10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the Quarterly period ended August 31, 2004

¨ Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from              to             

Commission File No. 0-12240

BIO-LOGIC SYSTEMS CORP.

(Exact Name of Registrant as Specified in its Charter)

Delaware	36-3025678
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification Number)

One Bio-logic Plaza, Mundelein, Illinois	60060
(Address of Principal Executive Offices)	(Zip Code)

Registrant’s Telephone Number, Including Area Code (847-949-5200)

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report): not applicable

Indicate by check x whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨

Indicate by check x whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).     YES  ¨    NO  x

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

Class	Outstanding at September 13, 2004
Common Stock $.01 par value	4,191,117

TABLE OF CONTENTS

			Page
Part I.	Financial Information
	Item 1.	Financial Statements
		Condensed Consolidated Balance Sheets at August 31, 2004 (Unaudited) and February 29, 2004	3
		Condensed Consolidated Statements of Operations and Retained Earnings for the three months and six months ended August 31, 2004 and 2003 (Unaudited)	4
		Condensed Consolidated Statements of Cash Flows for the six months ended August 31, 2004 and 2003 (Unaudited)	5
		Notes to Unaudited Condensed Consolidated Financial Statements (Unaudited)	6
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	10
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	14
	Item 4.	Controls and Procedures	14
Part II.	Other Information
	Item 1.	Legal Proceedings	15
	Item 4.	Submission of Matters to a Vote of Security Holders	15
	Item 6.	Exhibits	15
Signatures			16

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Part 1. Financial Information

Item 1. Financial Statements

Bio-logic Systems Corp.

Condensed Consolidated Balance Sheets

Unaudited

In Thousands

	August 31, 2004		February 29, 2004
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	14,517	$	12,750
Accounts receivable, net		5,131		6,279
Inventories, net		2,024		1,908
Prepaid expenses		368		498
Deferred income taxes		1,378		1,520
Total current assets		23,418		22,955
PROPERTY, PLANT AND EQUIPMENT - Net		2,085		2,051
INTANGIBLE ASSETS		1,660		1,584
OTHER ASSETS		23		78
OTHER RECEIVABLES		—		526
TOTAL ASSETS	$	27,186	$	27,194
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	946	$	1,357
Accrued salaries and payroll taxes		1,453		1,519
Accrued interest and other expenses		1,632		1,740
Accrued income taxes		160		358
Deferred revenue		1,122		1,269
Total current liabilities		5,313		6,243
DEFERRED INCOME TAXES		706		672
Total liabilities		6,019		6,915
COMMITMENTS		—		—
STOCKHOLDERS’ EQUITY:
Common stock, $.01 par value; authorized, 10,000,000 shares; 4,266,117 issued and 4,191,117 outstanding at August 31, 2004; 4,246,921 issued and 4,171,921 outstanding at February 29, 2004;		43		43
Additional paid-in capital		5,230		5,159
Retained earnings		16,261		15,444
Stockholders’ equity before treasury stock		21,534		20,646
Less treasury stock, at cost: 75,000 shares at August 31, 2004 and February 29, 2004		367		367
Total stockholders’ equity		21,167		20,279
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	27,186	$	27,194

The accompanying notes are an integral part of these statements.

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Bio-logic Systems Corp.

Condensed Consolidated Statements of Operations and Retained Earnings

Unaudited

In Thousands, Except Per Share Data

	Three Months Ended August 31,					Six Months Ended August 31,
	2004			2003		2004			2003
NET SALES	$	8,242		$	6,927	$	14,493		$	13,246
COST OF SALES		2,710			2,241		4,769			4,316
Gross Profit		5,532			4,686		9,724			8,930
OPERATING EXPENSES:
Selling, general & administrative		3,287			3,095		6,334			5,949
Research & development		1,270			1,132		2,278			2,144
Total operating expenses		4,557			4,227		8,612			8,093
OPERATING INCOME		975			459		1,112			837
OTHER INCOME (EXPENSE):
Interest income		29			22		60			38
Interest expense		(1	)		—		(8	)		—
Miscellaneous		1			—		1			2
Total other income (expense)		29			22		53			40
INCOME BEFORE INCOME TAXES		1,004			481		1,165			877
PROVISION FOR INCOME TAXES		301			81		348			203
NET INCOME	$	703		$	400	$	817		$	674
RETAINED EARNINGS, BEGINNING OF PERIOD		15,558			13,836		15,444			13,562
RETAINED EARNINGS, END OF PERIOD	$	16,261		$	14,236	$	16,261		$	14,236
EARNINGS PER SHARE:
Basic	$	0.17		$	0.10	$	0.19		$	0.16
Diluted	$	0.15		$	0.09	$	0.18		$	0.15

The accompanying notes are an integral part of these statements.

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Bio-logic Systems Corp.

Condensed Consolidated Statements of Cash Flows

Unaudited

In Thousands

	Six Months Ended August 31,
	2004			2003
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	817		$	674
Adjustments to reconcile net income to net cash flows provided by operating activities:
Depreciation and amortization		341			384
Deferred income tax provision		176			—
(Increases) decreases in assets:
Accounts receivable		1,148			674
Inventories		(116	)		581
Prepaid expenses		130			4
Increases (decreases) in liabilities:
Accounts payable		(411	)		(1,080	)
Accrued liabilities and deferred revenue		(321	)		87
Accrued income taxes		(198	)		(356	)
Net cash flows provided by operating activities		1,566			968
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures		(197	)		(143	)
Intangible assets		(255	)		(248	)
Other assets		55			129
Other receivables		526			—
Net cash flows provided by (used in) investing activities		129			(262	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options		72			11
Net cash flows provided by financing activities		72			11
INCREASE IN CASH AND CASH EQUIVALENTS		1,767			717
CASH AND CASH EQUIVALENTS - Beginning of period		12,750			10,678
CASH AND CASH EQUIVALENTS - End of period	$	14,517		$	11,395
SUPPLEMENTAL DISCLOSURES OF CASH FLOWS:
Cash paid during the period for:
Income taxes (net of refunds)	$	370		$	575

The accompanying notes are an integral part of these statements.

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Bio-logic Systems Corp. and Subsidiaries

Notes to Unaudited Condensed Consolidated Financial Statements

(Unaudited)

These unaudited interim condensed consolidated financial statements of Bio-logic Systems Corp. (the “Company,” “we” or “us”) were prepared under the rules and regulations for reporting on Form 10-Q. Accordingly, we omitted some information and footnote disclosures normally accompanying the annual financial statements. You should read these interim financial statements and notes in conjunction with the Company’s audited consolidated financial statements and their notes included in the Company’s annual report on Annual Report on Form 10-K for the fiscal year ended February 29, 2004, as filed with the Securities and Exchange Commission on June 1, 2004 (the “Annual Report”). In the Company’s opinion, the unaudited condensed consolidated financial statements include all adjustments necessary for a fair statement of the results of operations, financial position and cash flows for the interim periods. All adjustments were of a normal recurring nature. Operating results for the three and six months ended August 31, 2004 are not necessarily indicative of the results that may be expected for the fiscal year ending February 28, 2005. For additional information, refer to the Annual Report.

