UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

	For the quarterly period ended June 30, 2005.

OR

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

	For the transition period from to

Commission File Number: 1-11388

PLC SYSTEMS INC.

(Exact Name of Registrant as Specified in Its Charter)

Yukon Territory, Canada		04-3153858
(State or Other Jurisdiction of		(I.R.S. Employer Identification No.)
Incorporation or Organization)

10 Forge Park, Franklin, Massachusetts		02038
(Address of Principal Executive Offices)		(Zip Code)

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

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act) Yes o No ý

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 August 5, 2005
Common Stock, no par value		30,078,775

Item 1. Financial Statements

PLC SYSTEMS INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

	June 30, 2005			December 31, 2004
ASSETS
Current assets:
Cash and cash equivalents	$	2,645		$	9,678
Short-term investments	6,900			—
Accounts receivable – Edwards	1,099			1,144
Accounts receivable – other, net of allowance of $90 and $104 as of June 30, 2005 and December 31, 2004, respectively	212			261
Inventories, net	1,146			1,112
Prepaid expenses and other current assets	868			592
Total current assets	12,870			12,787

Equipment, furniture and leasehold improvements, net	268			293
Other assets	235			247
Total assets	$	13,373		$	13,327

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	393		$	328
Accrued compensation	561			430
Accrued other	291			301
Deferred revenue – Edwards	1,457			999
Deferred revenue – other	66			71
Total current liabilities	2,768			2,129

Deferred revenue – Edwards	4,087			4,181
Deferred revenue – other	188			188
Total long-term liabilities	4,275			4,369
Commitments and contingencies
Stockholders’ equity:
Preferred stock, no par value, unlimited shares authorized, none issued and outstanding
Common stock, no par value, unlimited shares authorized, 30,079 and 30,068 shares issued and outstanding as of June 30, 2005 and December 31, 2004	93,737			93,731
Accumulated deficit	(87,056		)	(86,582		)
Accumulated other comprehensive loss	(351		)	(320		)
Total stockholders’ equity	6,330			6,829
Total liabilities and stockholders’ equity	$	13,373		$	13,327

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

PLC SYSTEMS INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
Revenues:
Product sales – Edwards	$	1,438		$	1,224		$	2,846		$	2,586
Product sales – other	129			130			279			299
Service fees – Edwards	360			308			671			661
Service fees – other	55			134			129			159
Total revenues	1,982			1,796			3,925			3,705

Cost of revenues:
Product sales – Edwards	531			494			1,016			1,028
Product sales – other	69			81			136			137
Service fees – Edwards	144			140			282			287
Service fees – other	46			32			84			61
Total cost of revenues	790			747			1,518			1,513

Gross profit	1,192			1,049			2,407			2,192

Operating expenses:
Selling, general and administrative	897			866			1,777			1,856
Research and development	649			516			1,220			1,045
Total operating expenses	1,546			1,382			2,997			2,901

Loss from operations	(354		)	(333		)	(590		)	(709		)

Other income, net	64			82			116			108

Net loss	$	(290	)	$	(251	)	$	(474	)	$	(601	)

Basic and diluted loss per share	$	(0.01	)	$	(0.01	)	$	(0.02	)	$	(0.02	)

Average shares outstanding:
Basic	30,070			30,056			30,069			29,990
Diluted	30,070			30.056			30,069			29,990

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

PLC SYSTEMS INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Six Months Ended June 30,
	2005			2004
Operating activities:
Net loss	$	(474	)	$	(601	)

Adjustments to reconcile net loss to net cash provided by (used for) operating activities:
Depreciation and amortization	68			71

Change in assets and liabilities:
Accounts receivable – Edwards	44			142
Accounts receivable – other	64			(83		)
Inventories	(35		)	(262		)
Prepaid expenses and other assets	(276		)	(173		)
Accounts payable	65			254
Deferred revenue – Edwards	364			4,522
Deferred revenue – other	(1		)	13
Accrued liabilities	121			15
Net cash provided by (used for) operating activities	(60		)	3,898

Investing activities:
Purchase of short-term investments	(6,900		)	—
Purchase of equipment	(30		)	(104		)
Net cash used for investing activities	(6,930		)	(104		)

Financing activities:
Net proceeds from sales of common shares	6			90
Net cash provided by financing activities	6			90

Effect of exchange rate changes on cash and cash equivalents	(49		)	(10		)
Net increase (decrease) in cash and cash equivalents	(7,033		)	3,874

Cash and cash equivalents at beginning of period	9,678			6,377
Cash and cash equivalents at end of period	$	2,645		$	10,251

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

PLC SYSTEMS INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2005

1. Nature of Business

PLC Systems Inc. (“PLC” or the “Company”) is a medical device company specializing in innovative technologies for the cardiac and vascular markets. The Company currently manufactures lasers for use in the treatment of cardiovascular disease. PLC pioneered the CO₂ Heart Laser System (the “Heart Laser System”) that cardiac surgeons use to perform carbon dioxide (CO₂) transmyocardial revascularization (“TMR”) to alleviate symptoms of severe angina. In addition, PLC is completing the development of and manufacturing the Optiwave 980 cardiac laser ablation system (“Optiwave 980 System”) under an agreement with Edwards Lifesciences LLC (“Edwards”). Following commercial release, the Optiwave 980 System is expected to be utilized by surgeons to ablate cardiac tissue as a means to treat certain heart arrhythmias.

