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Aspect Medical Systems 10-Q 2007

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2
e10vq
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
(Mark One)
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2007
     
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: 0-24663
 
ASPECT MEDICAL SYSTEMS, INC.
(Exact Name of Registrant as Specified in Its Charter)
     
Delaware   04-2985553
(State or Other Jurisdiction of   (I.R.S. Employer Identification No.)
Incorporation or Organization)    
     
One Upland Road, Norwood, Massachusetts
(Address of Principal Executive Offices)
  02062
(Zip Code)
(617) 559-7000
(Registrant’s Telephone Number, Including Area Code)
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YES þ       NO o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
Large accelerated filer o       Accelerated filer þ       Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
YES o       NO þ
The Registrant had 19,494,654 shares of Common Stock, $0.01 par value per share, outstanding as of August 1, 2007.
 
 

 


Table of Contents

ASPECT MEDICAL SYSTEMS, INC.
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 Ex-31.1 Section 302 Certification of the CEO
 Ex-31.2 Section 302 Certification of the CFO
 Ex-32.1 Section 906 Certification of the CEO
 Ex-32.2 Section 906 Certification of the CFO

 


Table of Contents

PART I — FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS.
ASPECT MEDICAL SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data and per share amounts)
                 
    June 30,     December 31,  
    2007     2006  
    (unaudited)        
ASSETS
               
Current assets:
               
Cash and cash equivalents
  $ 80,287     $ 9,724  
Short-term portion of restricted cash
    82       140  
Short-term investments
    48,710       45,253  
Accounts receivable, net of allowance of $249 at June 30, 2007 and $218 at December 31, 2006
    11,828       12,486  
Current portion of investment in sales-type leases
    1,521       1,493  
Inventory
    6,876       6,501  
Deferred tax assets
    1,844       1,844  
Other current assets
    2,478       2,157  
 
           
Total current assets
    153,626       79,598  
Property and equipment, net
    8,633       7,798  
Long-term portion of restricted cash
    929       911  
Long-term investments
    10,229       7,442  
Long-term investment in sales-type leases
    3,071       2,817  
Deferred financing fees
    4,451        
Long-term deferred tax assets
    24,027       26,398  
 
           
Total assets
  $ 204,966     $ 124,964  
 
           
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
  $ 1,516     $ 1,925  
Accrued liabilities
    9,585       8,428  
Deferred revenue
    65       1,865  
 
           
Total current liabilities
    11,166       12,218  
Long-term portion of deferred revenue
    56       3,498  
Long-term debt
    125,000        
Commitments and contingencies
               
Stockholders’ equity:
               
Preferred Stock, $.01 par value; 5,000,000 shares authorized, no shares issued or outstanding
           
Common Stock, $.01 par value; 60,000,000 shares authorized, 19,481,201 and 22,363,564 shares issued and outstanding at June 30, 2007 and December 31, 2006, respectively
    197       226  
Treasury Stock, at cost; 276,493 shares
    (5,008 )     (5,008 )
Additional paid-in capital
    173,650       168,440  
Accumulated other comprehensive income (loss)
    37       (1 )
Accumulated deficit
    (100,132 )     (54,409 )
 
           
Total stockholders’ equity
    68,744       109,248  
 
           
Total liabilities and stockholders’ equity
  $ 204,966     $ 124,964  
 
           
The accompanying notes are an integral part of these condensed consolidated financial statements.

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Table of Contents

ASPECT MEDICAL SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
(unaudited)
                                 
    Three Months Ended     Six Months Ended  
    June 30, 2007     July 1, 2006     June 30, 2007     July 1, 2006  
Product revenue
  $ 23,079     $ 21,181     $ 45,514     $ 41,623  
Strategic alliance revenue
    3,562       1,450       5,246       2,896  
 
                       
Total revenue
    26,641       22,631       50,760       44,519  
 
                       
 
                               
Costs of revenue (1)
    5,767       5,411       11,846       10,757  
 
                       
Gross profit
    20,874       17,220       38,914       33,762  
 
                       
 
                               
Operating expenses: (1)
                               
Research and development
    4,194       3,568       8,414       7,215  
Sales and marketing
    10,199       9,072       20,244       17,805  
General and administrative
    4,016       3,203       7,680       6,141  
 
                       
Total operating expenses
    18,409       15,843       36,338       31,161  
 
                       
 
                               
Income from operations
    2,465       1,377       2,576       2,601  
 
                               
Other income (expense):
                               
Interest income
    1,020       781       2,001       1,517  
Interest expense
    (115 )           (115 )      
 
                       
Income before income taxes
    3,370       2,158       4,462       4,118  
 
                       
 
                               
Provision for income taxes
    1,882       33       2,458       56  
 
                       
Net income
  $ 1,488     $ 2,125     $ 2,004     $ 4,062  
 
                       
 
                               
Net income per share:
                               
Basic
  $ 0.07     $ 0.09     $ 0.09     $ 0.18  
Diluted
  $ 0.07     $ 0.09     $ 0.09     $ 0.17  
 
                               
Weighted average shares used in computing net income per share:
                               
Basic
    21,836       22,442       22,122       22,389  
Diluted
    23,275       23,513       23,076       23,784  
 
                               
(1) Stock-based compensation included in costs and expenses:
                               
Costs of revenue
  $ 141     $ 106     $ 286     $ 211  
Research and development
    490       373       1,014       743  
Sales and marketing
    789       623       1,597       1,251  
General and administrative
    717       551       1,457       1,089  
The accompanying notes are an integral part of these condensed consolidated financial statements.

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ASPECT MEDICAL SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
                 
    Six Months Ended  
    June 30,     July 1,  
    2007     2006  
Cash flows from operating activities:
               
Net income
  $ 2,004     $ 4,062  
Adjustments to reconcile net income to net cash provided by operating activities –
               
Depreciation and amortization
    1,080       753  
Provision for doubtful accounts
    56       77  
Stock-based compensation expense
    4,354       3,294  
Deferred tax asset
    2,371        
Changes in assets and liabilities –
               
Decrease in accounts receivable
    602       434  
Increase in inventory
    (375 )     (1,341 )
Increase in other current assets
    (321 )     (1,005 )
Increase in investment in sales-type leases
    (282 )     (75 )
Increase in other long-term assets
    (371 )      
Decrease in accounts payable
    (409 )     (75 )
Increase (decrease) in accrued liabilities
    1,108       (3,052 )
(Decrease) increase in deferred revenue
    (5,242 )     1,661  
 
           
Net cash provided by operating activities
    4,575       4,733  
 
           
 
               
Cash flows from investing activities:
               
Decrease (increase) in restricted cash
    40       (1,018 )
Acquisitions of property and equipment
    (1,894 )     (2,018 )
Purchases of marketable securities
    (76,154 )     (20,635 )
Proceeds from sales and maturities of marketable securities
    69,947       25,264  
 
           
Net cash (used for) provided by investing activities
    (8,061 )     1,593  
 
           
 
               
Cash flows from financing activities:
               
Payment on stock repurchase plan
    (47,386 )      
Payment of deferred financing fees
    (4,471 )      
Proceeds from issuance of common stock
    906       1,956  
Proceeds from long-term debt
    125,000        
 
           
Net cash provided by financing activities
    74,049       1,956  
 
           
Net increase in cash and cash equivalents
    70,563       8,282  
Cash and cash equivalents, beginning of period
    9,724       20,437  
 
           
Cash and cash equivalents, end of period
  $ 80,287     $ 28,719  
 
           
The accompanying notes are an integral part of these condensed consolidated financial statements.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
(1) Basis of Presentation
     The accompanying unaudited condensed consolidated financial statements of Aspect Medical Systems, Inc. (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Quarterly Report on Form 10-Q and Regulation S-X promulgated pursuant to the Securities Exchange Act of 1934, as amended. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all normal, recurring adjustments considered necessary for a fair presentation have been included. The unaudited condensed consolidated financial statements and notes included herein should be read in conjunction with the audited consolidated financial statements and accompanying notes thereto for the year ended December 31, 2006 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”). Interim results of operations are not necessarily indicative of the results to be expected for the full year or any other interim period.
     The Company follows a system of fiscal quarters as opposed to calendar quarters. Therefore, the first three quarters of each fiscal year end on the Saturday closest to the end of the calendar quarter and the last quarter of the fiscal year always ends on December 31.
(2) Summary of Significant Accounting Policies
     A summary of the significant accounting policies used by the Company in the preparation of its financial statements are as follows:
Principles of Consolidation
     The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated.
Foreign Currency
     The functional currency of the Company’s international subsidiaries is the U.S. dollar. Foreign currency transaction gains and losses are recorded in the consolidated statements of operations and have not been material.
Cash, Cash Equivalents and Marketable Securities
     The Company invests its excess cash in money market accounts, certificates of deposit, high-grade commercial paper, high grade corporate bonds and debt obligations of various government agencies. The Company considers all debt instruments purchased with an original maturity of three months or less to be cash equivalents.
     The Company accounts for its investments in marketable securities in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities. In accordance with SFAS No. 115, the Company has classified all of its investments in marketable securities as available-for-sale at June 30, 2007 and December 31, 2006. The investments are reported at fair value, with any unrealized gains or losses excluded from earnings and reported as a separate component of stockholders’ equity as accumulated other comprehensive income (loss) in the accompanying condensed consolidated balance sheets. Investments that have contractual maturities of more than twelve months are included in long-term investments in the accompanying condensed consolidated balance sheets.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
Revenue Recognition
     The Company primarily sells its BIS monitors through a combination of a direct sales force and distributors. The Company sells its BIS Module Kits to original equipment manufacturers who in turn sell them to the end-user. BIS Sensors are sold through a combination of a direct sales force, distributors and original equipment manufacturers. Direct sales of BIS monitors and BIS Module Kits are structured as sales, sales-type lease arrangements or sales under the Company’s Equipment Placement (“EP”) program. Sales, sales-type lease agreements and sales under the EP program are subject to the Company’s standard terms and conditions of sale and do not include any customer acceptance criteria, installation or other post shipment obligations (other than warranty) or any rights of return. The Company’s BIS monitor is a standard product and does not require installation as it can be operated with the instructions included in the operator’s manual.
     The Company recognizes revenue when earned in accordance with Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition, and Emerging Issues Task Force (“EITF”) Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. Revenue is recognized when persuasive evidence of an arrangement exists, product delivery has occurred or services have been rendered, the price is fixed or determinable and collectability is reasonably assured. For product sales, revenue is not recognized until title and risk of loss have transferred to the customer. The Company’s revenue arrangements with multiple elements are divided into separate units of accounting if specified criteria are met, including whether the delivered element has stand-alone value to the customer and whether there is objective and reliable evidence of the fair value of the undelivered items. The consideration received is allocated among the separate units based on their respective fair values, and the applicable revenue recognition criteria are applied to each of the separate units.
     The Company follows SFAS No. 13, Accounting For Leases, for its sales-type lease agreements. Under the Company’s sales-type leases, customers purchase BIS Sensors and the BIS monitor for the purchase price of the BIS Sensors plus an additional charge per BIS Sensor to pay for the purchase price of the BIS monitor and related financing costs over the term of the agreement. In accordance with SFAS No. 13, the minimum lease payment, consisting of the additional charge per BIS Sensor, less the unearned interest income, which is computed at the interest rate implicit in the lease agreement, is recorded as the net investment in sales-type leases. The Company recognizes equipment revenue under sales-type lease agreements either at shipment or delivery in accordance with the agreed upon contract terms with interest income recognized over the life of the sales-type lease. The cost of the BIS monitor acquired by the customer is recorded as costs of revenue in the same period it is acquired by the customer.
     In addition, the Company reviews and assesses the net realizability of its investment in sales-type leases at each reporting period. This review includes determining, on a customer specific basis, if a customer is significantly underperforming relative to the customer’s cumulative level of committed BIS Sensor purchases as required by the sales-type lease agreement. If a customer is underperforming, the Company records an allowance for lease payments as a charge to revenue to reflect the lower estimate of the net realizable investment in sales-type lease balance.
     As of June 30, 2007, the Company has determined that no sales-type lease agreement, against which an allowance for lease payments has been established, constitutes an impaired asset.
     Under the Company’s EP program, the customer is granted the right to use the BIS monitors for a mutually agreed upon period of time. During this period, the customer purchases BIS Sensors at a price that includes a premium above the list price of the BIS Sensors to cover the rental of the equipment, but without any minimum purchase commitments. At the end of the agreed upon period, the customer has the option of purchasing the BIS monitors, continuing to use them under the EP program or returning them to the Company. Under the EP program, no equipment revenue is recognized as the equipment remains the Company’s property and title does not pass to the customer, and the criteria for sales-type leases under SFAS No. 13 are not met. The BIS monitors utilized in the EP program are depreciated over two years and the depreciation is charged to costs of revenue. BIS Sensor revenue is recognized either at shipment or delivery of the BIS Sensors in accordance with the agreed upon contract terms.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
     The Company’s obligations under warranty are limited to repair or replacement of any product that the Company reasonably determines to be covered by the warranty. The Company records an estimate for its total warranty obligation in accordance with SFAS No. 5, Accounting for Contingencies.
Research and Development Costs
     The Company charges research and development costs to operations as incurred. Research and development costs include costs associated with new product development, product improvements and extensions, clinical studies and project consulting expenses.
Allowance for Doubtful Accounts
     The Company makes estimates and judgments in determining its allowance for doubtful accounts based on the Company’s historical collections experience, historical write-offs of its receivables, current trends, credit policies and a percentage of the Company’s accounts receivable by aging category. The Company also reviews the credit quality of its customer base as well as changes in its credit policies. The Company continually monitors collections and payments from its customers and adjusts the allowance for doubtful accounts as needed.
Inventory
     The Company values inventory at the lower of cost or estimated market value, and determines cost on a first-in, first-out basis. The Company regularly reviews inventory quantities on hand and records a provision for excess or obsolete inventory primarily based on production history and on its estimated forecast of product demand. The medical device industry in which the Company markets its products is characterized by rapid product development and technological advances that could result in obsolescence of inventory. Additionally, the Company’s estimates of future product demand may prove to be inaccurate, in which case it would need to change its estimate of the provision required for excess and obsolete inventory. If revisions are deemed necessary, the Company would recognize the adjustments in the form of a charge to its costs of revenue at the time of the determination.
Warranty
     Equipment that the Company sells is generally covered by a warranty period of one year. The Company accrues a warranty reserve for estimated costs to provide warranty services. The Company’s estimate of costs to service its warranty obligations is based on historical experience and an expectation of future conditions. Warranty expense, included in costs of revenue in the condensed consolidated statements of income, for the three and six months ended June 30, 2007 and July 1, 2006, and accrued warranty cost, included in accrued liabilities in the condensed consolidated balance sheet at June 30, 2007, were as follows:
                                 
    Three Months Ended     Six Months Ended  
    June 30, 2007     July 1, 2006     June 30, 2007     July 1, 2006  
Beginning balance
  $ 215     $ 194     $ 220     $ 159  
Warranty expense
    15       30       19       88  
Deductions and other
    (7 )     (23 )     (16 )     (46 )
 
                       
Ending balance
  $ 223     $ 201     $ 223     $ 201  
 
                       
Shipping and Handling Costs
     Shipping and handling costs are included in costs of revenue in the condensed consolidated statements of income.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
Advertising Costs
     Advertising costs are expensed as incurred. These costs are included in sales and marketing expense in the condensed consolidated statements of income.
Property and Equipment
     Property and equipment is recorded at cost and depreciated using the straight-line method over the estimated useful lives of the related property and equipment. The costs of improvements to the Company’s leased buildings are capitalized as leasehold improvements and amortized on the straight-line method over the shorter of the life of the lease or the useful life of the asset. Repair and maintenance expenditures are charged to expense as incurred. The Company does not develop software for internal use and the costs of software acquired for internal use are accounted for in accordance with the American Institute of Certified Public Accountant’s Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.
Income Taxes
     The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. Under this method, deferred tax assets and liabilities are recognized for the expected future tax consequences, utilizing currently enacted tax rates of temporary differences between the carrying amounts and the tax basis of assets and liabilities. Deferred tax assets are recognized, net of any valuation allowance, for the estimated future tax effects of deductible temporary differences and tax operating loss and credit carryforwards. See Note 6 for additional disclosure relating to income taxes and the adoption and application of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109 (“FIN 48”).
Concentration of Credit Risk
     Financial instruments that potentially expose the Company to concentrations of credit risk primarily consist of cash, cash equivalents, investments, accounts receivable and investment in sales-type lease receivables. The Company does not require collateral or other security to support financial instruments subject to credit risk. To minimize the financial statement risk with respect to accounts receivable and investment in sales-type lease receivables, the Company maintains reserves for potential credit losses and such losses, in the aggregate, have not exceeded the reserves established by management. The Company maintains cash, cash equivalents and investments with various financial institutions. The Company performs periodic evaluations of the relative credit quality of investments and the Company’s investment policy is designed to limit exposure to any one institution or type of investment. The primary objective of the Company’s investment strategy is the safety of the principal invested. The Company does not maintain foreign exchange contracts or other off-balance sheet financial investments.
Single or Limited Source Suppliers
     The Company currently obtains certain key components of its products from single or limited sources. The Company purchases components pursuant to purchase orders, and in select cases, long-term supply agreements, and generally does not maintain large volumes of inventory. The Company has experienced shortages and delays in obtaining certain components of its products in the past. The Company may experience similar shortages and delays in the future. The disruption or termination of the supply of components or a significant increase in the costs of these components from these sources could have a material adverse effect on the Company’s business, financial position and results of operations and cash flows.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
Net Income Per Share
     In accordance with SFAS No. 128, Earnings Per Share, basic net income per share amounts for the three and six months ended June 30, 2007 and July 1, 2006, were computed by dividing net income by the weighted average number of common shares outstanding during those periods and diluted net income per share was computed using the weighted average number of common shares outstanding and other dilutive securities, including stock options, unvested restricted stock, and convertible debt during those periods.
     For the three and six months ended June 30, 2007 and July 1, 2006, approximately 2,569,000 and 2,371,000, respectively, of potentially dilutive instruments, consisting of common stock options and unvested restricted stock, have been excluded from the computation of diluted weighted average shares outstanding as their effect would be antidilutive.
     Basic and diluted net income per share amounts for the three and six months ended June 30, 2007 and July 1, 2006 were determined as follows:
                                 
    Three Months Ended     Six Months Ended  
    June 30,     July 1,     June 30,     July 1,  
    2007     2006     2007     2006  
Basic:
                               
Net income
  $ 1,488     $ 2,125     $ 2,004     $ 4,062  
Weighted average shares outstanding
    21,836       22,442       22,122       22,389  
 
                       
 
                               
Basic net income per share
  $ 0.07     $ 0.09     $ 0.09     $ 0.18  
 
                       
 
                               
Diluted:
                               
Net income
  $ 1,488     $ 2,125     $ 2,004     $ 4,062  
Interest expense on convertible debt, net
    115             115        
 
