Urologix (ULGX) 10-Q 2006 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005

or

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

For the transaction period from            to            

Commission File Number 0-28414

UROLOGIX, INC.

(Exact name of registrant as specified in its charter)

Minnesota	41-1697237
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

14405 21st Avenue North, Minneapolis, MN 55447

(Address of principal executive offices)

Registrant’s telephone number, including area code: (763) 475-1400

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

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of November 1, 2005, the Company had outstanding 14,313,943 shares of common stock, $.01 par value.

PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Urologix, Inc.

Condensed Balance Sheets

(In thousands, except per share data)

	September 30, 2005			June 30, 2005
	(unaudited)			(*)
ASSETS
Current assets:
Cash and cash equivalents	$	10,255		$	10,599
Available-for-sale investments		34			171
Accounts receivable, net of allowances of $185 and $167		4,248			4,243
Inventories		2,053			1,742
Prepaids and other current assets		370			252
Total current assets		16,960			17,007
Property and equipment:
Machinery, equipment and furniture		10,607			9,977
Less accumulated depreciation		(7,824	)		(7,526	)
Property and equipment, net		2,783			2,451
Other assets		1,579			1,670
Goodwill		10,193			10,193
Other intangible assets, net		7,619			7,785
Total assets	$	39,134		$	39,106
LIABILITIESAND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	1,631		$	1,533
Accrued compensation		437			811
Other accrued expenses		989			1,175
Deferred income		297			314
Total current liabilities		3,354			3,833
Deferred tax liability		1,208			1,152
Deferred income		846			896
Other accrued expenses		69			80
Total liabilities		5,477			5,961
COMMITMENTS AND CONTINGENCIES (Note 9)
Shareholders’ equity:
Common stock, $.01 par value, 25,000 shares authorized; 14,314 and 14,308 shares issued and outstanding		143			143
Additional paid-in capital		110,469			110,110
Accumulated deficit		(76,961	)		(77,107	)
Accumulated other comprehensive income		6			(1	)
Total shareholders’ equity		33,657			33,145
Total liabilities and shareholders’ equity	$	39,134		$	39,106

(*) The Balance Sheet at June 30, 2005 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

The accompanying notes to financial statements are an integral part of these statements.

Urologix, Inc.

Condensed Statements of Operations

(In thousands, except per share data)

(Unaudited)

	Three Months Ended September 30,
	2005			2004
Sales	$	6,157		$	6,051
Cost of goods sold		2,032			1,838
Gross profit		4,125			4,213
Costs and expenses:
Selling, general and administrative		3,171			2,727
Research and development		796			642
Amortization of intangible assets		41			41
Total costs and expenses		4,008			3,410
Operating earnings		117			803
Interest income, net		57			26
Net earnings before taxes	$	174		$	829
Provision for income taxes		(28	)		(109	)
Net earnings	$	146		$	720
Net earnings per common share - basic	$	0.01		$	0.05
Net earnings per common share - diluted	$	0.01		$	0.05
Weighted average number of shares used in basic per share calculations		14,311			14,212
Weighted average number of shares used in diluted per share calculations		14,404			15,040

The accompanying notes to financial statements are an integral part of these statements.

Urologix, Inc.

Condensed Statements of Cash Flows

(In thousands)

(Unaudited)

	Three Months Ended September 30,
	2005			2004
Operating Activities:
Net earnings	$	146		$	720
Adjustments to reconcile net earnings to net cash (used for) provided by operating activities:
Depreciation and amortization		473			479
Provision for bad debts		18			37
Loss on disposal of assets		1			—
Employee stock-based compensation expense		337			—
Deferred income taxes		56			68
Change in operating items:
Accounts receivable		(23	)		(233	)
Inventories		(555	)		(180	)
Prepaids and other assets		(27	)		108
Accounts payable		98			200
Accrued expenses and deferred income		(639	)		(1,013	)
Net cash (used for) provided by operating activities		(115	)		186
Investing Activities:
Purchase of property and equipment		(396	)		(11	)
Proceeds from sale/maturity of available-for-sale investments		145			1,115
Net cash (used for) provided by investing activities		(251	)		1,104
Financing Activities:
Proceeds from exercise of stock options		22			372
Net cash provided by financing activities		22			372
Net increase / (decrease) in cash and cash equivalents		(344	)		1,662
Cash and cash equivalents:
Beginning of period		10,599			5,142
End of period		10,255		$	6,804
Supplemental cash-flow information
Net value of inventory transferred to property and equipment	$	241		$	118

The accompanying notes to financial statements are an integral part of these statements.

Urologix, Inc.

Notes to Condensed Financial Statements

September 30, 2005

(Unaudited)

1. Basis of presentation

The accompanying unaudited condensed financial statements of Urologix, Inc. (the “Company” or “Urologix”) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. The balance sheet as of September 30, 2005 and the statements of operations and cash flows for the three months ended September 30, 2005 and 2004 are unaudited but include all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the financial position at such date and the operating results and cash flows for those periods. Certain information normally included in financial statements and related footnotes prepared in accordance with generally accepted accounting principles has been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The accompanying financial statements should be read in conjunction with the financial statements and notes included in Urologix’ Annual Report on Form 10-K for the year ended June 30, 2005.

Results for any interim period shown in this report are not necessarily indicative of results to be expected for any other interim period or for the entire year. Certain prior year amounts have been reclassified to conform to current year presentation.

2. Use of Estimates

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

3. Stock-Based Compensation

We have a stock option plan that provides for the granting of incentive stock options to employees and nonqualified stock options to employees, directors and consultants. As of September 30, 2005, we had reserved 4,450,910 shares of common stock under this plan, and 991,898 shares were available for future grants. Options expire ten years from the date of grant and typically vest 25 percent after the first year of service with the remaining vesting 1/36^theach month thereafter. Under the current terms of our stock option plan, persons serving as non-employee directors at the date of the annual shareholder meeting automatically receive a grant to purchase 10,000 shares of common stock at a price equal to fair market value on the date of grant. Such options are immediately exercisable on the date of grant, and expire 10 years from the date of grant, subject to earlier termination one year after the person ceases to be a director of the Company.

In addition to the stock option plan described above, Fred B. Parks, the Company’s Chairman and Chief Executive Officer, received an option to purchase 225,000 shares in connection with his original employment agreement dated May 21, 2003. The option is a non-qualified option exercisable at a price of $2.75. The 225,000 share grant began vesting over the period commencing on May 27, 2003 and ends on May 27, 2007, with 56,268 shares vesting on May 27, 2004, and 1/36th of the remaining 168,732 shares vesting on the 27th of each of the 36 months following May 27, 2004.

Urologix, Inc.

