SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Quarterly report pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2004

Commission file number    0-28288

CARDIOGENESIS CORPORATION

26632 Towne Center Drive
Suite 320
Foothill Ranch, California 92610
(Address of principal executive offices)

(714) 649-5000
(Registrant’s telephone number, including area code)

     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.

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2.)

Yes o No x

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

41,388,994 shares of Common Stock, no par value
As of October 31, 2004

CARDIOGENESIS CORPORATION
TABLE OF CONTENTS

CARDIOGENESIS CORPORATION

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

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CARDIOGENESIS CORPORATION

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

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CARDIOGENESIS CORPORATION

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

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CARDIOGENESIS CORPORATION

1. Summary of Significant Accounting Policies:

Interim Financial Information (unaudited):

          The interim financial statements in this report reflect all adjustments, consisting of normal recurring adjustments, that are, in the opinion of management, necessary for a fair presentation of the results of operations and cash flows for the interim periods covered and of the financial position of the Company at the interim balance sheet date. Results for interim periods are not necessarily indicative of results to be expected for the full fiscal year. The year-end balance sheet information was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America. These financial statements should be read in conjunction with CardioGenesis’ audited financial statements and notes thereto for the year ended December 31, 2003, contained in the Company’s Annual Report on Form 10-K, as filed with the U.S. Securities and Exchange Commission (“SEC”).

          These financial statements contemplate the realization of assets and the satisfaction of liabilities in the normal course of business. CardioGenesis has sustained significant operating losses for the last several years and may continue to incur losses in the future. Management believes its cash balance as of September 30, 2004 is sufficient to meet the Company’s capital and operating requirements for the next 12 months.

          CardioGenesis may require additional financing in the future. There can be no assurance that CardioGenesis will be able to obtain additional debt or equity financing, if and when needed, on terms acceptable to the Company. Any additional debt or equity financing may involve substantial dilution to CardioGenesis’ stockholders, restrictive covenants or high interest costs. The failure to raise needed funds on sufficiently favorable terms could have a material adverse effect on CardioGenesis’ business, operating results and financial condition. CardioGenesis’ long term liquidity also depends upon its ability to increase revenues from the sale of its products and achieve profitability. The failure to achieve these goals could have a material adverse effect on the business, operating results and financial condition.

Net Loss Per Share:

          Basic earnings per share (“EPS”) is computed by dividing the net loss by the weighted average number of common shares outstanding for the period. Diluted EPS is computed giving effect to all dilutive potential common shares that were outstanding during the period. Dilutive potential common shares consist of incremental shares issuable upon the exercise of stock options and warrants using the “treasury stock” method.

          Options to purchase 4,175,710 and 4,477,290 shares of common stock were outstanding at September 30, 2004 and 2003, respectively. Warrants to purchase 275,000 shares of common stock at prices ranging from $.35 to $.44 per share were outstanding as of September 30, 2004. Warrants to purchase 75,000 shares of common stock at $1.63 per share were outstanding as of September 30, 2004 and 2003. Warrants to purchase 3,139,535 shares of common stock at a price of $1.37 per share were outstanding as of September 30, 2004. Both the options and warrants were not included in the calculation of diluted EPS because their inclusion would have been anti-dilutive.

2. Inventories:

          Inventories are stated at lower of cost (first-in, first-out) or market and consist of the following (in thousands):

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3. Stock-Based Compensation:

          The Company has adopted the disclosure only provisions of SFAS 123, as amended by SFAS 148 “Accounting for Stock-Based Compensation, Transition and Disclosure”. CardioGenesis, however, continues to apply APB 25 and related interpretations in accounting for its plans and follows the aforementioned disclosure-only provisions of SFAS 123, as amended by SFAS 148. Had compensation cost for the Stock Option Plan, the Director’s Stock Option Plan and the Employee Stock Purchase Plan been determined based on the fair value of the options at the grant date for awards in the three and nine months ended September 30, 2004 and 2003, consistent with the provisions of SFAS 123, CardioGenesis’ net loss and net loss per share would have changed to the pro forma amounts indicated below (in thousands, except per share amounts):

          The above pro-forma disclosures are not necessarily representative of the effects on reported net (loss) income for future years. The aggregate fair value and weighted average fair value per share of options granted in the three months ended September 30, 2004 and 2003 were $50,000 and $86,000 and $0.47 and $0.86, respectively. The aggregate fair value and weighted average fair value per share of options granted in the nine months ended September 30, 2004 and 2003 were $574,000 and $590,000 and $0.64 and $0.31, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model.