                       
Net income, as adjusted
  $ 1,603     $ 2,125     $ 2,119     $ 4,062  
 
                       
Weighted average shares outstanding
    21,836       22,442       22,122       22,389  
Effect of dilutive stock options and restricted stock
    638       1,071       553       1,395  
Conversion of convertible debt
    801             401        
 
                       
Weighted average shares assuming dilution
    23,275       23,513       23,076       23,784  
 
                       
 
                               
Diluted net income per share
  $ 0.07     $ 0.09     $ 0.09     $ 0.17  
 
                       
Comprehensive Income
     Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. Other than the Company’s net income, the only other element of comprehensive income is the unrealized gains (losses) on its marketable securities for all periods presented.
Stock-Based Compensation
     The Company has three stock-based employee compensation plans, one stock-based non-employee director compensation plan and an employee stock purchase plan. Stock options and restricted common stock generally vest over three to four years and provide, in certain instances, for the acceleration of vesting upon a change of control of the Company. Options under these plans terminate ten years from the date of grant. The Company’s stock option plans provide for the grant, at the discretion of the Board of Directors, of options for the purchase of up to 11,410,000 shares of common stock to employees, directors, consultants and advisors.
     Effective January 1, 2006, the Company adopted SFAS No. 123R using the modified prospective transition method. Under this transition method, compensation expense recognized during the three and six months ended June 30, 2007 and July 1, 2006 included: (a) compensation expense for all share-based awards granted prior to, but not yet vested, as of

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
December 31, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, and (b) compensation expense for all share-based awards granted subsequent to December 31, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R.
Stock Option Activity:
     A summary of stock option activity as of June 30, 2007 is as follows:
                                 
                    Weighted        
            Weighted     Average        
    Number of     Average     Remaining     Aggregate  
    Options     Exercise Price     Contractual Life     Intrinsic Value  
Outstanding at December 31, 2006
    4,160     $ 17.00                  
Granted
    427       16.03                  
Exercised
    (105 )     15.81                  
Canceled
    (54 )     24.79                  
 
                             
Outstanding at June 30, 2007
    4,428     $ 17.10       6.18     $ 9,820  
 
                       
Vested or expected to vest at June 30, 2007
    4,341     $ 17.02       6.13     $ 9,815  
 
                       
Exercisable at June 30, 2007
    3,119     $ 15.39       5.22     $ 9,714  
 
                       
     Cash received from stock option exercises under all stock-based compensation plans for the three and six months ended June 30, 2007 was approximately $434,000 and $906,000, respectively, and was approximately $712,000 and $1,956,000 for the three and six months ended July 1, 2006, respectively. The intrinsic value of options exercised during the three and six months ended June 30, 2007 was approximately $300,000 and $981,000, respectively, and was approximately $1,415,000 and $3,508,000 for the three and six months ended July 1, 2006, respectively. The estimated fair value of options that vested during the three and six months ended June 30, 2007 was approximately $1,687,000 and $3,470,000, respectively, and was approximately $1,562,000and $3,132,000 for the three and six months ended July 1, 2006, respectively.
     A summary of unvested restricted stock activity as of June 30, 2007 is as follows:
                 
            Weighted Average  
    Number of     Grant Date Fair  
    Shares     Value  
Unvested at December 31, 2006
    47     $ 23.95  
Granted
    324       16.16  
Vested
    (50 )     17.45  
 
           
Unvested at June 30, 2007
    321     $ 17.06  
 
           
     As of June 30, 2007, total compensation cost related to unvested restricted stock not yet recognized was $5,450,000, which is expected to be recognized in the statement of income over a weighted-average period of 39 months. The fair value of shares that vested for the three and six months ended June 30, 2007 was approximately $439,000 and $871,000, respectively, and was approximately $90,000 and $145,000, respectively for the three and six months ended July 1, 2006.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
     Grant-date fair value:
     The Company uses the Black-Scholes option pricing model to calculate the grant-date fair value of an award. The following table provides information regarding options granted during the three and six months ended June 30, 2007 and July 1, 2006, and the assumptions the Company used to calculate the grant-date fair value:
                                 
    Three Months Ended   Six Months Ended
    June 30,   July 1,   June 30,   July 1,
    2007   2006   2007   2006
Options granted
    33,325       55,125       425,925       559,485  
Weighted average exercise price
  $ 16.03     $ 25.55     $ 16.14     $ 28.89  
Weighted average grant date fair value
  $ 7.50     $ 11.64     $ 7.61     $ 12.49  
 
                               
Assumptions:
                               
Risk-free interest rate
    4.72 %     5.06 %     4.54 %     4.70 %
Expected term
  5 years   5 years   5 years   5 years
Expected volatility
    45 %     44 %     46 %     42 %
Expected dividend yield
                       
Expense:
     The Company uses the straight-line attribution method to recognize expense for all options and restricted stock granted prior to the adoption of SFAS No. 123R and for all options and restricted stock granted after January 1, 2006, the adoption date of SFAS No. 123R. The amount of stock-based compensation expense recognized during a period is based on the value of the portion of the awards that are ultimately expected to vest. Stock-based compensation expense is recorded on a straight-line basis over the requisite service period, which is generally the vesting period. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The term “forfeitures” is distinct from “cancellations” or “expirations” and represents only the unvested portion of the surrendered option. For the three and six months ended June 30, 2007, the Company applied a forfeiture rate of approximately 5.0%. The Company re-evaluates its forfeiture rate on a quarterly basis and adjusts the rate as necessary. Prior to the adoption of SFAS No. 123R, the Company recorded forfeitures on an actual basis as they occurred. The Company’s results for the three and six months ended June 30, 2007 include stock-based compensation expense of approximately $2,137,000 and $4,354,000, and approximately $1,653,000 and $3,294,000 in the three and six months ended July 1, 2006, respectively, which amounts are included in the condensed consolidated statements of income within the applicable operating expense where the Company reports the option holders’ and restricted stock holders’ compensation cost.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
     As of June 30, 2007, total compensation cost related to unvested stock options not yet recognized was $12,779,000, which is expected to be recognized in the statement of income over a weighted-average period of approximately 14 months.
     For the three and six months ended June 30, 2007, the Company recorded stock-based compensation expense for non-employees of approximately $9,000 and $15,000, respectively, resulting from the grant of stock options to purchase 800 shares of common stock to one consultant and an award of 600 shares of common stock to another consultant.
     For the three months ended July 1, 2006, the Company awarded 300 shares of common stock to a consultant which resulted in approximately $7,000 of stock-based compensation expense. For the six months ended July 1, 2006, the Company granted options to purchase 800 shares of common stock to a consultant which resulted in approximately $10,000 of stock-based compensation expense and awarded 600 shares of common stock to a consultant which resulted in approximately $15,000 of stock-based compensation expense.
Use of Estimates
     The preparation of financial statements in conformity with generally accepted accounting principles in the United States 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 revenues and expenses during the reporting period. Actual results could differ from those estimates.
Fair Value of Financial Instruments
     The estimated fair market values of the Company’s financial instruments, which include cash equivalents, investments, accounts receivable, investment in sales-type leases, accounts payable and long-term debt, approximate their carrying values.
Reclassifications
     Certain amounts in the prior years’ financial statements have been reclassified to conform with the current year presentation.
Recent Accounting Pronouncements
     In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”, including an amendment of FASB Statement No. 115 (“SFAS No. 159”). SFAS No. 159 permits entities to choose, at specified election dates, to measure eligible items at fair value (the “fair value option”). A business entity is required to report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting period. SFAS No. 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company does not believe that the adoption of SFAS No. 159 will have a material impact on its results of operations, financial position or cash flow.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
(3) Comprehensive Income
     The Company’s total comprehensive income is as follows:
                                 
    Three Months Ended     Six Months Ended  
    June 30,     July 1,     June 30,     July 1,  
    2007     2006     2007     2006  
Net income
  $ 1,488     $ 2,125     $ 2,004     $ 4,062  
Other comprehensive income:
                               
Unrealized gain on marketable securities
    42       26       37       37  
 
                       
Comprehensive income
  $ 1,530     $ 2,151     $ 2,041     $ 4,099  
 
                       
(4) Investment in Sales-Type Leases
     The components of the Company’s net investment in sales-type leases are as follows:
                 
    June 30,     December 31,  
    2007     2006  
Total minimum lease payments receivable
  $ 6,297     $ 6,148  
Less:
               
Unearned interest income
    1,003       972  
Allowance for lease payments
    702       866  
 
           
Net investment in sales-type leases
    4,592       4,310  
Less — current portion
    1,521       1,493  
 
           
 
  $ 3,071     $ 2,817  
 
           
(5) Inventory
     Inventory consists of the following:
                 
    June 30,     December 31,  
    2007     2006  
Raw materials
  $ 3,281     $ 3,607  
Work-in-progress
    74       156  
Finished goods
    3,521       2,738  
 
           
 
  $ 6,876     $ 6,501  
 
           

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
(6) Income Taxes
     The Company is subject to income tax in numerous jurisdictions and at various rates worldwide and the use of estimates is required in determining the provision for income taxes. For the three and six months ended June 30, 2007, the Company recorded a tax provision of $1,882,000 and $2,458,000, respectively. Income before income taxes for the three and six months ended June 30, 2007 was $3,370,000 and $4,462,000, respectively. The provision for income taxes was the result of applying an effective income tax rate of 56% and 55% to income before tax for the three and six months ended June 30, 2007, respectively. For the three and six months ended June 30, 2007, the difference between the effective tax rate and the U.S. federal statutory income tax rate of 34% was due mainly to the impact of state income taxes and the disallowance for tax purposes of certain stock-based compensation deductions in accordance with SFAS No. 123R. For the three and six months ended July 1, 2006, the Company recorded a tax provision of $33,000 and $56,000, respectively, and continued to maintain a full valuation allowance on its tax benefits.
     Through the third quarter of 2006, the Company maintained a full valuation allowance on its deferred tax assets. Upon achieving three-years of cumulative profitability, the Company began to weigh the positive and negative evidence included in SFAS 109 “Accounting For Income Taxes,” on a quarterly basis to determine if it believed that it was more likely than not that some or all of its deferred tax assets would be realized. In connection with this analysis, the Company reviewed its cumulative history of earnings before taxes over a three-year period and its projections of future taxable income. As of December 31, 2006, after finalizing the 2007 forecast, the Company concluded that the projections supported taxable income for the foreseeable future, and therefore, the Company reversed $28,200,000 of its valuation allowance. The projections of future taxable income include significant judgment and estimation. If the Company is not able to achieve sufficient taxable income in future periods, it might need to record additional valuation allowances on its deferred tax assets in future periods that could be material to the Company’s consolidated financial statements.
     The Company adopted the provisions of FIN 48 on January 1, 2007. As a result of adoption, the Company recognized a charge of approximately $371,000 to the January 1, 2007 retained earnings balance. As of January 1, 2007, the Company had gross unrecognized tax benefits of $726,000. Of this total, $626,000 (net of the federal benefit on state tax issues) represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in future periods. Also as of the adoption date, the Company had not accrued interest expense related to these unrecognized tax benefits. When appropriate the Company will recognize interest accrued and penalties if incurred, related to unrecognized tax benefits as a component of income tax expense. There were no significant changes to any of these amounts during the six months ended June 30, 2007. The Company does not reasonably estimate that the unrecognized tax benefit will change significantly within the next twelve months.
     The Company or one of its subsidiaries files income tax returns in the U.S. federal jurisdiction, and various states and foreign jurisdictions. The Company is generally no longer subject to income tax examinations by U.S. federal, state and local or non-U.S. income tax examinations by tax authorities for years before 1992.
(7) Segment Information and Enterprise Reporting
     The Company operates in one reportable segment as it markets and sells one family of anesthesia monitoring systems. The Company does not disaggregate financial information by product or geographically, other than sales by region and sales by product, for management purposes. Substantially all of the Company’s assets are located within the United States. All of the Company’s products are manufactured in the United States.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
     Revenue by geographic region and as a percentage of total revenue by geographic region is as follows:
                                 
    Three Months Ended     Six Months Ended  
    June 30,     July 1,     June 30,     July 1,  
    2007     2006     2007     2006  
Geographic Area by Region
                               
Domestic
  $ 20,708     $ 17,845     $ 39,082     $ 34,662  
International
    5,933       4,786       11,678       9,857  
 
                       
Total
  $ 26,641     $ 22,631     $ 50,760     $ 44,519  
 
                       
                                 
    Three Months Ended     Six Months Ended  
    June 30,     July 1,     June 30,     July 1,  
    2007     2006     2007     2006  
Geographic Area by Region
                               
Domestic
    78 %     79 %     77 %     78 %
International
    22       21       23       22  
 
                       
Total
    100 %     100 %     100 %     100 %
 
                       
     The Company did not have sales in any individual country, other than the United States, that accounted for more than 10% of the Company’s total revenue for the three and six months ended June 30, 2007 or July 1, 2006.
(8) Commitments and Contingencies
     Leases
     In February 2006, the Company entered into a lease agreement pursuant to which the Company agreed to lease approximately 136,500 square feet of research and development, sales and marketing, production and general and administrative space in Norwood, Massachusetts. The lease expires in December 2016, and the Company has been granted the option to extend the term for three additional five-year periods. In connection with this lease, the Company provided a security deposit in the amount of $911,000 to the lessor in accordance with the terms of the lease agreement. This lease is classified as an operating lease. The lease contains a rent escalation clause that requires additional rental amounts in the later years of the term. Rent expense is being recognized on a straight-line basis over the minimum lease term.
(9) Loan Agreements
     In May 2001, the Company entered into an agreement with a commercial bank for a revolving line of credit which expires in May 2008. The Company is entitled to borrow up to $5,000,000 under the revolving line of credit. Interest on any borrowings under the revolving line of credit is, at the election of the Company, either the prime rate or at the London Inter-Bank Offer Rate, or LIBOR, plus 2.25%. Up to $1,500,000 of the $5,000,000 revolving line of credit is available for standby letters of credit. At June 30, 2007, the Company had outstanding standby letters of credit with the commercial bank of approximately $991,000. At June 30, 2007, there was no outstanding balance under this revolving line of credit.
     The revolving line of credit agreement contains restrictive covenants that require the Company to maintain liquidity and net worth ratios and is secured by certain investments of the Company, which are shown as restricted cash in the accompanying condensed consolidated balance sheets. The Company is required to maintain restricted cash in an amount equal to 102% of the outstanding amounts under the revolving line of credit agreement. At June 30, 2007, the Company had $1,011,000 classified as restricted cash on the condensed consolidated balance sheet relating to standby letters of credit issued in connection with the Company’s leased building in Norwood, Massachusetts and its old Newton facility. At June 30, 2007, the Company was in compliance with all covenants contained in the revolving line of credit agreement.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
(10) Termination and Repurchase Agreement with Boston Scientific Corporation
     On June 11, 2007, the Company entered into a Termination and Repurchase Agreement with Boston Scientific Corporation. Under the terms of the agreement, the Company and Boston Scientific Corporation agreed to terminate the following agreements:
    the OEM Product Development Agreement dated as of August 7, 2002 (as amended January 31, 2005 and February 5, 2007, the “2002 Agreement”), pursuant to which the Company was to develop certain products that Boston Scientific Corporation would then commercialize in the area of monitoring patients under sedation in a range of less invasive medical specialties, and pursuant to which the Company granted Boston Scientific Corporation an exclusive option to become the distributor for a period of time of certain products;
 
    the Product Development and Distribution Agreement dated as of May 23, 2005 (the “2005 Agreement”) pursuant to which the Company was to develop new applications of its brain-monitoring technology in the area of the diagnosis and treatment of neurological, psychiatric and pain disorders and Boston Scientific was appointed the exclusive distributor of such products; and
 
    the Letter Agreement dated August 7, 2002, and Security Agreement dated August 7, 2002, pursuant to which Boston Scientific Corporation agreed to make revolving interest-bearing loans to Aspect from time to time at the request of Aspect, such revolving loans being evidenced by a promissory note in the original principal amount of $5,000,000 dated August 7, 2002.
     In addition to the termination of the agreements referenced above, the Company repurchased 2,000,000 shares of its common stock held by Boston Scientific Corporation at a price of approximately $15.91 per share. This price represents the average of the closing prices of the Company’s common stock as reported on the Nasdaq Global Market for the 20 consecutive trading days up to and including the date of the Termination and Repurchase Agreement. The Company repurchased these shares on June 13, 2007 for $31,816,000. These shares have been cancelled and retired. In accordance with the agreement, for a period of 180 days following the date of the agreement, the Company has the right to purchase any or all of the balance of Boston Scientific Corporation’s position in the Company at a price of $15.00 per share or the average of the closing prices for the Company’s common stock over the 10 trading days prior to the Company’s exercising its right to repurchase, whichever is higher. Additionally, Boston Scientific Corporation has agreed that for a period of 180 days after the effective date of the agreement that it would not sell, contract to sell, grant any option to purchase or dispose of any of the shares of the Company’s common stock held of record by Boston Scientific Corporation on the effective date.
     In connection with the termination of the 2002 Agreement and the 2005 Agreement, the Company recognized approximately $3,550,000 of strategic alliance revenue for the quarter ended June 30, 2007. Of this amount, approximately $3,835,000 represents the amount that had been recorded previously in deferred revenue relating to the 2002 Agreement, which represented the unamortized portion of the purchase price of $7.00 in excess of the closing price of the Company’s common stock on August 7, 2002 of $2.59. The $3,835,000 was offset by approximately $285,000 for a receivable from Boston Scientific Corporation which had been recorded in the financial statements for the quarter ended March 31, 2007 relating to the 2005 Agreement with Boston Scientific Corporation. Upon the termination of the 2005 Agreement, the Company reversed the receivable amount against strategic alliance revenue where it was originally recorded in the income statement.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
(11) Convertible Debt
     In June 2007, the Company completed a private placement of $125,000,000 aggregate principal amount of 2.5% convertible notes due 2014 (the “notes”). The notes are senior unsecured obligations and will rank equally with all of its existing and future senior debt and to all of the Company’s subordinated debt. Interest on the notes is payable semiannually in cash on June 15th and December 15th of each year with the first payment being made on December 15, 2007. The notes will mature on June 15, 2014. Net proceeds received from the issuance of the notes were approximately $121,000,000, which is net of the underwriter’s discount of approximately $4,000,000. In connection with the notes offering, the Company incurred total offering costs of approximately $4,471,000 which have been recorded as deferred financing fees in the condensed consolidated balance sheet and are being amortized on a straight-line basis over the term of the notes. As of June 30, 2007, approximately $20,000 of the offering costs had been amortized to interest expense.
     Holders may convert their notes at their option on any day prior to the close of business on the scheduled trading day immediately preceding March 15, 2014 only under the following circumstances:
    during the five business day period after any five consecutive trading day period (the “measurement period”) in which the price per note for each trading day of that measurement period was less than 97% of the product of the last reported sale price of the Company’s common stock and the conversion rate on each such day;
 
    during any calendar quarter (and only during such quarter) after the calendar quarter ending September 30, 2007, if the last reported sale price of the Company’s common stock for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 120% of the applicable conversion price in effect on the last trading day of the immediately preceding calendar quarter; or
 