Consolidation - The unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned domestic subsidiaries, Neuro Diagnostics, Inc. and Bio-logic International Corp., and its wholly-owned foreign subsidiary, Bio-logic Systems Corp., Ltd. All significant intercompany balances and transactions have been eliminated in consolidation.

Cash and Cash Equivalents - Cash equivalents include all highly liquid investments purchased with average maturities of three months or less.

Accounts Receivable - The majority of the Company’s accounts receivable are due from companies in the medical and health care industries. Credit is extended based on evaluation of a customer’s financial condition. New non-institutional customers are generally subject to a deposit. Accounts receivable are stated at amounts due from customers net of an allowance for doubtful accounts, and are generally due within 30 days for domestic customers and 60 days for international customers. Accounts outstanding longer than the contractual payment terms are considered past due. The Company determines its allowance by considering a number of factors, including the length of time trade accounts receivable are past due and the Company’s previous loss history. The Company writes off accounts receivable when they become uncollectable, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts. Charges for doubtful accounts are recorded in selling, general and administrative expenses.

Inventories - Inventories consist principally of components, parts and supplies, and are stated at the lower of cost, determined by the First-in, First-out method, or market. Inventories (in thousands) consist of the following:

	August 31, 2004		February 29, 2004
Raw Materials	$	1,373	$	1,245
Work In process		1,220		1,060
Finished Goods		294		263
Gross Inventory		2,887		2,568
Less Reserves		863		660
Net Inventory	$	2,024	$	1,908

Property, Plant and Equipment - Property, plant and equipment are stated at cost. The cost of maintenance and repairs is charged to income as incurred, and significant renewals and betterments are capitalized. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets ranging from three years to forty years.

Intangible Assets - Intangible assets consist primarily of capitalized software costs for research and development, as well as certain patent, trademark and license costs. Capitalized software development costs are recorded in accordance with Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed,” with costs being amortized using the straight-line method over a five-year period.

Patent, trademark and license costs are amortized using the straight-line method over their estimated useful lives of five years. On an ongoing basis, management reviews the valuation of intangible assets to determine if there has been impairment by comparing the related assets’ carrying value to the undiscounted estimated future cash flows and/or operating income from related operations.

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The following table (in thousands) summarizes the components of gross and net intangible asset balances:

	August 31, 2004							February 29, 2004
	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount		Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount
Capitalized Research and Development	$	2,009	$	(529	)	$	1,480	$	1,771	$	(382	)	$	1,389
Patents and Trademarks		190		(91	)		99		181		(76	)		105
Licenses		185		(104	)		81		177		(87	)		90
Total Amortizable Intangible Assets	$	2,384	$	(724	)	$	1,660	$	2,129	$	(545	)	$	1,584

Long-Lived Assets – The Company regularly reviews long-lived assets for impairment in accordance with SFAS No. 144, “Accounting for the Impairment of Long-Lived Assets.” No impairment was realized for the six-month periods ended August 31, 2004 and 2003.

Other Assets – Other assets consist mainly of long-term trade receivables. Any required reserves for long-term trade receivables are recorded as part of the Allowance for Doubtful Accounts; there are currently no reserve requirements.

Other Receivables – Other receivables at February 29, 2004 consisted of a medical claim that was settled with the Company’s stop-loss insurance carrier during fiscal 2005.

Revenue Recognition – The Company derives revenue from the sales of electrodiagnostic systems, disposable supplies, extended warranty contracts, non-warranty repair, and governmental research and development “grants.” With the exception of domestic customers associated with certain group purchasing contracts, the terms of sale for systems and related supplies are generally freight on board (FOB) shipping point.

Domestically, the Company sells its neurology and sleep systems through a direct sales force, and uses a dealer network to sell its hearing screening and diagnostic systems; internationally, the entire line of electrodiagnostic systems and supplies is sold through distributors located in various countries. There is no general right for a customer, dealer or distributor to return product. All sales are final, regardless of the distribution channel; returns are rare and are usually done due to order error or product quality reasons.

The Company recognizes revenue when it is realized or realizable and earned, in accordance with Statement of Position No. 97-2, “Software Revenue Recognition;” specifically, when there is persuasive evidence of an arrangement, delivery has occurred, the sales price is fixed or determinable, and collectibility is reasonably assured. Set-up and training revenue related to system sales is not recognized until the service is completed. Revenue from the performance of non-warranty repair activities is recognized in the period in which the work is performed. Revenue from extended warranty contracts is recognized over the life of the warranty.

Revenue from research and development contracts relate to governmental grants awarded by the National Institute of Health. The grant covers reimbursement of specific expenses related to the feasibility and development of projects for which the grants were given, and the Company recognizes revenue in the same period the qualifying costs are incurred. The Company’s obligation is to perform these feasibility and development activities in accordance with the terms of the grant, with no obligation for the work to result in a successful outcome such as a new product or successful discovery.

The Company carries a sales reserve that reduces revenue for potential future product returns as well as unperformed set-up and training, and reviews its adequacy quarterly. To date, this reserve has not been significant.

Royalties and Intangible Amortization Expenses – Royalty expenses and the amortization of intangibles are recorded as part of product cost.

Advertising – Advertising costs are expensed as incurred.

Research and Development Costs – Research and development (R&D) costs are expensed as incurred. Capitalized research and development costs reflect internally-generated software development costs associated with bringing new products to market, or significantly adding new features and functions to existing products. The Company accounts for the capitalization of software development costs in accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, Or Otherwise Marketed;” specifically: (a) R&D costs incurred in determining technological feasibility are expensed; (b) all material costs from the point where technological feasibility is determined up to the point when the product is available for general release to customers are capitalized; and (c) capitalization ceases when the developed product is available for general release to customers.

Income Taxes - Deferred tax assets and liabilities are computed annually for differences between financial statement basis and tax basis of assets and liabilities using enacted tax rates for the years in which the differences are expected to become recoverable. A valuation allowance is established where necessary to reduce deferred tax assets to the amount expected to be realized.

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Deferred federal income taxes are not provided for the undistributed earnings of the Company’s foreign subsidiary. Undistributed foreign earnings were $2,615,920 and $2,876,107 as of August 31 and February 29, 2004, respectively.

Use of Estimates - In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Fair Value of Financial Instruments - The Company’s financial instruments include cash equivalents, accounts receivable, and accounts payable. The carrying value of cash equivalents, accounts receivable and accounts payable approximate their fair value because of the short-term nature of these instruments.

Shipping and Handling Costs - In accordance with Emerging Issues Task Force 00-10, “Accounting for Shipping and Handling Fees and Costs,” the Company has reflected billings to customers for freight and handling as net sales and associated freight-out as cost of sales.

Stock-Based Compensation - The Company maintains a stock incentive plan. The Company accounts for this plan under the recognition and measurement principles of Accounting Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. No compensation costs are recognized for stock option grants. All options granted under the Company’s plan have an exercise price equal to or greater than the market value of the underlying common stock on the date of grant.