Edwards is the Company’s exclusive worldwide distributor for all surgical cardiac ablation products and, in the United States, acts as the Company’s exclusive distributor for TMR products. Edwards is also the Company’s largest shareholder, owning approximately 18% of its outstanding common stock as of June 30, 2005, and has a representative on the Board of Directors.

2. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. These financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004. Certain prior year amounts have been reclassified to conform to the current year’s presentation.

3. Edwards Transaction

In February 2004, the Company signed an agreement with Edwards to assume development of the Optiwave 980 System. Under the terms of the agreement, the Company will have exclusive manufacturing rights to build the Optiwave 980 System and other related surgical products. The Company will be responsible, among other things, for ongoing research and development and manufacture of the product and for obtaining regulatory approvals. Edwards will be responsible for the approval, funding and conduct of any clinical studies designed to obtain data in support of a new product approval or clearance as required by the FDA or other regulatory body.

In conjunction with signing this new agreement, the terms of the Company’s TMR distribution agreement with Edwards were modified to (1) extend the term of the agreement until at least October 17, 2017 and (2) reduce the Company’s share of revenue on TMR kits sold to hospitals. The Company received as consideration from Edwards, a lump-sum payment of $4,533,333, which was recorded as deferred revenue in the Company’s Consolidated Balance Sheet. See Note 8, “Revenue Recognition”.

4. Loss per Share

For the three and six months ended June 30, 2005 and 2004, basic and diluted loss per share have been computed using only the weighted average number of common shares outstanding during the period without giving effect to any potential future issues of common stock related to stock option programs and warrants since their inclusion would be antidilutive.

For the three months ended June 30, 2005 and 2004, 5,818,422 and 6,190,422 shares, respectively, and for the six months ended June 30, 2005 and 2004, 5,818,422 and 6,190,422 shares, respectively, attributable to outstanding stock options and warrants were excluded from the calculation of diluted loss per share because the effect was antidilutive. The following table sets forth the computation of basic and diluted loss per share:

	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
	(In thousands, except earnings per share)
Net loss available for common shareholders	$	(290	)	$	(251	)	$	(474	)	$	(601	)
Weighted average outstanding shares of common stock	30,070			30,056			30,069			29,990
Dilutive effect of employee stock options and warrants	—			—			—			—
Common stock and common stock equivalents	30,070			30,056			30,069			29,990
Loss per share:
Basic	$	(0.01	)	$	(0.01	)	$	(0.02	)	$	(0.02	)
Diluted	$	(0.01	)	$	(0.01	)	$	(0.02	)	$	(0.02	)

5. Stock-Based Compensation

The Company grants stock options for a fixed number of shares to employees and certain other individuals with exercise prices equal to the fair value of the shares at the dates of grant. The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-based Compensation (“SFAS 123”), as amended, and presently accounts for its stock option plans in accordance with the provisions of Accounting Principles Board Opinion 25, Accounting for Stock Issued to Employees (“APB 25”).

The following table illustrates the effect on net loss and basic loss per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation:

	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
	(In thousands, except per share data)
Net loss attributable to common stockholders— As reported	$	(290	)	$	(251	)	$	(474	)	$	(601	)
Deduct total stock-based compensation expense determined under fair value based method for all stock option awards	(132		)	(359		)	(166		)	(392		)
Net loss attributable to common stockholders— Pro forma	$	(422	)	$	(610	)	$	(640	)	$	(993	)
Loss per basic and diluted share attributable to common stockholders— As reported	$	(0.01	)	$	(0.01	)	$	(0.02	)	$	(0.02	)
Loss per basic and diluted share attributable to common stockholders— Pro forma	$	(0.01	)	$	(0.02	)	$	(0.02	)	$	(0.03	)

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

	Three Months Ended June 30,
	2005		2004
Expected life (years)	3		3
Interest rate	3.68	%	2.53	%
Volatility	.401		.734
Expected dividend yield	None		None

Recent Accounting Pronouncement

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), Share-Based Payments (“SFAS 123R”), which is a revision of SFAS No. 123. SFAS 123R supersedes APB 25. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. The disclosure-only approach permitted by SFAS 123 and elected by the Company is no longer an alternative. Accordingly, the adoption of SFAS 123R’s fair value method may have a significant impact on the results of operations, although it will have no impact on the Company’s overall financial position. The impact of adoption of SFAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted SFAS 123R, the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net income and earnings per share above. The Company is required to adopt the provisions of SFAS 123R effective January 1, 2006.

6. Comprehensive Loss

Total comprehensive loss for the three and six month periods ended June 30, 2005 amounted to $307,000 and $505,000, respectively. Comprehensive loss is comprised of net loss plus the increase/decrease in currency translation adjustment.