4. Commitments and Contingencies:

           In November 2003, the Company’s employment relationship with Darrell Eckstein, CardioGenesis’ former President, Chief Operating Officer, Acting Chief Financial Officer, Chief Accounting Officer, Treasurer and Secretary was terminated. In connection with his departure, Mr. Eckstein has made certain breach of contract claims arising out of his employment agreement with the Company, as well as certain tort claims and is seeking unspecified monetary damages. Pursuant to the terms of Mr. Eckstein’s employment agreement, the matter has been submitted to binding arbitration. The Company believes Mr. Eckstein’s claims are without merit and is vigorously defending against these claims. However, if Mr. Eckstein were to prevail on some or all of his claims, the Company cannot give any assurances that such claims would not have a material adverse effect on the Company’s financial condition, results of operations or cash flows. Because of the preliminary stage of this case, an estimate of potential damages, if any, would be premature and speculative. As a result, the Company has not made any such estimate.

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5. Recently Issued Accounting Standards

     In December 2003, the FASB issued Interpretation No. 46R (“FIN 46R”), a revision to FIN 46, “Consolidation of Variable Interest Entities.” FIN 46R clarifies some of the provisions of FIN 46 and exempts certain entities from its requirements. FIN 46R is effective at the end of the first interim period ending after March 15, 2004. Entities that have adopted FIN 46 prior to this effective date can continue to apply the provisions of FIN 46 until the effective date of FIN 46R. The adoption of FIN 46R did not have an effect on the Company’s consolidated financial statements.

     In March 2004, the Emerging Issues Task Force finalized its consensus on EITF Issue 03-6, “Participating Securities and the Two-Class Method Under FASB Statement No. 128, Earnings Per share” (EITF 03-6). EITF 03-6 clarifies what constitutes a participating security and requires the use of the two-class method for computing basic earnings per share when participating convertible securities exist. EITF 03-6 is effective for fiscal periods beginning after March 31, 2004. Adoption of EITF 03-6 is not expected to have a material effect on our consolidated financial statements.

6. Subsequent Event:

     On October 27, 2004, the Company completed a financing transaction with Laurus Master Fund, Ltd, a Cayman Islands corporation (“Laurus”), pursuant to which the Company issued a Secured Convertible Term Note (the “Note”) in the aggregate principal amount of $6.0 million and a warrant to purchase an aggregate of 2,640,000 shares of the Company’s common stock to Laurus in a private offering. Net proceeds to the Company from the financing, after payment of fees and expenses to Laurus and its affiliates, were $5,754,500, $2,877,250 of which was received by the Company and $2,877,250 of which was deposited in a restricted cash account. Funds deposited in the restricted cash account will only be released to the Company, if at all, upon satisfaction of certain conditions.

     The Note matures on October 26, 2007, absent earlier redemption by the Company or earlier conversion by Laurus. Annual interest on the Note is equal to the “prime rate” published in The Wall Street Journal from time to time, plus two percent (2.0%), provided, that, such annual rate of interest may not be less than six and one-half percent (6.5%), subject to certain downward adjustments resulting from certain increases in the market price of the Company’s common stock. Interest on the Note is payable monthly in arrears on the first day of each month during the term of the Note, commencing November 1, 2004. In addition, commencing May 1, 2005, the Company is required to make monthly principal payments of $100,000 per month. To the extent that funds are released from the restricted cash account prior to repayment in full of the unrestricted portion of the Note proceeds, the monthly payment amount may be increased by an amount equal to the amount released from the restricted cash account divided by the remaining number of monthly principal payments due on or prior to the maturity date. The note is convertible into shares of the Company’s common stock at the option of Laurus and, in certain circumstances, at the Company’s option.