Notes to Condensed Financial Statements

September 30, 2005

(Unaudited)

On July 1, 2005 we adopted the fair value recognition provisions of SFAS No. 123R “Share-Based Payment” using the modified prospective method. As a result, as of September 30, 2005, our results of operations reflect compensation expense for new stock options granted and vested under our stock incentive plan, and the unvested portion of previous stock option grants which vested during the quarter. Amounts recognized in the financial statements related to stock-based compensation were as follows (in thousands, except for per share data):

	Three months ended
	2005		2004
Total cost of stock-based compensation	$	337	$	—
Amount capitalized in inventory and property and equipment		—		—
Amounts charged against earnings, before income tax benefits		337		—
Amount of income tax benefit recognized in earnings		—		—
Amount charged against net earnings	$	337	$	—
Impact on net earnings per common share:
Basic	$	0.02		—
Diluted	$	0.02		—

Stock-based compensation expense was reflected in the September 30, 2005 statement of operations as follows (in thousands):

Cost of goods sold	$	14
Selling, general and administrative		272
Research and development		51
	$	337

Prior to July 1, 2005, we accounted for stock-based employee compensation arrangements in accordance with the provisions and related interpretations of Accounting Principles Board Opinion 25, “Accounting for Stock Issued to Employees.” Had compensation cost for stock-based compensation been determined consistent with SFAS 123, the net earnings and net earnings per share would have been adjusted to the following pro-forma amounts (in thousands, except for per share data):

	Three months ended September 30, 2004
Net earnings, as reported	$	720
Employee stock-based compensation expense included in net earnings		—
Less: stock-based employee compensation expense determined under fair value based method, net of tax		(618	)
Pro forma net earnings	$	102
Net earnings per share:
Basic - as reported	$	0.05
Basic - pro forma	$	0.01
Diluted - as reported	$	0.05
Diluted - pro forma	$	0.01

6

Urologix, Inc.

Notes to Condensed Financial Statements

September 30, 2005

(Unaudited)

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. We use historical data to estimate expected volatility, the period of time that option grants are expected to be outstanding, as well as employee termination behavior. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for the estimated life of the option. The following assumptions were used to estimate the fair value of options granted during the three-month periods ended September 30, 2005 and 2004 using the Black-Scholes option-pricing model:

	2005		2004
Volatility	86.9	%	88.4	%
Risk-free interest rates	3.9	%	2.9	%
Expected option life	4 years		4 years
Stock dividend yield	—		—

A summary of our option activity for the three-month period ended September 30, 2005 is as follows:

	Number of Options	Weighted-avg. Exercise Price Per Option		Weighted-avg. Remaining Contractual Term	Aggregate Intrinsic Value
Outstanding at July 1, 2005	1,574,800	$	6.60
Options granted	291,000		5.47
Options forfeited	22,592		8.10
Options expired	15,802		11.03
Options exercised	6,217		3.64
Outstanding at September 30, 2005	1,821,189		6.37	7.7	—
Exercisable at September 30, 2005	996,087		6.88	6.9	—

There is no aggregate intrinsic value for options outstanding or exercisable at September 30, 2005 as the average price of our stock for the first quarter of fiscal 2006 was less than the average exercise price of options outstanding or exercisable.

The weighted average fair value of our options at their grant date was approximately $3.39 and $7.68 for the three-month periods ended September 30, 2005 and 2004, respectively. The total intrinsic value of options exercised during the three-month periods ended September 30, 2005 and 2004 was $8,000 and $527,000, respectively.

A summary of the status of our nonvested shares as of September 30, 2005 is as follows:

	Number of Options		Weighted-avg. Grant- Date Fair Value
Nonvested at July 1, 2005	668,584		4.15
Options granted	291,000		3.39
Options forfeited	(22,592	)	5.09
Options vested	(111,890	)	5.27
Nonvested at September 30, 2005	825,102		3.61

As of September 30, 2005, there was $3.1 million of total unrecognized compensation cost related to nonvested share-based compensation granted under our plan. That cost is expected to be recognized over a weighted-average period of 2.7 years. The total fair value of shares vested during the three-month periods ended September 30, 2005 and 2004 were $590,000 and $623,000, respectively.

Urologix, Inc.

Notes to Condensed Financial Statements

September 30, 2005

(Unaudited)

4. Basic and diluted earnings per share

Basic earnings per share was computed by dividing the net earnings by the weighted average number of shares of common stock outstanding during the periods presented. Diluted earnings per share was computed by dividing the net earnings by the weighted average number of shares of common stock outstanding plus all dilutive potential common shares that result from stock options. The number of shares used in earnings per share computations are as follows (in thousands):

	Three months ended September 30,
	2005	2004
Weighted average common shares outstanding - basic	14,311	14,212
Dilutive effect of stock options	93	828
Weighted average common shares outstanding - diluted	14,404	15,040

The dilutive effect of stock options in the above table excludes 1,023,000 and 434,000 of options for which the exercise price was higher than the average market price for the three month periods ended September 30, 2005 and 2004, respectively.

5. Inventories

Inventories consisted of the following as of (in thousands):

	September 30, 2005		June 30, 2005
Raw materials	$	1,393	$	1,153
Work in process		344		320
Finished goods		316		269
Total inventories	$	2,053	$	1,742

Urologix, Inc.

Notes to Condensed Financial Statements

September 30, 2005

(Unaudited)

6. Other intangible assets, net

Other intangible assets consist of developed technologies, customer base and trademarks. Developed technologies and customer base are amortized using the straight-line method over their estimated useful lives of 15 and 14 years, respectively. The trademark asset is considered to be an intangible with an indefinite useful life, and it will not be amortized until its useful life is determined to be no longer indefinite.

Balances of other intangible assets, net, were as follows (in thousands):

	As of September 30, 2005
	Carrying Amount		Accumulated Amortization		Net
Amortizing intangibles:
Developed technologies	$	7,500	$	2,500	$	5,000
Customer base		2,300		821		1,479
Subtotal		9,800		3,321		6,479
Non-amortizing intangibles:
Trademarks						1,140
Total other intangible assets						7,619

7. Comprehensive earnings

Comprehensive earnings includes all changes in equity during a period except those resulting from investments by and distributions to shareholders. Our comprehensive earnings are as follows (in thousands):

	Three months ended September 30,
	2005		2004
Net earnings	$	146	$	720
Change in net unrealized gains on investments		7		(7	)
Comprehensive income	$	153	$	713

Urologix, Inc.

Notes to Condensed Financial Statements

September 30, 2005

(Unaudited)

8. Warranty

Some of our products are covered by warranties against defects in material and workmanship for periods of up to twenty-four months. We record a liability for warranty claims at the time of sale. The amount of the liability is based on the trend in the historical ratio of product failure rates, material usage and service delivery costs to sales, the historical length of time between the sale and resulting warranty claim and other factors.

Warranty provisions and claims for the three month periods ended September 30, 2005 and 2004 were as follows (in thousands):

Fiscal Year	Beginning Balance at July 1		Warranty Provisions		Warranty Claims			Ending Balance at September 30
2006	$	141	$	136	($	149	)	$	128
2005	$	215	$	77	($	140	)	$	152

9. Legal Proceedings

Our business exposes us to product liability claims that are inherent in the testing, production, marketing and sale of medical devices. Management believes any losses that may occur from these matters are adequately covered by insurance, and the ultimate outcome of these matters will not have a material effect on the financial position or results of operations of the Company.