7. Inventories

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

	June 30, 2005		December 31, 2004
Raw materials	$	973	$	889
Work in progress	71		130
Finished goods	102		93
	$	1,146	$	1,112

At June 30, 2005 and December 31, 2004, inventories are stated net of a reserve of $505,000 and $528,000, respectively, for potentially obsolete inventory.

8. Revenue Recognition

The Company records revenue from the sale of TMR kits and Optiwave 980 Systems at the time of shipment to Edwards. TMR kit revenues include the amount invoiced to Edwards for kits shipped pursuant to purchase orders received, as well as an amortized portion of deferred revenue related to Edwards’ payment of $4,533,333 in February 2004. This payment was made by Edwards in exchange for a reduction in the prospective purchase price the Company receives from Edwards upon a sale of the kits (see Note 3). The Company is amortizing this payment from Edwards into its Consolidated Statement of Operations as revenue over a seven year period under the units-of-revenue method as prescribed by Emerging Issues Task Force (EITF) 88-18, Sales of Future Revenue. Management determined that a seven year timeframe was the most appropriate amortization period based on a valuation model they used to assess the economic fairness of the payment. Factors management considered in developing this valuation model included the estimated foregone revenues over a seven year period resulting from the reduction in the prospective purchase price payable to the Company by Edwards, a discount rate deemed appropriate to the transaction and an estimate of the remaining economic useful life of the current TMR kit design, without any benefit being given to potential future product improvements the Company may make. For the three and six months ended June 30, 2005, the Company has recorded amortization of $98,000 and $174,000, respectively.

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

Under the terms of the Edwards TMR distribution agreement, once Edwards has recovered a prescribed amount of revenue from a hospital for the use or purchase of a TMR laser,

any additional revenues earned by Edwards are shared with the Company pursuant to a formula established in the distribution agreement. The Company only records its share of such additional revenue, if any, at the time the revenue is earned.

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

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

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

9. Warranty and Preventative Maintenance Costs

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

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

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

	Six Months Ended June 30,
	2005		2004
Balance, beginning of period	$	60	$	60
Payments made	—		—
Change in liability for warranties issued during the year	—		7
Change in liability for preexisting warranties	—		(7		)

Balance, end of period	$	60	$	60

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

This quarterly report (including certain information incorporated herein by reference) contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Statements containing terms such as “believes”, “plans”, “expects”, “anticipates”, “intends”, “estimates” and similar expressions reflect uncertainty and are forward-looking statements. Forward-looking statements are based on current plans and expectations and involve known and unknown important risks and uncertainties that could cause actual results to

differ materially from those described in the forward-looking statements. Such important factors and uncertainties include, but are not limited to, those set forth below under the heading “Certain Factors that May Affect our Future Results” and elsewhere in this quarterly report.

Overview

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

Edwards is our exclusive worldwide distributor for all surgical cardiac ablation products and, in the United States, acts as our exclusive distributor for TMR products. Edwards is our largest customer, accounting for approximately 91% and 90%, respectively, of our total sales for the three and six months ended June 30, 2005 and 88% in the year ended December 31, 2004. We expect this sales trend to continue for the foreseeable future.

Approximately 85% and 86%, respectively, of our revenues in the three and six months ended June 30, 2005 and 90% in the year ended December 31, 2004, came from the sale and service of TMR lasers and related disposable kits. Although not a direct measure, we believe a leading indicator of the adoption rate of TMR as a treatment for severe angina is TMR kit shipments to hospitals. We remain largely dependent on the success of Edwards’ sales and marketing efforts to increase our installed base of TMR lasers and increase TMR procedure volumes and revenues.

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

Application of Critical Accounting Policies and Estimates

This management’s discussion and analysis of financial condition and results of operations is based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. Our significant accounting policies are more fully described in Note 2 of the Notes to Consolidated Financial Statements as well as in “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Estimates”, each as contained in our Annual Report on Form 10-K for the year ended December 31, 2004. No significant changes were made to those policies during the three months ended June 30, 2005.

Inventories

Inventories are stated at the lower of cost or market value. A specific obsolescence allowance is provided for slow moving, excess and obsolete inventory based on our best estimate

of the net realizable value of inventory on hand taking into consideration factors such as (1) actual trailing twelve month sales, (2) expected future product line demand, based in part on sales forecast input received from Edwards, and (3) service part stocking levels which, in management’s best judgment, are advisable to maintain in order to meet warranty, service contract and time and material spare part demands. Historically, we have found our reserves to be adequate.

Allowance for Doubtful Accounts

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

Warranty and Preventative Maintenance Costs

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

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

Revenue Recognition

We record revenue from the sale of TMR kits and Optiwave 980 Systems at the time of shipment to Edwards. TMR kit revenues include the amount invoiced to Edwards for kits shipped pursuant to purchase orders received, as well as an amortized portion of deferred revenue related to Edwards’ payment to us of $4,533,333 in February 2004 in exchange for a reduction in the prospective purchase price we receive from Edwards upon a sale of the kits. We are amortizing this payment from Edwards into our Consolidated Statement of Operations as revenue over a seven year period under the units-of-revenue method as prescribed by Emerging Issues Task Force (EITF) 88-18, Sales of Future Revenue. We determined that a seven year timeframe was the most appropriate amortization period based on a valuation model we used to assess the economic fairness of the payment. Factors we considered in developing this valuation model included the estimated foregone revenues over a seven year period resulting from the reduction in the prospective purchase price payable to us by Edwards, a discount rate deemed appropriate to the transaction and an estimate of the remaining economic useful life of the current TMR kit design, without any benefit being given to potential future product improvements we may make. For the three and six months ended June 30, 2005, we recorded amortization of $98,000 and $174,000, respectively.

