to lower the manufacturing cost of our EndoSheath products, and to provide for increased manufacturing capacity of our ENT EndoSheaths. The 3BY Agreements provide for, among other things, the manufacture of certain of our products by 3BY, and a loan of up to $267,500 from us to 3BY for the purchase and installation of certain manufacturing equipment by 3BY, at 3BY’s facility, to be used to manufacture certain of our products. As of December 31, 2003, we had advanced $267,500 to 3BY. During FY 05 it became apparent we would not be producing the quantity of ENT EndoSheaths that we had anticipated, increasing the risk associated with the repayment of the advance. To eliminate this risk and secure title to the equipment, we took ownership of the equipment, as provided for in the Loan Agreement, effective October 1, 2004.

We received production from 3BY from September 30, 2004 through March 31, 2005. In May 2005, we realized this transition was not going to be as successful as we had planned, due to a variety of issues surrounding quality, consistency of personnel and cost. As a result, we decided to bring the manufacture of all EndoSheaths back to our facility in Natick, MA.   On October 2, 2005, the Company and 3BY entered into a Termination and Settlement Agreement (the “Termination Agreement”) pursuant to which the Company and 3BY terminated the 3BY Agreements. Included in the Termination Agreement is a

provision for the Company to purchase from 3BY 180,000 units of the Company’s basic ENT Slide-On EndoSheath. This purchase order was completed in May 2006, and the equipment located at 3BY was returned to our Natick, MA facility. In addition, the Company will pay 3BY $16,700 for costs related to equipment purchased by 3BY.

We assemble our flexible endoscopes for the medical and industrial segments at our Orangeburg, New York facility using purchased components and subassemblies, as well as certain proprietary components produced by us. Most purchased components and subassemblies are available from more than one supplier. However, certain critical components, such as image bundles for all endoscopes manufactured for the medical segment and operator control bodies for sigmoidoscopes, are currently being purchased solely from Pentax, who competes with our medical segment in the endoscope market. These components are being purchased pursuant to a supply agreement, which expires in March 2007, and will automatically renew for additional two-year periods, unless it is terminated by either party with six months prior written notice of intent not to renew. We believe that while substitute components, which are currently produced by sources other than Pentax, would be available, such substitute components may be more expensive and of a lower quality and may require a redesign of our endoscope and additional regulatory clearances. Moreover, such substitute components may not be immediately available in quantities needed by us. Our inability to obtain a sufficient quantity of such critical components on favorable terms could materially adversely affect our business. To date, we have encountered no significant difficulties or delays in obtaining a sufficient quantity of such critical components or subassemblies for our medical endoscopes. However, there can be no assurance that no difficulties or delays will be experienced in the future as we increase our manufacturing operations. The industrial segment purchased approximately $1,828,000 and $1,867,000 worth of products, for the manufacture of both medical and industrial products, from Pentax in FY 06 and FY 05, respectively.

Our borescopes are assembled using components and subassemblies purchased from independent vendors. While most components and subassemblies are currently available from more than one supplier, certain critical components are currently purchased only from Machida Endoscope Company, Ltd., an unaffiliated Japanese company. The failure of us to obtain a sufficient quantity of such components on favorable terms could materially adversely affect our business.

We purchase light sources, cameras, adapters, accessories and imaging systems for industrial applications from a variety of vendors.

Competition

We believe that the primary competitive factors in the medical market for flexible endoscopes and EndoSheaths are the safety and effectiveness (including optical quality) of the products offered, ease of product use, product reliability, price, physician familiarity with the manufacturer and its products and third-party reimbursement policies. In our industrial markets, we believe that product effectiveness, ease of product use, product reliability and price are the principal competitive factors. Our ability to compete in our markets is affected by our product development and innovation capabilities, our ability to obtain required regulatory clearances, our ability to protect the proprietary technology included in its products, our manufacturing and marketing skills and our ability to attract and retain skilled employees.