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

          This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains descriptions of our expectations regarding future trends affecting our business. These forward-looking statements and other forward-looking statements made elsewhere in this document are made in reliance upon the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Please read the section below titled “Risk Factors” to review conditions which we believe could cause actual results to differ materially from those contemplated by the forward-looking statements. Forward-looking statements are identified by words such as “believes,” “anticipates,” “expects,” “intends,” “plans,” “will,” “may” and similar expressions. In addition, any statements that refer to our plans, expectations, strategies or other characterizations of future events or circumstances are forward-looking statements. Our business may have changed since the date hereof and we undertake no obligation to update these forward looking statements.

          The following discussion should be read in conjunction with financial statements and notes thereto included in this Quarterly Report on Form 10-Q.

Overview

          CardioGenesis Corporation, formerly known as Eclipse Surgical Technologies, Inc. (“CardioGenesis”, “the Company”), incorporated in California in 1989, designs, develops and distributes laser-based surgical products and disposable fiber-optic accessories for the treatment of advanced cardiovascular disease through transmyocardial revascularization (“TMR”) and percutaneous myocardial channeling (“PMC”), formerly referred to as percutaneous transluminal myocardial revascularization (“PMR”). The new name PMC more literally depicts the immediate physiologic tissue effect of the CardioGenesis Axcis(TM) Percutaneous Myocardial Channeling (PMC) system to ablate precise, partial thickness channels into the heart muscle from the inside of the left ventricle.

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          In February 1999, we received final approval from the Food and Drug Administration (“FDA”) for our TMR products for certain indications, and we are now able to sell those products in the U.S. on a commercial basis. We have also received the European Conforming Mark (“CE Mark”) allowing the commercial sale of our TMR laser systems and our PMC catheter system to customers in the European Community. Effective July 1999, the Health Care Financial Administration began providing Medicare coverage for TMR. Hospitals and physicians are now eligible to receive Medicare reimbursement for TMR equipment and procedures.

          We have completed pivotal clinical trials involving PMC, and study results were submitted to the FDA in a Pre Market Approval (“PMA application”) in December 1999 along with subsequent amendments. In July 2001, the FDA Advisory Panel recommended against approval of PMC for public sale and use in the United States. In February 2003, the FDA granted an independent panel review of our pending PMA application for PMC by the Medical Devices Dispute Resolution Panel (“MDDRP”). In July 2003, the FDA agreed to review additional data in support of our PMA supplement for PMC under the structure of an interactive review process between us and the FDA review team. The independent panel review by the MDDRP was cancelled in lieu of the interactive review, but the FDA has agreed to reschedule the MDDRP hearing in the future, if the dispute cannot be resolved. In August 2004, we met with the FDA and agreed on the steps needed to design and initiate a new clinical trial to confirm the safety and efficacy of PMC. We are working closely with the FDA in clarifying and formalizing the clinical research requirements necessary to achieve approval. Once the requirements are clarified and the related costs are clearly understood, we expect to move forward, either on our own or with a corporate partner in the interventional cardiology arena. There can be no assurance, however, that we will receive a favorable determination from the FDA.

          As of September 30, 2004, we had an accumulated deficit of $165,879,000. We may incur operating losses in the future. The timing and amounts of our expenditures will depend upon a number of factors, including the costs incurred for the launch of new products, the timing of market acceptance of our products and the status and timing of regulatory approvals.

Results of Operations

Net Revenues

          Net revenues were $2,837,000 for the quarter ended September 30, 2004, a decrease of $757,000, or 21%, when compared to net revenues of $3,594,000 for the quarter ended September 30, 2003. The decrease in net revenues was primarily attributed to a decrease in laser revenue of $662,000. Laser revenue was impacted by the Medicare Coverage Advisory Committee (MCAC) review by the Centers for Medicare & Medicaid Services (CMS) of laser myocardial revascularization. The MCAC review was announced in late May and the results of the review were not announced until late September, thus, affecting the entire span of the third quarter. The MCAC review, as well as the review conducted by Blue Cross/Blue Shield in the second quarter, caused a lot of confusion in the TMR marketplace, and our laser sales were negatively impacted.