10. Asset Acquisition

During the first quarter of fiscal 2006 we acquired the Cooled ThermoTherapy assets of three regional mobile service providers for a purchase price of $391,000. The asset acquisition was to facilitate the launch of our own Cooled ThermoTherapy mobile service also during the first quarter of fiscal 2006. The purchase price was assigned to the fair value of the assets acquired as follows (in thousands):

Equipment	$	309
Inventory		81
Supplies		1
	$	391

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following is a discussion and analysis of Urologix’ financial condition and results of operations as of and for the three month periods ended September 30, 2005 and 2004. This section should be read in conjunction with the condensed financial statements and related notes in Item 1 of this report and Urologix’ Annual Report on Form 10-K for the year ended June 30, 2005.

Cautionary Note Regarding Forward-Looking Statements

This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains, in addition to historical information, forward-looking statements that are based on our current expectations, beliefs, intentions or future strategies. These statements are subject to risks and uncertainties that could cause actual results to differ materially from the statements, including the need to maintain profitability and increase revenues; the rate of adoption of Cooled ThermoTherapy™ (transurethral microwave thermotherapy) products, our sole products, by the medical community; the impact of competitive treatments, products and pricing; the Company’s ability to develop and market new products, including the company-owned Cooled ThermoTherapy mobile service, and the Company’s ability to generate revenue from new products; the development and effectiveness of the Company’s sales organization and marketing efforts; developments in the reimbursement environment for the Company’s products including the determination of reimbursement rates for Cooled ThermoTherapy; the ability of third-party suppliers to produce and supply products; the Company’s ability to successfully defend its intellectual property against infringement and the cost and expense associated with that effort. We caution readers not to place undue reliance on any of these forward-looking statements, which speak only as of the date made. A detailed discussion of risks and uncertainties may be found below in “Factors That May Affect Our Future Results and The Trading Price of Our Common Stock” and in our Annual Report on Form 10-K for the year ended June 30, 2005.

OVERVIEW

Urologix, Inc., based in Minneapolis, develops, manufactures and markets minimally invasive medical products for the treatment of urological disorders.

We have developed and offer non-surgical, catheter-based therapies that use a proprietary cooled microwave technology for the treatment of BPH, a disease that dramatically affects more than 23 million men worldwide by causing adverse changes in urinary voiding patterns. We market our products under the Targis and Prostatron names. Both systems utilize Cooled ThermoTherapy, a targeted microwave energy combined with a unique cooling mechanism that protects healthy tissue and enhances patient comfort while providing safe, effective, lasting relief from the symptoms of BPH. Cooled ThermoTherapy can be performed without anesthesia or intravenous sedation and, as a result, can be performed in a physician’s office or an outpatient clinic. We believe Cooled ThermoTherapy provides an efficacious, safe and cost-effective solution for BPH that is clinically superior to medication and is without the complications and side effects inherent in surgical procedures.

We believe that third-party reimbursement is essential to the adoption of Cooled ThermoTherapy, and that clinical efficacy, overall cost effectiveness and physician advocacy is key to obtaining this reimbursement. We estimate that 60% to 80% of patients who receive treatment in the United States will be eligible for Medicare coverage. The remaining patients will either be covered by private insurers, including traditional indemnity health insurers and managed care organizations, or they will be private-paying patients. As a result, Medicare reimbursement is particularly critical for widespread market adoption of Cooled ThermoTherapy in the United States.

The level of Medicare reimbursement for Cooled ThermoTherapy is dependent on the site of service. The Centers for Medicare and Medicaid Services (CMS) reimburses for outpatient hospital-based procedures, including Cooled ThermoTherapy, with a fixed rate or prospective payment system. Under this method of reimbursement, a hospital receives a fixed reimbursement for each Cooled ThermoTherapy treatment performed in its facility, approximately $2,100 in calendar year 2005, although the rate varies depending on a wage index and other factors for each hospital. The urologist performing the Cooled ThermoTherapy treatment receives reimbursement of approximately $500 per procedure.

CMS reimburses for Cooled ThermoTherapy treatments performed in the urologist’s office. The reimbursement rate (inclusive of the physician’s fee) in calendar year 2005 for Cooled ThermoTherapy procedures performed in the urologist’s office is approximately $3,900 compared to $4,000 in calendar 2004, which is subject to geographic adjustment. Reimbursement rates for calendar year 2006 will be published in the November 2005 edition of the Federal Register.

CMS had a CPT Code covering Cooled ThermoTherapy on the ASC list of Medicare approved procedures providing a reimbursement rate for ambulatory surgical centers (ASC). As a result, procedures performed in an ASC were reimbursed under a two part system similar to hospitals: the ASC received a fixed fee of approximately $1,300, the highest amount allowable under the system, while the urologist performing the procedure was reimbursed the same amount as if the treatment had occurred in a hospital, approximately $500. The relatively low facility reimbursement rate relative to the cost of the procedure potentially limited the number of Cooled ThermoTherapy treatments done in an ASC. Effective July 2005, the CPT code covering Cooled ThermoTherapy was deleted from the ASC list of Medicare approved procedures. As a result, effective with that change, urologists who perform Cooled ThermoTherapy procedures in an ASC are reimbursed at the office-based reimbursement rates, approximately $3,900 (inclusive of the physician’s fee) in calendar year 2005, subject to geographic adjustment.

Our goal is to grow Cooled ThermoTherapy as a standard of care for the treatment of BPH. Our business strategy to achieve this goal is (i) educate both patients and physicians on the benefits of Cooled ThermoTherapy compared to other treatment options, (ii) increase the use of Cooled ThermoTherapy by physicians who already have access to a Cooled ThermoTherapy system, (iii) increase the number of physicians who provide Cooled ThermoTherapy to their patients, and (iv) satisfy demand for Cooled ThermoTherapy systems through the efficient use of both new systems and systems already in use.

We expect to continue to invest in sales and marketing programs and research and development projects as we focus on growing our revenues, continue clinical trials in support of regulatory and reimbursement approvals, and continue improving our therapy. Our future profitability will be dependent upon, among other factors, our success in achieving increased treatment volume and market adoption of the Cooled ThermoTherapy procedures in the physician’s office, our success in obtaining and maintaining necessary regulatory clearances, our ability to manufacture at the volumes and quantities the market requires, the extent to which Medicare and other health care payers continue to reimburse costs of Cooled ThermoTherapy procedures performed in physicians’ offices, hospitals, and ambulatory surgery centers and the amount of reimbursement provided.

In addition, on July 1, 2005 we adopted the fair value recognition provisions of SFAS No. 123R “Share-Based Payment.” The adoption of this statement resulted in the Company recognizing $337,000 of stock-based compensation expense during the first quarter of fiscal 2006. This expense is reflected as cost of goods sold of $14,000, selling, general and administrative expense of $272,000 and research and development expense of $51,000 in our statement of operations. The decrease in stock-based compensation expense compared to the pro-forma expense of $618,000 in the first quarter of fiscal 2005 is due primarily to the reduction in unvested options as of the beginning of fiscal 2006, and to the final vesting of options granted in fiscal 2001 and 2002 with weighted average fair values of $4.76 and $8.99, respectively, compared to the continuing vesting and expense associated with options granted in fiscal 2003 and 2004 with lower weighted-average fair values of $2.72 and $2.70, respectively.