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

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

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

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

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

Results of Operations

Results for the three and six months ended June 30, 2005 and 2004 and the related percent of revenues were as follows:

	Three Months Ended June 30,								Six Months Ended June 30,
	2005				2004				2005				2004
	$		%		$		%		$		%		$		%
	(dollars in thousands)

Total revenues	1,982		100		1,796		100		3,925		100		3,705		100
Total cost of revenues	790		40		747		42		1,518		39		1,513		41
Gross profit	1,192		60		1,049		58		2,407		61		2,192		59
Selling, general & administrative	897		45		866		48		1,777		45		1,856		50
Research & development	649		33		516		29		1,220		31		1,045		28
Loss from operations	(354	)	(18	)	(333	)	(19	)	(590	)	(15	)	(709	)	(19	)
Other income	64		3		82		5		116		3		108		3
Net loss	(290	)	(15	)	(251	)	(14	)	(474	)	(12	)	(601	)	(16	)

	Three Months Ended								Six Months Ended
	June 30,				Increase (decrease)				June 30,				Increase (decrease)
	2005		2004		over 2004				2005		2004		over 2004
	$		$		$		%		$		$		$		%
	(dollars in thousands)

Product sales	1,567		1,354		213		16		3,125		2,885		240		8
Service fees	415		442		(27	)	(6	)	800		820		(20	)	(2	)
Total revenues	1,982		1,796		186		10		3,925		3,705		220		6
Product cost of sales	600		575		25		4		1,152		1,165		(13	)	(1	)
Service fees cost of sales	190		172		18		10		366		348		18		5
Total cost of revenues	790		747		43		6		1,518		1,513		5		—
Gross profit	1,192		1,049		143		14		2,407		2,192		215		10
Selling, general & administrative expenses	897		866		31		4		1,777		1,856		(79	)	(4	)
Research & development expenses	649		516		133		26		1,220		1,045		175		17
Total operating expenses	1,546		1,382		164		12		2,997		2,901		96		3
Other income	64		82		(18	)	(22	)	116		108		8		7
Net loss	(290	)	(251	)	(39	)	(16	)	(474	)	(601	)	127		21

Product Sales

TMR laser revenues, the largest component of product sales in the three and six months ended June 30, 2005, increased by $3,000, and decreased by $278,000, or 17%, respectively, as compared to the three and six months ended June 30, 2004.

In the three months ended June 30, 2005 the $3,000 increase in TMR laser revenues is primarily a result of a higher average domestic selling price on TMR laser sales and increased revenue sharing earned under the TMR distribution agreement offset by a decrease in the number of new TMR laser units sold by Edwards in the second quarter of 2005 (four) compared to the second quarter of 2004 (six).

In the six months ended June 30, 2005, the $278,000 decline in TMR laser revenues is primarily a result of a decrease in the number of new TMR laser units sold by Edwards in the six months ended June 30, 2005 (eight) compared to the six months ended June 30, 2004 (twelve) and decreased revenue sharing earned under the TMR distribution agreement. These decreases were partly offset by a higher average domestic selling price on TMR laser sales in the 2005 period.

Disposable TMR kit revenues, the second largest component of product sales, increased by $44,000, or 8%, and $221,000, or 23%, respectively, in the three and six months ended June 30, 2005 as compared to the three and six months ended June 30, 2004. The increase in the three months ended June 30, 2005 is primarily related to a $30,000, or 6%, increase in domestic disposable revenue. This $30,000 increase resulted from an increase in deferred revenue amortization related to the $4,533,333 payment by Edwards offset slightly by a lower volume of

kit shipments to Edwards. International disposable revenue was $14,000 in the three months ended June 30, 2005 as compared to $0 in the three months ended June 30, 2004.

The increase in disposable TMR kit revenues in the six months ended June 30, 2005 is primarily related to a $185,000, or 20%, increase in domestic disposable revenue. This $185,000 increase resulted from a higher volume of kit shipments to Edwards as well as an increase in deferred revenue amortization related to the $4,533,333 payment by Edwards. International disposable revenue increased by $36,000, or 65%, due to a 20% increase in the number of TMR kits shipped to international customers in the six months ended June 30, 2005 as compared to the six months ended June 30, 2004.

Optiwave 980 System revenues from Edwards increased $192,000 and $345,000, respectively, in the three and six months ended June 30, 2005 as compared to the three and six months ended June 30, 2004 when we had no such sales. The Optiwave 980 System revenues we have recognized to date consist of laser power sources sold to Edwards for use in marketing evaluations that they are conducting. We do not expect any additional significant revenues from Optiwave 980 System sales until such time that Edwards successfully completes its marketing evaluations and commercially launches the system into the market.