The flexible endoscopes and related products currently sold and under development by us face competition primarily from medical products companies such as Olympus and Pentax. In addition, any company that is able to significantly redesign conventional flexible endoscopes to simplify the disinfection process, or significantly improve the current methods of disinfecting flexible endoscopes, would provide competition for our products. The principal competitors for our industrial products are Olympus and Welch Allyn, Inc. In FY 05, a competing manufacturer of EndoSheaths emerged in the European market. We believe this competitor is selling products with features that are within the claims of our patents. We are defending, and intend to continue to defend, our intellectual property rights vigorously. We believe our product quality, breadth of product offerings and financial resources are superior to that competitor’s. In FY 06, the existence of the competitor did not inhibit us from increasing the sales of ENT EndoSheaths in our European market.

Our competitors and some potential competitors have greater financial resources, research and development personnel and manufacturing and marketing capabilities than we do. In addition, it is possible that other large health care companies may enter the flexible endoscope market in the future.

Patents and Proprietary Rights

Our success depends in part on our ability to maintain patent protection for our products, to preserve our trade secrets and to operate without infringing the proprietary rights of third parties. Our strategy regarding the protection of proprietary rights and innovations is to seek patents on those portions of our technology that we believe are patentable, and to protect as trade secrets other confidential and proprietary information.

We, along with our subsidiaries, currently hold 29 U.S. patents and have 9 U.S. patent applications pending. In addition, we have 20 foreign patents and have 17 foreign patent applications pending. All of these patents relate to our disposable EndoSheaths and reusable flexible endoscopes. The issued patents will expire on various dates in the years 2006 through 2022. In addition to those listed above, we have 2 U.S. patents issued and 5 U.S. patents  pending in the U.S. and 12 corresponding foreign applications for Complementary Metal Oxide Semiconductor (“CMOS”) image sensor design patents. There can be no assurance that our pending patent applications will result in patents being issued or that our competitors will not circumvent, or challenge the validity of, any patents issued to us. In addition, in the event that another party infringes our patent rights, the enforcement of such rights is at our option and can be a lengthy and costly process, with no guarantee of success.

Some of the technology used in, and that may be important to, our products is not covered by any patent or patent application. We seek to maintain the confidentiality of our proprietary technology by requiring all employees who work with proprietary information to sign confidentiality agreements and by limiting access by outside parties to such confidential information. However, there can be no assurance that these measures will prevent the unauthorized disclosure or use of this information, or that others will not be able to independently develop such information. Moreover, as is the case with our patent rights, the enforcement of our trade secret rights can be lengthy and costly, with no guarantee of success.

To date, no claims have been brought against us alleging that our technology or products infringe any intellectual property rights of others. However, there can be no assurance that such claims will not be brought against us in the future or that any such claims will not be successful.

Government Regulation

The medical products that we currently market and that are under development are regulated as medical devices by the FDA under the federal Food, Drug and Cosmetic Act (the “FDC Act”) and require regulatory clearance prior to commercialization in the United States. Under the FDC Act, the FDA regulates clinical testing, manufacturing, labeling, distribution and promotion of medical devices in the

United States. Various states and other countries in which our products may be sold in the future may impose additional regulatory requirements.

Following the enactment of the Medical Device Amendments to the FDC Act in May 1976, the FDA classified medical devices in commercial distribution into one of three classes, Class I, II, or III. This classification is based on the controls necessary to reasonably ensure the safety and effectiveness of the medical device. Class I devices are those devices whose safety and effectiveness can reasonably be ensured through general controls, such as adequate labeling, pre-market notification, and adherence to the FDA’s Quality System Regulations (“QSR”). Some Class I devices are further exempted from some of the general controls. Class II devices are those devices whose safety and effectiveness can reasonably be ensured through the use of special controls, such as performance standards, post-market surveillance, patient registries and FDA guidelines. Class III devices are devices that must receive pre-market approval by the FDA to ensure their safety and effectiveness. Generally, Class III devices are limited to life-sustaining, life-supporting or implantable devices.