          For the quarter ended September 30, 2004, domestic handpiece revenue increased by $24,000 for the quarter ended September 30, 2003. In the third quarter of 2004, domestic handpiece revenue consisted of $527,000 in sales to customers operating under the loaned laser program and $1,903,000 in sales to customers not operating under the loaned laser program. For those sales to customers operating under the loaned laser program, $187,000 was attributed to premiums associated with handpiece sales. In the third quarter of 2003, domestic handpiece revenue consisted of $833,000 in sales of product to customers operating under the loaned laser program and $1,573,000 of sales to customers not operating under the loaned laser program. For those sales to customers operating under the loaned laser program, $314,000 was attributed to premiums associated with the handpiece sales.

          For the quarter ended September 30, 2004, domestic laser revenue decreased by $662,000 for the same quarter in 2003. International sales, accounting for less than 1% of net revenues for the quarter ended September 30, 2004 decreased $62,000 from the prior year when international sales accounted for 3% of total sales. We define international sales as sales to customers located outside of the United States. In addition, service and other revenue of $176,000 decreased $57,000 or 24% for the quarter ended September 30, 2004 when compared to $233,000 for the quarter ended September 30, 2003.

          Net revenues were $10,254,000 for the nine months ended September 30, 2004, an increase of $148,000, or 1%, when compared to net revenues of $10,106,000 for the nine months ended September 30, 2003.

          For the nine months ended September 30, 2004, domestic handpiece revenue increased by $508,000 compared to the nine months ended September 30, 2003. For the nine months ended September 30, 2004, domestic handpiece revenue consisted of $1,487,000 in sales to customers operating under the

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loaned laser program and $5,866,000 in sales to customers not operating under the loaned laser program. For those sales to customers operating under the loaner laser program, $471,000 was attributed to premiums associated with handpiece sales. For the nine months ended September 30, 2003, domestic handpiece revenue consisted of $1,990,000 in sales of product to customers operating under the loaned laser program and $4,855,000 of sales to customers not operating under the loaned laser program. For those sales to customers operating under the loaned laser program, $540,000 was attributed to premiums associated with the handpiece sales.

          For the nine months ended September 30, 2004, domestic laser revenue decreased by $325,000 compared to the same period in 2003. International sales, accounting for approximately 4% of net revenues for the nine months ended September 30, 2004, increased $36,000 from the same period in the prior year when international sales accounted for 4% of total sales. In addition, service and other revenue of $725,000 decreased $71,000 or 9% for the nine months ended September 30, 2004 when compared to $796,000 for the nine months ended September 30, 2003.

Gross Profit

          Gross profit decreased to 82% of net revenues for the quarter ended September 30, 2004 as compared to 83% of net revenues for the quarter ended September 30, 2003. Gross profit in absolute dollars decreased by $635,000 to $2,338,000 for the quarter ended September 30, 2004, as compared to $2,973,000 for the quarter ended September 30, 2003. The decrease in gross margin as a percent of net revenues for the quarter ended September 30, 2004 was primarily attributed to the decrease in laser sales during the quarter. This decrease in laser sales resulted in a smaller revenue base contributing to the decrease in gross margin because our fixed costs remained relatively unchanged from period to period. Gross profit increased to 85% of net revenues for the nine months ended September 30, 2004 as compared to 83% of net revenues for the nine months ended September 30, 2003. Gross profit in absolute dollars increased by $323,000 to $8,684,000 for the nine months ended September 30, 2004, as compared to $8,361,000 for the nine months ended September 30, 2003. The increase in gross margin as a percent of net revenues for the nine months ended September 30, 2004 resulted from higher average selling prices of our products, ongoing improvements in manufacturing by our contract manufacturer, and lower net book values associated with the sale of our lasers.

Research and Development

          Research and development expenditures of $520,000 decreased $210,000 for the quarter ended September 30, 2004 when compared to expenditures of $730,000 for the quarter ended September 30, 2003. Research and development expenditures of $1,189,000 decreased $647,000 for the nine months ended September 30, 2004 when compared to $1,836,000 for the nine months ended September 30, 2003. The decrease in overall research and development expense during the quarterly and nine month periods was primarily attributed to a decrease in the expenses related to our pursuit of PMC approval.