We must successfully increase our disposable manufacturing capacity to meet Edwards’ sales demand once they commercially launch the Optiwave 980 System. We believe it will take us approximately six months to sufficiently increase our disposable manufacturing capability if and when Edwards provides us with a sales forecast and, therefore, we do not expect at this time to generate any revenues from the sale of Optiwave disposables in 2005.

Other product sales, relating to sales of new and refurbished surgical tubes, decreased $26,000, or 19%, and $48,000, or 19%, respectively, in the three and six months ended June 30, 2005 as compared to the three and six months ended June 30, 2004.

Service Fee Revenues

Service fee revenues decreased $27,000, or 6%, and $20,000, or 2%, in the three and six months ended June 30, 2005, respectively, as compared to the three and six months ended June 30, 2004. International service fee revenues decreased $79,000, or 59%, and $30,000, or 19%, in the three and six months ended June 30, 2005, respectively, as compared to the three and six months ended June 30, 2004. This decrease was offset in part by an increase in domestic service fee revenues of $52,000, or 17% and $10,000, or 2%, respectively, in the three and six months ended June 30, 2005 as compared to the three and six months ended June 30, 2004 due to increased billings to Edwards for service related calls.

Gross Profit

Total gross profit was $1,192,000, or 60%, and $2,407,000, or 61%, respectively, of total revenues for the three and six months ended June 30, 2005 as compared with gross profit of $ 1,049,000, or 58%, and $2,192,000, or 59%, of total revenues, for the three and six months ended June 30, 2004. The increase in gross profit dollars in the three months ended June 30, 2005 as compared to the three months ended June 30, 2004 is due to (1) an increase in additional revenue sharing earned under the TMR distribution agreement, (2) higher disposable TMR revenues, (3) new product sales of Optiwave 980 Systems and (4) a higher average domestic

selling price on TMR laser sales. These increases were offset in part by (1) a decrease in the number of new TMR lasers sold, (2) higher unabsorbed period overhead expenditures, (3) a decrease in other product sales relating to sales of new and refurbished surgical tubes and (4) a decrease in service related revenues.

The increase in gross profit dollars in the six months ended June 30, 2005 as compared to the six months ended June 30, 2004 is due to (1) higher disposable TMR revenues, (2) new product sales of Optiwave 980 Systems and (3) a higher average domestic selling price on TMR laser sales. These increases were offset in part by (1) a decrease in the number of new TMR lasers sold, (2) higher unabsorbed period overhead expenditures (3) a decrease in other product sales relating to sales of new and refurbished surgical tubes and (4) a decrease in service related revenues.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 4% and decreased 4%, respectively, in the three and six months ended June 30, 2005 as compared to the three and six months ended June 30, 2004. In the three month period, the increase is primarily a result of increased expenditures related to salary and related fringe benefits and bad debt expenses offset in part by lower legal and administrative fees. In the six month period, the decrease is related to lower legal and administrative fees and bad debt expenses offset in part by increased salary and related fringe benefits and insurance expenditures.

Research and Development Expenses

A major component of our research and development expenses was salaries and associated fringe benefits, which accounted for 35% and 37% of expenditures, respectively, in the three months ended June 30, 2005 and 2004 and 47% and 42% of expenditures, respectively, in the six months ended June 30, 2005 and 2004.

The increased expenditures in the three and six months ended June 30, 2005 as compared to the three and six months ended June 30, 2004 were incurred in connection with product development work on an additional internal research and development initiative.

We expect to continue to incur significant new research and development expenditures in 2005 in pursuit of our business strategy to broaden and diversify our product portfolio. In particular, we expect our annual 2005 research and development expenditures to increase in the aggregate approximately $600,000 compared to 2004 as a result of expected continued work on the Optiwave 980 System and product development work on an additional internal research and development initiative.

Other Income

The largest component of other income is interest income earned on our cash and short-term investments. Interest income increased by $34,000 and $60,000, respectively, in the three and six months ended June 30, 2005 compared to the three and six months ended June 30, 2004 due to higher average interest earned on our cash and short-term investments. A second component of other income decreased $52,000 in both the three and six months ended June 30, 2005 as a result of non-recurring proceeds from an insurance settlement received in the second

quarter of 2004.

Net Loss

The net loss in the three months ended June 30, 2005 and 2004 was $290,000 and $251,000, respectively. This increase in the net loss resulted primarily from higher operating expenses offset in part by higher gross margin dollars generated. The net loss in the six months ended June 30, 2005 and 2004 was $474,000 and $601,000, respectively. This decrease in the net loss resulted primarily from higher gross margin dollars generated offset slightly by higher operating expenses.

We expect to incur a net loss in the twelve months ended December 31, 2005, primarily as a result of our planned increased investments in research and development expenses, as discussed above.