The following table illustrates the effect on net income (in thousands) and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based compensation:

	Three Months Ended August 31,						Six Months Ended August 31,
	2004			2003			2004			2003
Net income, as reported	$	703		$	400		$	817		$	674
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards		(210	)		(135	)		(378	)		(293	)
Pro-forma net income	$	493		$	265		$	439		$	381
Earnings per share:
Basic     - as reported	$	0.17		$	0.10		$	0.19		$	0.16
- pro forma	$	0.12		$	0.06		$	0.10		$	0.09
Diluted  - as reported	$	0.15		$	0.09		$	0.18		$	0.15
- pro forma	$	0.11		$	0.06		$	0.10		$	0.09

Earnings per Share – Basic earnings per share is based on the weighted average number of shares outstanding during the fiscal year.

Diluted earnings per share is based on the combination of weighted average number of shares outstanding and potential dilutive shares, which totaled 4,586,729 and 4,568,446 for the second quarter of fiscal 2005 and the first six months of fiscal 2005, respectively.

Comprehensive Income - SFAS No. 130, “Reporting Comprehensive Income,” requires disclosure of the components of and total comprehensive income in the period in which such components are recognized in the financial statements. Comprehensive income is defined as the change in equity (net assets) of a business enterprise arising from transactions and other events and circumstances from non-owner sources. It includes all changes in stockholders’ equity during the reporting period except those resulting from investments by owners and distributions to owners. The Company does not have changes in stockholders’ equity other than those resulting from investments by and distributions to owners. The functional currency for the Company’s international operations is the U.S. dollar.

Segment, Customer and Geographic Information - SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information,” requires disclosures of certain segment information based on the way management evaluates segments for making decisions and assessing performance. It also requires disclosure of certain information about products and services, the geographic areas in which the Company operates and major customers.

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Revenue (in thousands) from customers by segment is as follows:

	Three Months Ended August 31,				Six Months Ended August 31,
	2004		2003		2004		2003
Electrodiagnostic products and systems	$	6,144	$	4,853	$	10,548	$	9,331
Supplies, warranty, service and repair		2,098		2,074		3,945		3,915
Total	$	8,242	$	6,927	$	14,493	$	13,246

Revenue (in thousands) from customers by geographic area is as follows:

	Three Months Ended August 31,				Six Months Ended August 31,
	2004		2003		2004		2003
United States	$	6,538	$	5,418	$	11,621	$	10,368
Japan		534		226		839		709
Canada		109		219		380		469
United Kingdom		207		224		303		410
Brazil		126		238		192		292
Other		728		602		1,158		998
Total	$	8,242	$	6,927	$	14,493	$	13,246

For the fiscal quarters ended August 31, 2004 and 2003, there were no sales to a single customer that accounted for greater than 10% of revenue.

Long-lived assets include fixed assets (property, plant and equipment) and intangible assets. The Company has fixed assets in the United States and Israel; all intangible assets are domiciled in the United States. Long-lived assets by country (in thousands) are as follows:

	August 31, 2004		February 29, 2004
United States	$	3,711	$	3,589
Israel		34		46
Total	$	3,745	$	3,635

Contingency - On April 22, 2004, two plaintiffs filed a product liability claim against us and certain other defendants seeking specific damages of $12,300,000, as well as unspecified damages for future loss of income earning capacity. A brief description of this lawsuit may be found in Part II, Item 1 of this Form 10-Q. The Company intends to vigorously defend against the claims brought before us in this suit. Although the outcome of any litigation is inherently uncertain, the Company believes that the Company’s product liability insurance coverage is adequate to cover liabilities resulting from this litigation, and therefore the results of this litigation should not have a material adverse effect on the Company’s business, assets, financial condition, liquidity and results of operations.

Reclassifications - Certain reclassifications were made to fiscal 2004 amounts to conform to current year financial presentation.

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

This report contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933 that reflect our current expectations about our future results, performance, prospects and opportunities. These forward-looking statements are subject to significant risks, uncertainties and other factors, including those identified in Exhibit 99.1 “Risk Factors” filed with this Form 10-Q, which may cause actual results to differ materially from those expressed in, or implied by, such statements. The forward-looking statements within this Form 10-Q may be identified by words such as “believes,” “anticipates,” “expects,” “intends,” “may,” “would,” “will” and other similar expressions. These words are not, however, the exclusive means of identifying these statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. Except as expressly required by the federal securities laws, we undertake no obligation to publicly update or revise any forward-looking statements to reflect events or circumstances occurring subsequent to the filing of this Form 10-Q with the SEC or for any other reason. You should carefully review and consider the various disclosures we make in this report and our other reports filed with the SEC that attempt to advise interested parties of the risks, uncertainties and other factors that may affect our business. The following discussion and analysis should be read in conjunction with the Unaudited Condensed Consolidated Financial Statements and the Notes to the Unaudited Condensed Consolidated Financial Statements in Part I. Item 1 of this Form 10-Q.

Overview

We are a healthcare technology company operating in two segments: computerized medical electro-diagnostic products and systems; and related supplies, warranty, service and repair. Our customers are generally hospitals, clinics, universities and physicians. Our systems conduct tests that are typically used by medical practitioners to aid in the diagnosis of certain neurological disorders, brain disorders and tumors, sensory disorders, sleep disorders and hearing loss (including audiological and hearing screening and diagnosis).

Our electro-diagnostic products and systems segment accounted for 75% of our total net sales in the fiscal quarter ended August 31, 2004, consistent with the historical contributions of this segment to our total net sales. This segment generally accounts for between 70% and 75% of our total net sales. System sales typically represent capital expenditures on the part of our customers. The U.S. hearing screening market continues to decline and become a replacement market, with an estimated 85% of the estimated 4 million newborns now being screened annually. Our focus for these systems will be on diagnostic products for babies referred for further testing after initial screening, such as M^.A^.S^.T^.E^.R^™ that has gained strong acceptance by audiologists for aiding in the determination of appropriate therapies to benefit the infant. The EEG market for short-term EEG and long-term monitoring is growing slowly, with significant competition from a feature and technology point of view. Our sleep diagnostic products and systems target the growing market for sleep apnea monitoring. We have experienced some price erosion in sleep diagnostic systems as a result of the strong competition in this area. The timing on system sales can be affected by many factors, including product features, pricing, order size (especially for neurology system sales to hospitals), customers’ trial periods and approval processes, and the hospital or medical practitioner’s capital availability. These factors can materially impact revenues and earnings from one quarter to the next.

Our supplies, warranty, service and repair segment sells disposable products to our installed customer base as well as to owners of our competitors’ systems. Certain proprietary hearing products such as the Ear Muffin^™ transducer are the basis for much of the revenue and profit growth in this segment. We experience intense competition related to our Ear Muffin^™ products, which are designed for use on Bio-logic’s systems, as well as for use as an equivalent product to replace the Natus^® EarCoupler^® and Flexicoupler^® disposables. In addition to the one-year warranty that is provided as part of purchasing our electrodiagnostic systems, we offer our customers extended warranties up to five years. We also generate revenue by servicing and repairing customer systems that are out of warranty. Finally, a small part of our revenue in this segment is generated from governmental research grants.