Critical Accounting Policies:

In accordance with Securities and Exchange Commission guidance, we set forth below those material accounting policies that we believe are the most critical to an investor’s understanding of our financial results and condition, and require complex management judgment.

Revenue Recognition

We recognize revenue from the sale of Cooled ThermoTherapy system control units upon delivery to the customer. In addition to our sales of Cooled ThermoTherapy system control units, we place our Cooled ThermoTherapy system control units with customers under a variety of programs for both evaluation and long-term use, and also provide access to Cooled ThermoTherapy treatments via our mobile service. We retain title to the control units placed with our customers for evaluation and long-term use and do not recognize any revenue on these control units until title has transferred. These programs as well as our mobile service offerings are designed to expand access to our technology, and thus expand the market for our single-use treatment catheters. Revenue from our mobile service is recognized upon treatment of the patient. Revenue from the sale of single-use treatment catheters is recognized at the time of shipment. Revenue for warranty service contracts is deferred and recognized over the contract period. We record a provision for estimated sales returns on product sales in the same period as the related revenue is recorded. The provision for estimated sales returns is based on historical sales returns, analysis of credit memo data and other known factors.

Allowance for Doubtful Accounts

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. This allowance is a significant estimate and is regularly evaluated by us for adequacy by taking into consideration factors such as past experience, credit quality of the customer base, age of the receivable balances, both individually and in the aggregate, and current economic conditions that may affect a customer’s ability to pay. 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.

Product Warranty

We record a liability for warranty claims at the time of sale. The amount of the liability is based on the trend in the product failure rates, material usage and service delivery costs, the historical length of time between the sale and resulting warranty claim and other factors. Should actual product failure rates, material usage or repair costs differ from our estimates, revisions to the estimated warranty liability would be required.

Inventories and Related Allowance for Excess and Obsolete Inventory

We value our inventories, consisting primarily of control units, single-use treatment catheters, and raw materials to produce the control units and treatment catheters, at the lower of cost or market value on the first-in, first-out (“FIFO”) basis. The inventory cost includes both merchandise and freight. A periodic review of the inventory on hand is performed to determine if the inventory is properly stated at the lower of cost or market. In performing this analysis we consider, at a minimum, the following factors: average selling prices, reimbursement changes, and changes in demand for our products due to competitive conditions or market acceptance. Each type of inventory is analyzed to determine net realizable values. A provision is recorded to reduce the cost of inventories to the estimated net realizable values, if required.

We also analyze the level of inventory on hand on a periodic basis, in relation to estimated customer requirements to determine whether write-downs for excess, obsolete, or slow-moving inventory are required. Any significant or unanticipated change in the factors noted above could have a significant impact on the value of our inventories and on our reported operating results.

Valuation of Intangible Assets and Goodwill

At September 30, 2005, the net carrying value of goodwill was $10.2 million. Goodwill is tested for impairment annually or more frequently if changes in circumstance or the occurrence of events suggests an impairment exists. The test for impairment requires us to make several estimates about fair value, most of which are based on projected future cash flows. Our estimates associated with the impairment test are considered critical, due to the amount of goodwill recorded on our balance sheet and the judgment required in determining fair value amounts, including projected future cash flows.

As of September 30, 2005, other intangible assets consist of developed technologies, customer base and trademarks of $5.0 million, $1.5 million and $1.1 million, respectively. Developed technologies and customer base are amortized using the straight-line method over their estimated useful lives of 15 and 14 years, respectively. The trademark asset is considered to be an intangible asset with an indefinite useful life, and it will not be amortized until its useful life is determined to be no longer indefinite. We review intangible assets for impairment as changes in circumstance or the occurrence of events suggests the remaining value is not recoverable.

Income Taxes

We utilize the asset and liability method of accounting for income taxes. We recognize deferred tax liabilities or assets for the expected future tax consequences of temporary differences between the book and tax bases of assets and liabilities. We regularly assess the likelihood that our deferred tax assets will be recovered from future taxable income. We have recorded and continue to carry a full valuation allowance against our gross deferred tax assets that will not reverse against deferred tax liabilities within the scheduled reversal period. We consider projected future taxable income and ongoing tax planning strategies in assessing the amount of the valuation allowance. If we determine it is more likely than not that we will realize all or part of our deferred tax assets, we will adjust our earnings for the deferred tax in the period we make the determination. We continue to assess the need for a full valuation allowance against our gross deferred tax assets that will not reverse against deferred tax liabilities within the scheduled reversal period. We consider factors such as having a cumulative loss of $7 million in the past three fiscal years and one quarter. The valuation allowance at June 30, 2005 was $32.2 million. We expect to provide a full valuation allowance on our future tax benefits until we can sustain a level of profitability that demonstrates our ability to realize these assets.

Quarterly income tax expense is based on the expected annual tax rate for all of fiscal 2006. Changes in expected annual income and other factors could cause our annualized tax rate to change during the year.

Stock-Based Compensation

On July 1, 2005 we adopted the fair value recognition provisions of SFAS No. 123R “Share-Based Payment” using the modified prospective method. Under the modified prospective method, we recognize compensation expense on all stock option awards granted subsequent to July 1, 2005, as well as on any existing awards modified, repurchased or cancelled after July 1, 2005. In addition, compensation expense is recognized on the unvested portion of stock options granted prior to July 1, 2005. The amount of compensation expense is based on the fair value of the option award at the date of grant and is recognized over the requisite service period which corresponds to the option vesting period. Options typically vest 25 percent after the first year of service with the remaining vesting 1/36^th each month thereafter. Options granted to non-employee directors are immediately exercisable at the date of grant. Options are priced based on the closing price of a share of our common stock at the date of grant. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. To determine the inputs for the Black-Scholes option pricing model we use historical data to estimate expected volatility, the period of time that option grants are expected to be outstanding, as well as employee termination behavior. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for the estimated life of the option. The range of these assumptions and the range of option pricing at the different grant dates will impact our calculation of the fair value of the awards and will therefore impact the amount of expense reflected in our statement of operations for any given period.

RESULTS OF OPERATIONS

Net Sales

Net sales for the three month period ended September 30, 2005 was $6.2 million compared to $6.1 million during the same period of the prior fiscal year. The slight sales growth in the three month period ended September 30, 2005 is primarily attributable to sales from our mobile service which began in September 2005, as well as an increase in the number of domestic treatment catheters and Cooled ThermoTherapy system control units sold on a year-over-year basis, partially offset by a decrease in average per unit selling prices of single-use treatment catheters primarily due to the increased competition in the office-based BPH treatment market, as well as approximately $160,000 less revenue from our New Orleans territory as a result of the disruption from Hurricane Katrina.

Sales of our disposable treatment catheters accounted for 95% of our revenue in the first quarters of fiscal 2005 and 2004. At September 30, 2005, we had a domestic installed base of 518 Cooled ThermoTherapy systems, including the units that are being used by customers pursuant to our evaluation and long-term use programs and units being used in our Company-owned mobile service, compared to an installed base of 498 units at June 30, 2005.

