Natus®, AABR ®, ABaer®, ALGO®, AuDX ®, Biliband®, Bio-logic®, Ceegraph®, CHAMP®, Cool-Cap®, Ear Couplers®, Flexicoupler ®, MASTER®, Navigator®, neoBLUE ®, Oxydome®, Sleepscan®, Smart Scale®, Sonamed®, Traveler®, Warmette® and VAC PAC ® are registered trademarks of Natus Medical Incorporated. Accuscreen™, Bili-Lite Pad™, Bili-Lite™, Billi Bassinet™, Bili Mask™, Bili Meter™, Circumstraint™, EchoLink™, MiniMuffs™, Neometrics™, Papoose Board™, Smartpack™, Sonamed Clarity™, and Warm Lamp™ are non-registered trademarks of Natus. Solutions for Newborn CareSM is a non-registered service mark of Natus. Deltamed® and Coherence® are registered trademarks of Deltamed SA. Fischer-Zoth ®, AOAE®, Cochlea Scan® and Echo Screen ® are registered trademarks of Fischer-Zoth GmbH. Sleeprite® is a registered trademark of Excel-Tech Ltd. Neuromax™ and Xltek™ are non-registered trademarks of Excel-Tech Ltd.

Overview

The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") supplements the MD&A in the Annual Report on Form 10-K for the year ended December 31, 2007 of Natus Medical Incorporated ("Natus," "we," "us," or "our Company"), and presumes that readers have read or have access to the discussion and analysis in the Company's Annual Report. Management's discussion and analysis should be read in conjunction with the Company's condensed consolidated financial statements and accompanying footnotes, the discussion of certain risks and uncertainties contained in Part II, Item 1A of this report, and the cautionary information regarding forward-looking statements at the end of this section. MD&A includes the following sections:

• Our Business. A general description of the Company's business;

• Application of Critical Accounting Policies. A discussion of the accounting policies that are most important to the portrayal of the Company's financial condition and results of operations and that require significant estimates, assumptions, and judgments;

• Results of Operations. An analysis of the Company's results of operations for the periods presented in the financial statements;

• Liquidity and Capital Resources. An analysis of capital resources, sources and uses of cash, investing and financing activities, off-balance sheet arrangements, contractual obligations and interest rate hedging;

• Recent Accounting Pronouncements. See Note 1 to our Condensed Consolidated Financial Statements for a discussion of new accounting pronouncements that affect us; and

• Cautionary Information Regarding Forward-Looking Statements. Cautionary information about forward-looking statements.

Business

Natus is a provider of healthcare products used for the screening, detection, treatment, monitoring and tracking of common medical ailments such as hearing impairment, neurological dysfunction, epilepsy, sleep disorders, and newborn care. We develop, manufacture, and market advanced neurodiagnostic and newborn care products to healthcare professionals in over 100 countries. Our product offerings include computerized neurodiagnostic systems for audiology, neurology, polysomnography, and neonatology, as well as newborn care products such as hearing screening systems, phototherapy devices for the treatment of newborn jaundice, head-cooling products for the treatment of brain injury in newborns, and software systems for managing and tracking disorders and diseases for public health laboratories.

We have completed a number of acquisitions since 2003, consisting of either the purchase of a company, substantially all of the assets of a company, or individual products or product lines. The businesses we have acquired include Neometrics in 2003, Fischer-Zoth in 2004, Bio-logic, Deltamed, and Olympic in 2006, Xltek in 2007 and Sonamed and the neurology business of Schwarzer GmbH as of September 30, 2008.

Product Families

We categorize our products into the following product families, which are more fully described in our Annual Report on Form 10-K for the year ended December 31 2007:

• Hearing - Includes products for newborn hearing screening and diagnostic hearing assessment.

• Newborn Care - Includes products for the treatment of brain injury and jaundice in newborns.

• Neurology - Includes product lines for diagnostic electroencephalography ("EEG") analysis, diagnostic sleep analysis ("PSG"), electromyography ("EMG"), intra-operative monitoring ("IOM"), and newborn brain monitoring.

Segment and Geographic Information

We operate in one reportable segment in which we provide healthcare products used for the screening, detection, treatment, monitoring and tracking of common medical ailments such as hearing impairment, neurological dysfunction, epilepsy, sleep disorders and newborn care, including jaundice, brain injury, and metabolic testing.