Critical Accounting Policies and the Use of Estimates

Our “critical accounting policies” are those that require application of management’s most difficult, subjective, or complex judgments, often as a result of the need to make estimates about matters that are inherently uncertain and may change in future periods. They are not intended to be a comprehensive list of all of our significant accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles, with no need for management’s judgment in their application. There are also areas in which the selection of an available alternative policy would not produce a materially different result. We have identified the following as our critical accounting policies: revenue recognition, inventory valuation and the capitalization of software costs.

Revenue Recognition

We recognize revenue when it is realized or realizable and earned, in accordance with Statement of Position No. 97-2, “Software Revenue Recognition;” specifically, when there is persuasive evidence of an arrangement, delivery has occurred, the sales price is fixed or determinable, and collectibility is reasonably assured. Set-up and training revenue related to system sales is not recognized

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until the service is completed. With the exception of domestic customers associated with certain group purchasing contracts, the terms of sale for systems and related supplies are generally FOB shipping point. Revenue from the performance of non-warranty repair activities is recognized in the period in which the work is performed. Revenue from extended warranty contracts is recognized over the life of the warranty. All sales are final; there is no general right for a customer, dealer or distributor to return our products. Any exception regarding product returns requires senior management approval. A small sales reserve exists to cover potential future product returns, as well as unperformed set-up and training.

We also maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. This estimate is based on historical experience, current economic and industry conditions, and the financial condition of our customers. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Inventory Valuation

Inventories consist principally of components, parts, supplies, and demonstration equipment, and are valued at the lower of cost or market, and include materials, labor and manufacturing overhead. We write down inventory for estimated obsolescence and for unmarketability, equal to the difference between the cost of the inventory and its estimated market value, based on assumptions about future demand and market conditions. If future demands or market conditions were to be less favorable than what was projected, additional inventory write-downs may be required. Due to the proprietary nature of many of our raw materials and components, we generally do not sell excess or obsolete inventory to third parties. Demonstration inventory is sold at a discount, thus generating similar margins to new systems sold.

Capitalization of Software Costs

Capitalized software costs for research and development are amortized over a five-year period. On an ongoing basis, management reviews the valuation of these software costs to determine if there has been impairment to the carrying value of these assets, and adjusts this value accordingly.

Other significant accounting policies, not involving the same level of measurement uncertainties as those discussed above, are nevertheless important to an understanding of the financial statements. Policies relating to fair value of financial instruments, depreciation, and income taxes require judgments on complex matters that are often subject to multiple external sources of authoritative guidance such as the Financial Accounting Standards Board and the Securities and Exchange Commission.

Dollar amounts in the following discussion are in thousands except for per share amounts.

Results of Operations

Net Sales

Net sales for the three month period ended August 31, 2004 (the “Fiscal 2005 Second Quarter”) were $8,242, a 19% increase from $6,927 in the three month period ended August 31, 2003 (the “Fiscal 2004 Second Quarter”). Net sales for the six month period ended August 31, 2004 (the “Fiscal 2005 Six Months”) were $14,493, a 9% increase from $13,246 in the six month period ended August 31, 2003 (the “Fiscal 2004 Six Months”).

Domestic sales for the Fiscal 2005 Second Quarter, which include sales to Canada, were $6,647, or 81% of net sales. This represents an 18% increase from $5,637, or 81% of total sales, from the Fiscal 2004 Second Quarter. Domestic electro-diagnostic products and systems sales increased 29% in the Fiscal 2005 Second Quarter over the Fiscal 2004 Second Quarter, led by Sleepscan^TM VISION^TM, Ceegraph^TM VISION^TM and AuDX^® products. Our domestic supplies, warranty, service and repair sales decreased 5% over the Fiscal 2004 Second Quarter, primarily due to the conclusion of research studies supported by governmental grants. This reduction in revenue was partially offset by increases due to the recognition of extended warranty revenue.

Domestic sales (including sales to Canada) for the Fiscal 2005 Six Months, representing 83% of net sales, increased 11% to $12,001 compared to $10,837 for the Fiscal 2004 Six Months. Increases in the electro-diagnostics products and systems segment, led by sleep monitoring (Sleepscan VISION), epilepsy monitoring (Ceegraph^TM VISION) and hearing screening product lines, were partially offset by decreases in the supplies, warranty, service and repair segment, with reductions primarily due to the conclusion of governmental research grants.

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Foreign sales for the Fiscal 2005 Second Quarter, representing 19% of our net sales, increased 24% to $1,595 from $1,290 in the Fiscal 2004 Second Quarter. For the Fiscal 2005 Six Months, foreign sales represented 17% of net sales, and increased 3% to $2,492, compared to $2,409 for the Fiscal 2004 Six Months. The increase in foreign sales in the Fiscal 2005 Second Quarter reflected increased sales in both our electro-diagnostic products and systems segment and our supplies, services, warranty and repair segment. Sales growth in the hearing diagnostics area, where our Navigator Pro product line with our Auditory Evoked Potential (AEP) M^.A^.S^.T^.E^.R technology continued to gain international acceptance, helped to offset sales declines in hearing screening systems as well as in sleep and epilepsy monitoring systems. International sales in our supplies, warranty, service and repair segment for the quarter were positively affected by approximately $150 of sales of our new HALO^TM EarMuffin, which was introduced in the Fiscal 2005 Second Quarter.

For the Fiscal 2005 Six Months, foreign sales of our electro-diagnostic systems were flat; sales of our Navigator^® Pro hearing diagnostic systems increased significantly over the Fiscal 2004 Six Months, reflective of the continued acceptance of our hearing diagnostic product lines. This increase was offset by sales declines in our hearing screening systems and our sleep and epilepsy monitoring systems. Foreign sales of our supplies, warranty, service and repair segment for the Fiscal 2005 Six Months increased over the Fiscal 2004 Six Months as a result of strong Ear Muffin sales.

Cost of Sales

Cost of sales for the Fiscal 2005 Second Quarter was $2,710, compared to $2,241 for the Fiscal 2004 Second Quarter. Cost of sales as a percentage of net sales was 33% in the Fiscal 2005 Second Quarter and 32% in the Fiscal 2004 Second Quarter, due primarily to shifts in product mix due to strong sales of our sleep monitoring and epilepsy monitoring systems within the electro-diagnostic products and systems segment. Cost of sales increased to $4,769 for the Fiscal 2005 Six Months compared to $4,316 for the Fiscal 2004 Six Months, due primarily to volume changes. Cost of sales as a percentage of net sales was 33% for both the Fiscal 2005 Six Months and the Fiscal 2004 Six Months.

SG&A Expenses

Selling, general and administrative (“SG&A”) expenses for the Fiscal 2005 Second Quarter were $3,287, $192 higher than the $3,095 recorded for the Fiscal 2004 Second Quarter. This increase was primarily due to increased commissions and bonus expenses related to the strong sales quarter, travel, consulting and other payroll expenses, partly offset by a reduction in advertising expenses and legal, audit and tax fees. As a percentage of net sales, however, SG&A expenses were 40% for the Fiscal 2005 Second Quarter, as compared to 45% for the Fiscal 2004 Second Quarter. SG&A expenses increased $385 to $6,334 for the Fiscal 2005 Six Months compared to $5,949 for the Fiscal 2004 Six Months, due primarily to increased selling and marketing efforts relating to new product introductions in our disposables area, increased commissions and travel expenses associated with increased sales, and increased legal expenses, partly offset by reductions in telecommunications, audit and tax expenses.