Cost of Goods Sold and Gross Profit

Cost of goods sold includes raw materials, labor, overhead, and royalties incurred in connection with the production of our Cooled ThermoTherapy system control units and single-use treatment catheters. Cost of goods sold for the three month period ended September 30, 2005 increased to $2.0 million from $1.8 million during the three month period ended September 30, 2004. The increase in cost of goods sold is largely the result of approximately $70,000 of expenses related to the launch of our Cooled ThermoTherapy mobile service, an increase in the number of treatment catheters and control units sold, as well as approximately $14,000 of equity-based compensation expense related to the adoption of SFAS 123R on July 1, 2005.

Gross profit as a percentage of sales for the three month period ended September 30, 2005 decreased to 67% from 70% in the three month period ended September 30, 2004. The decrease in gross profit rates primarily resulted from decreased year-over-year average per unit selling prices of our single-use treatment catheters combined with increased expenses from the launch of our mobile service and equity-based compensation expense mentioned above.

Selling, General & Administrative

Selling, general and administrative expenses increased to $3.2 million for the three month period ended September 30, 2005 from $2.7 million in the same period of fiscal year 2005. The increase in expense is primarily the result of $272,000 of equity-based compensation related to the adoption of SFAS 123R, as well as increases in sales and marketing programs and field sales personnel focused on increasing the awareness and acceptance of Cooled ThermoTherapy.

Research and Development

Research and development expenses, which include expenditures for product development, regulatory compliance and clinical studies, increased to $796,000 from $642,000 for the three month periods ended September 30, 2005 and 2004, respectively. The increase in expenses resulted primarily from increased expenditures on product development activities related to our next generation Coolwave control unit as well as approximately $51,000 of equity-based compensation from the adoption of SFAS 123R.

Amortization of Intangible Assets

Amortization of intangible assets was $41,000 for both of the three month periods ended September 30, 2005 and 2004.

Net Interest Income

Net interest income for the three month period ended September 30, 2005 increased to $57,000 from $26,000 in the same period of the prior fiscal year due primarily to higher cash and investment balances and higher interest rates.

Provision for Income Taxes

Income tax expense decreased to $28,000 for the three month period ended September 30, 2005 from $109,000 in the prior year period primarily as a result of the decrease in operating earnings. Quarterly income tax expense is based on the expected annual tax rate for all of fiscal 2006. Changes in expected annual income and other factors could cause our annualized tax rate to change during the year. We currently expect income tax expense for the full year of fiscal 2006 to be at least $360,000.

LIQUIDITY AND CAPITAL RESOURCES

We have financed our operations since inception through sales of equity securities and, to a lesser extent, sales of our Cooled ThermoTherapy system control units and single-use treatment catheters. As of September 30, 2005, we had total cash, cash equivalents and available-for-sale investments of $10.3 million compared to $10.8 million as of June 30, 2005. Working capital increased to $13.6 million at September 30, 2005 from $13.2 million at June 30, 2005.

During the three months ended September 30, 2005, we used $115,000 of cash from operating activities primarily as a result of decreases in our accrued expenses and deferred income of $639,000 and increases in inventory of $555,000. The significant decrease in accrued expenses and deferred income resulted primarily from the payment of employee bonuses and fiscal 2005 year-end sales commissions during the first quarter of fiscal 2006. The increase in inventory is a result of increased production of Targis catheters and control units to meet increased demand, as well as increased purchases of raw materials for the anticipated production of our Coolwave product. These decreases in accrued expenses and increases in inventory were partially offset by depreciation and amortization of $473,000, employee stock-based compensation of $337,000 and our net earnings of $146,000.

During the first three months of fiscal 2006, we used $251,000 from investing activities resulting from the purchase of $396,000 of property and equipment partially offset by the sale/maturity of $145,000 of available-for-sale investments. The increase in the purchase of property and equipment is the result of the purchase of approximately $309,000 of equipment from three regional mobile service providers in the first quarter of fiscal 2006 to facilitate the launch of our own Cooled ThermoTherapy mobile service. The equipment purchased for the mobile service providers primarily consisted of vans, control units, ultrasounds and monitors and patient monitoring equipment. The remaining increase in property and equipment consisted largely of the purchase of computer equipment as well as additional equipment required for the launch of our mobile service.

During the three months ended September 30, 2005, we generated $22,000 in financing activities as a result of proceeds from the exercise of stock options.

We plan to continue offering customers a variety of programs for both evaluation and long-term use of our Cooled ThermoTherapy system control units in addition to purchase options, as well as grow our mobile service which provides physicians and patients with efficient access to our Cooled ThermoTherapy system control units on a pre-scheduled basis. As of September 30, 2005, our property and equipment, net, included approximately $2.1 million of control units used in evaluation or long-term use programs and units used in our Company-owned mobile service. Depending on the growth of these programs, we may use additional capital to finance these programs.

Based upon our financial performance in fiscal 2005 and the first three months of fiscal 2006, we believe our $10.3 million in cash, cash equivalents, and available-for-sale investments at September 30, 2005, together with the funds generated from operations, will be sufficient to fund our working capital and capital resources needs for the next 12 months. There can be no assurance, however, that we will not require additional financing in the future or that any additional financing will be available to us on satisfactory terms, if at all.

Off Balance Sheet Arrangements

We do not have any off balance sheet arrangements.

FACTORS THAT MAY AFFECT OUR FUTURE RESULTS AND THE TRADING PRICE OF OUR COMMON STOCK

The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our operations. The occurrence of any of the following risks could harm our business. In that case, the trading price of our common stock could decline, and investors may lose all or part of their investment.

We are faced with intense competition and rapid technological and industry change.

The medical device industry is characterized by rapid technological change, changing customer needs and frequent new product introductions. Our products may be rendered obsolete as a result of future innovations. We face intense competition from other device manufacturers and surgical manufacturers, as well as from pharmaceutical companies. Nearly all of our competitors are significantly larger than we are and have greater financial, technical, research, marketing, sales, distribution and other resources than we do. We believe that price competition will continue among products developed in our markets. Our competitors may develop or market technologies and products, including drug-based treatments that are more effective or commercially attractive than any we are developing or marketing. Our competitors may succeed in obtaining regulatory approval and introducing or commercializing products before we do. Such developments could have a significant negative effect on our business, financial condition and results of operations. Even if we are able to compete successfully, we may not be able to do so in a profitable manner.

Our products may not achieve market acceptance, which could limit our future revenue.

Physicians will not recommend Cooled ThermoTherapy procedures unless they conclude, based on clinical data and other factors, that it is an effective alternative to other methods of enlarged prostate treatment, including more established methods. Patient acceptance of the procedure will depend in part upon physician recommendations and on other factors, including the degree of invasiveness and the rate and severity of complications associated with the Cooled ThermoTherapy procedure compared with other therapies. Patient acceptance of the Cooled ThermoTherapy procedure also will depend upon the ability of physicians to educate these patients on their treatment choices. Health care payer acceptance of our procedure will require, among other things, evidence of the cost effectiveness of Cooled ThermoTherapy compared to other BPH therapies. Our marketing strategy must overcome the difficulties inherent in the introduction of new technology to the medical community. If our Cooled ThermoTherapy procedure is not widely accepted by physicians, patients or payers, or is accepted more slowly than expected, our business will be harmed. Further, we recently introduced our own mobile Cooled ThermoTherapy service. If this service is not accepted by physicians, patients, or payers, or is accepted more slowly than expected, our business will be harmed.