If a manufacturer or distributor of medical devices can establish that a new device is “substantially equivalent” to a legally marketed Class I or Class II medical device or to a Class III medical device for which the FDA has not required pre-market approval, the manufacturer or distributor may seek FDA marketing clearance for the device by filing a 510(k) Pre-market Notification. The 510(k) Pre-market Notification and the claim of substantial equivalence may have to be supported by various types of information indicating that the device is as safe and effective for its intended use as a legally marketed predicate device.

Following submission of the 510(k) Pre-market Notification, the manufacturer or distributor may not place the device into commercial distribution until an order is issued by the FDA. By regulation, the FDA has no specific time limit by which it must respond to a 510(k) Pre-market Notification. At this time, the FDA typically responds to the submission of a 510(k) Pre-market Notification within approximately 90 days. The FDA may declare that the device is “substantially equivalent” to another legally marketed device and allow the proposed device to be marketed in the United States. The FDA may, however, determine that the proposed device is not substantially equivalent, or may require further information, such as additional test data, before the FDA is able to make a determination regarding substantial equivalence. Such determination or request for additional information could delay the market introduction of our products and could have a material adverse effect on us.

Flexible endoscopes, EndoSheaths, and accessory products have been classified by the FDA as Class II devices, and a Section 510(k) Pre-market Notification must be submitted to and cleared by the FDA before such devices can be sold. We have received FDA clearance of our 510(k) Pre-market Notifications for all of our products that require clearance. We expect that we will be required to obtain 510(k) clearance for each additional disposable EndoSheath/reusable flexible endoscope system that we develop in the future.

Effective July 1998, our Natick, Massachusetts facility was certified as having established, and we continue to maintain, a quality system that meets the requirements of ISO 9001 and EN 46001. In addition, the certification confirmed conformance to the essential requirements of the Council Directive 93/42/EEC, and application of this system at every stage from initial design controls to final product release to distribution. The Orangeburg, NY facility falls under the Natick quality system, and is audited by members of the Natick Quality Assurance department. In August 2005, our Natick quality system was re-certified for continued conformance to ISO 13485. In addition to the three-year certification audits, we undergo annual surveillance audits to confirm that we are maintaining our quality system. The Natick and Orangeburg facilities are registered with the FDA as medical device manufacturers. As a result, these facilities are subject to the FDA’s QSR, which regulate their design, manufacturing, testing, quality control and documentation procedures. We are also required to comply with the FDA’s labeling requirements, as well

as its information reporting regulations. The export of medical devices is also subject to regulation in certain instances. Our compliance with these various regulatory requirements will be monitored through periodic inspections by the FDA and audits by independent authorities to maintain our ISO 13485 status. 3BY is certified as meeting the standards of ISO 9001 and ISO 13485, and is registered with the FDA as a contract manufacturer.

The process of obtaining required regulatory clearances can be lengthy and expensive, and compliance with ISO 13485 and the FDA’s QSR and regulatory requirements can be burdensome. Moreover, there can be no assurance that the required regulatory clearances will be obtained, and those obtained may include significant limitations on the uses of the product in question. In addition, changes in existing regulations or the adoption of new regulations could make regulatory compliance by us more difficult in the future. The failure to obtain the required regulatory clearances or to comply with applicable regulations may result in fines, delays or suspensions of clearances, seizures, recalls of products, operating restrictions or criminal prosecutions, and could have a material adverse effect on our operations.

Third-Party Reimbursement

Hospitals, medical clinics and physicians’ offices that purchase medical devices such as our EndoSheaths and flexible endoscopes generally rely on third-party payers, such as Medicare, Medicaid and private health insurance plans to pay for some or all of the costs of the screening, diagnostic and therapeutic procedures performed with these devices. Whether a particular procedure qualifies for third-party reimbursement depends upon such factors as the safety and effectiveness of the procedure, and reimbursement may be denied if the medical device used is experimental or was used for a non-approved indication. We believe, based upon our knowledge of third-party reimbursement practices, advice from consultants in this area and our own selling experience, that third-party reimbursement is available for most procedures that utilize our products. However, not all third-party payers will reimburse health-care providers separately for the cost of our EndoSheath.