Kit Shipments

We view disposable kit shipments to end users as an important metric in evaluating our business. We believe kit shipments are a reasonable indicator for the adoption of TMR as a therapy in the marketplace. Disposable kit shipments to end users during the three and six months ended June 30, 2005 and June 30, 2004 were as follows:

	Three Months Ended June 30,			Six Months Ended June 30,
	2005	2004	% Increase over 2004	2005	2004	% Increase over 2004

Domestic	566	502	13	1,005	884	14
International	5	1	400	55	46	20
Total	571	503	14	1,060	930	14

Liquidity and Capital Resources

At June 30, 2005, we had cash, cash equivalents and short-term investments of $9,545,000. We have no debt obligations.

During the six-month period ended June 30, 2005, we recorded a net loss of $474,000. In addition, we had net unfavorable working capital changes which resulted in net cash used for operating activities of approximately $60,000. Cash used in investing activities was approximately $6,930,000, consisting of the purchase of short-term investments of $6,900,000 and $30,000 of investments in equipment. We believe that our existing cash resources will meet our working capital requirements through the next 12 months.

We are largely dependent on the success of Edwards’ sales and marketing efforts in the U.S. to continue to increase the installed base of HL2 lasers and substantially increase TMR procedural volumes and revenues. Should the installed base of HL2 lasers or TMR procedural volume not increase sufficiently, our liquidity and capital resources will be negatively impacted. Additionally, other unanticipated decreases in operating revenues or increases in expenses or further changes or delays in third-party reimbursement to healthcare providers using our products

may adversely impact our cash position and require further cost reductions or the need to obtain additional financing. It is not certain that we, working with Edwards and our international distributors, will be successful in achieving broad commercial acceptance of the Heart Laser Systems, or that we will be able to operate profitably in the future on a consistent basis, if at all.

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

Furthermore, we have undertaken a new business strategy that involves broadening and diversifying our product portfolio beyond our current TMR offerings, by developing or acquiring new and innovative medical devices to address cardiac and vascular related markets. We believe this strategy will result in our incurring losses for at least the next 12-24 months as we increase our investments in both manufacturing and research and development staff necessary to pursue these new strategic initiatives, including, the Optiwave 980 System and an additional internal research and development initiative. We cannot be certain that we will be successful in implementing our new business strategy or that future sales, if any, from these planned new products will recover the investments we plan to make. If we are unsuccessful in implementing our new business strategy, or if the diversification of our product portfolio takes longer or costs more than anticipated, our liquidity and capital resources will be adversely affected and we may need to obtain additional financing.

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

Off-Balance Sheet Arrangements

None.

Certain Factors that May Affect our Future Results

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

We expect to incur significant operating losses in the near future

We incurred a net loss in the quarter ended June 30, 2005. We expect to continue to incur net losses for at least the next 12-24 months as we increase our spending in the areas of manufacturing and research and development for the Optiwave 980 System and other strategic research and development programs. Moreover, as we continue to pursue our new business strategy of acquiring or developing new medical devices to address cardiac and vascular related markets, we may continue to incur expenses that exceed the revenues we generate. We cannot provide any assurance that we will be successful with our new business strategy or that we will ever return to profitability.

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

We currently market one product line, which consists of two patented high-powered carbon dioxide lasers and related TMR disposable kits known as the Heart Laser Systems, which account for the majority of our total revenue. Approximately 85% and 86%, respectively, of our revenues in the three and six months ended June 30, 2005 and 90% in the year ended December 31, 2004, were derived from the sales and service of our Heart Laser Systems. This absence of a diversified product line means that we are directly and materially impacted by changes in the market for Heart Laser Systems.

Our company is dependent on one principal customer

Pursuant to the terms of our TMR distribution agreement with Edwards, Edwards is our exclusive distributor for our HL2 TMR laser and TMR kits in the United States. In addition, pursuant to the terms of our new distribution agreement with Edwards for the Optiwave 980 System (as well as any other additional surgical products that we may develop for the treatment of atrial fibrillation, or AF), Edwards is our exclusive worldwide distributor of those products. As a result of these exclusive distribution arrangements, Edwards accounted for 91% and 90% of our total revenues in the three and six months ended June 30, 2005, respectively, and 88% in the year ended December 31, 2004 and we expect Edwards to account for the significant majority of our revenue in the future. If our relationship with Edwards does not progress as anticipated, or if Edwards’ sales and marketing strategies fail to generate sales of our products in the future, our revenue will decrease significantly and our business, financial condition and results of operations will be seriously harmed.

Our company is dependent on certain suppliers

Some of the components for our Heart Laser Systems, most notably the power supply and certain optics and fabricated parts for the HL2, and certain components for the Optiwave 980 System, are only available from one supplier, and we have no assurance that we will be able to source any of our sole-sourced components from additional suppliers. We are dependent upon our sole suppliers to perform their obligations in a timely manner. In the past, we have experienced delays in product delivery from our sole suppliers and, because we do not have an alternative supplier to produce these products for us, we have little leverage to enforce timely delivery. Any delay in product delivery or other interruption in supply from these suppliers could prevent us from meeting our commercial demands for our products, which could have a material adverse effect on our business, financial condition and results of operations. Furthermore, we do not require significant quantities of any components because we produce a limited number of our products each

year. Our low-quantity needs may not generate substantial revenue for our suppliers. Therefore, it may be difficult for us to continue our relationships with our current suppliers or establish relationships with additional suppliers on commercially reasonable terms, if at all, and such difficulties may seriously harm our business, financial condition and results of operations.

