Item 2. Management's Discussion and Analysis

Forward-Looking Statements

The discussion in this Quarterly Report on Form 10-QSB contains forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are based on current expectations, estimates and projections about the software industry and certain assumptions made by the Company's management. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates," "could," "would," "may" and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict; therefore, actual results may differ materially from those expressed or forecasted in any such forward-looking statements. Unless required by law, the Company undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. However, readers should carefully review the risk factors set forth in other reports or documents the Company files from time to time with the SEC, particularly the Company's Annual Report on Form 10-KSB, Quarterly Reports on Form 10-QSB and any Current Reports on Form 8-K.

The following discussion should be read in conjunction with the unaudited financial statements and notes thereto in Part I, Item 1 of this Quarterly Report on Form 10-QSB and with the audited Financial Statements and Notes thereto, together with Management's Discussion and Analysis of Financial Condition and Results of Operations, which are included in the Company's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2006 as filed with the SEC.

Overview

We were incorporated in Delaware in 1990 to design, manufacture, sell and service image-directed, computer-controlled robotic software and hardware products for use in orthopedic surgical procedures. Although we have not received clearance to market the ROBODOC(R) System (ROBODOC) in the U.S., we are permitted to export the system provided certain requirements are met. Products approved for use by European Union member countries and Australia, Canada, India, Israel, Japan, Korea, New Zealand, Switzerland and South Africa, do not require U.S. FDA export approval. We are authorized to sell our robotic systems to international distributors, who in turn can resell the product in their territories. Our international distributors are KTEC in Japan, ROCOM Frontier in Korea and Paramount Impex in India.

Product revenue consists of sales of our principal orthopedic product, the ROBODOC(R) Surgical Assistant System ("ROBODOC"), which integrates the ORTHODOC(R) Presurgical Planner ("ORTHODOC") with a computer-controlled robot for use in joint replacement surgeries. We develop specialized operating software for several implant manufacturing companies. These implant manufacturers contract with us for the development of software for particular lines of new prosthesis to be used with the ROBODOC System.

We currently have no warranty reserves recorded.

Results of operations

We generated net income for the first quarter of 2007 of $69,000, or less than one cent per basic share and less than one cent per dilutive share, compared to net income for the first quarter of 2006 of $973,000 or $0.02 per basic share and $0.01 per dilutive share.

Net revenue

Net revenue of $963,000 in Q1 2007 decreased 57% when compared to $2,256,000 in the first quarter of 2006. The major components of revenue for Q1 2007 were comprised of $100,000 from a system upgrade, $54,000 from repairs and

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consumables, $58,000 from service contracts and $752,000 from software and implant development compared to $2,070,000 from systems sales, $138,000 from repairs and consumables and $48,000 from service contracts in the first quarter of 2006. The lack of system sales accounted for the largest decrease in revenue and is primarily the result of our current focus to obtain FDA clearance for the U.S. market.

Cost of revenue

Cost of revenue of $203,000 in Q1 2007 decreased 50% when compared to $402,000 in the first quarter of 2006, as a result of the decrease in systems productions and sales during the first quarter of 2007. Cost of revenue was 21% of revenue in Q1 2007 and 18% in Q1 2006, with the decrease in production the fixed cost variable in the cost of revenues equation become more significant in the comparative percentages.

Gross margin

Gross margin of $760,000 decreased 59% during the first quarter of 2007 when compared to $1,854,000 in the first quarter of 2006 and were 79% of revenue in Q1 2007 and 82% of revenue in Q1 2006. The decrease in production during the first quarter of 2007 as compared to the first quarter of 2006 had a larger component of fixed cost which limited our ability to reduce costs below a certain point.

Operating expenses

Operating expenses of $630,000 decreased 29% during the first quarter of 2007 when compared to $887,000 in the first quarter of 2006 and were 65% of revenue compared to 39% of revenue in the first quarter of 2006.

Selling, general and administrative expenses

Selling, general and administrative expense of $353,000 decreased 52% during the first quarter of 2007 when compared to $728,000 in the first quarter of 2006 and were 37% of revenue compared to 32% of revenue in the first quarter of 2006. Selling, general and administrative expense in Q1 2006 included $600,000 to a distributor as commission expense. Without this commission, selling, general and administrative expense would only have been $128,000 or 6% of revenue for Q1 2006 which was due to our limited operations at that time. The G&A expenses on an adjusted basis actually increased by $225,000 or 175% as we began to add permanent staff and reactivate our efforts to obtain FDA clearance.