Third-party payers use a variety of mechanisms to determine reimbursement amounts for procedures such as endoscopies. In most cases, payment is based upon amounts determined by the Centers for Medicare & Medicaid Services (“CMS”), a governmental agency under the U.S. Department of Health and Human Services. As part of its responsibilities, CMS assigns relative value units (“RVUs”) to over 10,000 physician services. An RVU for a specific procedure is comprised of values for work, practice expense and malpractice insurance, and when multiplied by a Conversion Factor, represents a dollar value for a specific procedure.

CMS has multiple fee schedules to accommodate payment to the hospital, the ambulatory surgery center (“ASC”) and the physician. Physician services are reimbursed based on where the service is performed. If the physician performs the service in his or her office and the office bears the burden of overhead costs, the physician is reimbursed based on non-facility relative value units to accommodate the overhead costs. If the physician performs the service within a hospital or ASC, the payment is lower, reflecting the physician work and malpractice expenses, but without the overhead since the facility bears that financial burden. The 2006 physician fee schedule did not change significantly from 2005. There was little change in hospital outpatient payments under Medicare, as well. Based upon a review of calendar year 2006 fee schedules for the hospital outpatient and physician payment for procedures that utilize our ENT EndoSheath, ENT Channeled EndoSheath, ENT Sensory EndoSheath, TNE D EndoSheath and TNE Bx EndoSheath, physicians will receive between 49% and 154% more by performing procedures in their offices, than if they performed those procedures in hospitals, due to the increased office expense for the purchase of the device. For a diagnostic cystoscopy, the physician will receive 87% more by doing the procedure in his or her office, than if they performed that procedure in the hospital, again because the increase in fee accommodates the cost of the device purchased by the physician practice.

We believe that, based upon the resource-based practice expense RVU, the number of procedures performed in non-facility settings will increase. This increase will be due primarily to the increased differential in payments that physicians will receive for performing these procedures. As these procedures move to non-facility settings, physicians will have to contend with the cost and effort required to reprocess endoscopes. We believe our disposable EndoSheaths, which eliminate the time and cost of cleaning endoscopes, will provide an economically beneficial alternative to the use of endoscopes without EndoSheaths. This economic benefit is based upon the provider not having to purchase multiple endoscopes, expensive special endoscopes with channels and expensive sterilizing equipment and supplies as well as not having to spend valuable time cleaning endoscopes. In addition, we believe that with approximately 77 million people in the United States over the age of 50, there will be an increase in the potential number of procedures that physicians will be performing. We believe our disposable EndoSheaths combined with the resource-based system for setting values for physician services together represent a sound economic solution for physicians to perform diagnostic and therapeutic procedures in their offices.

There can be no assurance that third-party reimbursement will continue to be available for procedures performed with our products or that the cost of our EndoSheaths would be covered by such reimbursement in the future. In addition, reimbursement standards and rates may change. We believe that the inability of users of our GI and pulmonary EndoSheaths to obtain adequate reimbursement from third-party payors has had a materially adverse effect on us.

Product Liability and Insurance

The nature of our products exposes the Company to significant product liability risks. We maintain product liability insurance with coverage limits of $2,000,000 per year. We believe that this level of coverage is adequate, given our past sales levels and our anticipated sales levels for FY 07. We evaluate the adequacy of this coverage annually to determine if we need to increase it. No product liability claims have been brought against us to date. However, there can be no assurance that product liability insurance will continue to be available to us on acceptable terms, or that product liability claims in excess of our insurance coverage, if any, will not be successfully asserted against us in the future.