    upon the occurrence of specified corporate events.
     The notes will be convertible, regardless of the foregoing circumstances, at any time from, and including, March 15, 2014 through the scheduled trading day immediately preceding the maturity date of the notes.
     The initial conversion rate for the notes will be 52.4294 shares of common stock per $1,000 in principal amount of notes, which is equivalent to an initial conversion price of approximately $19.07 per share of common stock. The conversion rate will be subject to adjustment in some events but will not be adjusted for accrued interest. In addition, if a “make-whole fundamental change” (as defined in the indenture dated as of June 20, 2007 between the Company and U.S. Bank National Association, (the “Indenture”) occurs prior to the maturity date of the notes, the Company will in some cases increase the conversion rate for a holder that elects to convert its notes in connection with such “make-whole fundamental change”. No adjustment to the conversion rate will be made if the Company’s stock price is less than $15.57 per share or if the stock price exceeds $50.00 (in each case subject to adjustment).
     Unless the Company obtains stockholder authorization to utilize the net share settlement feature of the notes and the Company irrevocably elects such settlement method at any time on or prior to the 45th scheduled trading day preceding the maturity date of the notes, upon conversion the Company will deliver a number of shares of its common stock equal to the conversion rate on the related conversion date for each $1,000 principal amount of notes. The Company will deliver cash in lieu of any fractional shares of its common stock based on the last reported sale price of its common stock on the related conversion date (or, if the conversion date is not a trading day, on the next succeeding trading day). If the Company obtains stockholder approval of the net share settlement feature in connection with the potential conversion of the notes, then upon conversion of the notes the Company would (1) pay cash in an amount equal to the lesser of one-fortieth of the principal amount of the notes being converted and the daily conversion value (the product of the conversion rate and the current trading price) of the notes being converted and (2) issue shares of its common stock only to the extent that the daily conversion value of the notes exceeded one-fortieth of the principal amount of the notes being converted for each trading day of the relevant 40 trading day observation period.
     The Company will not make any sinking fund payments in connection with the notes and the notes may not be redeemed by the Company prior to maturity date.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
     In connection with the offering of the notes, the Company repurchased an additional 1,000,000 shares of its common stock for $15,570,000 in privately negotiated transactions. These shares have been cancelled and retired.
(12) Stock Repurchase Program
     On August 3, 2006, the Company’s Board of Directors authorized the repurchase of up to 2,000,000 shares of the Company’s common stock through the open market or in privately negotiated transactions. The repurchase program may be suspended or discontinued at any time. As of June 30, 2007, the Company has repurchased a total of 276,493 shares of common stock under this repurchase program for $5,008,000. Of the total shares repurchased, 276,493 shares are held in treasury pending use for general corporate purposes, including issuances under various employee stock plans. As of June 30, 2007, the Company is authorized to repurchase an additional 1,723,507 shares of common stock in the future.
(13) Subsequent Event
     On July 10, 2007, the Company exercised its right under the Termination and Repurchase Agreement and repurchased an additional 2,500,000 shares of common stock from Boston Scientific Corporation for $37,655,000. The repurchased shares were cancelled and retired. The remaining number of shares of common stock available to be repurchased from Boston Scientific Corporation is 1,513,239.

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Item 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Overview
     We develop, manufacture and market an anesthesia monitoring system that we call the BIS® system. The BIS system is based on our patented core technology, the Bispectral Index, which we refer to as the BIS index. The BIS system provides information that allows clinicians to assess and manage a patient’s level of consciousness in the operating room, intensive care and procedural sedation settings and is intended to assist the clinician in better determining the amount of anesthesia or sedation needed by each patient. Our proprietary BIS system includes our BIS monitor, BIS Module Kit or BISx system, which allows original equipment manufacturers to incorporate the BIS index into their monitoring products, and our group of sensor products, which we collectively refer to as BIS Sensors.
     The following chart summarizes our principal product offerings:
                 
    Initial        
    Commercial   Date of Clearance of    
Product   Shipment   510 (k) Notification   Description
EQUIPMENT
               
 
               
   BIS VIEW
  Pending   June 2007   Basic-featured standalone monitor which has few optional user configurations compared with the BIS VISTA monitor.
 
               
   BIS VISTA
    2006     September 2005   Monitor that offers an enhanced display and user interface as well as greater processing capability compared to our other monitors.
 
               
   BISx system
    2004     February 2004   BIS monitoring solution that provides the processing technology required to obtain BIS information from a single device the approximate size of a hockey puck. The BISx system is designed to integrate with a wide range of patient monitoring platforms sold by original equipment manufacturers.
 
               
   BIS XP System
    2001     June 2001   BIS system offering enhanced performance capabilities and expanded benefits as compared to the previous version of the BIS system, designed to enable more precise measurement of brain activity to assess the level of consciousness.
 
               
   BIS Module Kit — 4
   Channel Support
    2001     October 2000   Same as standard BIS Module Kit plus 4 channel EEG monitoring capability.
 
               
   A-2000 BIS Monitor
    1998     February 1998   Compact, lightweight, portable third-generation BIS monitor.
 
               
   BIS Module Kit
    1998     October 2000   Components of BIS monitoring technology that are integrated into equipment sold by original equipment manufacturers.
 
               
   SENORS
               
 
               
   Semi-Reusable
   (SRS) Sensor
    2005     February 2005   Semi-reusable version of a BIS Sensor that uses the same algorithm and hardware as our other disposable sensors. Currently available only in markets outside the United States, excluding Japan.
 
               
   BIS Extend Sensor
    2002     October 2000   Disposable sensor with electronic memory device for use with our BIS Monitors, BIS Module Kit and BISx System that was designed for patients who are typically monitored for extended periods.

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    Initial        
    Commercial   Date of Clearance of    
Product   Shipment   510 (k) Notification   Description
   BIS Pediatric
   Sensor
    2001     October 2000   Disposable sensor with electronic memory device for use with our BIS Monitors, BIS Module Kit and BISx System that is smaller and easier to apply to children.
 
               
   BIS Quatro Sensor
    2001     October 2000   Disposable sensor with electronic memory device for use with our BIS Monitors, BIS Module Kit and BISx System that is designed to offer enhanced performance in deep anesthetic states and enhanced resistance to interference from noise sources.
 
               
   BIS Sensor Plus
    2001     January 2000   Second-generation disposable sensor for use with our BIS Monitors and BIS Module Kit.
 
               
   BIS Standard
   Sensor
    1997     October 1996   Disposable sensor for use with our BIS Monitors and BIS Module Kit.
     We derive our revenue primarily from sales of BIS monitors, our original equipment manufacturer products (including BIS Module Kits and the BISx system) and related accessories, which we collectively refer to as Equipment, and sales of BIS Sensors. We have also historically derived a portion of our revenue from our strategic alliances, primarily with Boston Scientific Corporation, which was terminated in June 2007. To assist management in assessing and managing our business, we segregate our revenue by sales by region, sales by products and revenue derived from our strategic alliance, as shown in the following table:
                                 
    Three Months Ended   Six Months Ended
    June 30,   July 1,   June 30,   July 1,
    2007   2006   2007   2006
    (dollars in thousands)
Domestic revenue
  $ 20,708     $ 17,845     $ 39,082     $ 34,662  
Percent of total revenue
    78 %     79 %     77 %     78 %
 
                               
International revenue
  $ 5,933     $ 4,786     $ 11,678     $ 9,857  
Percent of total revenue
    22 %     21 %     23 %     22 %
 
                               
Total revenue
  $ 26,641     $ 22,631     $ 50,760     $ 44,519  
 
                               
BIS Sensor revenue
  $ 18,563     $ 15,868     $ 36,117     $ 31,453  
Percent of total revenue
    70 %     70 %     71 %     71 %
 
                               
Equipment revenue
  $ 4,516     $ 5,313     $ 9,397     $ 10,170  
Percent of total revenue
    17 %     24 %     19 %     23 %
 
                               
Strategic alliance revenue
  $ 3,562     $ 1,450     $ 5,246     $ 2,896  
Percent of total revenue
    13 %     6 %     10 %     6 %
 
                               
Total revenue
  $ 26,641     $ 22,631     $ 50,760     $ 44,519  
     At June 30, 2007, we had cash, cash equivalents, restricted cash and investments of approximately $140.2 million and working capital of approximately $142.5 million.
     We follow a system of fiscal quarters as opposed to calendar quarters. Therefore, the first three quarters of each fiscal year end on the Saturday closest to the end of the calendar quarter and the last quarter of the fiscal year always ends on December 31.
     We believe our ability to grow our revenue is directly related to our ability to sell our Equipment to healthcare organizations and influence our customers after they purchase our Equipment to continue to purchase and use our BIS Sensors. We believe the increase in our installed base of Equipment resulting from the sale of BIS monitors and the sale of original equipment manufacturers’ equipment incorporating our BIS Module Kit or BISx system has been the primary reason for the growth in revenue from the sale of BIS Sensors. In order to successfully grow our revenue, we need to continue to focus on both selling our Equipment and increasing the use of our sensors and increasing procedure penetration. To achieve this growth, we plan to continue to implement new sales and marketing programs. We expect that as we grow our business, revenue from the sale of BIS Sensors will contribute an increasing percentage of product revenue. Additionally, we believe that, over time, revenue from the sale of BIS Module Kits and our BISx system will increase as a percentage of total

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Equipment revenue as healthcare organizations purchase our technology as part of an integrated solution offered by our original equipment manufacturers.
     In order to sustain profitability, we believe that we need to continue to maintain our gross profit margin and control the growth of our operating expenses. To maintain our gross profit margin we believe we must continue to focus on maintaining the average unit sales prices of our BIS Sensors, increasing revenue from the sale of BIS Sensors as a percentage of total revenue, as BIS Sensors have a higher gross profit margin than Equipment, and continuing to reduce the costs of manufacturing our products.
     For those healthcare organizations desiring to acquire our BIS monitors directly from us, we offer two options. Our customers have the option either to purchase BIS monitors outright or to acquire BIS monitors pursuant to a sales-type lease agreement whereby the customer contractually commits to purchase a minimum number of BIS Sensors per BIS monitor per year. Under our sales-type leases, customers purchase BIS Sensors and the BIS monitor for the purchase price of the BIS Sensors plus an additional charge per BIS Sensor to pay for the purchase price of the BIS monitor and related financing costs over the term of the agreement. We also grant these customers an option to purchase the BIS monitors at the end of the term of the agreement, which is typically three to five years. We recognize Equipment revenue under sales-type lease agreements either at shipment or delivery in accordance with the agreed upon contract terms with interest income recognized over the life of the sales-type lease. The cost of the BIS monitor acquired by the customer is recorded as costs of revenue in the same period it is acquired. Revenue from sales-type leases accounted for approximately 2% and 3% of total product revenue in the three and six months ended June 30, 2007 and approximately 4% and 2% in the three and six months ended July 1, 2006, respectively.
     Under certain limited circumstances, we also offer customers the opportunity to use the BIS monitors under our Equipment Placement program, which we refer to as the EP program. Under the EP program, the customer is granted the right to use the BIS monitors for a mutually agreed upon period of time. During this period, the customer purchases BIS Sensors at a price that includes a premium above the list price of the BIS Sensors to cover the rental of the equipment, but without any minimum purchase commitments. At the end of the agreed upon period, the customer has the option of purchasing the BIS monitors, continuing to use them under the EP program or returning them to us.
     We have subsidiaries in The Netherlands and the United Kingdom to facilitate the sale of our products into the international market. We are continuing to develop our international sales and distribution program through a combination of distributors and marketing partners, including companies with which we have entered into original equipment manufacturer relationships.
     We are party to a distribution agreement with Nihon Kohden Corporation to distribute BIS monitors in Japan. Nihon Kohden has received approval from the Japanese Ministry of Health, Labor and Welfare for marketing in Japan our A-1050 EEG Monitor with BIS, our A-2000 BIS Monitor, our BIS module (our product that integrates BIS monitoring technology into equipment sold by original equipment manufacturers) and, most recently in 2005, our BIS XP system. In January 2002, the Japanese Ministry of Health, Labor and Welfare granted reimbursement approval for use of our BIS monitors. With this approval, healthcare providers in Japan are eligible to receive partial reimbursement of 1,000 Yen each time BIS monitoring is used. Sales to Nihon Kohden represented approximately 13% of international revenue in both the three and six months ended June 30, 2007 and approximately 11% and 12% of international revenue in the three and six months ended July 1, 2006.
     During the first quarter of 2006, we adopted Financial Accounting Standards Board, or FASB, Statement of Financial Accounting Standard, or SFAS, 123 (revised 2004), Share-Based Payment, or SFAS No. 123R, using the modified prospective transition method. Prior to the adoption of SFAS No. 123R, we accounted for share-based payments to employees using the intrinsic value method under Accounting Principles Bulletin, or APB, Opinion No. 25, Accounting for Stock Issued to Employees, and, as such, generally recognized no compensation expense for employee stock options. For the three and six months ended June 30, 2007, we recognized approximately $2.1 million and $4.4 million, respectively, of stock-based compensation expense in our condensed consolidated statements of income and in the three and six months ended July 1, 2006, we recognized approximately $1.7 million and $3.3 million of stock-based compensation expense. See Note 2 of the Notes to our Condensed Consolidated Financial Statements contained in Item 1 of this Quarterly Report on Form 10-Q for further information regarding our adoption of SFAS No. 123R.
     Various factors may adversely affect our quarterly operating results through the third quarter of 2007 and beyond. These factors include the impact of the shift in our placements from BIS monitors to original equipment manufacturer products, which may lead to a reduction in gross margin on Equipment, the continued challenges of the worldwide economy and the risk that we may not realize expected benefits of industry pronouncements on anesthesia awareness, including the Sentinel

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Event Alert issued by the Joint Commission on Accreditation of Healthcare Organizations, the Practice Advisory on Interoperative Awareness, which was approved by the American Society of Anesthesiologists House of Delegates in October 2005 and the position statement regarding unintended awareness issued by the American Association of Nurse Anesthetists, or AANA. In addition, in Japan, Nihon Kohden received approval of the BIS XP system in 2005 and we may not recognize the potential benefits of this approval for some time, if at all.
Recent Developments
Sale of 2.50% Convertible Senior Notes due 2014
     In June 2007, we completed a private placement of $125,000,000 aggregate principal amount of 2.5% convertible notes due 2014, which we refer to as the notes. The notes are senior unsecured obligations and will rank equally with all of our existing and future senior debt and to all of our subordinated debt. Interest on the notes is payable semiannually in cash on June 15th and December 15th of each year with the first payment being made on December 15, 2007. The notes will mature on June 15, 2014. Net proceeds received from the issuance of the notes were approximately $121,000,000, which is net of the underwriter’s discount of approximately $4,000,000. In connection with the notes offering, we incurred total offering costs of approximately $4,471,000.
     The initial conversion rate for the notes is 52.4294 shares of common stock per $1,000 in principal amount of notes, which is equivalent to an initial conversion price of approximately $19.07 per share of common stock. The conversion rate will be subject to adjustment in some events but will not be adjusted for accrued interest. No adjustment to the conversion rate will be made if our stock price is less than $15.57 per share or if our stock price exceeds $50.00 (in each case subject to adjustment).
     Currently, the notes are convertible, under certain circumstances, solely into shares of our common stock. However, if we obtain stockholder approval of the net share settlement feature in connection with the potential conversion of such notes, and irrevocably elect to use such feature, then upon conversion of such notes we would (1) pay cash in an amount equal to the lesser of one-fortieth of the principal amount of the notes being converted and the daily conversion value (the product of the conversion rate and the current trading price) of the notes being converted and (2) issue shares of our common stock only to the extent that the daily conversion value of the notes exceeded one-fortieth of the principal amount of the notes being converted for each trading day of the relevant 40 trading day observation period.
Termination of Alliance with Boston Scientific Corporation and Related Stock Repurchase
     In June 2007, we terminated our alliance with Boston Scientific Corporation and regained the commercial rights to products developed under the alliance that we previously shared. In connection with the termination of our alliance we have also repurchased an aggregate of 4,500,000 shares of our common stock from Boston Scientific Corporation, and we have an option, which is exercisable during the six-month period following June 11, 2007, to repurchase the remaining 1,513,239 shares of our common stock held by Boston Scientific Corporation.
Termination and Repurchase Agreement.
     On June 11, 2007, we entered into a termination and repurchase agreement with Boston Scientific Corporation pursuant to which:
    We agreed to repurchase, and Boston Scientific Corporation agreed to sell, 2,000,000 shares of our common stock held by Boston Scientific Corporation at a price per share of $15.91 per share, which represents the average of the closing prices of our common stock for the 20 consecutive trading days up to and including the date of the agreement. We plan to complete this purchase on or about June 13, 2007.
 
    Boston Scientific Corporation agreed that for a period of 180 days after the date of the termination and repurchase agreement, it would not, without our prior written consent, sell, contract to sell, grant any option to purchase, or dispose of any of the shares of common stock held of record by Boston Scientific Corporation on the date of the agreement, except to us.
 
    Boston Scientific Corporation granted to us an option, which we may exercise from time to time in one or more transactions until December 7, 2007, to purchase up to all of the remaining 4,013,239 shares of our common stock held of record by Boston Scientific Corporation on the date of the termination and repurchase agreement at a repurchase price equal to the greater of (x) $15.00 per share and (y) the average of the closing prices of our common stock as reported on the NASDAQ Global Market for the 10 consecutive trading days up to and including the date of our exercise of such option. Subsequent to the end of the quarter, we exercised this option in part and repurchased an additional 2,500,000 shares from Boston Scientific Corporation at a purchase price of $15.06 per share.
 
    We and Boston Scientific Corporation mutually agreed to terminate in their entirety the following agreements between the parties:
 
    The original equipment manufacturer product development agreement dated as of August 7, 2002, as amended. Under this agreement, Boston Scientific had an option to distribute products in the area of procedural sedation.
 
    The product development and distribution agreement dated as of May 23, 2005 pursuant to which Aspect was seeking to develop new applications of its brain-monitoring technology in the area of the diagnosis and treatment of neurological, psychiatric and pain disorders, and Boston Scientific Corporation was appointed the exclusive distributor of such products, assuming successful development. Under the termination agreement, Boston Scientific Corporation is relieved from all current and future obligations, including its commitment to provide $25 million over five years to support our research in the areas of depression and Alzheimer’s disease, of which it had paid $10 million to date.
 