Our end-user customer base includes hospitals, clinics, laboratories, physicians, nurses, audiologists, and governmental agencies. Most of our international sales are to distributors who resell our products to end users or sub-distributors.

Information regarding our sales and long-lived assets in the U.S. and in countries outside the U.S. is contained in Note 12- Segment, Customer and Geographic Information of our condensed consolidated financial statements included in this report.

Revenue by Product Category

We generate our revenue either from sales of Devices and Systems, which are generally non-recurring, and from related Supplies and Services, which are generally recurring. The products that are attributable to these categories are described in our Annual Report on Form 10-K for the year ended December 31, 2007. Revenue from Devices and Systems, and Supplies and Services, as a percent of total revenue for the three and nine months ended September 30, 2008 and 2007 is as follows:

                                          Devices     Supplies
                                            and         and
                                          Systems     Services     Other     Total
       Three months ended September 30,
       2008                                    61 %         37 %       2 %     100 %
       2007                                    62 %         37 %       1 %     100 %
       Nine months ended September 30,
       2008                                    62 %         36 %       2 %     100 %
       2007                                    60 %         38 %       2 %     100 %

Sales to no single end-user customer comprised more than 10% of our revenue, and revenue from services was less than 10% of our revenue in all periods presented.

We sell our products primarily through a direct sales force in the U.S. and to distributors who sell our products in over 100 other countries. We intend to continue expansion of our international operations because we believe international markets represent a significant growth opportunity. International sales made to distributors are characterized by lower gross profits due to the discount from our list prices that the distributors receive. International sales contributed to 28% and 30% of our revenue during the three and nine months ended September 30, 2008, respectively, and to 31% and 32% of our revenue during the same periods in 2007. We anticipate that international revenue will increase as a percentage of revenue in the future.

2008 Third Quarter Overview

Our revenue increased 44.7% to $41.7 million in the third quarter ended September 30, 2008, compared to $28.8 million reported in the comparable quarter of the previous year. Net income increased 51.8% to $4.8 million, or $0.17 per diluted share, for the third quarter of 2008, compared with net income of $3.2 million, or $0.14 per diluted share, for the third quarter of 2007.

On July 2, 1008, we acquired Schwarzer Neurology, a division of Schwarzer GmbH for EUR 4.4 million, or approximately $6.9 million including direct costs of the acquisition. Schwarzer Neurology develops and markets computer-based electrodiagnostic systems and disposable supplies used by medical practitioners to aid in the detection, diagnosis, and monitoring of neurologic disorders.

On October 2, 2008 we acquired all of the common stock of NeuroCom International, Inc. ("NeuroCom") for $18 million in cash, excluding direct costs of the acquisition. NeuroCom, based in Clackamas, Oregon, develops and markets computerized systems for the assessment and rehabilitation of balance and mobility disorders.

Application of Critical Accounting Policies

We prepare our financial statements in accordance with accounting principles generally accepted in the United States of America ("GAAP"). In so doing, we must often make estimates and use assumptions that can be subjective and, consequently, our actual results could differ from those estimates. For any given individual estimate or assumption we make, there may also be other estimates or assumptions that are reasonable.

We believe that the following critical accounting policies require the use of significant estimates, assumptions, and judgments. The use of different estimates, assumptions, and judgments could have a material affect on the reported amounts of assets, liabilities, revenue, expenses, and related disclosures as of the date of the financial statements and during the reporting period.

• Revenue recognition

• Allowance for doubtful accounts

• Inventory is carried at the lower of cost or market value

• Carrying value of intangible assets

• Share-based compensation

These critical accounting policies are described in more detail in our Annual Report on Form 10-K for the year ended December 31, 2007, under Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations. There have been no changes to these policies during the three and nine months ended September 30, 2008.

Results of Operations

The following table sets forth, for the periods indicated, selected consolidated
statements of operations data as a percentage of total revenue. Our historical
operating results are not necessarily indicative of the results for any future
period.