Research and Development

We believe that our future success depends in part upon our ability to develop new products and enhance our existing products. In the past, we have devoted significant resources to research and development.

Our research and development expenses, excluding stock-based compensation charges and credits, in FY 04, FY 05 and FY 06 were approximately $689,000, $1,422,000 and $2,228,000, respectively. When non-cash stock-based compensation charges and credits are included, our research and development expenses in FY 04, FY 05 and FY 06 were approximately $3,272,000, $1,422,000 and $2,234,000, respectively.

In FY 04, our research and development efforts focused on completing products for the ENT Slide-On Sensory EndoSheath and the TNE D endoscope with Slide-On EndoSheath. In addition, we completed the development of our ENT-1000 small diameter endoscope with Slide-On EndoSheath System. In FY 05, our research and development efforts focused on the introduction of our TNE Bx and cystoscopes, each with Slide-On EndoSheaths. The ENT Slide-On Channeled EndoSheath, the ENT Slide-On Sensory EndoSheath, the TNE D and TNE Bx endoscopes and their Slide-On EndoSheaths are all marketed and sold to physicians in the ENT market by MENT, our exclusive distributor for these products in the U.S.A. and Canada. We also market all these products internationally through our network of independent distributors. In FY 06, our research and development efforts focused on the introduction of our ENT-3000 portable endoscope with battery-powered LED light source, and efforts to establish processes for high

volume and low cost manufacture of EndoSheaths. In addition, we incurred higher spending for personnel and supplies for a variety of programs, including a new D-shaped endoscope design and the design of a new family of video endoscopes.

Our plans for product development in FY 07 include the design of a new family of videoscopes, design and cost improvements to our TNE D, TNE Bx and cystoscopes and to continue to establish processes for low cost manufacture of EndoSheaths. Also, we expect our R&D expense will include development efforts regarding new technologies that will enhance the competitive position of our endoscopes. Our goal remains to release products where we believe our EndoSheath technology can increase physicians’ practice efficiency, provide for patient safety and result in lower costs to provide medical care.

Employees

As of April 30, 2006, the Company had 89 employees, including temporary employees. No Company employees are represented by a labor union. The Company believes that its employee relations are good. The Company’s success depends in large part upon its ability to attract and retain highly qualified scientific, management, sales and marketing personnel.

Executive Officers of the Company

Ron Hadani, age 49, has been our President and Chief Executive Officer since February 2003. From 2001 to February 1, 2003, Mr. Hadani was a self-employed consultant, working in various capacities with early-stage companies in the U.S and Israel. From 1999-2001, he served as President of Kontran Medical, LLC. From 1997-1999 he served as Divisional Vice President of U.S. Surgical, a division of Tyco International, Ltd.

James A. Tracy, age 57, joined the Company in July 1997 and was elected Vice President Finance in August 1997. From 1994 to 1996 Mr. Tracy was the Vice President Finance at ORS Environmental Systems, a manufacturer of environmental equipment and sensor instrumentation. He received a CPA certificate in 1975.

Mark S. Landman, age 52, has served as Vice President Operations of the medical segment since July 1999. Mr. Landman joined the Company in January 1991, and served in a variety of roles in product development, project management, manufacturing engineering and material control from that date to July 1999.

Jitendra Patel, age 53, has served as Vice President Sales and Marketing of the industrial segment since August 2000. From August 1995 to July 2000, he served as the Manager of Sales and Marketing for that segment.

Gerald D. Erb, age 54, has served as Vice President Marketing and Sales for the medical segment since September 27, 2004. From 2001 to September 2004, Mr. Erb served as principal of Erb Associates, a strategic consulting practice for medical services, information technology and imaging device companies. From 1998 to 2000, Mr. Erb served as the Chief Executive Officer of Secure Archive, Inc., a cardiology information technology software company.