Sales, General and Administrative

          Sales, general and administrative expenditures of $2,746,000 increased $382,000 or 16% for the quarter ended September 30, 2004 when compared to $2,364,000 for the quarter ended September 30, 2003. The increase in expenses resulted primarily from a $298,000 increase in employee related expenses due to additional headcount and a $91,000 increase in physician training.

          Sales, general and administrative expenditures of $8,398,000 increased $992,000 or 13% for the nine months ended September 30, 2004 when compared to $7,406,000 for the nine months ended September 30, 2003. The increase in expenses resulted primarily from an $810,000 increase in employee related expenses due to additional headcount, a $215,000 increase in marketing costs and a $114,000 increase in physician training costs. These increases were offset by a decrease in facilities and office expense of $143,000 due to cost containment efforts.

Net Loss

          The net loss for the quarter ended September 30, 2004 was $924,000 compared to $129,000 for the quarter

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ended September 30, 2003. The increase in net loss is primarily related to a decrease in revenue of $757,000 and an increase in selling, general and administrative expenses of $382,000.

          The net loss for the nine months ended September 30, 2004 was $921,000 compared to a net loss of $886,000 for the nine months ended September 30, 2003. The increase in net loss is primarily related to an increase in selling, general, and administrative costs of $992,000 offset by a decrease in research and development expenses of $647,000 and an increase in gross profit of $323,000.

Liquidity and Capital Resources

          Cash and cash equivalents were $2,920,000 at September 30, 2004 compared to $1,013,000 at December 31, 2003, an increase of $1,907,000. We used $189,000 of cash for operating activities in the nine months ended September 30, 2004 primarily to fund our operating loss and to purchase laser inventory. Net inventories increased $367,000 to $1,706,000 at September 30, 2004 compared to $1,339,000 at December 31, 2003. This increase was primarily related to $386,000 in purchases of laser inventory.

          Cash used in investing activities in the nine months ended September 30, 2004 was $235,000 due to the acquisition of property and equipment. Cash provided by financing activities was $2,331,000 due to sales of common stock from the exercise of stock options as well as the sale of equity securities described below.

          On January 22, 2004, we sold 3,139,535 shares of common stock to private investors for a total price of $2,700,000. We also issued warrants to purchase 3,139,535 additional shares of common stock at a price of $1.37 per share. The warrants are immediately exercisable and have a term of five years.

          We have incurred significant losses for the last several years and at September 30, 2004 we have an accumulated deficit of $165,879,000. Our ability to maintain current operations is dependent upon achieving profitable operations in the future. Our plans include increasing sales through increased direct sales and marketing efforts on existing products and achieving timely regulatory approval for certain other products.

          We also plan to continue our cost containment efforts by focusing on sales, general and administrative expenses. Over the past three years, we have significantly reduced our cost of revenues, primarily due to the outsourcing of a significant portion of our manufacturing, which allows us to purchase products at lower costs. To reduce operating expenses, we have focused our efforts on reducing overall expenses in functions that are not essential to core and critical activities.

          Currently, our primary goals are to increase revenues, further clinical adoption of the TMR procedure, develop new products for our TMR platform, and achieve consistent profitability. Our actions have been guided by this initiative, and the resulting cost containment measures have helped to conserve our cash. Our focus is upon core and critical activities, thus operating expenses that are nonessential to our core operations have been eliminated.

          On October 27, 2004, we completed a financing transaction with Laurus Master Fund, Ltd, a Cayman Islands corporation (“Laurus”), pursuant to which we issued a Secured Convertible Term Note (the “Note”) in the aggregate principal amount of $6.0 million and a warrant to purchase an aggregate of 2,640,000 shares of common stock of the Company to Laurus in a private offering. Net proceeds to the Company from the financing, after payment of fees and expenses to Laurus and its affiliates, were $5,754,500, $2,877,250 of which was received by the Company and $2,877,250 of which was deposited in a restricted cash account. Funds deposited in the restricted cash account will only be released to the Company, if at all, upon satisfaction of certain conditions.