                                           Three Months Ended         Nine Months Ended
                                                June 30,                September 30,
                                           2008           2007         2008         2007
Revenue                                     100.0 %        100.0 %      100.0 %     100.0 %
Cost of revenue                              38.0           35.1         38.2        36.2

Gross profit                                 62.0           64.9         61.8        63.8

Operating expenses:
Marketing and selling                        23.9           23.4         24.5        23.9
Research and development                      9.7           13.5         10.1        14.4
General and administrative                   11.8           12.7         12.8        13.5

Total operating expenses                     45.4           49.6         47.4        51.8

Income from operations                       16.6           15.3         14.4        12.0
Other income, net                             1.4            0.7          0.8         0.8

Income before provision for income tax       18.0           16.0         15.2        12.8
Income tax provision                          6.5            5.0          5.7         4.5

Net income                                   11.5 %         11.0 %        9.5 %       8.3 %

We acquired Xltek in November 2007, Sonamed in May 2008, and Schwarzer Neurology in July 2008. Where significant, we have noted the impact of these acquisitions on our results of operations for the three and nine months ended September 30, 2008, as compared to the same periods in 2007.

Three Months Ended September 30, 2008 and 2007

Revenue increased $12.9 million, or 45%, to $41.7 million in the three months ended September 30, 2008, compared to $28.8 million in the same period in 2007. Xltek contributed to $9.8 million of the increase.

Revenue from devices and systems increased $7.7 million, or 43%, to $25.5 million in the three months ended September 30, 2008, compared to $17.9 million in the same period 2007. Xltek contributed to $7.5 million of revenue from devices and systems. In addition, we experienced an increase in revenue from our newborn and diagnostic hearing products and newborn care products that was partially offset by reductions in revenue from our Bio-logic diagnostic neurology products.

Revenue from supplies and services increased $5.1 million, or 50%, to $15.4 million in the third quarter of 2008 compared to $10.3 million in the 2007 third quarter. Xltek contributed to $2.2 million of the increase. Revenue from disposable supplies used with the Company's newborn hearing screening devices increased $1.8 million, or 22%, to $9.6 million.

Revenue from sales outside the U.S. increased $2.7 million, or 30%, to $11.8 million in the third quarter of 2008 compared to $9.1 million for the same period in 2007. Xltek and Schwarzer Neurology contributed to $2.7 million of the increase, respectively.

Gross profit as a percentage of revenue was 62.0% for the three months ended September 30, 2008 compared to 64.9% for the respective period in 2007. The results of Schwarzer Neurology and product mix reduced consolidated gross profit for the three months ended September 30, 2008, compared to the same period in 2007. Cost of revenue increased $5.7 million, or 56%, to $15.8 million in the three months ended September 30, 2008, from $10.1 million in 2007. Gross profit increased $7.2 million, or 38%, to $25.9 million in 2008 from $18.7 million in 2007.

Total operating costs increased by $4.7 million, or 32%, to $18.9 million in the three months ended September 30, 2008, compared to $14.3 million in the same period in 2007. The operations of Xltek, Sonamed, and Schwarzer Neurology contributed to $3.6 million of the increase in operating costs. The net increase in total operating costs from factors other than the foregoing was primarily attributable to increases in outside consulting costs and employee compensation.

Marketing and selling expenses increased $3.2 million, or 48%, to $10.0 million in the three months ended September 30, 2008 compared to $6.8 million in the same period in 2007. The operations of Xltek, Sonamed, and Schwarzer Neurology contributed to $1.9 million of the increase in marketing and selling expense, including the compensation of Xltek sales personnel who became employees of the Natus domestic sales organization effective January 1, 2008. The remainder of the increase was primarily due to increased sales compensation, related travel expenses, and commission payments to distributors of the Company's diagnostic hearing products.

Research and development expenses increased $187,000, or 4.8%, to $4.1 million for in the three months ended September 30, 2008 compared to $3.9 million in the same period in 2007. The operations of Xltek, Sonamed, and Schwarzer Neurology resulted in an increase of $969,000 of research and development expenses, which were offset by a reduction in other research and development costs resulting primarily from restructuring activities implemented after the acquisition of Xltek in November 2007. Research and development expenses as a percent of total revenue decreased from 13.5% in the three months ended September 30, 2007 to 9.7% for the three months ended September 30, 2008.

General and administrative expenses increased $1.3 million, or 34%, to $4.9 million in the three months ended September 30, 2008 compared to $3.7 million in the same period in 2007. The operations of Xltek, Sonamed, and Schwarzer Neurology contributed to $708,000 of the increase in general and administrative expenses. Outside services, consulting costs associated with our information technology infrastructure, and higher compensation costs accounted for the remainder of the cost increase.