Third- party reimbursement is critical to market acceptance of our products.

Our future revenues are subject to uncertainties regarding health care reimbursement and reform. In the United States, health care providers, such as hospitals and physicians, generally rely on third-party payers. Third-party reimbursement is dependent upon decisions by the CMS, contract Medicare carriers, individual managed care organizations, private insurers, foreign governmental health programs and other payers of health care cost. Failure to receive or maintain favorable coding, coverage and reimbursement determinations for Cooled ThermoTherapy by these organizations could discourage physicians from using our products. We may be unable to sell our products on a profitable basis if third-party payers deny coverage, provide low reimbursement rates or reduce their current levels of reimbursement.

The continuing efforts of government, insurance companies, health maintenance organizations and other payers of health care costs to contain or reduce costs of health care may affect our future revenues and profitability. With recent federal and state government initiatives directed at lowering the total cost of health care, the United States Congress and state legislatures will likely continue to focus on health care reform including the reform of Medicare and Medicaid systems, and on the cost of medical products and services. Additionally, third-party payers are increasingly challenging the prices charged for medical products and services. Also, the trend toward managed health care in the United States and the concurrent growth of organizations such as HMO’s that could control or significantly influence the purchase of health

care services and products, as well as legislative proposals to reform health care or reduce government insurance programs, may also result in lower prices for, or rejection of, our products. The cost containment measures that health care payers and providers are instituting and the effect of any health care reform could cause reductions in the amount of reimbursement available, and could have a materially adverse effect on our revenues and ability to operate profitably.

We have only attained profitability recently.

Although we produced net earnings of $146,000 for the three months ended September 30, 2005 and $2.8 million for the year ended June 30, 2005, we have incurred losses of approximately $77 million since our inception. If physicians do not continue to purchase and use our Cooled ThermoTherapy systems to treat patients with BPH, we may not be able to maintain profitability. Because we will continue to incur additional expenses relating to sales and marketing activities and research and development activities, we will need to increase the revenues we receive from sales of our products in order to continue to operate in a profitable manner. We cannot assure you that we will be able to increase our revenues, maintain profitable operations, or successfully implement our business plan or future business opportunities.

We depend upon our Cooled ThermoTherapy products for all of our revenues.

All of our revenues are derived from sales of our Cooled ThermoTherapy system control units and single-use treatment catheters. As a result, our success is solely dependent upon the success of our Cooled ThermoTherapy products. To date, our Cooled ThermoTherapy systems have not achieved widespread market adoption. If we are unable to widely commercialize the use of these systems successfully through our marketing initiatives, including our company-owned Cooled ThermoTherapy mobile service, our business, financial condition and results of operations will be materially and adversely affected. Further, higher than expected manufacturing, marketing and distribution costs, lower than expected reimbursement levels, lower than expected usage by physicians, and/or other competitive forces may require us to alter our pricing or marketing structure in a manner that could have a material and adverse effect on us.

We have limited manufacturing experience and are dependent upon a limited number of third-party suppliers to manufacture our products.

We produce the single-use treatment catheters for the Targis system and in January 2004 we began manufacturing the Targis system control unit. Our success will depend upon our ability to cost-effectively manufacture a reliable product and deliver that product in a timely manner. Because we lack extensive manufacturing experience, we may encounter difficulties in maintaining production efficiencies, quality control and assurance, component supply and qualified personnel. We cannot assure you that we will be able to manufacture a reliable product and deliver that product to customers in a timely fashion. Our failure to maintain a reputation among our customers as a timely, responsive manufacturer or higher than expected manufacturing costs would adversely affect our business.

Other than the Targis system control unit and procedure kits, we outsource all other manufacturing for our products. We assemble Targis control units and procedure kits using materials and components supplied by various subcontractors and suppliers, as well as components we fabricate. We rely on single sources for several components, one of which is obtained from a source that has a patent for the technology. Our reliance on outside suppliers for our components involves risks including limited control over the price and uncertainty regarding timely delivery and quality of parts. Additionally, we currently have a supply agreement with Accellent Endoscopy (formerly Venusa) for the production of the Prostatron single-use treatment catheter that extends though April 2006 with an automatic renewal term.

The termination or interruption of any of these relationships, or the failure of these manufacturers or suppliers to supply products or components to us on a timely basis or in sufficient quantities, likely would cause us to be unable to meet customer orders for our products and harm our reputation with customers and our business. Identifying and qualifying alternative suppliers of components or manufacturers of products takes time and involves significant additional costs and may delay the production of our products. Further, if we obtain a new supplier for a component, manufacture our product with an alternative component or if our products are manufactured by an alternative manufacturer, we may need to obtain FDA approval of a PMA supplement to reflect changes in product manufacturing and the FDA may require additional testing of any component from new suppliers prior to our use of these components. Further, if FDA approval of a PMA supplement is required, any delays in delivery of our product to customers would be extended and our costs associated with the change in product manufacturing would increase.

The failure of our third-party manufacturers to manufacture the products for us, and the failure of our components suppliers to supply us with the components, consistent with our requirements as to quality, quantity and timeliness would materially harm our business.

We are dependent on adequate protection of our patent and proprietary rights.

We rely on patents, trade secrets, trademarks, copyrights, know-how, license agreements and contractual provisions to establish and protect our intellectual property rights. However, these legal means afford us only limited protection and may not adequately protect our rights or remedies to gain or keep any advantages we may have over our competitors.

We cannot assure you that others may not independently develop the same or similar technologies or otherwise obtain access to our technology and trade secrets. Our competitors, many of which have substantial resources and may make substantial investments in competing technologies, may apply for and obtain patents that will prevent, limit, or interfere with our ability to manufacture or market our products. Further, while we do not believe that any of our products or processes interfere with the rights of others, third parties may nonetheless assert patent infringement claims against us in the future.

Costly litigation may be necessary to enforce patents issued to us, to protect trade secrets or “know-how” we own, to defend us against claimed infringement of the rights of others or to determine the ownership, scope, or validity of our proprietary rights and the rights of others. In connection with the settlement of a patent infringement suit we filed in March 2002, we granted ProstaLund AB, ProstaLund Operations AB and Circon Corporation (a/k/a ACMI Corporation) a non-exclusive, royalty free license under certain of our patents to sell the ProstaLund transurethral microwave thermotherapy system marketed in the United States by ACMI Corporation as the CoreTherm device.

Any claim of infringement against us may involve significant liabilities to third parties, could require us to seek licenses from third parties, and could prevent us from manufacturing, selling, or using our products. The occurrence of this litigation or the effect of an adverse determination in any of this type of litigation could have a material adverse effect on our business, financial condition and results of operations.

Our business of the manufacturing, marketing, and sale of medical devices involves the risk of liability claims and such claims could seriously harm our business, particularly if our insurance coverage is inadequate.