Research and Development Expenses

Research and development (“R&D”) expenses for the Fiscal 2005 Second Quarter were $1,270, compared to $1,132 recorded for the Fiscal 2004 Second Quarter. The increase in R&D expenses was primarily due to increased investment in software development costs both domestically and abroad. As a percentage of net sales, R&D expenses were 15% for the Fiscal 2005 Second Quarter and 16% for the Fiscal 2004 Second Quarter. R&D expenses increased $134 to $2,278 for the Fiscal 2005 Six Months compared to $2,144 for the Fiscal 2004 Six Months. R&D expenses represented 16% of net sales for both the Fiscal 2005 Second Quarter and the Fiscal 2004 Second Quarter. The increased R&D spending was due to continued investment in our product development programs and a lower level of capitalized software development costs, partly offset by a reduction in consulting expenses.

Operating Income

We had operating income in the Fiscal 2005 Second Quarter of $975, compared to $459 for the Fiscal 2004 Second Quarter. Operating income for the Fiscal 2005 Six Months was $1,112 compared to $837 for the Fiscal 2004 Six Months. These increases were primarily due to higher gross profit, partially offset by increased SG&A and R&D expenses.

Interest Income

Net interest income for the Fiscal 2005 Second Quarter increased to $28 from $22 for the Fiscal 2004 Second Quarter, primarily due to increases in cash balances.

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Income Tax

Income tax expense was $301 and $348 for the Fiscal 2005 Second Quarter and the Fiscal 2005 Six Months, respectively, both at 30% of pretax income. Income tax expense was $81 and $203 for the Fiscal 2004 Second Quarter and the Fiscal 2004 Six Months, respectively, or 17% and 23%, respectively, of pre-tax income. We began recording the favorable impact of historical and current year federal research and experimentation tax credits in the Fiscal 2004 Second Quarter, generating the lower tax expense for both the Fiscal 2004 Second Quarter and the Fiscal 2004 Six Months. Our income tax rate reflects the combination of federal and state effective tax rates, adjusted for the favorable impact of deferred tax assets and anticipated tax credits.

Net Income

Net income for the Fiscal 2005 Second Quarter was $703, compared to $400 for the Fiscal 2004 Second Quarter. Diluted earnings per share (EPS) for the Fiscal 2005 Second Quarter was $0.15, compared to an EPS of $0.09 per diluted share for the Fiscal 2004 Second Quarter. The increase in EPS was due to increased net income, partially offset by an increase in the number of diluted shares. Net income for the Fiscal 2005 Six Months was $817, compared to $674 for the Fiscal 2004 Six Months. EPS for the Fiscal 2005 Six Months was $0.18 per diluted share, compared to an EPS of $0.15 per diluted share for the Fiscal 2004 Six Months. The increase in EPS was again due to increased net income, partially offset by an increase in the number of diluted shares.

Liquidity and Capital Resources

As of August 31, 2004, we had working capital of $18,105, a $1,393 increase from a working capital balance of $16,712 at February 29, 2004. Total cash and cash equivalents increased $1,767, from $12,750 at February 29, 2004 to $14,517 at August 31, 2004.

Cash Provided by Operating Activities

Net cash provided by operating activities for the Fiscal 2005 Six Months was $1,566 compared to $968 for the Fiscal 2004 Six Months. This increase was primarily due to a decrease in accounts receivable related to improved collections and an increase in net income, partially offset by replenishments of inventory levels and reductions in the accounts payable balance.

Net inventory as of August 31, 2004 was $2,024, a $116 increase from the February 29, 2004 level of $1,908. The increased shipment activity that occurred in the fourth quarter of fiscal 2004 reduced inventory levels below sustainable levels, and we increased our inventory levels to replenish our operating stock. We manage inventory by using a metric of days inventory on hand (DIOH), which relates the dollar amount of ending inventory levels to the amount of cost of sales that it generated. DIOH as of August 31, 2004 was 76 days, a decrease from the 78 days we reported as of February 29, 2004.

Accounts receivable as of August 31, 2004 was $5,131, a decrease of $1,148 from the February 29, 2004 level of $6,279. This reduction was principally driven by collections during the first quarter of fiscal 2005 related to receivables generated as part of sales during the fourth quarter of fiscal 2004. The two key measurements we use to manage our receivables are: (1) days sales outstanding (DSO), and (2) the amount of customer account balances that are over 90 days past due. DSO allows us to analyze changes in our receivables balance as a function of the sales that generated that balance, rather than looking at the dollar change in the account on a standalone basis. We use the exhaustion method to calculate DSO, which assumes that the receivables balance was generated from the most recent sales. Using this methodology, our DSO at August 31, 2004 was 55 days, a six-day decrease from our DSO of 61 days as of February 29, 2004. Our other receivables measurement of past due balances greater than 90 days is indicative of the potential risk to us of the existence of uncollectible accounts that could exist in our receivables balances. At August 31, 2004, our past due receivables balances greater than 90 days decreased over 30% from its February 29, 2004 level.

Cash Used in Investing Activities

Net cash provided by investing activities for the Fiscal 2005 Six Months was $129, compared to cash flows used in investing activities of $262 for the Fiscal 2004 Six Months. In the Fiscal 2005 Second Quarter we collected a $526 receivable related to a medical claim that was settled with our stop-loss insurance carrier. This provision of cash was partly offset by increased capital spending and by an increase in the level of software development costs associated with our neurology products compared to that which was recorded in fiscal 2004.

Cash Flows Provided by Financing Activities

Net cash flows provided by financing activities for the Fiscal 2005 Six Months were $72, compared to $11 for the Fiscal 2004 Six Months, related to the exercise of stock options. In November 2002, our Board of Directors authorized the repurchase of 250,000 of our shares of common stock, of which 80,700 have been acquired to date. No shares have been repurchased during the current fiscal year.

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We believe available cash balances and cash flows from operations will satisfy our liquidity and capital requirements for the foreseeable future. As of August 31, 2004, our cash balances of $14,517 represented over 50% of our total assets, and we had no interest bearing debt. To the extent that our capital and liquidity requirements are not satisfied by available cash balances and cash flows from operations, we have available to us a $1,000,000 unsecured bank line of credit, with an interest rate set at the bank’s prime rate.

From time to time, we explore various corporate finance transactions such as business combinations or acquisitions, certain of which may include the issuance of our securities. However, we have no agreements or commitments with respect to any particular transaction and there can be no assurance that any such transaction would be completed.

Recent Litigation

On April 22, 2004, two plaintiffs filed a product liability claim against us and certain other defendants seeking damages. A brief description of this lawsuit may be found in Part II, Item 1 of this Form 10-Q. Please also see the disclosure in Exhibit 99.1, “Risk Factors” under the caption “Product liability suits against us could result in expensive and time consuming litigation, payment of substantial damages and an increase in our insurance rates.”