The Company adopted an integration and restructuring plan in February 2008 that was designed to eliminate redundant costs resulting from prior acquisitions and to improve efficiencies in operations. These actions were phased in during the first nine months of 2008. Costs under the plan, which were primarily for severance benefits, stay bonuses, and duplicative salaries, totaled approximately $700,000. These expenses were incurred approximately ratably from the time employees were notified of the plan through their targeted separation-of-employment date. The Company accrued $64,000 and $301,000 of employee termination benefits in the three and nine months ended September 30, 2008. The plan is expected to result in annual operating cost reduction of approximately $2.4 million in 2009 and beyond. The Company had no similar costs in the respective period in 2007.

Other income, net consists of investment income and net capital gains and losses from our investment portfolio, interest expense, net currency exchange gains and losses, and other miscellaneous income and expenses. We reported net other income of $567,000 in the three months ended September 30, 2008, compared to $213,000 in the same period in 2007 due primarily to interest income and foreign currency gains, partially offset by interest expense.

We recorded income tax expense of $2.7 million in the three months ended September 30, 2008, compared to $1.5 million in the same period in 2007. Our effective tax rate in the third quarter of 2008 was 36.1% compared to an effective rate of 32.0% in the third quarter of 2007. The lower effective tax rate in 2007 was primarily attributable to discrete tax adjustments including a true-up of research and development tax credits for which there were not corresponding items in 2008.

Nine Months Ended September 30, 2008 and 2007

Certain reclassifications have been made to the breakdown of revenue from devices and systems versus supplies and services in the results for the nine months ended September 30, 2007 to conform to the current presentation.

Revenue increased $34.3 million, or 41%, to $118.4 million in the nine months ended September 30, 2008, compared to $84.1 million reported in the same period in 2007. Xltek contributed to $28.3 million of the increase.

Revenue from devices and systems increased $21.5 million, or 41%, to $73.8 million in the nine months ended September 30, 2008, compared to $52.3 million reported in the same period in 2007. Xltek contributed to $21.1 million of this increase. Revenue from our newborn hearing and newborn care products was partially offset by decreases in revenue from our other diagnostic neurology products.

Revenue from supplies and services increased $12.6 million, or 42%, to $42.4 million in the nine months ended September 30, 2008, compared to $29.8 million reported in the same period in 2007. Xltek contributed to $6.9 million of the increase. Revenue from disposable supplies used with the Company's newborn hearing screening devices increased 15%, to $26.1 million.

Revenue from sales outside the U.S. increased $8.9 million, or 34%, to $35.2 million for the nine months ended September 30, 2008, compared to $26.3 million reported in the same period in 2007. Xltek and Schwarzer Neurology contributed to $6.0 million of the increase. Revenue from the Company's newborn care products and hearing screening products also contributed to the increase.

Gross profit as a percentage of revenue was 61.8% for the nine months ended September 30, 2008 compared to 63.8% for the respective period in 2007. The results of Xltek and Schwarzer Neurology, and product mix reduced consolidated gross profit for the nine months ended September 30, 2008, compared to the same period in 2007. Cost of revenue increased $14.8 million, or 48%, to $45.2 million in the nine months ended September 30, 2008, from $30.5 million in 2007. Gross profit increased $19.6 million, or 36%, to $73.2 million in 2008 from $53.7 million in 2007.

Total operating costs increased by $12.6 million, or 29%, to $56.2 million in the nine months ended September 30, 2008, compared to $43.6 million in the same period in 2007. The operations of Xltek, Sonamed, and Schwarzer Neurology contributed to $9.7 million of the increase in operating costs. The net increase in total operating costs from factors other than the foregoing was primarily attributable to increases in employee compensation and outside consulting costs.

Marketing and selling expenses increased $8.9 million, or 44%, to $29.0 million in the nine months ended September 30, 2008 from $20.1 million in the same period in 2007. The operations of Xltek, Sonamed, and Schwarzer Neurology contributed to $5.0 million of the increase, including the compensation of Xltek sales personnel who became employees of the Natus domestic sales organization effective January 1, 2008. The remainder of the increase came primarily from increased sales compensation, related travel expenses, and commission payments to distributors of the Company's diagnostic hearing products.