Our business exposes us to potential product liability claims that are inherent in the testing, production, marketing and sale of medical devices. Like other participants in the medical device market, we are from time to time involved in lawsuits, claims and proceedings alleging product liability and related claims such as negligence. If product liability claims become substantial, our reputation could be damaged significantly, thereby harming our business. We may be required to pay substantial damage awards as a result of any successful product liability claims. Any product liability claim against us, whether with or without merit, could result in costly litigation, and divert the time, attention, and resources of our management.

As a result of our exposure to product liability claims, we currently carry product liability insurance covering our products with policy limits per occurrence and in the aggregate that we have deemed to be sufficient. We cannot predict, however, whether this insurance is sufficient, or if not, whether we will be able to obtain sufficient insurance to cover the risks associated with our business or whether such insurance will be available at premiums that are commercially reasonable. In addition, these insurance policies must be renewed annually. Although we have been able to obtain liability insurance, such insurance may not be available in the future on acceptable terms, if at all. A successful claim against us or settlement by us in excess of our insurance coverage or our inability to maintain insurance in the future could have a material adverse effect on our business, financial condition and results of operations.

Our products may be subject to product recalls even after receiving FDA clearance or approval, which would harm our reputation and our business.

The FDA and similar governmental authorities in other countries in which our products are sold, have the

authority to request and, in some cases, require the recall of our products in the event of material deficiencies or defects in design or manufacture. A government-mandated or voluntary recall by us could occur as a result of component failures, manufacturing errors or design defects. Any recall of product would divert managerial and financial resources, harm our reputation with our customers and damage our business.

In December 2003, we determined that a component of one of our Cooled ThermoTherapy system control units may not perform properly under certain conditions. We advised our customers who are using the affected units of an appropriate product protocol to follow pending our implementation of a software solution to resolve the performance issue. We submitted the software update addressing the problem to the FDA and have received its approval. We completed the installation of the approved software update during the third quarter of fiscal 2005.

We have limited inventory of Prostatron control units and if customer demand exceeds our expectations, we will experience delays and expense in meeting customer demand that could be significant.

We have previously contracted with third parties for the production of the Prostatron product line pursuant to written supply agreements. Our supply agreement for the production of the Prostatron control unit with EDAP ended on October 1, 2003. At this time, we do not have plans to enter into another supply agreement for the manufacture of Prostatron control units, as we believe our current inventory of Prostatron control units combined with Company owned control units located at customer sites will adequately support future customer requirements. If, for any reason, customer demand exceeds our current projections, we could experience significant delays and expend significant resources in obtaining a new supply agreement with EDAP or another manufacturer to meet this customer demand. Therefore, we are likely to experience significant delays in fulfilling unexpected, significant customer demand for our Prostatron control units.

We are dependent on key personnel.

Failure to attract and retain skilled personnel could hinder our research and development as well as our sales and marketing efforts. Our future success depends to a significant degree upon the continued services of key sales, technical and senior management personnel, including Fred B. Parks, our Chairman of the Board and Chief Executive Officer. We have an employment agreement with Mr. Parks that provides that Mr. Parks will serve as our Chairman and Chief Executive Officer and that either party may terminate Mr. Parks’ employment at any time with or without cause. If we terminate Mr. Parks’ employment without cause, however, we would be required to make specified payments to him as described in his employment agreement. We do not have key person life insurance on Mr. Parks. Our future success also depends on our continuing ability to attract, retain and motivate highly qualified managerial, technical and sales personnel. Our inability to retain or attract qualified personnel could have a significant negative effect and thereby materially harm our business and financial condition.

Government regulation can have a significant impact on our business.

Government regulation in the United States and other countries is a significant factor affecting the research and development, manufacture and marketing of our products. In the United States, the FDA has broad authority under the federal Food, Drug and Cosmetic Act and the Public Health Service Act to regulate the distribution, manufacture and sale of medical devices. Sales of medical devices outside the United States are subject to government regulation and restrictions that vary from country to country. The process of obtaining FDA and other required regulatory approvals is lengthy and expensive.

We may not be able to obtain necessary approvals for clinical testing or for the manufacturing or marketing of our products in the United States or in other countries. Failure to comply with applicable regulatory approvals can, among other things, result in fines, suspension of regulatory approvals, product recalls, operating restrictions and criminal prosecution. In addition, government regulations may be established that could prevent, delay, modify or rescind regulatory approval of our products. Any such position or change of position by the FDA may adversely impact our business and financial condition. Regulatory approvals, if granted, may include significant limitations on the indicated uses for which our products may be marketed in the United States or in other countries. In addition to obtaining such approvals, the FDA and foreign regulatory authorities may impose numerous other requirements on us. The FDA prohibits the marketing of approved medical devices for unapproved uses. In addition, product approvals can be withdrawn for failure to comply with regulatory standards or the occurrence of unforeseen problems following initial

marketing. We may not be able to obtain regulatory approvals for our products on a timely basis, or at all, and delays in receipt of or failure to receive such approvals, the loss of previously obtained approvals, or failure to comply with existing or future regulatory requirements would have a significant negative effect on our financial condition and results of operations. In addition, the health care industry in the United States is generally subject to fundamental change due to regulatory, as well as political, influences. We anticipate that Congress and state legislatures will continue to review and assess alternative health care delivery and payment systems. Potential approaches that have been considered include controls on health care spending through limitations on the growth of private purchasing groups and price controls. We cannot predict what impact the adoption of any federal or state health care reform measures may have on our business.

We, along with our distributors and health care providers who purchase our products and services, are subject to state and federal laws prohibiting kickbacks or other forms of bribery in the health care industry. We may be subject to civil and criminal prosecution for violations of any of these laws by our agents or us.

We have limited cash resources and may not have additional financing available to us.

We used approximately $115,000 of net cash from operating activities in the three-month period ended September 30, 2005 and ended that period with approximately $10.3 million of cash, cash equivalents, and available-for-sale investments. We believe our $10.3 million in cash, cash equivalents, and available-for-sale investments, together with the funds generated from product sales, will be sufficient to fund our working capital and capital resources needs for the next 12 months. Our business plan and financing needs are subject to change depending on, among other things, success of our efforts to continue to effectively manage expenses, market conditions, business opportunities and cash flow from operations, if any. We may require additional financing to continue our business, the receipt of which cannot be assured. Such additional financing could be sought from a number of sources, including possible sales of equity or debt securities or loans from banks or other financial institutions. We may not be able to obtain additional financing from any source on reasonable terms, if at all. Any future capital that is available may be raised on terms that are dilutive to our shareholders.

Fluctuations in our future operating results may negatively affect the market price of our common stock.

Our operating results have fluctuated in the past and can be expected to fluctuate from time to time in the future. Some of the factors that may cause these fluctuations include but are not limited to:

• the timing, volume and pricing of customer orders for both control units and single-use treatment catheters,

• the impact to the marketplace of competitive products and pricing,

• costs and expenses related to our effort to protect our intellectual property,

• the timing of expenditures related to sales and marketing, and research and development, and

• product availability.

If our operating results are below the expectations of securities analysts or investors, the market price of our common stock may fall abruptly and significantly.

Our stock price may be volatile and a shareholder’s investment could decline in value.