Kenneth A. Spector, age 54, has served as Vice President Research & Development for the Company since September 27, 2004. From 2000 to September 2004, Mr. Spector served as a principal at Kasal Consulting, a consulting practice dedicated to developing new products for the medical device industry. From 1998 to 2000, Mr. Spector served as the Vice President Research & Development for Cortek, Inc., a start-up company that developed medical devices for the spinal fusion market.

Officers are elected on an annual basis and serve at the discretion of the Board of Directors.

Item 1A                    Risk Factors

You should carefully consider the risks and uncertainties we describe below and the other information in this Annual Report or incorporated by reference before deciding to invest in, or retain, shares of our common stock. These are not the only risks and uncertainties that we face. Additional risks and uncertainties that we do not currently know about or that we currently believe are immaterial, or that we have not predicted, may also harm our business operations or adversely affect us. If any of these risks or uncertainties actually occurs, our business, financial condition, operating results or liquidity could be materially harmed.

We have a history of operating losses and we may not achieve or maintain profitability in the future.

We have incurred substantial losses since our inception, and there can be no assurance that we will achieve a profitable level of operations in the future. We anticipate a negative cash flow during FY 07, due primarily to spending for research and development, operations and capital expenditures. We had cash and marketable securities totaling $6.1 million as of March 31, 2006. Although we do not anticipate the need for additional financing in FY 07, management may seek new financing, if terms are favorable. However, there can be no assurance that such financing will be available on terms acceptable to us, if at all.

Reimbursements from third-party health care payers is uncertain due to factors beyond our control and changes in third-party health care payers’ policies could adversely affect our sales growth.

There can be no assurance that third-party reimbursement will continue to be available for procedures performed with our products. In addition, reimbursement standards and rates may change. We believe that the failure of users of our GI and pulmonary products to obtain adequate reimbursement from third-party payers has had a materially adverse effect on our sales.

Our products and manufacturing practices are subject to regulation by the FDA and by other state and foreign regulatory agencies.

Our products are medical devices and therefore subject to extensive regulation in the United States and in the foreign countries where we do business. The process of obtaining required regulatory clearances can be lengthy and expensive, and compliance with the FDA’s Quality Systems Regulation can be burdensome. Moreover, there can be no assurance that the required regulatory clearances will be obtained, and those obtained may include significant limitations on the uses of the product in question. In addition, changes in existing regulations or the adoption of new regulations could make regulatory compliance by us more difficult in the future. The failure to obtain the required regulatory clearances or to comply with applicable regulations may result in fines, delays, suspensions of clearances, seizures, recalls of products, operating restrictions or criminal prosecutions, and could have a material adverse effect on our operations.

We currently purchase certain critical components from a manufacturer under a supply agreement, and if that manufacturer is unable or unwilling to produce our product requirements in quality and quantity to our satisfaction, our business will be harmed.

Certain critical components of our products, such as image bundles, are currently being purchased solely from Pentax, a competitor of ours. These components are being purchased pursuant to a supply agreement that expires in March 2007, and is renewable automatically for two years. It is subject to termination by mutual consent or upon breach or bankruptcy. We believe that while substitute components, which are currently produced by sources other than Pentax, would be available, such substitute components may be more expensive and of a lower quality and may require a redesign of our endoscope and additional regulatory clearances. Moreover, such substitute components may not be

immediately available in quantities needed by us. Our inability to obtain a sufficient quantity of such critical components on favorable terms could materially adversely affect our business. In addition, our industrial borescopes are assembled using components and subassemblies purchased from independent vendors. While most components and subassemblies are currently available from more than one supplier, certain critical components are currently purchased only from Pentax and Machida Endoscope Company, Ltd. The failure of us to obtain a sufficient quantity of such components on favorable terms could materially adversely affect our business.

If we do not continue to develop and commercialize new products and identify new markets for our products and technology, we may not remain competitive, and our revenues and operating results could suffer.