    An agreement and related security agreement pursuant to which Boston Scientific Corporation agreed to make available to us revolving interest-bearing loans of up to $5,000,000. There were no amounts outstanding under this agreement.
Registration Rights Agreement
     We also entered into a registration rights agreement with Boston Scientific Corporation pursuant to which, at any time on or after our option to purchase the shares has expired, if we have not repurchased all of the shares of common stock held by Boston Scientific Corporation, and it continues to hold 10% or more of our outstanding common stock, Boston Scientific Corporation may request that we file a registration statement covering any such remaining shares.
Interim Results of BRITE Major Depression Study
     On May 21, 2007, we announced interim study results from our BRITE, or Biomarkers for Rapid Identification of Treatment Effectiveness, trial in major depression. The interim study results suggest that our EEG-based research technology is a significant predictor of patient response to treatment of depression with a selective serotonin reuptake inhibitor, or SSRI, after one week of treatment. Further, the study results suggest that the technology may help expedite the process of identifying effective antidepressant drug therapy. Our Antidepressant Treatment Response, or ATR, index achieved statistical significance in predicting seven week clinical response as measured by the standard Hamilton Depression Rating Scale after just one week on treatment with an SSRI. In addition, a retrospective analysis of BRITE trial subjects demonstrated that patients who received treatment in accordance with the ATR index were significantly more likely to respond to treatment than the other patients in the trial.
     We are conducting the BRITE trial in collaboration with leading depression researchers at ten facilities across the United States. Enrollment for the trial, which includes approximately 375 subjects, was completed in March 2007 and an analysis of the full study results is planned for the second half of 2007. There can be no guarantee that the results of the full study will support, or be consistent with, the results of the interim study or that, if they are consistent, we will be able to recognize any potential benefits to our business from the BRITE trial results.
Critical Accounting Policies and Estimates
     Management’s discussion and analysis of financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. Note 2 of the Notes to Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q includes a summary of our significant accounting policies and methods used in the preparation of our financial statements. In preparing these financial statements, we have made estimates and judgments in determining certain amounts included in the financial statements. The application of these accounting policies involves the exercise of judgment and use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates. We believe that our critical accounting policies and estimates are as follows:
Revenue Recognition
     We sell our BIS monitors primarily through a combination of a direct sales force and distributors. Our original equipment manufacturer products are sold to original equipment manufacturers who in turn sell them to the end-user. BIS Sensors are sold through a combination of a direct sales force, distributors and original equipment manufacturers. Direct product sales are structured as sales, sales-type lease arrangements or sales under our EP program. We recognize revenue when earned in accordance with Staff Accounting Bulletin, or SAB, No. 104, Revenue Recognition, and Emerging Issues Task Force, or ,EITF Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. Revenue is recognized when persuasive evidence of an arrangement exists, product delivery has occurred or services have been rendered, the price is fixed or determinable and collectibility is reasonably assured. For product sales, revenue is not recognized until title and risk of loss have transferred to the customer.
     We also recognize revenue from prepaid license and royalty fees. This revenue is deferred until product shipment or delivery in accordance with the terms of the agreement and license and royalty fees are earned in accordance with the terms of the respective agreements. In August 2002, we recorded approximately $6.3 million of deferred revenue related to an OEM product development and distribution agreement with Boston Scientific Corporation, which we refer to as the 2002 OEM product development and distribution agreement. In June 2007, we terminated the 2002 OEM product development and distribution agreement and as a result, at that time we recognized the remaining $3,835,000 that had been previously deferred under this agreement.
     In May 2005, we entered into a product development and distribution agreement with Boston Scientific Corporation, which we refer to as the 2005 product development and distribution agreement. Pursuant to this agreement, Boston Scientific Corporation agreed to provide to us up to $25.0 million to fund the development of products that incorporate EEG analysis technology for the diagnosis of neurological, psychiatric or pain disorders or screening or monitoring patient response to treatment options for such disorders. In June 2007, we terminated the 2005 product development and distribution agreement with Boston Scientific Corporation. In connection with the termination of the agreement, we reversed a receivable of approximately $285,000 that we had recorded in March 2007 against the strategic alliance revenue where it had originally been recorded in the statement of income. Revenue was being recognized on allowable product development activities pursuant to this agreement as the services were performed and costs were incurred.
     We follow SFAS No. 13, Accounting For Leases, in connection with our sales-type lease agreements. Under our sales-type leases, customers purchase BIS Sensors and the BIS monitor for the purchase price of the BIS Sensors plus an additional charge per BIS Sensor to pay for the purchase price of the BIS monitor and related financing costs over the term of the agreement. The minimum lease payment, consisting of the additional charge per BIS Sensor, less the unearned interest income, which is computed at the interest rate implicit in the lease, is recorded as the net investment in sales-type leases. We recognize Equipment revenue under sales-type lease agreements either at shipment or delivery in accordance with the agreed upon contract terms with interest income recognized over the life of the sales-type lease. The cost of the BIS monitor acquired by the customer is recorded as costs of revenue in the same period it is acquired. We review and assess the net realizability of our investment in sales-type leases at each reporting period. This review includes determining, on a customer specific basis, if a customer is significantly underperforming relative to the customer’s cumulative level of committed BIS Sensor purchases as required by the sales-type lease agreement. If a customer is underperforming, we record an allowance for lease payments as a charge to revenue to reflect the lower estimate of the net realizable investment in sales-type lease

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balance. Changes in the extent of underperformance in the agreements could increase or decrease the amount of revenue recorded in future periods.
     We recognize revenue either at shipment or delivery in accordance with the agreed upon contract terms with distributors and original equipment manufacturers in accordance with SAB No. 104. Contracts executed for sales to distributors and original equipment manufacturers include a clause that indicates that customer acceptance is limited to confirmation that our products function in accordance with our applicable product specifications in effect at the time of delivery. Formal acceptance by the distributor or original equipment manufacturer is not necessary to recognize revenue provided that we objectively demonstrate that the criteria specified in the acceptance provisions are satisfied. Each product is tested prior to shipment to ensure that it meets the applicable product specifications in effect at the time of delivery. Additionally, we have historically had a minimal number of defective products shipped to distributors and original equipment manufacturers, and any defective products are subject to repair or replacement under warranty as distributors and original equipment manufacturers do not have a right of return.
Stock-Based Compensation
     SFAS No. 123R, which we adopted in the first quarter of 2006, requires that stock-based compensation expense associated with equity instruments be recognized in the condensed consolidated statement of income, rather than being disclosed in a pro forma footnote to the condensed consolidated financial statements. Determining the amount of stock-based compensation to be recorded requires us to develop estimates to be used in calculating the grant-date fair value of stock options. We calculate the grant-date fair value using the Black-Scholes valuation model. The use of valuation models requires us to make estimates with respect to the following assumptions:
Risk-free interest rate: the implied yield currently available on U.S. Treasury zero-coupon issues with a remaining term equal to the expected term used as the assumption in the model.
Expected term: the expected term of an employee option is the period of time for which the option is expected to be outstanding. We use a Monte Carlo simulation model to estimate the expected term assumption in determining the grant date valuation as we believe that this information is currently the best estimate of the expected term of a new option.
Expected volatility: in estimating expected volatility, we consider both trends in historical volatility and the implied volatility of our publicly traded options. We used a combination of our implied volatility and historical volatility to estimate expected volatility for the three and six months ended June 30, 2007. We believe that in addition to the relevance of historical volatility, consideration of implied volatility achieves the objectives of SFAS No. 123R since it represents the expected volatility that marketplace participants would likely use in determining an exchange price for an option, and is therefore an appropriate assumption to use in the calculation of grant date fair value.
     Additionally, we are required to make assumptions regarding the forfeiture rate. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We used a forfeiture rate of approximately 5.0% in our calculation at June 30, 2007. We re-evaluate this forfeiture rate on a quarterly basis and adjust the rate as necessary.
     These assumptions involve significant judgment and estimates. Future stock-based compensation expense could vary significantly from the amount recorded in the current period due to changes in assumptions and due to the extent of stock option activity and the amount of restricted stock issued in future periods.
     As of June 30, 2007, the total unrecognized compensation cost related to unvested stock options and unvested restricted stock awards was $12.8 million and $5.5 million, respectively, which will be amortized over the weighted average remaining requisite service periods of 14 months and 39 months, respectively.

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Allowance for Doubtful Accounts
     We determine our allowance for doubtful accounts by making estimates and judgments based on our historical collections experience, current trends, historical write-offs of our receivables, our credit policies and a percentage of our accounts receivable by aging category. We also review the credit quality of our customer base as well as changes in our credit policies. We continuously monitor collections and payments from our customers. While credit losses have historically been within our expectations and the provisions established, our credit loss rates in the future may not be consistent with our historical experience. To the extent that we experience a deterioration in our historical collections experience or increased credit losses, bad debt expense would likely increase in future periods.
Inventories
     We value inventory at the lower of cost or estimated market value, and determine cost on a first-in, first-out basis. We regularly review inventory quantities on hand and record a provision for excess or obsolete inventory primarily based on production history and on our estimated forecast of product demand. The medical device industry in which we market our products is characterized by rapid product development and technological advances that could result in obsolescence of inventory. Additionally, our estimates of future product demand may prove to be inaccurate, in which case we would need to change our estimate of the provision required for excess or obsolete inventory. If revisions are deemed necessary, we would recognize the adjustments in the form of a charge to costs of revenue at the time of the determination. Therefore, although we continually update our forecasts of future product demand, any significant unanticipated declines in demand or technological developments, such as the introduction of new products by our competitors, could have a significant negative impact on the value of our inventory, results of operations and cash flows in future periods.
Warranty
     Equipment that we sell generally is covered by a warranty period of one year. We accrue a warranty reserve for estimated costs to provide warranty services. Our estimate of costs to service our warranty obligations is based on our historical experience and expectation of future conditions. While our warranty costs have historically been within our expectations and the provisions established, to the extent we experience an increased number of warranty claims or increased costs associated with servicing those claims, our warranty expenses will increase, and we may experience decreased gross profit margin and cash flow.
Income Taxes
     Through the third quarter of 2006, we maintained a full valuation allowance on our deferred tax assets. Upon achieving three-years of cumulative profitability, we began to weigh the positive and negative evidence included in SFAS 109 “Accounting For Income Taxes,” on a quarterly basis to determine if we believed that it was more likely than not that some or all of our deferred tax assets would be realized. In connection with this analysis, we reviewed our cumulative history of earnings before taxes over a three-year period and our projections of future taxable income. As of December 31, 2006, after finalizing the 2007 forecast, we concluded that the projections support taxable income for the foreseeable future, and therefore, we reversed $28.2 million of our valuation allowance. The projections of future taxable income include significant judgment and estimation. If we are not able to achieve sufficient taxable income in future periods, we might need to record additional valuation allowances on our deferred tax assets in future periods that could be material to our consolidated financial statements.

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Results of Operations
     The following tables present, for the periods indicated, financial information expressed as a percentage of revenue and a summary of our total revenue. This information has been derived from our condensed consolidated statements of income included elsewhere in this Quarterly Report on Form 10-Q. You should not draw any conclusions about our future results from the results of operations for any period.
                                 
    Three Months Ended     Six Months Ended  
    June 30,     July 1,     June 30,     July 1,  
    2007     2006     2007     2006  
Revenue
    100 %     100 %     100 %     100 %
Costs of revenue
    22       24       23       24  
 
                       
Gross profit margin
    78       76       77       76  
 
                               
Operating expenses:
                               
Research and development
    16       16       17       16  
Sales and marketing
    38       40       40       40  
General and administrative
    15       14       15       14  
 
                       
Total operating expenses
    69       70       72       70  
 
                       
 
                               
Income from operations
    9       6       5       6  
Interest income, net
    4       3       4       3  
 
                       
Income before income taxes
    13       9       9       9  
Provision for incomes taxes
    7             5        
 
                       
Net income
    6 %     9 %     4 %     9 %
 
                       
Three and Six Months Ended June 30, 2007 Compared with the Three and Six Months Ended July 1, 2006
                                                 
    Three Months Ended     Six Months Ended  
                    Percentage                     Percentage  
    June 30,     July 1,     Increase     June 30,     July 1,     Increase  
    2007     2006     (Decrease)     2007     2006     (Decrease)  
    (in thousands, except             (in thousands, except unit          
    unit amounts)             amounts)          
Revenue — Worldwide
                                               
BIS Sensor
  $ 18,563     $ 15,868       17 %   $ 36,117     $ 31,453       15 %
 
                                               
BIS monitor
    2,984       3,670       (19 )%     5,879       6,318       (7 )%
Original equipment manufacturer products
    856       1,173       (27 )%     1,973       2,771       (29 )%
Other equipment and accessories
    676       470       44 %     1,545       1,081       43 %
 
                                       
 
                                               
Total Equipment
    4,516       5,313       (15 )%     9,397       10,170       (8 )%
 
                                       
Total product revenue
    23,079       21,181       9 %     45,514       41,623       9 %
Strategic alliance
    3,562       1,450       146 %     5,246       2,896       81 %
 
                                       
Total revenue
  $ 26,641     $ 22,631       18 %   $ 50,760     $ 44,519       14 %
 
                                       
 
                                               
Unit Analysis — Worldwide
                                               
BIS Sensors
    1,331,000       1,124,000       18 %     2,568,000       2,211,000       16 %
BIS monitors
    849       1,193       (29 )%     1,807       2,045       (12 )%
Original equipment manufacturer BIS products
    1,056       1,294       (18 )%     2,530       2,794       (9 )%
Installed base
    43,366       36,226       20 %     43,366       36,226       20 %
     Revenue. Revenue from the sale of BIS Sensors increased approximately 17% in the three months ended June 30, 2007 compared with the three months ended July 1, 2006. The increase in revenue from the sale of BIS Sensors during this period was primarily attributable to an increase of approximately 18% in the number of BIS Sensors sold, which we attribute to the growth in the installed base of BIS monitors and original equipment manufacturer products and a slight increase in the domestic average selling price for BIS Sensors. During this period, sensor units sold domestically increased approximately 12% from approximately 795,000 BIS Sensors sold during the second quarter of 2006 to approximately 890,000 BIS Sensors sold during the second quarter of 2007, while sensor units sold internationally increased approximately 34%, from 329,000

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BIS Sensors sold during the second quarter of 2006 to 441,000 BIS Sensors sold during the second quarter of 2007. Our installed base of BIS monitors and original equipment manufacturer products increased approximately 20% to 43,366 units at June 30, 2007 compared with 36,226 units at July 1, 2006.
     During the three months ended June 30, 2007 compared with the three months ended July 1, 2006, total Equipment revenue decreased approximately 15%. The decrease in Equipment revenue during this period was primarily driven by a decrease of 27% in original equipment manufacturer product revenue and a decrease in BIS monitor revenue of approximately 19%, offset by an increase in other equipment revenue of 44%. The decrease in original equipment manufacturer product revenue was a result of a decrease of approximately 18% in the number of products shipped to our original equipment manufacturers combined with a decrease in the average selling price. In the second quarter of 2006, we shipped 1,294 original equipment manufacturer products compared with 1,056 original equipment manufacturer products shipped in the second quarter of 2007. The majority of the decrease in OEM product revenue related to domestic revenue which was attributable to a decrease of approximately 40% in original equipment manufacturer products shipped, from 379 products shipped in the three months ended July 1, 2006 compared with 228 original equipment manufacturer products shipped in the three months ended June 30, 2007. The 19% decrease in monitor revenue was driven by a decrease of approximately 29% in the number of monitor units shipped, from 1,193 monitor units shipped in the three months ended July 1, 2006 compared with 849 monitor units shipped in the three months ended June 30, 2007. The second quarter of 2006 was a strong quarter for monitor shipments as that was the first full quarter that we had commercial shipments of our VISTA monitor which was launched at the end of the first quarter of 2006. Additionally, the decrease in unit sales of monitors reflects the shift in our sales and marketing emphasis from expanding our customer base to developing our existing customers and increasing their sensor utilization and procedure penetration. The decrease in revenue from the shipment of monitors was offset by an increase in the average selling price of approximately 14%.
     In the six months ended June 30, 2007, revenue from the sale of BIS Sensors increased approximately 15% compared with the six months ended July 1, 2006. The increase in revenue from the sale of BIS Sensors was primarily attributable to an increase in the number of BIS Sensors sold, from approximately 2.2 million BIS Sensors sold during the six months ended July 1, 2006 to approximately 2.6 million sold during the six months ended June 30, 2007. BIS Sensor sales domestically increased 10%, from approximately 1.6 million sensors sold in the six months ended July 1, 2006 to approximately 1.7 million sensors sold in the six months ended June 30, 2007. The number of BIS Sensors sold internationally increased approximately 32% from approximately 627,000 BIS Sensors sold during the six months ended July 1, 2006 to approximately 827,000 sold during the six months ended June 30, 2007.
     In the six months ended June 30, 2007, total Equipment revenue decreased approximately 8% compared with the six months ended July 1, 2006. The decrease in Equipment revenue during the 2007 period was primarily driven by a decrease in original equipment manufacturer product revenue of approximately 29%. The decrease in original equipment manufacturer product revenue was the result of a decrease of approximately 9% in the number of products shipped to our original equipment manufacturers from 2,794 original equipment manufacturer products shipped in the first six months of 2006 compared with 2,530 products shipped in the first six months of 2007. The majority of this decrease was related to international with 2,228 original equipment manufacturer products shipped during the first six months of 2006 compared with 1,901 original equipment manufacturer products shipped during this same period of 2007.

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     In the three and six months ended June 30, 2007, we recorded strategic alliance revenue of approximately $3.6 million and $5.2 million, respectively, compared with strategic alliance revenue of approximately $1.5 million and $2.9 million, respectively, in the three and six months ended July 1, 2006. The strategic alliance revenue in all of these periods was primarily attributable to the revenue we recognized from our agreements with Boston Scientific Corporation. In June 2007, we entered into a Termination and Repurchase Agreement with Boston Scientific Corporation pursuant to which all agreements with Boston Scientific Corporation, including the 2002 OEM product development and distribution agreement and the 2005 product development and distribution agreement were terminated. In connection with the termination of these agreements, we recognized approximately $3.6 million of strategic alliance revenue in our statement of income for the three and six months ended June 30, 2007. This $3.6 million of revenue is composed of $3.8 million which was recognized from the 2002 OEM product development and distribution agreement net of a $285,000 receivable from Boston Scientific Corporation under the 2005 product development and distribution agreement.
     Our gross profit margin was approximately 78.4% and 76.7% of revenue in the three and six months ended June 30, 2007, respectively, compared with a gross profit margin of approximately 76.1% and 75.8% of revenue in the three and six months ended July 1, 2006, respectively. The increase in the gross profit margin in the three and six months ended June 30, 2007 compared with the three and six months ended July 1, 2006 is primarily attributable to the increased revenue we recognized from the termination of our agreements with Boston Scientific Corporation which had no related impact on costs of revenue.
     Our gross product margin was approximately 75.0% and 74.0% of revenue in the three and six months ended June 30, 2007, respectively, compared with a gross product margin of approximately 74.5% and 74.2% of revenue in the three and six months ended July 1, 2006, respectively. The slight increase in the gross product margin in the three months ended June 30, 2007 compared with the three months ended July 1, 2006 was a result of favorable changes in the mix of sensors to hardware and improvements in both BIS Sensor and BIS monitor average selling prices.
Expense Overview
                                                 
    Three Months Ended           Six Months Ended    
                    Percentage                   Percentage
    June 30,   July 1,   Increase   June 30,   July 1,   Increase
    2007   2006   (Decrease)   2007   2006   (Decrease)
    (in thousands)           (in thousands)        
Expenses
                                               
Research and development
  $ 4,194     $ 3,568       18 %   $ 8,414     $ 7,215       17 %
Sales and marketing
  $ 10,199     $ 9,072       12 %   $ 20,244     $ 17,805       14 %
General and administrative
  $ 4,016     $ 3,203       25 %   $ 7,680     $ 6,141       25 %
     Research and Development. The increase in research and development expenses in the three months ended June 30, 2007 compared with the three months ended July 1, 2006 was primarily attributable to an increase in compensation and benefits to research and development personnel of approximately $508,000 and an increase in clinical study expenses, excluding expenses related to the BRITE study which we had completed the enrollment for in March 2007, of approximately $62,000. Of the $508,000 increase in compensation and benefits, approximately $208,000 relates to an increase in salaries and wages primarily as a result of annual salary increases which became effective in January 2007 and additional headcount, and approximately $117,000 relates to an increase in stock-based compensation expense that was recorded as a result of the adoption of SFAS No. 123R, which requires the recognition of stock-based compensation expense in the financial statements for all share-based awards.
     For the six months ended June 30, 2007 compared with the six months ended July 1, 2006, the increase in research and development expenses was due primarily to an increase in compensation and benefits to research and development personnel of approximately $1.0 million. Of the $1.0 million increase, approximately $456,000 relates to an increase in salaries and wages and $294,000 relates to an increase in stock-based compensation expense recorded as a result of the adoption of SFAS No. 123R. We expect the level of research and development expenses in the third quarter of 2007 to be comparable to or below the level of research and development expenses in the second quarter of 2007.