Research and development

Research and development of $277,000 increased 75% during the first quarter of 2007 when compared to $158,000 in the first quarter of 2006 and were 29% of revenue compared to 7% of revenue in the first quarter of 2006. Although we had very limited research and development activity in the first quarter of 2006, we began to add staff and incur other development costs in our efforts to obtain FDA clearance through the latter part of 2006 and the first quarter of 2007.

Interest expense, net

Interest expense net for the first quarter of 2007 of $59,000 resulted from accrued interest of $68,000 on the prime +1% Novatrix note payable partially offset by $9,000 of interest earned on cash in bank.

Liquidity and Capital Resources

Our cash position is inadequate, and although we have identified potential sources of cash for future operations, there cannot be any assurance that we will receive these cash amounts, or that these cash amounts will be sufficient to assure continuing operations. The report of our Independent Registered Public Accounting Firm on our December 31, 2006 financial statements includes an explanatory paragraph indicating there is substantial doubt about our ability to continue as a going concern. We believe that we have a current plan to address these issues and enable us to continue operations. This plan includes obtaining additional equity or debt financing, the sale of assets, increasing product

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sales in existing markets, increasing sales of system upgrades, and further reductions in operating expenses as necessary. Although we believe that the plan will be realized, there is no assurance that these events will occur. In the event that we are unsuccessful in realizing the benefits of such plan, it is possible that we will seek bankruptcy protection. The March 31, 2007 unaudited financial statements do not include any adjustments to reflect the uncertainties related to the recoverability and classification of assets, or the amounts and classification of liabilities that may result from our inability to continue as a going concern.

At March 31, 2007, our "quick ratio" (cash and accounts receivable divided by current liabilities), a conservative liquidity measure designed to predict our ability to pay bills, was only .36. It has been difficult for us to meet obligations, including payroll, as they come due, and we expect this situation to continue through 2007.

Net cash used in operating activities was $785,000 for the three months ended March 31, 2007. This resulted primarily from income of $69,000, a decrease in unearned revenue of $810,000, an increase in inventory of $129,000 and an increase in other current assets of $77,000, offset in part by an increase in accounts payable of $48,000, an increase in accrued payroll and related expenses of $16,000 and an increase in accrued liabilities of $81,000.

The decrease in unearned revenue was primarily due to the recognition of unearned warranty revenues deferred from prior periods of $58,000 and the recognition of completed long term development projects of $752,000. The increase in inventory resulted from normal operational requirements for the development process. As a result of our past credit history we have been required by several suppliers to pre-pay or make a deposit on purchases and as a result other assets have increased. The increase in accrued liabilities was primarily the result of accrued interest on the Novatrix note.

Funds provided by financing activities for the three months ended March 31, 2007, were a result of scheduled advances on the Novatrix note.

We expect to derive most of the cash required to support our operations in 2007 through additional loans under the Novatrix note and sales of ROBODOC Systems, as well as from the sale of assets. Assuming the assets are not sold and we grant the license, we may not have enough cash to continue our Robodoc Systems operations and management may have to consider other alternatives. It is critical for us to maintain operations as a going concern in 2007. There can be no assurance that we can continue to convert inventory, collect receivables or raise additional funds on acceptable terms, if at all.

We do not have any material commitments for capital expenditures.

There are no seasonal aspects to our business.

We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, liquidity or capital resources that are material to our investors.

Critical Accounting Policies and Estimates

The preparation of our unaudited financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate the estimates, including those related to bad debts, inventories, warranties, contingencies and litigation. We base these estimates on historical experience and on other assumptions believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We have discussed our critical accounting policies with our Independent Registered Public Accounting Firm. Actual results may differ from these estimates under different assumptions or conditions.

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We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements:

We recognize revenue from sales of our products upon the completion of equipment installation and training at the end-user's site, except when the sales contract requires formal customer acceptance. Equipment sales with contractual customer acceptance provisions are recognized as revenue upon written notification of customer acceptance, which generally occurs after the completion of installation and training. Furthermore, due to business customs in Japan and the interpretation of Japanese law, all equipment sales to Japan are recognized after customer acceptance, which generally occurs after the completion of installation and training. Revenue related to maintenance and service contracts is recognized ratably over the duration of the contracts.

We periodically evaluate the need for allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

The Company writes down the inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those the Company projected, additional inventory write-downs may be required.