          The Note matures on October 26, 2007 absent earlier redemption by us or earlier conversion by Laurus. Annual interest on the Note is equal to the “prime rate” published in The Wall Street Journal from time to time, plus two percent (2.0%), provided, that, such annual rate of interest may not be less than six and one-half percent (6.5%), subject to certain downward adjustments resulting from certain increases in the market price of our common stock. Interest on the Note is payable monthly in arrears on the first day of each month during the term of the Note, commencing November 1, 2004. In addition, commencing May 1, 2005, the Company is required to make monthly principal payments of $100,000 per month. To the extent that funds are released from the restricted cash account prior to repayment in full of the unrestricted portion of the Note proceeds, the monthly payment amount may be

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increased by an amount equal to the amount released from the restricted cash account divided by the remaining number of monthly principal payments due on or prior to the maturity date. The note is convertible into shares of our common stock at the option of Laurus and, in certain circumstances, at our option. A more detailed discussion of the terms of such financing is contained in our Current Report on Form 8-K filed on October 28, 2004.

          We believe our cash balance as of September 30, 2004, when coupled with the proceeds of the Note financing described above, will be sufficient to meet our capital and operating requirements through the next 12 months. We will have a continuing need for new infusions of cash if we incur losses in the future. We plan to increase our sales through increased direct sales and marketing efforts on existing products and achieving regulatory approval for other products. If our direct sales and marketing efforts are unsuccessful or we are unable to achieve regulatory approval for our products, we will be unable to significantly increase our revenues. We believe that if we are unable to generate sufficient funds from revenues or from debt or equity issuances to maintain our current expenditure rate, it will be necessary to significantly reduce our operations until an appropriate solution is implemented. We may be required to seek additional sources of financing in addition to the convertible debt financing described above, which could include short-term debt, long-term debt or equity. There is a risk that we may be unsuccessful in obtaining such financing and that we will not have sufficient cash to fund our operations.

The following summarizes our contractual obligations at September 30, 2004, and the effect, if any, such obligations are expected to have on our liquidity and cash flow in future periods:

Critical Accounting Policies

          The preparation of the financial statements requires estimation and judgment that affect the reported amounts of net revenues, expenses, assets and liabilities. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances and which form the basis for making judgments about the carrying values of assets and liabilities. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. If these estimates differ significantly from actual results, the impact to the financial statements may be material.

          We have identified the following as critical accounting policies: revenue recognition, allowance for doubtful accounts, inventories and income taxes:

Revenue Recognition:

          We recognize revenue on product sales upon receipt of a purchase order, shipment of the products, the price is fixed or determinable and collection of sales proceeds is reasonably assured. Where purchase orders allow

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customers an acceptance period or other contingencies, revenue is recognized upon the earlier of acceptance or removal of the contingency.

          Revenues from sales to distributors and agents are recognized upon shipment when there is evidence that an arrangement exists, delivery has occurred under the Company’s standard FOB shipping point terms, the sales price is fixed or determinable and the ability to collect sales proceeds is reasonably assured. The contracts regarding these sales do not include any rights of return or price protection clauses.

          We frequently loan lasers to hospitals in return for the hospital purchasing a minimum number of handpieces at a premium over the list price. The loaned lasers are depreciated to cost of revenues over a useful life of 24 months.

          The revenue on the handpieces is recognized upon shipment at an amount equal to the list price. The premium over the list price represents revenue related to the use of the laser unit and is recognized ratably, generally over the 24-month useful life of the placed lasers

          Revenues from service contracts, rentals, and per procedure fees are recognized upon performance or over the terms of the contract as appropriate.

     Allowance for Doubtful Accounts:

          We regularly evaluate the collectability of accounts receivable based upon our knowledge of customers and compliance with credit terms. The allowance for doubtful accounts is adjusted based on such evaluation, with a corresponding provision included in general and administrative expenses.

     Inventories:

          Inventories are stated at the lower of cost (principally standard cost, which approximates actual cost on a first-in, first-out basis) or market value.