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     Sales and Marketing. The increase in sales and marketing expenses in the three months ended June 30, 2007 compared with the three months ended July 1, 2006 was primarily attributable to an increase of approximately $334,000 in compensation and benefits to domestic sales and marketing personnel, an increase of approximately $315,000 in the operating expenses associated with our international subsidiaries, an increase of approximately $230,000 in our commissions paid to our group purchasing organizations and an increase of approximately $188,000 in consulting expenses. Of the $334,000 increase in compensation and benefits for domestic sales and marketing personnel, approximately $222,000 relates to an increase in salaries and wages primarily as a result of annual salary increases and additional headcount, and approximately $116,000 relates to stock-based compensation expense that was recorded as a result of the adoption of SFAS No. 123R. The $315,000 increase in operating expenses for our international subsidiaries relates primarily to an increase in salaries and wages for international personnel of approximately $133,000 and an increase in commission expense of approximately $144,000.
     For the six months ended June 30, 2007 compared with the six months ended July 1, 2006, the increase in sales and marketing expenses was driven by an increase of approximately $1.1 million in the operating expenses associated with our international subsidiaries, an increase of approximately $941,000 in compensation and benefits to domestic sales and marketing personnel and an increase of approximately $342,000 in commissions paid to group purchasing organizations. The increase in operating expenses of our international subsidiaries was driven by an increase of $941,000 in compensation and benefits to our domestic sales and marketing personnel of which approximately $448,000 relates to an increase in salaries and wages and approximately $252,000 relates to stock-based compensation expense which was recorded as a result of the adoption of SFAS No. 123R. We expect the level of sales and marketing expenses in the third quarter of 2007 to be comparable to or below the level of sales and marketing expenses in the second quarter of 2007.
     General and Administrative. The increase in general and administrative expenses in the three months ended June 30, 2007 compared with the three months ended July 1, 2006 was primarily attributable to an increase in compensation and benefits to general and administrative personnel of approximately $433,000 and an increase of approximately $377,000 in professional fees, including legal fees and accounting related fees. The $433,000 increase in compensation and benefits was primarily the result of an increase of approximately $166,000 of stock-based compensation expense recorded as a result of the adoption of SFAS No. 123R and an increase in salaries and wages of approximately $125,000 primarily as a result of annual salary increases. The increase in professional fees during this period was primarily the result of costs associated with the termination agreement with Boston Scientific Corporation.
     For the six months ended June 30, 2007 compared with the six months ended July 1, 2006, the increase in general and administrative expenses was driven by an increase of approximately $859,000 in compensation and benefits to general and administrative personnel and an increase of $488,000 in professional fees, including legal fees and accounting related fees. Of the $859,000 increase in compensation and benefits, approximately $408,000 relates to an increase in stock-based compensation expense recorded as a result of SFAS No. 123R and approximately $231,000 relates to an increase in salaries and wages. The increase in professional fees was the result of costs associated with the termination agreement with Boston Scientific Corporation. We expect the level of general and administrative expenses in the third quarter of 2007 will comparable to or below the level of general and administrative expenses in the second quarter of 2007.
     Interest Income. Interest income increased to approximately $1.0 million in the three months ended June 30, 2007 from approximately $781,000 in the three months ended July 1, 2006, an increase of approximately 31%. For the six months ended June 30, 2007 compared with the six months ended July 1, 2006 interest income increased approximately 32% from approximately $1.5 million to approximately $2.0 million. The increase in interest income in the three and six months ended June 30, 2007 compared with the three and six months ended July 1, 2006 was primarily attributable to a higher cash and investment balance due to the net proceeds received from the 2.5% convertible senior notes due 2014 that we issued in June 2007. We expect interest income in the third quarter of 2007 to increase compared with interest income in the second quarter of 2007 due to a higher cash and investment balance.
     Interest Expense. Interest expense was approximately $115,000 in both the three and six months ended June 30, 2007 compared with no interest expense during the three and six month periods ended July 1, 2006. The increase in interest expense in the three and six months ended June 30, 2007 was the result of the 2.5% convertible senior notes due 2014 that we issued in June 2007. We expect interest expense in the third quarter of 2007 to increase compared with interest expense in the second quarter of 2007.
     Income Taxes. We are subject to income tax in numerous jurisdictions and at various rates worldwide and the use of estimates is required in determining the provision for income taxes. For the three and six months ended June 30, 2007, we recorded a tax provision of $1,882,000 and $2,458,000, respectively. Income before tax for the three and six months ended

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June 30, 2007 was $3,370,000 and $4,462,000, respectively. The provision was the result of applying an effective income tax rate of 56% and 55% to income before tax for the respective periods. For the three and six months ended June 30, 2007, the difference between the effective tax rates and the U.S. federal statutory income tax rate of 34% was due mainly to the impact of state income taxes and the disallowance for tax purposes of certain stock-based compensation deductions in accordance with SFAS 123R. For the three and six months ended July 1, 2006, we recorded a tax provision of $33,000 and $56,000, respectively, and continued to maintain a full valuation allowance on our tax benefits.
Liquidity and Capital Resources
     Our liquidity requirements have historically consisted of research and development expenses, sales and marketing expenses, capital expenditures, working capital and general corporate and administrative expenses. From our inception through June 30, 2007, we have raised approximately $212.2 million from equity and debt financings, including the following:
    net proceeds of approximately $54.6 million from our initial public offering of an aggregate of 4,025,000 shares of common stock in February 2000;
 
    approximately $3.4 million in equipment financing;
 
    approximately $5.1 million related to our investment in sales-type leases;
 
    proceeds of approximately $10.0 million related to our 2002 OEM product development and distribution agreement with Boston Scientific Corporation;
 
    proceeds of approximately $8.1 million from the sale of our common stock to Boston Scientific Corporation in 2004;
 
    $10.0 million in installment payments from Boston Scientific Corporation received in May 2005 and May 2006 pursuant to the 2005 product development and distribution agreement with Boston Scientific Corporation; and,
 
    net proceeds of $121.0 million received in connection with our 2.5% convertible senior notes that we issued in June 2007.
     In May 2001, we entered into an agreement with Fleet National Bank (now Bank of America), for a $5.0 million revolving line of credit, which expires in May 2008. The revolving line of credit contains restrictive covenants that require us to maintain liquidity and net worth ratios and is secured by certain investments, which are shown as restricted cash on our consolidated balance sheets. In connection with this revolving line of credit agreement, we are required to maintain restricted cash in an amount equal to 102% of the outstanding amounts under the revolving line of credit. At June 30, 2007, we were in compliance with all covenants contained in the revolving line of credit agreement. Interest on any borrowings under the revolving line of credit is, at our election, either the prime rate or the London Inter-Bank Offer Rate, or LIBOR, plus 2.25%. Up to $1.5 million of the $5.0 million revolving line of credit is available for standby letters of credit. At June 30, 2007, the interest rate on the line of credit was 8.25%, there was no amount outstanding under this line of credit and we had standby letters of credit outstanding relating to our leased facilities in the amount of approximately $991,000 which is shown on our consolidated balance sheet as restricted cash.
     In June 2007, we completed a private placement of $125.0 million aggregate principal amount of 2.5% convertible notes due 2014. Net proceeds received from the issuance of the notes was $121.0 million, which is net of the underwriters discount of $4.0 million. As of June 30, 2007, we have used approximately $47.4 million of these proceeds to repurchase 3.0 million shares of our common stock, of which 2.0 million shares were repurchased from Boston Scientific Corporation and 1.0 million shares were repurchased in connection with our 2.5% convertible senior note offering that we completed in June 2007.
     On August 3, 2006, our Board of Directors authorized the repurchase of up to 2,000,000 shares of our common stock from time to time on the open market or in privately negotiated transactions. As of June 30, 2007, we had repurchased 276,493 shares of our common stock for approximately $5.0 million under this plan. The plan was suspended in September 2006.
     Additionally, on July 10, 2007, we exercised our right under the Termination and Repurchase Agreement with Boston Scientific Corporation and repurchased 2.5 million shares of common stock from Boston Scientific Corporation for approximately $37.7 million. We expect to meet our near-term liquidity needs through the use of cash and short-term investments on hand at June 30, 2007 and cash generated from operations.
     We believe that the financial resources available to us, including our current working capital, our long-term investments and available revolving line of credit will be sufficient to finance our planned operations, capital expenditures and service on our convertible notes for at least the next twelve months. However, our future liquidity and capital requirements will depend upon numerous factors, including the resources required to further develop our marketing and sales organization domestically and internationally, to finance our research and development programs, to implement new marketing programs, to finance our sales-type lease program, to meet market demand for our products and to repay our convertible notes.

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     We expect to fund the growth of our business over the long term through cash flow from operations and through issuances of capital stock, promissory notes or other securities. Any sale of additional equity or debt securities may result in dilution to our stockholders, and we cannot be certain that additional public or private financing will be available in amounts or on terms acceptable to us, or at all. If we are unable to obtain this additional financing, we may be required to delay, reduce the scope of, or eliminate one or more aspects of our business development activities, which could harm the growth of our business.
     Currently, our 2.5% convertible senior notes due 2014 are convertible, under certain circumstance, solely into shares of our common stock. However, under the terms of the Indenture and such notes, we will have the option to settle potential conversions of these notes with cash and, if applicable, shares of our common stock, commonly referred to as “net share settlement”, if we first obtain stockholder approval of this net share settlement feature and we irrevocably elect to use such settlement method. If we obtain stockholder approval of the net share settlement feature in connection with the potential conversion of such notes, and we irrevocably elect to use such settlement method, then upon conversion of such notes we would (1) pay cash in an amount equal to the lesser of one-fortieth of the principal amount of the notes being converted and the daily conversion value (the product of the conversion rate and the current trading price) of the notes being converted and (2) issue shares of our common stock only to the extent that the daily conversion value of the notes exceeded one-fortieth of the principal amount of the notes being converted for each trading day of the relevant 40 trading day observation period. In order to fund the cash payments due upon conversion pursuant to our irrevocable election to utilize the net share settlement feature we may be required to use a significant portion or all of our existing cash or raise the cash for such payments through the sale of shares of our common stock or additional debt securities or through one or more other financing transactions. We may not have sufficient cash on hand or be able to acquire the necessary funds via financing on terms favorable to us or our stockholders, or at all, which would result in an event of default under the notes. Moreover, the use of a substantial portion of our existing cash may adversely affect our liquidity and cash available to fund growth of our business.
     Working capital at June 30, 2007 was approximately $142.5 million compared with approximately $67.4 million at December 31, 2006.
     Cash provided by operations. We received approximately $4.6 million from operations in the six months ended June 30, 2007 compared with cash received from operations of approximately $4.7 million in the six months ended July 1, 2006. The cash received in the six months ended June 30, 2007 was primarily attributable to our net income, $4.4 million of non-cash stock-based compensation expense and an increase of approximately $1.1 million in accrued liabilities. These were offset by a decrease in deferred revenue of approximately $5.2 million primarily related to the termination of the 2002 OEM product development and distribution agreement and the 2005 product development and distribution agreement with Boston Scientific Corporation and a decrease in our deferred tax asset of approximately $2.5 million. The cash received in the six months ended July 1, 2006 was primarily attributable to net income of approximately $4.1 million and an increase in non-cash stock-based compensation expense related to stock options of approximately $3.3 million. During the same period, these increases were offset by a decrease in accrued liabilities of approximately $3.1 million. The decrease in accrued liabilities was primarily driven by a decrease in accrued bonus as we paid our 2005 bonuses in the first quarter of 2006.
     Cash used for investing activities. We used approximately $8.1 million of cash in investing activities in the six months ended June 30, 2007 compared with approximately $1.6 million of cash provided by investing activities in the six months ended July 1, 2006. The cash used in the three months ended June 30, 2007 was primarily the result of net purchases of marketable securities of approximately $6.2 million and approximately $1.9 million in capital expenditures primarily due to spending related to our new facility and the purchase of components for our new automated sensor manufacturing lines. The cash received in the six months ended July 1, 2006 was primarily the result of net proceeds from sales and maturities of marketable securities of approximately $4.6 million offset by capital expenditures of approximately $2.0 million related to the purchase of components for two automated sensor manufacturing lines and $1.0 million of restricted cash for the lease of our new facility. We anticipate the level of capital expenditures in the third quarter of 2007 will decrease compared with the level of capital expenditures in the second quarter of 2007.
     Cash provided by financing activities. We received approximately $74.0 million of cash from financing activities in the six months ended June 30, 2007 compared with approximately $2.0 million provided by financing activities in the six months ended July 1, 2006 as a result of the proceeds received upon the issuance of $125.0 million of 2.5% convertible senior notes due 2014 in June 2007 offset by the purchase of approximately $47.4 million worth of our common stock. The cash received from financing activities during the six months ended July 1, 2006 was primarily the result of proceeds from the issuance of our common stock upon the exercise of stock options granted under our stock option plans.

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Off-Balance Sheet Arrangements
     We do not have any off-balance sheet arrangements or relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which are typically established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Income Taxes
     We are subject to income tax in numerous jurisdictions and at various rates worldwide and the use of estimates is required in determining the provision for income taxes. For the three and six months ended June 30, 2007, we recorded a tax provision of $1,882,000 and $2,458,000, respectively. Income before tax for the three and six months ended June 30, 2007 was $3,370,000 and $4,462,000, respectively. The provision was the result of applying an effective income tax rate of 56% and 55% to income before tax for the three and six months ended June 30, 2007, respectively. For the three and six months ended June 30, 2007, the difference between the effective tax rate and the U.S. federal statutory income tax rate of 34% was due mainly to the impact of state income taxes and the disallowance for tax purposes of certain stock-based compensation deductions in accordance with SFAS 123R. For the three and six months ended July 1, 2006, we recorded a tax provision of $33,000 and $56,000, respectively, and continued to maintain a full valuation allowance on our tax benefits.
     Through the third quarter of 2006, we maintained a full valuation allowance on our deferred tax assets. Upon achieving three-years of cumulative profitability, we began to weigh the positive and negative evidence included in SFAS 109 “Accounting For Income Taxes,” on a quarterly basis to determine if we believed that it was more likely than not that some or all of our deferred tax assets would be realized. In connection with this analysis, we reviewed our cumulative history of earnings before taxes over a three-year period and our projections of future taxable income. As of December 31, 2006, after finalizing the 2007 forecast, we concluded that the projections support taxable income for the foreseeable future, and therefore, we reversed $28.2 million of our valuation allowance. The projections of future taxable income include significant judgment and estimation. If we are not able to achieve sufficient taxable income in future periods, we might need to record additional valuation allowances on our deferred tax assets in future periods that could be material to our consolidated financial statements.
     We adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109, or FIN 48, on January 1, 2007. As a result of adoption, we recognized a charge of approximately $371,000 to the January 1, 2007 retained earnings balance. As of January 1, 2007, we had gross unrecognized tax benefits of $726,000. Of this total, $626,000 (net of the federal benefit on state tax issues) represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in any future periods. Also as of the adoption date, we had not accrued interest expense related to these unrecognized tax benefits. When appropriate we will recognize interest accrued and penalties if incurred, related to unrecognized tax benefits as a component of income tax expense. There were no significant changes to any of these amounts during the six months ended June 30, 2007. We do not reasonably estimate that the unrecognized tax benefit will change significantly within the next twelve months.
Effects of Inflation
     We believe that inflation and changing prices over the past year have not had a significant impact on our revenue or on our results of operations.
Recent Accounting Pronouncements
     In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”, including an amendment of FASB Statement No. 115, or SFAS No. 159. SFAS No. 159 permits entities to choose, at specified election dates, to measure eligible items at fair value. A business entity is required to report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting period. SFAS No. 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We do not believe that the adoption of SFAS No. 159 will have a material impact on our results of operations, financial position or cash flow.

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Forward-Looking Statements
     This Quarterly Report on Form 10-Q contains, in addition to historical information, forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, including information relating to our ability to maintain profitability, information with respect to market acceptance of our BIS system, continued growth in sales of our BIS monitors, original equipment manufacturer products and BIS Sensors, our dependence on the BIS system, regulatory approvals for our products, our ability to remain competitive and achieve future growth, information with respect to other plans and strategies for our business and factors that may influence our revenue and net income for the fiscal quarter ending September 29, 2007 and thereafter. These forward-looking statements involve risks and uncertainties and are not guarantees of future performance. Words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate” and variations of these words and similar expressions are intended to identify forward-looking statements. Our actual results could differ significantly from the results discussed in these forward-looking statements. The important factors discussed under Part II – Item 1A. “Risk Factors” below represent some of the current challenges to us that create risk and uncertainty. In addition, subsequent events and developments may cause our expectations to change. While we may elect to update these forward-looking statements we specifically disclaim any obligation to do so, even if our expectations change.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
   Interest Rate Exposure
     Our investment portfolio consists primarily of money market accounts, certificates of deposit, high-grade commercial paper, high grade corporate bonds and debt obligations of various governmental agencies. We manage our investment portfolio in accordance with our investment policy. The primary objectives of our investment policy are to preserve principal, maintain a high degree of liquidity to meet operating needs, and obtain competitive returns subject to prevailing market conditions. Investments are made with an average maturity of twelve months or less and a maximum maturity of 24 months. These investments are subject to risk of default, changes in credit rating and changes in market value. These investments are also subject to interest rate risk and will decrease in value if market interest rates increase. Due to the conservative nature of our investments and relatively short effective maturities of the debt instruments, we believe interest rate risk is mitigated. Our investment policy specifies the credit quality standards for our investments and limits the amount of exposure from any single issue, issuer or type of investment.
     Our investment in sales-type leases and line of credit agreement are also subject to market risk. The interest rates implicit in our sales-type leases are fixed and not subject to interest rate risk. In addition, the interest rate on the 2.5% convertible senior notes due 2014 is fixed and not subject to interest rate risk. The interest rate on our line of credit agreement is variable and subject to interest rate risk. The interest rate risk experienced to date related to the line of credit has been mitigated primarily by the fact that the line of credit, when drawn on, is generally outstanding for a short period of time in order to fund short-term cash requirements.
   Foreign Currency Exposure
     Most of our revenue, expenses and capital spending are transacted in U.S. dollars. The expenses and capital spending of our two international subsidiaries are transacted in the respective country’s local currency and subject to foreign currency exchange rate risk. Our foreign currency transactions are translated into U.S. dollars at prevailing rates. Gains or losses resulting from foreign currency transactions are included in current period income or loss as incurred. Currently, all material transactions are denominated in U.S. dollars, and we have not entered into any material transactions that are denominated in foreign currencies.
Item 4. Controls and Procedures.
  (a)   Evaluation of Disclosure 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, 2007. 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,

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    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, 2007, 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.
 