Edwards must successfully complete their marketing evaluations of the Optiwave 980 System before they commit to launch the product

Edwards is currently conducting marketing evaluations of the Optiwave 980 System at hospitals across the country. Edwards must complete these marketing evaluations and judge them to be successful before they will commit to launch the product into the market. Although we believe the evaluations of the product to date have been positive, we cannot assure you that Edwards will successfully complete these marketing evaluations of the Optiwave 980 System or that they will not decide to cancel the program in the future. Should Edwards decide for whatever reason not to market the Optiwave 980 System, our revenue growth prospects, financial condition and results of operations will be materially and adversely affected.

We must transition manufacturing of the Optiwave 980 disposable handpieces from Edwards and be able to manufacture them in required volumes at commercially reasonable costs

Assuming Edwards successfully completes their marketing evaluations of the Optiwave 980 System, we must successfully transition production of the Optiwave 980 disposable handpieces to our leased manufacturing space in Billerica, Massachusetts. We must hire new skilled manufacturing employees and we must develop and validate our manufacturing processes with respect to building these disposable handpieces. We expect to incur expenses to outfit our manufacturing space with the necessary production and test equipment and to train our employees on how to build the product. We will need to be able to manufacture these highly specialized disposable handpieces for which we have no comparable prior experience producing at any volume. Until such time as we become more proficient in these manufacturing methods, if ever, we may encounter problems, including those related to:

• production yields;

• quality control;

• training;

• shortages of qualified personnel; and

• potential capacity constraints.

Such problems could severely affect our ability to adequately scale up production and meet demand for our products on a timely basis, which could harm our business, financial condition and results of operations.

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

Our ability to operate our business successfully depends in significant part upon the retention and motivation of certain key technical, regulatory, production and managerial personnel and consultants and our ongoing ability to hire and retain additional qualified personnel in these areas. Competition for such personnel is intense, particularly in the Greater Boston area. We cannot

be certain that we will be able to attract such personnel and the loss of any of our current key employees or consultants could have a significant adverse impact on our business.

Our company may be unable to raise needed funds

As of June 30, 2005, we had cash, cash equivalents and short-term investments totaling $9,545,000. Based on our current operating plan, we anticipate that our existing capital resources should be sufficient to meet our working capital requirements for at least the next 12 months. However, if our business does not progress in accordance with our current business plan, we may need to raise additional funds in the future. We may not be able to raise additional capital upon satisfactory terms, or at all, and our business, financial condition and results of operations could be materially and adversely affected. To the extent that we raise additional capital by issuing equity or convertible securities, ownership dilution to our shareholders will result. To the extent that we raise additional capital through the incurrence of debt, our activities may be restricted by the repayment obligations and other restrictive covenants related to the debt.

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

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

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

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

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

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

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

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

In addition, although the Optiwave 980 System has received FDA clearance, it has not yet secured the CE Mark and it is therefore not yet ready for worldwide commercialization. If we are

unable to maintain regulatory clearances, secure the CE Mark for the Optiwave 980 System or achieve widespread commercial acceptance of the Heart Laser Systems or the Optiwave 980 System, our business, financial condition and results of operations will be materially and adversely affected.

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

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

Rapid technological changes in our industry could make our products obsolete

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

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

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

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

• product design and development;

• product testing;

• product labeling;

• product storage;

• premarket clearance and approval;

• advertising and promotion; and

• product sales and distribution.

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

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

• warning letters;

• patient or physician notification;

• restrictions on our products or manufacturing processes;

• voluntary or mandatory recalls;

• product seizures;

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

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

• fines;

• injunctions;

• suspension or withdrawal of marketing approvals or clearances; and

• civil and criminal penalties.

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

To date, we have received the following regulatory approvals for our products:

Heart Laser Systems

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

• has restricted the use of the Heart Laser Systems by not allowing us to market these products to treat patients whose condition is amenable to conventional treatments,

such as heart bypass surgery, stenting and angioplasty; and

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

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

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

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

Japan — We cannot market our product in Japan until we receive government approval.

Prior to marketing the Heart Laser Systems in Japan, we must receive approval from the Japanese government. This approval requires a clinical study in Japan with at least 60 patients. A study was completed in 1998 with the HL1. Although the results of this study have been submitted to the Japanese government, we do not know whether the clinical study will be sufficient or when, if ever, we will receive approval to sell the HL1 in Japan. In addition, it is unclear what impact the introduction of the HL2 into the U.S. and other international markets will have on our ability to market the HL1 in Japan.

Optiwave 980 System

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

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

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

if such clearance is obtained, that it will be obtained in a timely enough fashion for our products to remain competitive in the marketplace.