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our cash and variable-rate short-term cash equivalents are sensitive to changes in interest rates. Interest rate changes would result in a change in interest income. At current investment levels, our annual results of operations and statement of financial condition would vary by approximately $145,000 for every 1% change in the short-term interest rate. Exchange rate risk is not material for us. Less than US$25,000 resides in accounts denominated in foreign currency. Also, virtually all of our sales transactions are denominated in United States dollars, essentially eliminating the impact of exchange rates on the carrying value of our assets. Finally, the United States dollar is our functional currency for our Israeli operation, so there is no transaction or translation exchange rate concerns with that operation.

Item 4. Controls and Procedures

We carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and Corporate Controller, of the design and operation of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and Corporate Controller concluded that, as of August 31, 2004, our disclosure controls and procedures were effective to provide reasonable assurance that the information required to be disclosed in the reports we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

Any control system, no matter how well designed and operated, can provide only reasonable (not absolute) assurance that its objectives will be met. Furthermore, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected.

There was not any change in the our internal control over financial reporting that occurred during the quarterly period ended August 31, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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Part II. Other Information

Item 1. Legal Proceedings

As reported in our quarterly report on Form 10-Q for the fiscal quarter ended May 31, 2004, on April 22, 2004, Marcus L. Forsythe and Elizabeth Forsythe of Multnomah County, Oregon (the “Plaintiffs”) filed a Second Amended Complaint naming the Company as a defendant in a lawsuit against several parties that was filed in the Circuit Court of the State of Oregon for the County of Multnomah. The Plaintiffs allege that they have suffered damages as a result of auditory brain stem response and other related testing Mr. Forsythe underwent in April 2002 that was allegedly conducted, in part, using Bio-logic equipment. Plaintiffs seek to recover an aggregate of $12,300,000 in damages from the defendants for physical pain and suffering, emotional distress, the loss of past income and benefits, past and future medical, therapy, medication and household costs, and other foregone benefits, as well as unspecified damages for future loss of income earning capacity.

We intend to vigorously defend against the claims brought in the Forsythe litigation. Although the outcome of any litigation is inherently uncertain, we believe that our product liability insurance coverage is adequate to cover liabilities resulting from the Forsythe litigation, and therefore, that the Forsythe litigation should not have a material adverse effect on our business, assets, financial condition, liquidity and results of operations.

In addition to the legal proceeding described above, in the ordinary conduct of our business, we are subject to various other lawsuits and claims, covering a wide range of matters. Due to the inherent uncertainties of litigation, we cannot predict the ultimate outcome of these matters. An unfavorable outcome could have a material adverse impact on our business, financial condition and results of operations.

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

The Company’s annual meeting of stockholders was held on July 22, 2004. The Company’s stockholders voted as follows to elect two Class III directors to our board of directors:

Directors:	Votes For:	Authority Withheld:
Gabe Raviv, Ph.D	3,869,076	193,075
Craig W. Moore	3,812,589	249,562

In addition to Dr. Raviv and Mr. Moore, the following directors’ terms of office as directors continued after the meeting: Roderick G. Johnson, Albert Milstein and Lawrence D. Damron.

The Company’s stockholders also voted as follows to approve Bio-logic System Corp. 2004 Stock Incentive Plan:

Votes For:	Votes Against:	Abstentions:	Broker Non- Votes:
1,137,018	1,075,867	8,700	1,840,566

Item 6. Exhibits

31.1	Certification of Chief Executive Officer pursuant to Exchange Act Rule 13a-14(a) (under Section 302 of the Sarbanes-Oxley Act of 2002).
31.2	Certification of Principal Financial Officer pursuant to Exchange Act Rule 13-14(a) (under Section 302 of the Sarbanes-Oxley Act of 2002).
32.1	Certification of the Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.1	Risk Factors

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Signatures

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

Date: September 17, 2004	By:	/s/ Gabriel Raviv
		Gabriel Raviv,
		Chairman and Chief Executive Officer
		(principal executive officer)
Date: September 17, 2004	By:	/s/ Michael J. Hanley
		Michael J. Hanley,
		Corporate Controller
		(principal financial and accounting officer)

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EX-31.1

EXHIBIT 31.1

Certifications

I, Gabriel Raviv, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Bio-logic Systems Corp.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting;

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls over financial reporting.

Date: September 17, 2004

/s/ Gabriel Raviv

Gabriel Raviv

Chief Executive Officer

EX-31.2

EXHIBIT 31.2

Certifications

I, Michael J. Hanley, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Bio-logic Systems Corp.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting;

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls over financial reporting.

Date: September 17, 2004

/s/ Michael J. Hanley

Michael J. Hanley

Corporate Controller

(principal financial officer)

EX-32.1

EXHIBIT 32.1

CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report on Form 10-Q of Bio-logic Systems Corp. (the “Company”) for the quarterly period ended August 31, 2004 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Gabriel Raviv, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. 1350, as adopted pursuant to 906 of the Sarbanes-Oxley Act of 2002, that:

1. The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

2. The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company.

Date: September 17, 2004

/s/ Gabriel Raviv

Gabriel Raviv

Chief Executive Officer

EX-32.2

EXHIBIT 32.2

CERTIFICATION OF THE PRINCIPAL FINANCIAL OFFICER PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report on Form 10-Q of Bio-logic Systems Corp. (the “Company”) for the quarterly period ended August 31, 2004, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Michael J. Hanley, Corporate Controller of the Company, certify, pursuant to 18 U.S.C. 1350, as adopted pursuant to 906 of the Sarbanes-Oxley Act of 2002, that:

1. The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

2. The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company.

Date: September 17, 2004

/s/ Michael J. Hanley

Michael J. Hanley

Corporate Controller

(principal financial officer)

EX-99.1

EXHIBIT 99.1

Risk Factors

You should carefully consider the risks, uncertainties and other factors described below because they could materially and adversely affect our business, financial condition, operating results and prospects and could negatively impact the market price of our common stock. Also, you should be aware that the risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties that we do not yet know of, or that we currently think are immaterial, may also impair our business operations. You should also refer to the other information contained in this Quarterly Report on Form 10-Q, including our Unaudited Condensed Consolidated Financial Statements and the Notes to the Unaudited Condensed Consolidated Financial Statements in Part I. Item 1 of this Quarterly Report on Form 10-Q.

Risks Related to Our Business

We face aggressive competition in many areas of our business, and our business will be harmed if we fail to compete effectively.

We encounter aggressive competition from numerous companies in many areas of our business. Although we believe that our products currently compete favorably, we cannot give assurance that we can maintain our competitive position against our current and potential competitors. Many of our current and potential competitors have longer operating histories, greater name recognition and greater financial, technical and marketing resources than we have, and we may not be able to compete effectively with them. To remain competitive, we must develop new products and periodically enhance our existing products. We anticipate that we may have to adjust the prices of many of our products to stay competitive. In addition, new competitors may emerge and entire product lines may be threatened by new technologies or market trends that reduce the value of our existing product lines.