Our stock price has fluctuated in the past and may continue to fluctuate significantly, making it difficult for an investor to resell shares or to resell shares at an attractive price. The market prices for securities of emerging companies have historically been highly volatile. Future events concerning us or our competitors could cause such volatility, including:

• actual or anticipated variations in our operating results,

• technological innovations or new commercial products introduced by us or our competitors,

• developments regarding government and third-party reimbursement,

• changes in government regulation,

• government investigation of us or our products,

• changes in reimbursement rates or methods affecting our products,

• developments concerning proprietary rights,

• litigation or public concern as to the safety of our products or our competitors’ products,

• investor perception of us and our industry,

• general economic and market conditions including market uncertainty,

• national or global political events,

• public confidence in the securities markets and regulation by or of the securities markets, and

• changes in senior management.

In addition, the stock market is subject to price and volume fluctuations that affect the market prices for companies in general, and small-capitalization, high-technology companies in particular, which are often unrelated to the operating performance of these companies. Any failure by us to meet or exceed estimates of financial analysts is likely to cause a decline in our common stock price.

Future sales of shares of our common stock may negatively affect our stock price.

Future sales of our common stock could have a significant negative effect on the market price of our common stock. In addition, upon exercise of outstanding options, the number of shares outstanding of our common stock could increase substantially. This increase, in turn, could dilute future earnings per share, if any, and could depress the market value of our common stock. Dilution and potential dilution, the availability of a large amount of shares for sale, and the possibility of additional issuances and sales of our common stock may negatively affect both the trading price of our common stock and the liquidity of our common stock. These sales also might make it more difficult for us to sell equity securities or equity-related securities in the future at a time and price that we would deem appropriate.

Anti-takeover provisions in our articles of incorporation may have a negative effect on our stock price.

Certain provisions of our articles of incorporation and bylaws may make it more difficult for a third party to acquire, or discourage a third party from attempting to acquire, control of us. We have in place several anti-takeover measures that could discourage or prevent a takeover, even if an acquisition would be beneficial to our shareholders. Our stock option plans contain provisions that allow for the acceleration of vesting or payments of awards granted under the plans in the event of specified events that result in a “change in control.” In addition, we have adopted a shareholder rights plan that would cause substantial dilution to any person or group attempting to acquire our company on terms not approved in advance by our board of directors.

ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK

Our financial instruments include cash, cash equivalents, and available-for-sale investments. Our financial investment portfolio at September 30, 2005, is carried at market value. Increases and decreases in prevailing interest rates generally translate into decreases and increases in the fair value of these instruments. Also, fair values of interest rate sensitive instruments may be affected by the credit worthiness of the issuer, prepayment options, relative values of alternative instruments, the liquidity of the instrument and other general market conditions.

Market risk was estimated as the potential decrease in fair value resulting from a hypothetical 1% change in interest rates for the issues contained in the available-for-sale investment portfolio and was not materially different from the year-end carrying value. Due to the nature of our short-term investments, we have concluded that we do not have a material market risk exposure.

Our policy is not to enter into derivative financial instruments. We do not have any significant foreign currency exposure since we do not generally transact business in foreign currencies. Therefore, we do not have significant overall currency exposure. In addition, we do not enter into any futures or forward commodity contracts since we do not have significant market risk exposure with respect to commodity prices.

ITEM 4.CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

The Company’s Chief Executive Officer, Fred B. Parks, and Chief Financial Officer, Todd E. Paulson, have evaluated the Company’s disclosure controls and procedures as of the end of the period covered by this report and due to a material weakness in internal controls over financial reporting related to the Company’s accounting for income taxes, as described below, concluded that the Company’s disclosure controls and procedures were not effective in ensuring that information required to be disclosed by the Company in reports with the Securities and Exchange Commission is recorded, processed, summarized and reported on a timely basis. To address the material weakness described below, the Company performed other procedures related to the calculation of deferred income taxes in preparing the financial statements included in this report to ensure that such financial statements were fairly presented, in all material respects, in accordance with U.S. generally accepted accounting principles.

Management assessed the effectiveness of the Company’s internal control over financial reporting as of June 30, 2005. The assessment was provided in “Management’s Report on Internal Control over Financial Reporting” set forth in Part II, Item 9A “Controls and Procedures” in the Company’s Form 10-K for the fiscal year ended June 30, 2005. This assessment identified a material weakness (within the meaning of PCAOB Auditing Standard No. 2) in internal control over financial reporting related to the Company’s accounting for income taxes that led management to conclude that, as of June 30, 2005, the Company’s internal control over financial reporting was not effective based upon the criteria in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. This material weakness occurred because the Company’s management did not have adequate technical expertise with respect to income tax accounting to effectively oversee and review the Company’s accounting over this area. This lack of adequate technical expertise resulted in a material error in the Company’s accounting for income taxes, which was identified during the course of the Company’s 2005 audit. This error related to the Company not providing a sufficient valuation allowance against deferred tax assets that are not more likely than not to be realized. The Company had incorrectly netted deferred tax liabilities related to intangibles with indefinite lives against deferred tax assets related to net operating loss carryforwards with finite lives in determining the amount of allowance necessary. As a result, the Company restated its financial statements as of June 30, 2004 and 2003, and for each of the years in the three-year period ended June 30, 2004 and for all the quarters for the years ended June 30, 2005 and 2004.

(b)Changes in Internal Controls over Financial Reporting

In the first quarter of fiscal 2006, the Company developed and began the implementation of a remediation plan described below related to the material weakness in internal control over financial reporting identified above. Other than such actions noted below, there have been no changes in the Company’s internal control over financial reporting during the quarter ended September 30, 2005 that have materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

The Company’s remediation plan consists of implementing enhanced control procedures over accounting for income taxes that include education and training of Company management and staff to improve technical expertise with respect to income tax accounting. The Company is also evaluating whether to engage additional independent tax consulting resources to assist with the Company’s evaluation of complex issues concerning tax accounting and tax reserves and to assist management in developing its judgments with respect to such issues. The Company expects to have the remediation completed no later than December 31, 2005.

The Company’s management, including the Chief Executive Officer and Chief Financial Officer, does not expect that its disclosure controls and procedures and its internal controls over financial reporting will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Our business exposes us to product liability claims that are inherent in the testing, production, marketing and sale of medical devices. Management believes any losses that may occur from these matters are adequately covered by insurance, and the ultimate outcome of these matters will not have a material effect on the financial position or results of operations of the Company.

ITEM 6. EXHIBITS

Exhibit 31.1	Certification of Chief Executive Officer Pursuant to Section 13a-14 and 15d-14 of the Exchange Act.
Exhibit 31.2	Certification of Chief Financial Officer Pursuant to Section 13a-14 and 15d-14 of the Exchange Act.
Exhibit 32	Certification pursuant to 18 U.S.C. 1350.

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 November 9, 2005

Urologix, Inc.

(Registrant)

/s/ Fred B. Parks.

Fred B. Parks

Chairman and Chief Executive Officer

(Principal Executive Officer)

/s/ Todd E. Paulson

Todd E. Paulson

Vice President and Chief Financial Officer

(Principal Financial Officer)