The endoscopy industry is subject to continuous technological development and product innovation. If we do not continue to be innovative in the development of new products and applications, our competitive position will likely deteriorate as other companies successfully design and commercialize new products and applications. Accordingly, our success depends in part on developing new and innovative applications of our endoscopy technology and identifying new markets for and applications of existing products and technology. If we are unable to develop and commercialize new products and identify new markets for our products and technology, our products and technology could become obsolete and our revenues and operating results could be adversely affected.

Competition in the medical device industry is intense and many of our competitors have greater resources than we do.

The flexible endoscopes and related products currently sold and under development by us face competition primarily from medical products companies such as Olympus and Pentax. In addition, any company that is able to significantly redesign conventional flexible endoscopes to simplify the cleaning process, or significantly improve the current methods of cleaning flexible endoscopes, would provide competition for our products. The principal competitors for our industrial products are Olympus and Welch Allyn. Many of our competitors and potential competitors have greater financial resources, research and development personnel, and manufacturing and marketing capabilities than we have. Our competitors could utilize their greater financial resources to acquire other companies to gain enhanced name recognition and market share, as well as to acquire new technologies or products that could effectively compete with our product lines. In addition, it is possible that other large health care companies may enter the flexible endoscope market in the future.

Our ability to compete effectively depends upon our ability to distinguish our company and our products from our competitors and their products. Factors affecting our competitive position include:

·        product performance and design;

·        ability to sell products tailored to meet the applications needs of clients and patients;

·        quality of customer support;

·        product pricing;

·        product safety;

·        sales, marketing and distribution capabilities;

·        success and timing of new product development and introductions; and

·        intellectual property protection.

We may not be able to protect our intellectual property rights or technology effectively.

Our success depends in part on our ability to maintain patent protection for our products, to preserve our trade secrets and to operate without infringing the proprietary rights of third parties. There can be no assurance that our pending patent applications will result in patents being issued or that our competitors will not circumvent, or challenge the validity of, any patents issued to us. There can be no assurance that measures taken by us to protect our proprietary information will prevent the unauthorized disclosure or use of this information, or that others will not be able to independently develop such information. In addition, in the event that another party infringes our patent rights or other proprietary rights, the enforcement of such rights is at our option and can be a lengthy and costly process, with no guarantee of success. Moreover, there can be no assurance that claims alleging infringement by us of other’s proprietary rights will not be brought against us in the future or that any such claims will not be successful. If we are unable to maintain the proprietary nature of our technologies, our ability to market or be competitive with respect to some or all of our products may be affected, which could reduce our sales and affect our ability to become profitable.

Product liability suits against us may result in expensive and time consuming litigation, payment of substantial damages and an increase in our insurance rates.

The development, manufacture and sale of medical products involves a significant risk of product liability claims. We maintain product liability insurance with coverage limits of $2,000,000 per year. We believe that this level of coverage is adequate, given our past sales levels, our anticipated sales levels for FY 07 and our claims experience. We will reevaluate the adequacy of this coverage when and if our sales substantially increase, or another need arises. No product liability claims have been brought against us to date.  However, there can be no assurance that product liability insurance will continue to be available to us on acceptable terms, or that product liability claims in excess of our insurance coverage, if any, will not be successfully asserted against us in the future.

We sell our products in numerous international markets.

Our operating results may suffer if we are unable to manage our international operations effectively.

We sell our products in foreign countries, and we therefore are subject to risks associated with having international operations. Sales to unaffiliated customers outside of the United States were approximately $2,981,000, $3,370,000 and $4,122,000 for the fiscal years ended March 31, 2004, 2005 and 2006, respectively. Our international sales are subject to a number of risks, including:

·        foreign certification and regulatory requirements;

·        maintenance of agreements with competent distributors;

·        import and export controls;

·        currency exchange fluctuation; and

·        political and economic instability.

We may be unable to attract and retain management and other personnel we need to succeed.

Our success depends on the services of our senior management and other key research and development, manufacturing, sales and marketing employees. The loss of the services of one or more of these officers and/or employees could have a material adverse effect on our business.

Item 1B.                Unresolved Staff Comments

None.