(b)   Changes in Internal Controls.
 
    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, 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II — OTHER INFORMATION
Item 1A. Risk Factors
     You should carefully consider the following risk factors, in addition to other information included in this Quarterly Report on Form 10-Q, in evaluating our business. Failure to adequately overcome or address any of the following challenges could have a material adverse effect on our results of operations, business or financial condition. The following risk factors supersede the risk factors previously disclosed in Item 1A. of our 2006 Annual Report on Form 10-K.
Risks Relating to the Company
We will not continue to be profitable if hospitals and anesthesia providers do not buy and use our BIS system and purchase our BIS Sensors in sufficient quantities.
     We were profitable for the years ended December 31, 2006 and 2005. However, we will not continue to be profitable if hospitals and anesthesia providers do not buy and use our BIS system in sufficient quantities. Our customers may determine that the cost of the BIS system exceeds cost savings in drugs, personnel and post-anesthesia care recovery that may result from use of the BIS system. Also, if third party reimbursement is based on charges or costs, patient monitoring with the BIS system may have the effect of reducing reimbursement because the charges or costs for surgical procedures may decline as a result of monitoring with the BIS system. In addition, hospitals and anesthesia providers may not accept the BIS system as an accurate means of assessing a patient’s level of consciousness during surgery or in the intensive care unit. If extensive or frequent malfunctions occur, healthcare providers may also conclude that the BIS system is unreliable. If hospitals and anesthesia providers do not accept the BIS system as cost-effective, accurate and reliable, they will not buy and use the BIS system in sufficient quantities to enable us to continue to be profitable.
     The success of our business also depends in a large part on continued use of the BIS system by our customers and, accordingly, sales by us of BIS Sensors. We expect that over time, sales of BIS Sensors will increase as a percentage of our revenue as compared to sales of Equipment as we build our installed base of monitors and modules. If use of our BIS system, and accordingly, sales of our BIS Sensors, do not increase, our ability to grow our revenue and maintain profitability could be adversely affected.
We depend on our BIS system for substantially all of our revenue, and if the BIS system does not gain widespread market acceptance, then our revenue will not grow.
     We began selling our current BIS system in early 1998 and introduced commercially the latest version, the BIS XP system, at the end of the third fiscal quarter of 2001. We also offer BIS monitoring systems, including the BISx system, for integration into equipment sold by original equipment manufacturers. To date, we have not achieved widespread market acceptance of the BIS system for use in the operating room or in the intensive care unit from healthcare providers or professional anesthesia organizations. Because we depend on our BIS system for substantially all of our revenue and we have no other significant products, if we fail to achieve widespread market acceptance for the BIS system, we will not be able to sustain or grow our product revenue.
Various factors may adversely affect our quarterly operating results through the third fiscal quarter of 2007.
     Various factors may adversely affect our quarterly operating results through the third fiscal quarter of 2007. Among these factors are the following: first, we continue to shift the focus of our placements from BIS monitors to original equipment manufacturer products which may lead to a reduction in Equipment revenue and gross margin on Equipment. Second, although the Japanese Ministry of Health, Labor and Welfare, or the Japanese Ministry, has approved the sale of the BIS XP system through our distributor, Nihon Kohden, the potential benefits of this approval may not be recognized for some time, or at all. Third, on October 7, 2004, the Joint Commission on Accreditation of Healthcare Organizations, or JCAHO, issued a Sentinel Event Alert, or Alert, aimed at preventing and managing the impact of anesthesia awareness. The Alert identifies the incidence of awareness, describes common underlying causes and suggests steps for healthcare professionals and institutions to take in order to manage and prevent future occurrences and recommends healthcare organizations develop and implement policies to address anesthesia awareness. Additionally, on October 25, 2005, the American Society of Anesthesiologists House of Delegates approved a Practice Advisory on Intraoperative Awareness and Brain Monitoring, or Practice Advisory, including our BIS technology. The Practice Advisory recommends that the decision to use brain monitoring technology be made by individual practitioners on a case-by-case basis. Finally, in April 2006, the American Association of Nurse Anesthetists, or AANA, published a position statement regarding unintended awareness under general anesthesia. While we believe that the Alert, the Practice Advisory and the AANA position statement are favorable to our business, industry organizations and others in the anesthesia community may not agree with the position taken in the Alert, or in the Practice Advisory or the AANA position statement and, accordingly, potential benefits to our business that could have resulted from the Alert, the Practice Advisory and the AANA position statement may not be significant or realized at all.

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Fluctuations in our quarterly operating results could cause our stock price to decrease.
     Our operating results have fluctuated significantly from quarter to quarter in the past and are likely to vary in the future. These fluctuations are due to several factors relating to the sale of our products, including:
    the timing and volume of customer orders for our BIS system,
 
    market acceptance of our BIS VISTA monitor,
 
    use of and demand for our BIS Sensors,
 
    transition of sales focus from BIS monitors to original equipment manufacturer products,
 
    customer cancellations,
 
    introduction of competitive products,
 
    regulatory approvals,
 
    changes in management,
 
    turnover in our direct sales force,
 
    effectiveness of new marketing and sales programs,
 
    communications published by industry organizations or other professional entities in the anesthesia community that are unfavorable to our business,
 
    sales of convertible debt instruments and repurchases of shares of our common stock,
 
    the amount of our outstanding indebtedness and interest payments under debt obligations,
 
    reductions in orders by our distributors and original equipment manufacturers, and
 
    the timing and amount of our expenses.
     Because of these factors, it is likely that in some future quarter or quarters our operating results could fall below the expectations of securities analysts or investors. If our quarterly operating results are below expectations in the future, the market price of our common stock would likely decrease. In addition, because we do not have a substantial backlog of customer orders for our BIS system or our BIS Sensors, revenue in any quarter depends on orders received in that quarter. Our quarterly results may also be adversely affected because some customers may have inadequate financial resources to purchase our products or may fail to pay for our products after receiving them. In particular, hospitals continue to experience financial constraints, consolidations and reorganizations as a result of cost containment measures and declining third-party reimbursement for services, which may result in decreased product orders or an increase in bad debt allowances in any quarter.
If the estimates we make, and the assumptions on which we rely, in preparing our financial statements prove inaccurate, our actual results may vary from those reflected in our financial statements.
     Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of our assets, liabilities, revenues and expenses, the amounts of charges accrued by us and related disclosure of contingent assets and liabilities. This includes estimates and judgments regarding revenue recognition, warranty reserves, inventory valuations, valuation allowances for deferred tax assets, allowances for doubtful accounts and share-based compensation expense. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances at the time such estimates and judgments were made. There can be no assurance, however, that our estimates and judgments, or the assumptions underlying them, will be correct.

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We may need additional financing for our future capital needs and may not be able to raise additional funds on terms acceptable to us, or at all.
     We believe that the financial resources available to us, including our current working capital and available revolving line of credit, will be sufficient to finance our planned operations and capital expenditures through at least the next 12 months. If we are unable to increase our revenue and continue to maintain positive cash flow, we will need to raise additional funds. We may also need additional financing if:
    the research and development costs of our products or technology currently under development, including costs to fund our neuroscience program following termination in June 2007 of our alliance with Boston Scientific Corporation, increase beyond current estimates,
 
    we decide to expand faster than currently planned,
 
    we develop new or enhanced services or products ahead of schedule,
 
    we decide to undertake new sales and/or marketing initiatives,
 
    we are required to defend or enforce our intellectual property rights, or respond to other legal challenges with respect to our products, including product liability claims,
 
    sales of our products do not meet our expectations domestically or internationally,
 
    we are required or elect to pay the principal under our 2.5% convertible senior notes due 2014 in cash prior to maturity,
 
    we need to respond to competitive pressures, or
 
    we decide to acquire complementary products, businesses or technologies.
     We can provide no assurance that we will be able to raise additional funds on terms acceptable to us, if at all. If future financing is not available or is not available on acceptable terms, we may not be able to fund our future operations which would significantly limit our ability to implement our business plan or result in a default under our 2.5% convertible senior notes due 2014. In addition, we may have to issue equity securities that may have rights, preferences and privileges senior to our common stock or issue debt securities that may contain limitations or restrictions on our ability to engage in certain transactions in the future.
Cases of awareness with recall during monitoring with the BIS system could limit market acceptance of the BIS system and could expose us to product liability claims.
     Clinicians have reported to us cases of possible awareness with recall during surgical procedures monitored with the BIS system. In most of the cases that were reported to us, when BIS index values were recorded at the time of awareness, high BIS index values were noted, indicating that the BIS index correctly identified the increased risk of awareness with recall in these patients. However, in a small number of these reported cases, awareness with recall may not have been detected by monitoring with the BIS system. We have not systematically solicited reports of awareness with recall. It is possible that additional cases of awareness with recall during surgical procedures monitored with the BIS system have not been reported to us. Anesthesia providers and hospitals may elect not to purchase and use the BIS system if there is adverse publicity resulting from the report of cases of awareness with recall that were not detected during procedures monitored with the BIS system. If anesthesia providers and hospitals do not purchase and use the BIS system, then we may not sustain or grow our product revenue. Although our multi-center, multinational clinical studies have demonstrated that the use of BIS monitoring to help guide anesthetic administration may be associated with the reduction of the incidence of awareness with recall in adults using general anesthesia and sedation, we may be subject to product liability claims for cases of awareness with recall during surgical procedures monitored with the BIS system. Any of these claims could require us to spend significant time and money in litigation or to pay significant damages. Moreover, if the patient safety benefits of BIS monitoring are not persuasive enough to lead to wider adoption of our BIS technology or if any additional clinical research we undertake fails to support evidence of a link between the use of BIS monitoring and the incidence of awareness, our business could be adversely affected.

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We may not be able to compete with new products or alternative techniques developed by others, which could impair our ability to remain competitive and achieve future growth.
     The medical device industry in which we market our products is characterized by rapid product development and technological advances. Our competitors have received clearance by the United States Food and Drug Administration, or FDA, for, and have introduced commercially, anesthesia monitoring products. If we do not compete effectively with these monitoring products, our revenue will be adversely affected. Our current and planned products are at risk of obsolescence from:
    other new monitoring products, based on new or improved technologies,
 
    new products or technologies used on patients or in the operating room during surgery in lieu of monitoring devices,
 
    electrical or mechanical interference from new or existing products or technologies,
 
    alternative techniques for evaluating the effects of anesthesia,
 
    significant changes in the methods of delivering anesthesia, and
 
    the development of new anesthetic agents.
     We may not be able to improve our products or develop new products or technologies quickly enough to maintain a competitive position in our markets and to grow our business.
If we do not maintain our relationships with the anesthesia community, our growth will be limited and our business could be harmed. If anesthesiologists and other healthcare providers do not recommend and endorse our products, our sales may decline or we may be unable to increase our sales and profits.
     Physicians typically influence the medical device purchasing decisions of the hospitals and other healthcare institutions in which they practice. Consequently, our relationships with anesthesiologists are critical to our growth. We believe that these relationships are based on the quality of our products, our long-standing commitment to the consciousness monitoring market, our marketing efforts and our presence at medical society and trade association meetings. Any actual or perceived diminution in our reputation or the quality of our products, or our failure or inability to maintain our commitment to the consciousness monitoring market and our other marketing and product promotion efforts could damage our current relationships, or prevent us from forming new relationships, with anesthesiologists and other anesthesia professionals and cause our growth to be limited or decline and our business to be harmed.
     In order for us to sell our products, anesthesia professionals must recommend and endorse them. We may not obtain the necessary recommendations or endorsements from this community. Acceptance of our products depends on educating the medical community as to the distinctive characteristics, perceived benefits, safety, clinical efficacy and cost-effectiveness of our products compared to traditional methods of consciousness monitoring and the products of our competitors, and on training healthcare professionals in the proper application of our products. If we are not successful in obtaining and maintaining the recommendations or endorsements of anesthesiologists and other healthcare professionals for our products, our sales may decline or we may be unable to increase our sales and profits.
Negative publicity or unfavorable media coverage could damage our reputation and harm our operations.
     Certain companies that manufacture medical devices have received significant negative publicity in the past when their products did not perform as the medical community or patients expected. This publicity, and the perception such products may not have functioned properly, may result in increased litigation, including large jury awards, legislative activity, increased regulation and governmental review of company and industry practices. If we were to receive such negative publicity or unfavorable media attention, whether warranted or unwarranted, our reputation would suffer, our ability to market our products would be adversely affected, we may be required to change our products and become subject to increased regulatory burdens and we may be required to pay large judgments or fines. Any combination of these factors could further increase our cost of doing business and adversely affect our financial position, results of operations and cash flows.

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If we do not successfully develop or acquire and introduce enhanced or new products we could lose revenue opportunities and customers.
     Our success in developing or acquiring and commercializing new products and enhancements of current products is affected by our ability to:
    identify and respond, in a timely manner, to new market trends or opportunities;
 
    assess customer needs;
 
    successfully develop or acquire competitive products;
 
    complete regulatory clearance in a timely manner;
 
    successfully develop cost effective manufacturing processes;
 
    introduce such products to our customers in a timely manner; and
 
    achieve market acceptance of the BIS system.
     If we are unable to continue to develop or acquire and market new products and technologies, we may experience a decrease in demand for our products, and a loss of market share and our business would suffer. As the market for our BIS system matures, we need to develop or acquire and introduce new products for anesthesia monitoring or other applications. Additionally, we have begun to research the use of BIS monitoring to diagnose, track and manage neurological diseases, including Alzheimer’s disease and depression. We face at least the following two risks with respect to our planned development of new products and our entrance into potential new markets:
    we may not successfully adapt the BIS system to function properly for procedural sedation, when used with anesthetics we have not tested or with patient populations we have not studied, such as infants, and
 
    our technology is complex, and we may not be able to develop it further for applications outside anesthesia monitoring, such as the diagnosis and tracking of neurological diseases.
     We are focused on the market for brain monitoring products. The projected demand for our products could materially differ from actual demand if our assumptions regarding this market and its trends and acceptance of our products by the medical community prove to be incorrect or do not materialize or if other products or technologies gain more widespread acceptance, which in each case would adversely affect our business prospects and profitability.
     If we do not successfully adapt the BIS system for new products and applications both within and outside the field of anesthesia monitoring, or if such products and applications are developed but not successfully commercialized, then we could lose revenue opportunities and customers.
If our clinical trials are delayed or unsuccessful, our business could be adversely affected.
     We are conducting several clinical studies, including studies in the areas of interoperative awareness in children, depression and Alzheimer’s disease, and the association between deep anesthesia and long-term patient outcomes. Clinical trials require sufficient patient enrollment, which is a function of many factors, including the size of the patient population, the nature of the protocol and the eligibility criteria for the clinical trial. Delays in patient enrollment can result in increased costs and longer development times.
     We cannot predict whether we will encounter problems with respect to any of our completed, ongoing or planned clinical trials that will cause us or regulatory authorities to delay or suspend our clinical trials or delay the analysis of data from our completed or ongoing clinical trials. In addition, we cannot assure you that we will be successful in reaching the endpoints in these trials, or if we do, that the FDA or other regulatory agencies will accept the results.

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     Any of the following could delay the completion of our ongoing and planned clinical trials, or result in a failure of these trials to support our business:
    delays or the inability to obtain required approvals from institutional review boards or other governing entities at clinical sites selected for participation in our clinical trials,
 
    delays in enrolling patients and volunteers into clinical trials,
 
    lower than anticipated retention rates of patients and volunteers in clinical trials,
 
    negative results from clinical trials for any of our potential products, including those involving the management of depression and the early diagnosis and tracking of Alzheimer’s disease, and
 
    failure of our clinical trials to demonstrate the efficacy or clinical utility of our potential products.
     If we determine that the costs associated with attaining regulatory approval of a product exceed the potential financial benefits or if the projected development timeline is inconsistent with our determination of when we need to get the product to market, we may choose to stop a clinical trial and/or development of a product.
If we do not develop and implement a successful sales and marketing strategy, we will not expand our business.
     In the past, we have experienced high turnover in our direct sales force. It is possible that high turnover may occur in the future. If new sales representatives do not acquire the technological skills to sell our products in a timely and successful manner or we experience high turnover in our direct sales force, we may not be able to sustain and grow our product revenue. In addition, in order to increase our sales, we need to continue to strengthen our relationships with our international distributors and continue to add international distributors. Also, we need to continue to strengthen our relationships with our original equipment manufacturers and other sales channels and increase sales through these channels. On an ongoing basis, we need to develop and introduce new sales and marketing programs and clinical education programs to promote the use of the BIS system by our customers. If we do not implement these new sales and marketing and education programs in a timely and successful manner, we may not be able to achieve the level of market awareness and sales required to expand our business. We have only limited sales and marketing experience both in the United States and internationally and may not be successful in developing and implementing our strategy. Among other things, we need to:
    provide or assure that distributors and original equipment manufacturers provide the technical and educational support customers need to use the BIS system successfully,
 
    promote frequent use of the BIS system so that sales of our disposable BIS Sensors increase,
 
    establish and implement successful sales and marketing and education programs that encourage our customers to purchase our products or the products that are made by original equipment manufacturers incorporating our technology,
 
    manage geographically dispersed operations, and
 
    modify our products and marketing and sales programs for foreign markets.
We encourage our direct sales force, distributors and original equipment manufacturers to maximize the amount of our products they sell and they may engage in aggressive sales practices that may harm our reputation.
     We sell our products through a combination of a direct sales force, third party distributors and original equipment manufacturers. As a means to incentivize the sales force, distributors and original equipment manufacturers, the compensation we pay increases with the amount of our products they sell. For example, the compensation paid to the members of our direct sales force consists, in part, of commissions and, the greater the amount of sales, the higher the commission we pay. The participants in our sales channels may engage in sales practices that are aggressive or considered to be inappropriate by existing or potential customers. In addition, we do not exercise control over, and may not be able to provide sufficient oversight of, the sales practices and techniques used by third party distributors and original equipment manufacturers. Negative public opinion resulting from these sales practices can adversely affect our ability to keep and attract customers and could expose us to litigation.