     Income Taxes:

          We account for income taxes using the liability method under which deferred tax assets or liabilities are calculated at the balance sheet date using current tax laws and rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amounts expected to be realized.

Risk Factors

     In addition to the other information included in this Form 10-Q, the following risk factors should be considered carefully in evaluating us and our business.

     Our ability to maintain current operations is dependent upon sustaining profitable operations or obtaining financing in the future.

     We have incurred significant losses since inception. For example, for the fiscal years 2003, 2002 and 2001 we incurred net losses of $348,000, $530,000 and $10,247,000 respectively. We will have a continuing need for new infusions of cash if we continue to incur losses in the future. We plan to increase our revenues through increased direct sales and marketing efforts on existing products and achieving regulatory approval for other products. If our direct sales and marketing efforts are unsuccessful or we are unable to achieve regulatory approval for our products, we will be unable to significantly increase our revenues. We believe that if we are unable to generate sufficient funds from sales or from debt or equity issuances to maintain our current expenditure rate, it will be necessary to significantly reduce our operations, including our sales and marketing efforts and research and development. If we are required to significantly reduce our operations, our business will be harmed.

     We have recently obtained $6.0 million of convertible debt financing which we believe will be sufficient to

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satisfy our capital needs for at least the next 12 months. However, changes in our business, financial performance or the market for our products may require us to seek additional sources of financing, which could include short-term debt, long-term debt or equity. Although in the past we have been successful in obtaining financing, there is a risk that we may be unsuccessful in obtaining financing in the future on terms acceptable to us and that we will not have sufficient cash to fund our continued operations.

     Our revenues and operating income may be constrained:

	•		if commercial adoption of our TMR laser systems by healthcare providers in the United States declines;
	•		until such time, if ever, as we obtain FDA and other regulatory approvals for our PMC laser systems; and
	•		for an uncertain period of time after such approvals are obtained.

     We may not be able to successfully market our products if third party reimbursement for the procedures performed with our products is not available for our health care provider customers.

     Few individuals are able to pay directly for the costs associated with the use of our products. In the United States, hospitals, physicians and other healthcare providers that purchase medical devices generally rely on third party payors, such as Medicare, to reimburse all or part of the cost of the procedure in which the medical device is being used. Effective July 1, 1999, the Centers for Medicare and Medicaid Services (“CMS”), formerly the Health Care Financing Administration, commenced Medicare coverage for TMR systems for any manufacturer’s TMR procedures. Hospitals and physicians are eligible to receive Medicare reimbursement covering 100% of the costs for TMR procedures. If CMS were to materially reduce or terminate Medicare coverage of TMR procedures, our business and results of operation would be harmed.

     In July 2004, CMS convened the Medicare Advisory Committee (“MCAC”) to review the clinical evidence regarding laser myocardial revascularization as a treatment option for Medicare patients. The MCAC meeting was a non-binding public hearing to consider the body of scientific evidence concerning the safety and efficacy of laser myocardial revascularization and to provide advice and recommendations to the CMS on clinical issues. The MCAC reviewed more than six years of clinical evidence on laser myocardial revascularization and heard testimony from a group of leading physicians regarding TMR. CMS does not have a pending National Coverage Determination relating to laser myocardial revascularization. In September 2004, we confirmed that CMS does not intend to commence any action on TMR coverage at this time.

     As PMC has not been approved by the FDA, the CMS has not approved reimbursement for PMC. If we obtain FDA approval for PMC in the future and CMS does not provide reimbursement, our ability to successfully market and sell our PMC products may be affected.

     Even though Medicare beneficiaries appear to account for a majority of all patients treated with the TMR procedure, the remaining patients are beneficiaries of private insurance and private health plans. We have limited experience to date with the acceptability of our TMR procedures for reimbursement by private insurance and private health plans. If private insurance and private health plans do not provide reimbursement, our business will suffer.

     If we obtain the necessary foreign regulatory registrations or approvals for our products, market acceptance in international markets would be dependent, in part, upon the availability of reimbursement within prevailing healthcare payment systems. Reimbursement is a significant factor considered by