Research and development expenses decreased $114,000, or 0.9%, to $12.0 million in the nine months ended September 30, 2008 from $12.1 million in 2007. The operations of Xltek, Sonamed, and Schwarzer Neurology resulted in an increase of $2.6 million in research and development expenses, which was offset by a reduction in other research and development costs resulting from leveraging investments in infrastructure made in 2007. Research and development expenses as a percent of total revenue decreased from 14.4% in the nine months ended September 30, 2007, to 10.1% for the respective period in 2008.

General and administrative expenses increased $3.8 million, or 34%, to $15.2 million in the nine months ended September 30, 2008 from $11.4 million in the same period in 2007. The operations of Xltek, Sonamed, and Schwarzer Neurology contributed to $2.1 million of the increase. A reduction of general and administrative expenses as a percent of total revenue from 13.5% reported for the nine months ended September 30, 2007, to 12.8% for the respective period in 2008 resulted primarily from synergies associated with the acquisition of Xltek and leveraging investments in infrastructure made in 2007.

The Company adopted an integration and restructuring plan in February 2008 that was designed to eliminate redundant costs resulting from prior acquisitions and to improve efficiencies in operations. These actions were phased in during the first nine months of 2008. Costs under the plan, which were primarily for severance benefits, stay bonuses, and duplicative salaries, totaled approximately $700,000. These expenses were incurred approximately ratably from the time employees were notified of the plan through their targeted separation-of-employment date. The Company accrued $64,000 and $301,000 of employee termination benefits in the three and nine months ended September 30, 2008. The plan is expected to result in annual operating cost reduction of approximately $2.4 million in 2009 and beyond. The Company had no similar costs in the respective period in 2007.

Other income, net consists of investment income and net capital gains and losses from our investment portfolio, interest expense, net currency exchange gains and losses, and other miscellaneous income and expenses. We reported net other income of $954,000 in the nine months ended September 30, 2008, compared to $688,000 in the same period in 2007 due primarily to interest income and foreign currency gains, partially offset by interest expense.

We recorded income tax expense of $6.8 million in the nine months ended September 30, 2008, compared to $3.8 million in the same period in 2007. Our effective tax rate in the first nine months of 2008 was 37.8% compared to an effective rate of 35.2% in the first nine months of 2007. The lower effective tax rate in 2007 was primarily attributable to discrete tax adjustments including a true-up of research & development tax credits for which there were no corresponding items in 2008.

Liquidity and Capital Resources

Liquidity is our ability to generate sufficient cash flows from operating activities to meet our obligations and commitments. In addition, liquidity includes the ability to obtain appropriate financing or to raise capital. Therefore, liquidity cannot be considered separately from capital resources that consist of our current funds and the potential to increase those funds in the future. We plan to use our capital resources in meeting our commitments and in achieving our business objectives.

As of September 30, 2008, we had cash and cash equivalents of $68.0 million, short-term investments of $1.0 million, stockholders' equity of $229.0 million, and working capital of $107.2 million, compared with cash and cash equivalents of $11.9 million, stockholders' equity of $115.7 million, and working capital of $19.2 million as of December 31, 2007. In early October 2008 we completed the acquisition of NeuroCom for $18 million in cash, excluding costs of the acquisition.

We believe that our current cash, cash equivalents, and short-term balances, including cash generated from the underwritten sales of our common stock in April and May 2008, and any cash generated from operations, will be sufficient to meet our ongoing operating and capital requirements for the foreseeable future. We have completed three acquisitions in 2008, including the NeuroCom acquisition in the fourth quarter of 2008, one in 2007 and three in 2006. We intend to continue to acquire additional technologies, products or businesses, and these acquisitions could be significant. These actions would likely affect our future capital requirements and the adequacy of our available funds. We may be required to raise additional funds through public or private financings, strategic relationships, or other arrangements. Any equity financing may be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants and increase our cost of capital.

On September 2, 2008, the Company executed the Second Amendment to its Amended and Restated Credit Agreement (the "Second Amendment") with Wells Fargo Bank, National Association ("Wells Fargo"). The Second Amendment increases the borrowing limit of the Company's Revolving Line of Credit to $25 million and makes other changes to the terms of the credit facility. The credit facility contains covenants, including covenants relating to liquidity and other financial measurements, and provides for events of default, including failure to pay any interest when due, failure to perform or observe covenants, bankruptcy or insolvency events and the occurrence of a material adverse effect. The Company has granted Wells Fargo a security interest in all of the assets of the Company.

Cash provided by operations decreased by $1.5 million for the nine months ended . . .