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

Changes in third party reimbursement for our TMR procedure could materially affect future demand for our TMR products

Currently, Medicare and Blue Cross Blue Shield provide coverage for TMR when it is performed as both a sole therapy treatment and when used as an adjunct to bypass surgery. Certain other private insurance companies and health maintenance organizations also currently provide reimbursement for these TMR procedures performed with our products, and physician reimbursement codes have been established for both surgical procedures; however, we have limited data as to the breadth of this coverage for the TMR procedures by private insurance companies and health maintenance organizations. Should third party insurance reimbursement for our TMR products be reduced or eliminated in the future, our business, financial condition and results of operations would be materially and adversely affected.

In July 2004, CMS convened the Medicare Coverage Advisory Committee (MCAC) to review and discuss the evidence and clinical data regarding TMR. The MCAC is an advisory panel consisting of clinicians and other medical experts which CMS utilizes to supplement their own internal expertise. Although the MCAC was not convened for the purpose of making a reimbursement coverage recommendation, we believe CMS has reviewed the information presented at the MCAC meeting and has decided to continue existing Medicare coverage for TMR without any modification. No assurance can be given that CMS will not choose to alter Medicare coverage in the future, which could include (1) issuing new guidelines clarifying the patient criteria for Medicare reimbursement, (2) reducing, modifying or eliminating the existing reimbursement coverage for TMR or (3) requesting additional clinical studies to be performed.

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

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

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

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

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

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

We are subject to risks associated with international operations

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

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

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

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

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

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

• actual or anticipated quarterly increases or decreases in revenue, gross margin or

earnings, and changes in our business, operations or prospects;

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

• announcements relating to strategic relationships or mergers;

• conditions or trends in the medical device industry;

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

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

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

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

We have no intention to pay dividends

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

Item 3. Quantitative and Qualitative Disclosures about Market Risk

A portion of our operations consists of sales activities in foreign jurisdictions. We manufacture our products exclusively in the U.S. and sell our products in the U.S. and abroad. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the foreign markets in which we distribute our products. Our operating results are exposed to changes in exchange rates between the U.S. dollar and foreign currencies, especially the Euro. When the U.S. dollar strengthens against the Euro, the value of foreign sales decreases. When the U.S. dollar weakens, the functional currency amount of sales increases. No assurance can be given that foreign currency fluctuations in the future will not adversely affect our business, financial condition and results of operations, although at present we do not believe that our exposure is significant as international sales represented only 4% and 6% of our consolidated sales in the three and six months ended June 30, 2005 and 6% in the year ended December 31, 2004. We do not hedge any balance sheet exposures and intercompany balances against future movements in foreign exchange rates.

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

Item 4. Controls and Procedures

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of June 30, 2005.

The term “disclosure controls and procedures”, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of June 30, 2005, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended June 30, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Part II. Other Information

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

On May 18, 2005, the Company held its 2005 Annual Meeting of Shareholders (the “Shareholders Meeting”). At the Shareholders Meeting, the following matters were approved by the vote specified below:

1. Kevin J. Dunn and Brent Norton were elected as Class III directors and will hold office until the annual meeting of shareholders in 2008 or until their successors are duly elected and qualified. Mr. Dunn received 27,607,466 shares of common stock voting in favor of his election and 400,917 shares of common stock were withheld. Dr. Norton received 27,617,675 shares of common stock voting in favor of his election and 390,708 shares of common stock were withheld.

2. To approve the 2005 Stock Incentive Plan. The votes were cast as follows: 10,782,898 shares of common stock were voted for the Plan, 1,716,366 shares of common stock were voted against the Plan, 183,939 shares of common stock abstained from the vote and 15,325,180 shares of common stock were broker non-votes.

3. The ratification of the appointment of Vitale, Caturano & Co., Ltd. as the Company’s independent registered public accounting firm for the year ending December 31, 2005 was approved. The votes were cast as follows: 27,803,348 shares of common stock were voted for the ratification, 142,949 shares of common stock were voted against the ratification and 62,086 shares of common stock abstained from the vote.

EXHIBIT INDEX

Exhibit Number			Description of Document

10.1			2005 Stock Incentive Plan, incorporated by reference to the Registrant’s current report on Form 8-K filed with the Securities and Exchange Commission on May 24, 2005.

10.2			Form of Stock Option Grant Letter for Employees of the Registrant under the 2005 Stock Incentive Plan, incorporated by reference to the Registrant’s current report on Form 8-K filed with the Securities and Exchange Commission on May 24, 2005.

10.3			Form of Stock Option Grant Letter for Non-Employee Directors of the Registrant under the 2005 Stock Incentive Plan, incorporated by reference to the Registrant’s current report on Form 8-K filed with the Securities and Exchange Commission on May 24, 2005.

31.1			Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2			Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1			Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

	PLC SYSTEMS INC.

Date: August 11, 2005	By:	/s/ James G. Thomasch
		James G. Thomasch
		Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer)

Part I.	Financial Information:

	Item 1.	Financial Statements

		Condensed Consolidated Balance Sheets (unaudited)

		Condensed Consolidated Statements of Operations (unaudited)

		Condensed Consolidated Statements of Cash Flows (unaudited)

		Notes to Condensed Consolidated Financial Statements (unaudited)

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

	Item 3.	Quantitative and Qualitative Disclosures about Market Risk

	Item 4.	Controls and Procedures

Part II.	Other Information:

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

	Item 6.	Exhibits