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Our third-party distribution and original equipment manufacturer relationships could negatively affect our profitability, cause sales of our products to decline and be difficult to terminate if we are dissatisfied.
     Sales through distributors could be less profitable than direct sales. Sales of our products through multiple channels could also confuse customers and cause the sale of our products to decline. We do not control our original equipment manufacturers and distribution partners. Our partners could sell competing products, may not incorporate our technology into their products in a timely manner and may devote insufficient sales efforts to our products. In addition, our partners are generally not required to purchase minimum quantities. As a result, even if we are dissatisfied with the performance of our partners, we may be unable to terminate our agreements with these partners or enter into alternative arrangements.
We may not be able to generate enough additional revenue from our international expansion to offset the costs associated with establishing and maintaining foreign operations.
     A component of our growth strategy is to expand our presence in international markets. We conduct international business primarily in Europe and Japan, and we are attempting to increase the number of countries in which we do business. It is costly to establish international facilities and operations and to promote the BIS system in international markets. We have encountered barriers to the sale of our BIS system outside the United States, including less acceptance by anesthesia providers for use of disposable products, such as BIS Sensors, delays in regulatory approvals outside of the United States, particularly in Japan, and difficulties selling through indirect sales channels. In addition, we have little experience in marketing and distributing products in international markets. Revenue from international activities may not offset the expense of establishing and maintaining these international operations.
We may not be able to meet the unique operational, legal and financial challenges that we will encounter in our international operations, which may limit the growth of our business.
     We are increasingly subject to a number of challenges which specifically relate to our international business activities. These challenges include:
    failure of local laws to provide adequate protection against infringement of our intellectual property,
 
    protectionist laws and business practices that favor local competitors, which could slow or prohibit our growth in international markets,
 
    difficulties in terminating or modifying distributor arrangements because of restrictions in markets outside the United States,
 
    less acceptance by foreign anesthesia providers of the use of disposable products, such as BIS Sensors,
 
    delays in regulatory approval of our products,
 
    currency conversion issues arising from sales denominated in currencies other than the United States dollar,
 
    foreign currency exchange rate fluctuations,
 
    longer sales cycles to sell products like the BIS system to hospitals and outpatient surgical centers, which could slow our revenue growth from international sales, and
 
    longer accounts receivable payment cycles and difficulties in collecting accounts receivable.
     If we are unable to meet and overcome these challenges, our international operations may not be successful, which would limit the growth of our business and could adversely impact our results of operations.
We may experience customer dissatisfaction and our reputation could suffer if we fail to manufacture enough products to meet our customers’ demands.
     We rely on third-party manufacturers to assemble and manufacture the components of our BIS monitors, original equipment manufacturer products and a portion of our BIS Sensors. We manufacture substantially all BIS Sensors in our own manufacturing facility. We have only one manufacturing facility. If we fail to produce enough products at our own manufacturing facility or at a third-party manufacturing facility for any reason, including damage or destruction of the facility, or experience a termination or modification of any manufacturing arrangement with a third party, we may be unable to deliver products to our customers on a timely basis. Even if we are able to identify alternative facilities to manufacture our

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products, if necessary, we may experience disruption in the supply of our products until such facilities are available. Although we believe we possess adequate insurance for damage to our property and the disruption of our business from casualties, such insurance may not be sufficient to cover all of our potential losses and may not be available to us on acceptable terms or at all. Additionally, failure to deliver products on a timely basis could lead to customer dissatisfaction and damage our reputation.
Our reliance on sole-source suppliers could adversely affect our ability to meet our customers’ demands for our products in a timely manner or within budget.
     Some of the components that are necessary for the assembly of our BIS system, including some of the components used in our BIS Sensors, are currently provided to us by sole-source suppliers or a limited group of suppliers. We purchase components through purchase orders, and in select cases, long-term supply agreements, and generally do not maintain large volumes of inventory. We have experienced shortages and delays in obtaining some of the components of our BIS systems in the past, and we may experience similar shortages or delays in the future. The disruption or termination of the supply of components could cause a significant increase in the costs of these components, which could affect our profitability. A disruption or termination in the supply of components could also result in our inability to meet demand for our products, which could lead to customer dissatisfaction and damage our reputation. If a supplier is no longer willing or able to manufacture components that we purchase and integrate into the BIS system, we may attempt to design replacement components ourselves that would be compatible with our existing technology. In doing so, we would incur additional research and development expenses, and there can be no assurance that we would be successful in designing or manufacturing any replacement components. Furthermore, if we are required to change the manufacturer of a key component of the BIS system, we may be required to verify that the new manufacturer maintains facilities and procedures that comply with quality standards and with all applicable regulations and guidelines. The delays associated with the verification of a new manufacturer could delay our ability to manufacture BIS system products in a timely manner or within budget.
We may be required to bring litigation to enforce our intellectual property rights, which may result in substantial expense and may divert our attention from the implementation of our business strategy.
     We believe that the success of our business depends, in part, on obtaining patent protection for our products, defending our patents once obtained and preserving our trade secrets. We rely on a combination of contractual provisions, confidentiality procedures and patent, trademark and trade secret laws to protect the proprietary aspects of our technology. These legal measures afford only limited protection, and competitors may gain access to our intellectual property and proprietary information. Any patents we have obtained or will obtain in the future might also be invalidated or circumvented by third parties. Our pending patent applications may not issue as patents or, if issued, may not provide commercially meaningful protection, as competitors may be able to design around our patents or produce alternative, non-infringing designs. Litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets and to determine the validity and scope of our proprietary rights. Any litigation could result in substantial expense and diversion of our attention from the business and may not be adequate to protect our intellectual property rights.
We may be sued by third parties which claim that our products infringe on their intellectual property rights, particularly because there is substantial uncertainty about the validity and breadth of medical device patents.
     We may be subject to litigation by third parties based on claims that our products infringe the intellectual property rights of others. This risk is exacerbated by the fact that the validity and breadth of claims covered in medical technology patents involve complex legal and factual questions for which important legal principles are unresolved. Any litigation or claims against us, whether or not valid, could result in substantial costs, could place a significant strain on our financial resources and could harm our reputation. In addition, intellectual property litigation or claims could force us to do one or more of the following:
    cease selling, incorporating or using any of our products that incorporate the challenged intellectual property, which would adversely affect our revenue,
 
    obtain a license from the holder of the infringed intellectual property right, which license may not be available on reasonable terms, if at all, and
 
    redesign our products, which may be costly, time-consuming and may not be successful.

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We could be exposed to significant product liability claims which could divert management attention and adversely affect our cash balances, our ability to obtain and maintain insurance coverage at satisfactory rates or in adequate amounts and our reputation.
     The manufacture and sale of our products expose us to product liability claims and product recalls, including those which may arise from misuse or malfunction of, or design flaws in, our products or use of our products with components or systems not manufactured or sold by us. There may be increased risk of misuse of our products if persons not skilled in consciousness monitoring attempt to use our BIS monitoring products. Product liability claims or product recalls, regardless of their ultimate outcome, could require us to spend significant time and money in litigation or to pay significant damages. We currently maintain product liability insurance; however, it may not cover the costs of any product liability claims made against us. Furthermore, we may not be able to obtain insurance in the future at satisfactory rates or in adequate amounts. In addition, publicity pertaining to the misuse or malfunction of, or design flaws in, our products could impair our ability to successfully market and sell our products and could lead to product recalls.
Several class action lawsuits have been filed against the underwriters of our initial public offering which may result in negative publicity and potential litigation against us that would be costly to defend and the outcome of which is uncertain and may harm our business.
     The underwriters of our initial public offering are named as defendants in several class action complaints which have been filed allegedly on behalf of certain persons who purchased shares of our common stock between January 28, 2000 and December 6, 2000. These complaints allege violations of the Securities Act and the Securities Exchange Act of 1934, as amended, or the Securities Exchange Act. Primarily they allege that there was undisclosed compensation received by our underwriters in connection with our initial public offering. While we and our officers and directors have not been named as defendants in these suits, based on comparable lawsuits filed against other companies, there can be no assurance that we and our officers and directors will not be named in similar complaints in the future. In addition, the underwriters may assert that we are liable for some or all of any liability that they are found to have to the plaintiffs, pursuant to the indemnification provisions of the underwriting agreement we entered into as part of the initial public offering, or otherwise.
     We can provide no assurance as to the outcome of these complaints or any potential suit against us or our officers and directors. Any conclusion of these matters in a manner adverse to us could have a material adverse affect on our financial position and results of operations. In addition, the costs to us of defending any litigation or other proceeding, even if resolved in our favor, could be substantial. Such litigation could also substantially divert the attention of our management and our resources in general. Even if we are not named as defendants in these lawsuits, we may also be required to incur significant costs and our management may be distracted by being required to provide information, documents or testimony in connection with the actions against our underwriters. Uncertainties resulting from the initiation and continuation of any litigation or other proceedings and the negative publicity associated with this litigation could harm our ability to compete in the marketplace.
Aspect and Boston Scientific recently terminated the strategic alliance and other agreements and we may not have sufficient funding to finance our neuroscience programs.
     On June 11, 2007, we announced that we and Boston Scientific Corporation entered into a termination and repurchase agreement under which we jointly agreed to terminate the following agreements between the parties:
    the original equipment manufacturer product development agreement dated as of August 7, 2002, pursuant to which we were seeking to develop certain products that Boston Scientific Corporation would then commercialize in the area of monitoring patients under sedation in a range of less invasive medical specialties, and pursuant to which we granted Boston Scientific Corporation an exclusive option to become the distributor for a period of time of certain of our products;
 
    the product development and distribution agreement dated as of May 23, 2005, pursuant to which we were seeking to develop new applications of its brain-monitoring technology in the area of the diagnosis and treatment of neurological, psychiatric and pain disorders and Boston Scientific Corporation was appointed the exclusive distributor of such products. Under this agreement, which we refer to as the neuroscience alliance, Boston Scientific Corporation had agreed to provide $25.0 million of funding over a five year period. We received $10.0 million under this agreement.
 
    the letter agreement dated August 7, 2002, and the security agreement dated August 7, 2002, pursuant to which Boston Scientific Corporation agreed to make revolving interest-bearing loans to us from time to time at our request, such revolving loans being evidenced by a promissory note in the original principal amount of $5,000,000 dated August 7, 2002 made by us in favor of Boston Scientific Corporation.

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     As a result of the termination of our alliance with Boston Scientific Corporation, we have regained the commercial rights to products subject to the alliance that we previously shared, but we have lost the support that Boston Scientific Corporation would have provided under the alliance to develop and market products for monitoring patients under sedation and for neuroscience applications. Specifically, we will lose funding and distribution support from Boston Scientific Corporation for these products. Consequently, we may need to find alternative sources of funds, which may not be available, and we may need to develop our own distribution capabilities or use a third-party distributor. There can be no guarantee that we will be able to develop these new products successfully on our own or that we will be able to reach any agreement with a third-party distributor on terms acceptable to us, or at all.
We may not reserve amounts adequate to cover product obsolescence, claims and returns, which could result in unanticipated expenses and fluctuations in operating results.
     Depending on factors such as the timing of our introduction of new products which utilize our BIS technology, as well as warranty claims and product returns, we may need to reserve amounts in excess of those currently reserved for product obsolescence, excess inventory, warranty claims and product returns. These reserves may not be adequate to cover all costs associated with these items. If these reserves are inadequate, we would be required to incur unanticipated expenses which could result in unexpected fluctuations in quarterly operating results.
We may not be able to compete effectively, which could result in price reductions and decreased demand for our products.
     We are facing increased competition in the domestic level of consciousness monitoring market as a result of a number of competitors’ monitoring systems which have been cleared for marketing by the FDA. These products are marketed by well-established medical products companies with significant resources. We may not be able to compete effectively with these and other potential competitors. We may also face substantial competition from companies which may develop sensor products that compete with our proprietary BIS Sensors for use with our BIS monitors or with third-party monitoring systems or anesthesia delivery systems that incorporate the BIS index. We also expect to face competition from companies currently marketing conventional electroencephalogram, or EEG, monitors using standard and novel signal-processing techniques. Other companies may develop anesthesia-monitoring systems that perform better than the BIS system and/or sell for less. In addition, one or more of our competitors may develop products that are substantially equivalent to our FDA-approved products, in which case they may be able to use our products as predicate devices to more quickly obtain FDA approval of their competing products. Medical device companies developing these and other competitive products may have greater financial, technical, marketing and other resources than we do. Competition in the sale of anesthesia-monitoring systems could result in price reductions, fewer orders, reduced gross margins and loss of market share. We are seeking to develop new products and technologies in the areas of depression and Alzheimer’s disease. If we are not successful in developing new products or technologies, or if we experience delays in development or release of such products, we may not be able to compete successfully.
Our ability to market and sell our products and generate revenue depends upon receipt of domestic and foreign regulatory approval of our products and manufacturing operations.
     Our products are classified as medical devices and are subject to extensive regulation in the United Sates by the FDA and other federal, state, and local authorities. These regulations relate to the manufacturing, labeling, sale, promotion, distribution, importing, exporting and shipping of our products. Before we can market new products or a new use of, or claim for, an existing product in the United States, we must obtain clearance or approval from the FDA. If the FDA concludes that any of our products do not meet the requirements to obtain clearance of a premarket notification under Section 510(k) of the Food, Drug and Cosmetic Act, then we would be required to file a premarket approval application. For example, there can be no guarantee that the FDA will accept our BRITE trial results as supportive of a 510(k) notification without requiring additional studies and/or a premarket approval application. Both of these processes can be lengthy, expensive, may require extensive data from preclinical studies and clinical trials and may require significant user fees. The premarket approval process typically is more burdensome, expensive, time-consuming and uncertain than the premarket notification process. We may not obtain clearance of a 510(k) notification or approval of a premakret approval application with respect to any of our products on a timely basis, if at all. If we fail to obtain timely clearance or approval for our products, we will not be able to market and sell our products, which will limit our ability to generate revenue. We may also be required to obtain clearance of a 510(k) notification from the FDA before we can market certain previously marketed products which we modify after they have been cleared. We have made certain enhancements to our currently marketed products which we have determined do not necessitate the filing of a new 510(k) notification. However, if the FDA does not agree with our determinations, it will require us to file a new 510(k) notification for the modification, and we may be prohibited from marketing the modified devices until we obtain FDA clearance, or be required to recall devices that may be on the market, or be subject to other sanctions.
     Medical devices may be marketed only for the indications for which they are approved or cleared. The FDA may fail to approve or clear indications that are necessary or desirable for successful commercialization of our products. The FDA also may refuse our request for 510(k) clearance or premarket approval of new products, new intended uses, or modification to products once they are approved or cleared. Our approvals or clearance can be revoked if safety or effectiveness problems develop.
     Our promotional materials and training methods must comply with the FDA and other applicable laws and regulations. If the FDA determines that our promotional materials or training constitute promotion of an unapproved use, it could request that we modify our training or promotional materials or subject us to regulatory or enforcement actions, including the issuance of an untitled letter, a warning letter, injunction, seizure, civil monetary penalties, or criminal prosecution. It also is possible that other federal, state, or foreign enforcement authorities might take action if they consider our promotional or training materials to constitute promotion of an unapproved use, which could result in significant fines or penalties under other statutory authorities, such as laws prohibiting false claims for reimbursement. In that event, our reputation could be damaged, adoption of the products could be impaired, and we might not be able to promote the products for certain uses for which we had expected to promote them.
     The FDA also requires us to adhere to current Good Manufacturing Practices regulations, also known as the Quality System Regulation (QSR) in the case of medical devices, which include production controls, design controls, testing, quality control, documentation procedures, verification and validation of the design and of the production process, purchasing controls for materials and components, implementation of corrective and preventive actions, and servicing, among other requirements. The FDA may at any time inspect our facilities to determine whether adequate compliance with QSR requirements has been achieved. Compliance with the QSR regulations for medical devices is difficult and costly. In addition, we may not continue to be compliant as a result of future changes in, or interpretations of, regulations by the FDA or other regulatory agencies. If we do not achieve continued compliance, the FDA may issue a warning letter, withdraw marketing clearance, require product recall, seize products, seek an injunction or consent decree, or seek criminal prosecution, among other possible remedies. When any change or modification is made to a device or its intended use, the manufacturer may be required to reassess compliance with the QSR regulations, which may cause interruptions or delays in the marketing and sale of our products.
     Sales of our products outside the United States are subject to foreign regulatory requirements that vary from country to country. The time required to obtain approvals from foreign countries may be longer than that required for FDA approval, and requirements for foreign licensing may differ from FDA requirements.

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     The federal, state and foreign laws and regulations regarding the manufacture and sale of our products are subject to future changes, as are administrative interpretations of regulatory agencies. If we fail to comply with applicable federal, state or foreign laws or regulations, we could be subject to enforcement actions, including product seizures, recalls, withdrawal of clearances or approvals and civil and criminal penalties.
Even if we obtain the necessary FDA clearances or approvals, if we or our suppliers fail to comply with ongoing regulatory requirements our products could be subject to restrictions or withdrawal from the market.
     We are subject to the Medical Device Reporting, or MDR, regulations that require us to report to the FDA if our products may have caused or contributed to patient death or serious injury, or if our device malfunctions and a recurrence of the malfunction would likely result in a death or serious injury. We must also file reports of device corrections and removals and adhere to the FDA’s rules on labeling and promotion. Our failure to comply with these or other applicable regulatory requirements could result in enforcement action by the FDA, which may include any of the following:
    untitled letters, warning letters, fines, injunctions and civil penalties,
 
    administrative detention, which is the detention by the FDA of medical devices believed to be adulterated or misbranded,
 
    customer notification, or orders for repair, replacement or refund,
 
    voluntary or mandatory recall or seizure of our products,
 
    operating restrictions, partial suspension or total shutdown of production,
 
    refusal to review pre-market notification or pre-market approval submissions,
 
    rescission of a substantial equivalence order or suspension or withdrawal of a pre-market approval, and
 
    criminal prosecution.
     Any of the foregoing actions by the FDA could have a material adverse effect on our business and results of operations.
We may be subject, directly or indirectly, to federal and state healthcare fraud and abuse laws and regulations and, if we are unable to fully comply with such laws, could face substantial penalties.
     Our operations may be directly or indirectly affected by various state and federal healthcare fraud and abuse laws, including the federal Anti-Kickback Statute, which prohibits any person from knowingly and willfully offering, paying, soliciting or receiving remuneration, directly or indirectly, to induce or reward either the referral of an individual, or the furnishing or arranging for an item or service, for which payment may be made under federal healthcare programs, such as the Medicare and Medicaid programs. If our past or present operations are found to be in violation of these laws, we or our officers may be subject to civil or criminal penalties, including large monetary penalties, damages, fines, imprisonment and exclusion from Medicare and Medicaid program participation. If enforcement action were to occur, our business and financial condition would be harmed.
If we do not retain our senior management and other key employees, we may not be able to successfully implement our business strategy.
     Our president and chief executive officer, Nassib Chamoun, joined us at our inception in 1987. Our chairman, J. Breckenridge Eagle, began serving as a director in 1988. Many other members of our management and key employees have extensive experience with us and other companies in the medical device industry. Our success is substantially dependent on the ability, experience and performance of these members of our senior management and other key employees. Because of their ability and experience, if we lose one or more of the members of our senior management or other key employees, our ability to successfully implement our business strategy could be seriously harmed.
If we do not attract and retain skilled personnel, or if we do not maintain good relationships with our employees, we will not be able to expand our business.
     Our products are based on complex signal-processing technology. Accordingly, we require skilled personnel to develop, manufacture, sell and support our products. Our future success will depend largely on our ability to continue to hire, train, retain and motivate additional skilled personnel, particularly sales representatives who are responsible for customer education and training and post-installation customer support. Consequently, if we are not able to attract and retain skilled personnel, we will not be able to expand our business.