Demand for some of our products depends on the capital spending policies of our customers. Changes in these policies could negatively affect our business.

A majority of our customers are hospitals, physician offices and clinics. Many factors, including public policy spending provisions, available resources and economic cycles have a significant effect on the capital spending policies of these entities. These factors can have a significant effect on the demand for our products.

Our sales efforts through group purchasing organizations and sales to high volume purchasers may reduce our average selling prices, which could reduce our revenue and gross profits from these sales.

We have entered, and may enter in the future, into agreements with customers who purchase high volumes of our products. Our agreements with these customers may contain discounts off of our normal selling prices and other special pricing considerations, which could cause our revenue and profit margins to decline. In addition, we have entered into agreements to sell our products to members of group purchasing organizations, which negotiate volume purchase prices for medical devices and supplies for member hospitals, group practices and other clinics. While we make sales directly to group purchasing organization members, the members of these organizations now receive volume discounts off our normal selling price and may receive other special pricing considerations from us from time to time. Our sales efforts through group purchasing organizations may conflict with our direct sales efforts to our existing customers. If we enter into agreements with new group purchasing organizations and some of our existing customers begin purchasing our products through those group purchasing organizations, our revenue and profit margins could decline.

The complexity presented by international operations could negatively affect our business.

International revenues (excluding Canada) from continuing operations, accounted for approximately 17% of our total revenues for the first six months of fiscal 2005, 19% of our total revenues in fiscal 2004 and 16% of our total revenues in fiscal 2003. While we plan to continue expanding our presence in international markets, our international operations present a number of risks, including the following:

• Foreign laws may limit our ability to properly maintain our distribution channels. For example, a number of foreign laws restrict our ability to terminate a distributor for taking actions that adversely affect our business, such as manufacturing and selling competing products.

• Fluctuations in currency exchange rates have, on occasion, forced us to lower our prices, thereby reducing our margins for some of our products.

• If we fail to obtain and maintain necessary foreign regulatory approvals in order to market and sell our products outside of the U.S., we may not be able to sell our products in other countries.

• Because we rely on distributors to sell our products outside of the U.S., our revenues could decline if our existing distributors reduce the volume of purchases from us, or if our relationship with any of these distributors is terminated.

Other risks that could affect our international business include:

• The impact of possible recessions in economies outside the U.S.

• Political and economic instability, including instability related to war and terrorist attacks in the U.S. and abroad.

• Decreased healthcare spending by foreign governments that would reduce international demand for our products.

• Greater difficulty in accounts receivable collection and longer collection periods.

• Reduced acceptance of our products and systems due to language translation concerns.

• Reduced protection for intellectual property rights in some countries and potentially conflicting intellectual property rights of third parties under the laws of various foreign jurisdictions.

• A strengthening of the dollar that could make our products less competitive in foreign markets, because our sales contracts call for payment in U.S. dollars.

Our business could be harmed if our competitors establish cooperative relationships with large medical device vendors or rapidly acquire market share through industry consolidation.

We expect that the medical device industry will continue to consolidate. Large medical device vendors may acquire or establish cooperative relationships with our current competitors, or new competitors or alliances among competitors may emerge and rapidly acquire significant market share, either of which would harm our business and financial prospects.

Our dependence on suppliers for materials could impair our ability to manufacture our products.

We contract with third parties for the supply of some of the components used in our products and in the production of our disposable products. The lead-time involved in the manufacturing of some of these components can be lengthy and unpredictable. Some of these suppliers are not obligated to continue to supply us. For certain of these materials and components, relatively few alternative sources of supply exist. We may not be able to find a sufficient alternative supplier in a reasonable time period, or on commercially reasonable terms, if at all, which could impair our ability to produce and supply our products.

Additionally, replacement or alternative sources might not be readily obtainable due to regulatory requirements and other factors applicable to our manufacturing operations. Incorporation of components from a new supplier into our products may require a new or supplemental filing with applicable regulatory authorities and clearance or approval of the filing before we could resume product sales. This process may take a substantial period of time, and we cannot be assured that we would be able to obtain the necessary regulatory clearance or approval. This could create supply disruptions that would harm our product sales and operating results.

Finally, an uncorrected defect or supplier’s variation in a component or raw material, either unknown to us or incompatible with our manufacturing process, could harm our ability to manufacture the affected product.

Our ability to market and sell our products depends upon receipt of domestic and foreign regulatory approval of our products and manufacturing operations. Our failure to obtain or maintain regulatory approvals and compliance could negatively affect our business.

Our products and manufacturing operations are subject to extensive regulation in the United States by the FDA and by similar regulatory agencies in many other countries in which we do business. Unless an exemption applies, each medical device that we seek to market in the U.S. must first receive 510(k) premarket clearance pursuant to Section 510(k) of the Food, Drug, and Cosmetics Act of 1938, as amended. The principal risks that we face in obtaining and maintaining the regulatory approvals necessary to market our products include:

• The approval process for medical devices in the United States and abroad can be lengthy and expensive. The FDA’s 510(k) clearance process usually takes three to 12 months, but can take longer. The process of obtaining premarket approval is

2

much more costly, lengthy and uncertain than the 510(k) premarket clearance process, where the new product is based on products already in the marketplace that have previously received FDA approval. Premarket approval generally takes one to three years, but can take even longer. We cannot assure you that the FDA will ever grant either 510(k) clearance or premarket approval for any product we propose to market. As a result, we may expend substantial resources in developing and testing a new product but fail to obtain the necessary approvals or clearances to market or manufacture the product on a timely basis, if at all. Furthermore, if the FDA concludes that these future products using our technology do not meet the requirements to obtain 510(k) clearance (the intended use of the product is similar to existing products in the market, and the product is not based on new technological breakthroughs), we would have to seek premarket approval as a new product. We cannot assure you that the FDA will not impose the more burdensome premarket approval requirement on modifications to our existing products or future products, which in either case could be costly and cause us to divert our attention and resources from our business.

• When we modify a medical device for which we have received marketing approval, we must determine whether the modification requires us to seek new regulatory approvals. If the FDA or other regulatory agency does not agree with our determination, we may be prohibited from marketing the modified device until we receive the requisite regulatory approval or clearance. In addition, the FDA actively enforces regulations prohibiting marketing of devices for uses that have not been cleared or approved by the FDA.

If we fail to comply with applicable regulations, we could be subject to a number of enforcement actions, including warning letters, fines, product seizures, recalls, injunctions, total or partial suspension of production, operating restrictions or limitations on marketing, refusal of the government to grant new clearances or approvals, withdrawal of marketing clearances or approvals and civil and criminal penalties.

Other regulating legislation other than the FDA to which our business is subject to includes the Environmental Protection Act, the Occupational Safety and Health Act, and state and local counterparts to these acts.

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

The sale and use of our products could lead to the filing of product liability claims by persons claiming to have been injured using one of our products or claiming that one of our products failed to perform properly. For information concerning an existing product liability action against the Company, see Part II, Item 1 of this Form 10-Q. A product liability claim brought against us, with or without merit, could result in substantial damages and be costly and time consuming to defend, either of which could materially harm our business or financial condition. Our product liability insurance may not be adequate to protect our assets from the full financial impact of defending a product liability claim. These claims could increase our product liability insurance rates or prevent us from securing any coverage in the future.

Our operating results could suffer if future changes in technology or market conditions result in adjustments to our recorded asset balance for intangible assets.

We currently carry approximately $1.66 million of intangible assets on our books, the most significant of which relates to internally-developed software development costs. The determination of related estimated useful lives and whether these assets are impaired involves significant judgments. Due to the highly competitive nature of the medical device industry, new technologies could impair the value of our intangible assets if they create market conditions where our products are no longer competitive.

We may not be able to protect our intellectual property rights and, as a result, we could lose competitive advantages that could adversely affect our operating results.

Our success depends, in part, on our ability and the ability of our licensors to obtain, assert and defend patent rights, protect trade secrets and operate without infringing upon the proprietary rights of others. We currently own or have rights to eight U.S. patents. We may not, however, be able to obtain additional licenses to patents of others or be able to develop additional patentable technology of our own. Any patents issued to us may not provide us with competitive advantages, or the patents or proprietary rights of others may have an adverse effect on our ability to do business. Others may independently develop similar products or design around or infringe such patents or proprietary rights owned by or licensed to us. Any patent obtained or licensed by us may not be held to be valid and enforceable if challenged by another party.

Although we endeavor to protect our patent rights from infringement, we may not be aware, or become aware, of patents issued to our competitors or others that conflict with our own. Such conflicts could result in a rejection of important patent applications or the invalidation of important patents, which could have a materially adverse effect on our competitive position. In the event of such conflicts, or in the event we believe that competitive products infringe upon patents to which we hold rights, we may pursue patent

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infringement litigation or interference proceedings against, or may be required to defend against such litigation or proceedings involving, holders of such conflicting patents or competing products. Such litigation or proceedings may have a materially adverse effect on our competitive position, and there can be no assurance that we will be successful in any such litigation or proceeding. Litigation and other proceedings relating to patent matters, whether initiated by us or a third party, can be expensive and time consuming, regardless of whether the outcome is favorable to us, and can result in the diversion of substantial financial, managerial and other resources. An adverse outcome could subject us to significant liabilities to third parties or require us to cease any related development or commercialization activities. In addition, if patents that contain dominating or conflicting claims have been or are subsequently issued to others and such claims are ultimately determined to be valid, we may be required to obtain licenses under patents or other proprietary rights of others. Any licenses required under any such patents or proprietary rights may not be made available on terms acceptable to us, if at all. If we do not obtain such licenses, we could encounter delays or could find that the development, manufacture or sale of products requiring such licenses is foreclosed.

We rely on proprietary know-how and confidential information and employ various methods, such as entering into confidentiality and non-compete agreements with our current employees and with certain third parties to whom we have divulged proprietary information, to protect the processes, concepts, ideas and documentation associated with our technologies. Such methods may not afford significant protection to us, and may not be able to adequately protect our trade secrets or to ensure that other companies would not acquire information that we consider proprietary.

Our operating results may decline if we do not succeed in developing, acquiring and marketing additional products or improving our existing products.

The development and acquisition of additional products and technologies, and the improvement of our existing products requires significant investments in research and development. If we fail to successfully sell new products and update our existing products, our operating results may decline as our existing products reach the end of their commercial life cycles.

Our business is likely to be adversely affected if we are unable to retain our senior executive officers and key business and technical personnel.

We are dependent upon the services of our senior executives, in particular Gabriel Raviv, our Chief Executive Officer, and other key business and technical personnel. We do not maintain key-man life insurance on our senior executives. The loss of the services of Mr. Raviv or other senior executives or key employees could have a material adverse effect on us. Also, our continued commercialization will depend upon, among other things, the successful recruiting and retention of highly skilled managerial and marketing personnel with experience in business activities such as ours. Competition for the type of highly skilled individuals sought by us is intense. There can be no assurance that we will be able to retain existing key employees or that we will be able to find, attract and retain skilled personnel on acceptable terms.

If we breach any of the agreements under which we license commercialization rights to products or technology from others, we could lose licenses that are important to our business.

We license rights to products and technology that are important to our business and we expect to enter into additional licenses in the future. Under these licenses, we are subject to commercialization and development, sublicensing, royalty, insurance and other obligations. If we fail to comply with any of these requirements, or otherwise breach a license agreement, the licensor may have the right to terminate the license in whole or to terminate the exclusive nature of the license. In addition, upon the termination of the license, we may be required to license to the licensor any related intellectual property that we develop.

We may be unable to successfully develop and/or commercialize our new and existing products.

The successful development and commercialization of new products will depend upon our ability to obtain regulatory approvals. If we are unable to obtain these approvals, we will be unable to market and sell our products, which will negatively affect our business. Even if we are able to obtain regulatory approval for our products, we may have difficulty in bringing these products to market. In addition, once our products are brought to market, their shipment may be delayed or the products may have to be discontinued based on design, mechanical, software, regulatory or other issues. These matters may adversely affect our business and reputation.

Risks Related to Our Common Stock

The trading price of our common stock may fluctuate substantially in the future.

The trading price of our common stock may fluctuate widely as a result of a number of factors, some of which are not in our control, including:

• Our ability to meet or exceed our own forecasts or expectations of analysts or investors.

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• Quarter to quarter variations in our operating results.

• Announcements regarding clinical activities or new products by us or our competitors.

• General conditions in the medical device industry.

• Changes in our own forecasts or earnings estimates by analysts.

• Price and volume fluctuations in the overall stock market, which have particularly affected the market prices of many medical device companies.

• General economic conditions.

In addition, the market for our stock may experience price and volume fluctuations unrelated or disproportionate to our operating performance. As a result, you may not be able to sell shares of our common stock at or above the price at which you purchased them. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against that company. If any securities litigation is initiated against us, with or without merit, we could incur substantial cost, and our management’s attention and resources could be diverted from our business.

Our executive officers, directors, principal stockholders and their affiliates hold a substantial portion of our stock and could exercise significant influence over matters requiring stockholder approval, regardless of the wishes of other stockholders.

As of August 31, 2004, our executive officers, directors, principal stockholders and individuals or entities affiliated with them beneficially owned in the aggregate approximately 25% of our outstanding common stock. If some or all of these stockholders act together, they could significantly influence all matters that our stockholders vote upon, including the election of directors and determination of significant corporate actions. This concentration of ownership could delay or prevent a change of control transaction that could otherwise be beneficial to our stockholders.

Provisions of our amended certificate of incorporation, by-laws and Delaware law, and an agreement among certain stockholders and the Company, may discourage a third party from acquiring us.

Provisions of our amended certificate of incorporation, by-laws and Delaware law, including provisions providing for a staggered board of directors, as well as an agreement among certain stockholders and the Company granting those stockholders rights of first refusal in the event that one or more of such stockholders either obtains a written bona fide offer from a third party to sell or transfer any of their shares of our common stock, could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders.

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