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     In addition, we may be subject to claims that we engage in discriminatory or other unlawful practices with respect to our hiring, termination, promotion and compensation processes for our employees. Such claims, with or without merit, could be time consuming, distracting and expensive to defend, could divert attention of our management from other tasks important to the success of our business and could adversely affect our reputation as an employer.
Our employees may engage in misconduct or other improper activities, including insider trading.
     We are exposed to the risk that employee fraud or other misconduct could occur. Misconduct by employees could include intentional failures to comply with FDA regulations, to provide accurate information to the FDA, to comply with manufacturing standards we have established, to comply with federal and state healthcare fraud and abuse laws and regulations, to accurately report financial information or data or to disclose unauthorized activities to us. Employee misconduct could also involve the improper use of customer information or information obtained in the course of clinical trials, which could result in regulatory sanctions and serious harm to our reputation. We have adopted a Code of Business Conduct and Ethics, but it is not always possible to identify and deter employee misconduct, and the precautions we take to detect and prevent this activity may not be effective in controlling unknown or unmanaged risks or losses.
     In addition, during the course of our operations, our directors, executives and employees may have access to material, non-public information regarding our business, our results of operations or potential transactions we are considering. Despite the adoption of an Insider Trading Policy, we may not be able to prevent a director or employee from trading in our common stock on the basis of or while having access to material, non-public information. If a director or employee was to be investigated, or an action was to be brought against a director or employee, for insider trading, it could have a negative impact on our reputation and our stock price. Such a claim, with or without merit, could also result in substantial expenditures of time and money, and divert attention of our management team from other tasks important to the success of our business.
Failure of users of the BIS system, or users of future products we may develop, to obtain adequate reimbursement from third-party payors could limit market acceptance of the BIS system and other products, which could prevent us from sustaining profitability.
     Anesthesia providers are generally not reimbursed separately for patient monitoring activities utilizing the BIS system. For hospitals and outpatient surgical centers, when reimbursement is based on charges or costs, patient monitoring with the BIS system may reduce reimbursements for surgical procedures, because charges or costs may decline as a result of monitoring with the BIS system. Failure by hospitals and other users of the BIS system to obtain adequate reimbursement from third-party payors, or any reduction in the reimbursement by third-party payors to hospitals and other users as a result of using the BIS system, could limit market acceptance of the BIS system, which could prevent us from sustaining profitability.
     In addition, market acceptance of future products serving the depression and Alzheimer’s disease markets could depend upon adequate reimbursement from third-party payors. The ability and willingness of third-party payors to authorize coverage and sufficient reimbursement to compensate and encourage physicians to use such products is uncertain.
Transactions engaged in by our largest stockholders, our directors or executives involving our common stock may have an adverse effect on the price of our stock.
     As of June 30, 2007, our largest three stockholders each own greater than 10% of our outstanding common stock. Subsequent sales of our shares by these stockholders could have the effect of lowering our stock price. The perceived risk associated with the possible sale of a large number of shares by these stockholders, or the adoption of significant short positions by hedge funds or other significant investors, could cause some of our stockholders to sell their stock, thus causing the price of our stock to decline. In addition, actual or anticipated downward pressure on our stock price due to actual or anticipated sales of stock by directors or officers of Aspect could cause other institutions or individuals to engage in short sales of our common stock, which may further cause the price of our stock to decline.
     From time to time our directors and executive officers sell shares of our common stock on the open market. These sales are publicly disclosed in filings made with the SEC. In the future, our directors and executive officers may sell a significant number of shares for a variety of reasons unrelated to the performance of our business. Our stockholders may perceive these sales as a reflection on management’s view of the business and result in some stockholders selling their shares of our common stock. These sales could cause the price of our stock to drop.

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We have various mechanisms in place to discourage takeover attempts, which may reduce or eliminate our stockholders’ ability to sell their shares for a premium in a change of control transaction.
     Various provisions of our certificate of incorporation and by-laws and of Delaware corporate law may discourage, delay or prevent a change in control or takeover attempt of our company by a third party that is opposed by our management and board of directors. Public stockholders who might desire to participate in such a transaction may not have the opportunity to do so. These anti-takeover provisions could substantially impede the ability of public stockholders to benefit from a change of control or change in our management and board of directors. These provisions include:
    preferred stock that could be issued by our board of directors to make it more difficult for a third party to acquire, or to discourage a third party from acquiring, a majority of our outstanding voting stock,
 
    classification of our directors into three classes with respect to the time for which they hold office,
 
    non-cumulative voting for directors,
 
    control by our board of directors of the size of our board of directors,
 
    limitations on the ability of stockholders to call special meetings of stockholders,
 
    inability of our stockholders to take any action by written consent, and
 
    advance notice requirements for nominations of candidates for election to our board of directors or for proposing matters that can be acted upon by our stockholders at stockholder meetings.
Risks Related to the Issuance of $125 Million Principal Amount of 2.5% Convertible Senior Notes due 2014
Our increased indebtedness as a result of the issuance of $125 million principal amount of 2.5% convertible senior notes, or the notes, may harm our financial condition and results of operations.
     Our level of indebtedness could have important consequences to investors, because:
    it could adversely affect our ability to satisfy our obligations under the notes;
 
    a substantial portion of our cash flows from operations will have to be dedicated to interest payments, principal payments and, if we irrevocably elect to net share settle the notes, conversion payments and may not be available for operations, working capital, capital expenditures, expansion, acquisitions or general corporate or other purposes;
 
    it may impair our ability to obtain additional financing in the future;
 
    it may limit our flexibility in planning for, or reacting to, changes in our business and industry; and
 
    it may make us more vulnerable to downturns in our business, our industry or the economy in general.
     Our operations may not generate sufficient cash to enable us to service our debt. If we fail to make a payment on the notes, we could be in default on the notes, and this default could cause us to be in default on our other indebtedness outstanding at that time. Conversely, a default on our other outstanding indebtedness may cause a default under the notes.
We may not have the cash necessary to pay interest on the notes, to settle conversions of the notes (if we have obtained stockholder approval to elect net share settlement of the notes, and we irrevocably elect such settlement method) or to repurchase the notes upon a fundamental change.
     The notes bear interest semi-annually at a rate of 2.5% per annum. In addition, we may in certain circumstances be obligated to pay additional interest. If at any time on or prior to the 45th scheduled trading day preceding the maturity date of the notes we obtain stockholder approval of the net share settlement feature in connection with the potential conversion of the notes, and if we irrevocably elect to use such feature, then upon conversion of the notes we would (1) pay cash in an amount equal to the lesser of one-fortieth of the principal amount of the notes being converted and the daily conversion value (the product of the conversion rate and the current trading price) of the notes being converted and (2) issue shares of our common stock only to the extent that the daily conversion value of the notes exceeded one-fortieth of the principal amount of the notes being converted for each trading day

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of the relevant 40 trading day observation period. Holders of notes also have the right to require us to repurchase all or a portion of their notes for cash upon the occurrence of a fundamental change. Any of our future debt agreements or securities may contain similar provisions. We may not have sufficient funds to pay interest, pay any such cash amounts to the note holders upon conversion or make the required repurchase of the notes at the applicable time and, in such circumstances, may not be able to arrange the necessary financing on favorable terms, if at all. In addition, our ability to pay interest, pay cash to the note holders upon conversion or make the required repurchase, as the case may be, may be limited by law or the terms of other debt agreements or securities. Our failure to pay such cash amounts to holders of notes or make the required repurchase, as the case may be, however, would constitute an event of default under the indenture governing the notes which, in turn, could constitute an event of default under other debt agreements or securities, thereby resulting in their acceleration and required prepayment and further restrict our ability to make such payments and repurchases.
The net share settlement feature of the notes, if available, may have adverse consequences.
     If we have obtained stockholder approval to elect net share settlement of the notes, the net share settlement feature of the notes may:
    result in holders receiving no shares of our common stock upon conversion or fewer shares of our common stock relative to the conversion value of the notes;
 
    reduce our liquidity because we will be required to pay the principal portion in cash;
 
    delay holders’ receipt of the proceeds upon conversion; and
 
    subject holders to market risk before receiving any shares upon conversion.
     If we obtain stockholder approval of the net share settlement feature in connection with the potential conversion of the notes, and if we irrevocably elect to use such feature, then upon conversion of the notes we would (1) pay cash in an amount equal to the lesser of one-fortieth of the principal amount of the notes being converted and the daily conversion value (the product of the conversion rate and the current trading price) of the notes being converted and (2) issue shares of our common stock only to the extent that the daily conversion value of the notes exceeded one-fortieth of the principal amount of the notes being converted for each trading day of the relevant 40 trading day observation period.
     Because the consideration due upon conversion of notes is based in part on the trading prices of our common stock, any decrease in the price of our common stock after notes are tendered for conversion may significantly decrease the value of the consideration received upon conversion. Furthermore, because under net share settlement we must settle at least a portion of our conversion obligation in cash, the conversion of notes may significantly reduce our liquidity.
Future sales of our common stock in the public market or the issuance of securities senior to our common stock could adversely affect the trading price of our common stock and the value of the notes and our ability to raise funds in new securities offerings.
     Future sales of our common stock, the perception that such sales could occur or the availability for future sale of shares of our common stock or securities convertible into or exercisable for our common stock could adversely affect the market prices of our common stock and the value of the notes prevailing from time to time and could impair our ability to raise capital through future offerings of equity or equity-related securities. In addition, we may issue common stock or equity securities senior to our common stock in the future for a number of reasons, including to finance our operations and business strategy, to adjust our ratio of debt to equity, to satisfy our obligations upon the exercise of options or for other reasons.
     As of June 30, 2007, we had outstanding options to purchase 4,428,491 shares of our common stock at a weighted average exercise price of $15.39 per share (1,309,322 of which have not yet vested) issued to employees, directors and consultants pursuant to our 1991 Amended and Restated Stock Option Plan, 1998 Stock Incentive Plan, the Amended and Restated 1998 Director Equity Incentive Plan and 2001 Stock Incentive Plan, as amended. In order to attract and retain key personnel, we may issue additional securities, including stock options, restricted stock grants and shares of common stock, in connection with our employee benefit plans, or may lower the price of existing stock options. No prediction can be made as to the effect, if any, that the sale, or the availability for sale, of substantial amounts of common stock by our existing stockholders pursuant to an effective registration statement or under Rule 144, through the exercise of registration rights or the issuance of shares of common stock upon the exercise of stock options, or the perception that such sales or issuances could occur, could adversely affect the prevailing market prices for our common stock and the value of the notes.

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Conversion of the notes will dilute the ownership interest of existing stockholders, including holders who had previously converted their notes.
     To the extent we issue any shares of our common stock upon conversion of the notes, the conversion of some or all of the notes will dilute the ownership interests of existing stockholders, including holders who have received shares of our common stock upon prior conversion of the notes. Any sales in the public market of the common stock issuable upon such conversion could adversely affect prevailing market prices of our common stock. In addition, the existence of the notes may encourage short selling by market participants because the conversion of the notes could depress the price or our common stock.
Provisions in the indenture for the notes may deter or prevent a business combination that may be favorable to note holders.
     If a fundamental change occurs prior to the maturity date of the notes, holders of the notes will, have the right, at their option, to require us to repurchase all or a portion of their notes. In addition, if a make-whole fundamental change occurs prior to the maturity date of the notes, we will in some cases increase the conversion rate for a holder that elects to convert its notes in connection with such make-whole fundamental change. In addition, the indenture governing the notes prohibits us from engaging in certain mergers or acquisitions unless, among other things, the surviving entity assumes our obligations under the notes. These and other provisions could prevent or deter a third party from acquiring us.
The notes may not be rated or may receive a lower rating than anticipated.
     We do not intend to seek a rating on the notes. However, if one or more rating agencies rates the notes and assigns the notes a rating lower than the rating expected by investors, or reduces or indicates that they may reduce their rating in the future, the market price of the notes and our common stock could be harmed.
The effective subordination of the notes to our secured indebtedness to the extent of the collateral securing such indebtedness may limit our ability to satisfy our obligations under the notes.
     The notes will be our senior unsecured obligations and rank equally with any of our existing or future senior debt and senior to any of our future subordinated debt. However, the notes will be effectively subordinated to our secured indebtedness to the extent of the value of the collateral securing such indebtedness. As of June 30, 2007, we did not have any secured indebtedness outstanding. The provisions of the indenture governing the notes do not prohibit us from incurring secured indebtedness in the future. Consequently, in the event of a bankruptcy, liquidation, dissolution, reorganization or similar proceeding with respect to us, the holders of any secured indebtedness will be entitled to proceed directly against the collateral that secures such secured indebtedness. Therefore, such collateral will not be available for satisfaction of any amounts owed under our unsecured indebtedness, including the notes, until such secured indebtedness is satisfied in full.
The structural subordination of the notes to our secured liabilities and all liabilities and preferred equity of our subsidiaries may limit our ability to satisfy our obligations under the notes.
     The notes will be effectively subordinated to all unsecured and secured liabilities and preferred equity of our subsidiaries. In the event of a bankruptcy, liquidation, dissolution, reorganization or similar proceeding with respect to any such subsidiary, we, as a common equity owner of such subsidiary, and, therefore, holders of our debt, including holders of the notes, will be subject to the prior claims of such subsidiary’s creditors, including trade and other payables, but excluding intercompany indebtedness. As of June 30, 2007, our subsidiaries had an accounts payable and accrued liabilities balance of approximately $1.1 million. The provisions of the indenture governing the notes do not prohibit our subsidiaries from incurring additional liabilities or issuing preferred equity in the future.

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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
     The following table provides information regarding repurchases of common stock made by us during the fiscal quarter ended June 30, 2007:
ISSUER PURCHASES OF EQUITY SECURITIES (1)
                                 
                    (c) Total Number of   (d) Maximum
                    Shares Purchased as   Number of Shares
    (a) Total Number           Part of Publicly   that May Yet be
    of Shares   (b) Average Price   Announced Plans or   Purchased Under the
Period   Purchased   Paid per Share   Programs   Plans or Programs
June 1, 2007 – June 30, 2007 (1)
    1,000,000     $ 15.57       1,000,000       0  
June 1, 2007 – June 30, 2007 (2)
    2,000,000     $ 15.91       2,000,000       4,013,239  
Total
    3,000,000     $ 15.74       3,000,000       4,013,239  
 
(1)   These shares were repurchased in connection with our 2.5% convertible senior note offering in June 2007. We repurchased 1,000,000 shares of common stock for $15,570,000 in privately negotiated transactions. The repurchased shares were cancelled and retired.
 
(2)   On June 13, 2007, we repurchased 2,000,000 shares of common stock held by Boston Scientific Corporation at a price of approximately $15.91 per share, or an aggregate of $31,816,000. The repurchased shares were cancelled and retired.
 
(3)   In addition to the repurchases made during the quarter ended June 30, 2007, on July 10, 2007, we repurchased 2,500,000 shares of common stock from Boston Scientific Corporation for $37,655,000. This subsequent repurchase is not reflected in the foregoing table. The repurchased shares were cancelled and retired.
Item 4. Submission of Matters to a Vote of Security Holders.
     On May 23, 2007, we held our 2007 annual meeting of stockholders. At the meeting, David W. Feigal, Jr., John J. O’Connor and Donald R. Stanski were elected as Class I Directors of Aspect, to serve until our 2010 annual meeting of stockholders or until their successors are duly elected and qualified. The results of the voting were as follows: a total of 20,457,666 shares of common stock were voted in favor of the election of Mr. Feigal and 510,185 shares of common stock were withheld; a total of 20,444,901 shares of common stock were voted in favor of the election of Mr. O’Connor and 522,950 shares of common stock were withheld. 21,138,690 shares of common stock were voted in favor of the election of Mr. Stanski and 829,161 shares of common stock were withheld. There were no broker non-votes.
     The terms of office of the following directors, who were not up for re-election at our 2007 annual meeting of stockholders, continued after our 2007 annual meeting of stockholders: Boudewijn L.P.M. Bollen, Nassib G. Chamoun, J. Breckenridge Eagle, Michael A. Esposito, Jr., M.D., Edwin M. Kania and James J. Mahoney, Jr.
     Stockholders approved an amendment to our 2001 Stock Incentive Plan to increase the number of shares of the Company’s stock authorized for issuance by a vote of 13,565,892 in favor, 4,551,440 against, 6,675 abstaining and 2,843,844 broker non-votes.
     Stockholders also ratified the selection of Ernst & Young LLP by the audit committee of our board of directors as our independent registered public accounting firm for the fiscal year ending December 31, 2007 by a vote of 20,935,111in favor, 14,423 against and 18,317 abstaining.
Item 6. Exhibits.
 The exhibits listed in the Exhibit Index immediately preceding the exhibits are filed as part of this Quarterly Report on Form 10-Q.

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SIGNATURE
     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.
         
  ASPECT MEDICAL SYSTEMS, INC.
 
 
     Date: August 9, 2007  By:   /s/ Michael Falvey    
    Michael Falvey   
    Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)   
 

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EXHIBIT INDEX
     
EXHIBIT    
NUMBER   EXHIBIT
10.1
  Termination and Repurchase Agreement by and between Aspect Medical Systems, Inc. and Boston Scientific Corporation is incorporated herein by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K dated June 11, 2007.
 
   
10.2
  Registration Rights Agreement by and between Aspect Medical Systems, Inc. and Boston Scientific Corporation dated as of June 11, 2007 is incorporated herein by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K dated June 11, 2007.
 
   
10.3
  Indenture by and between Aspect Medical Systems, Inc. and U.S. Bank National Association dated as of June 20, 2007 is incorporated herein by reference to Exhibit 4.1 to the Registrant’s Current Report on Form 8-K dated June 20, 2007.
 
   
10.4
  Registration Rights Agreement by and between Aspect Medical Systems, Inc. and Goldman, Sachs & Co. dated June 20, 2007 is incorporated herein by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K dated June 20, 2007.
 
   
31.1
  Certification by Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as amended.
 
   
31.2
  Certification by Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as amended.
 
   
32.1
  Certification by Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
   
32.2
  Certification by Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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