Overview

The Company is a medical device manufacturer with revenues of $30.0 million for the year ended October 31, 2008. Domestic product sales and service revenue accounted for 79.4% of fiscal 2008 revenue while international product sales accounted for the remaining 20.6%.

The Company, through its Medical Graphics Corporation subsidiary, designs and markets non-invasive cardio-respiratory diagnostic systems that are sold under the MedGraphics and New Leaf brand and trade names. These cardio-respiratory diagnostic systems have a wide range of applications in healthcare, wellness and health and fitness. Revenue consists of equipment and supply sales as well as service revenue. Equipment and supply sales reflect sales of non-invasive cardio-respiratory diagnostic equipment and aftermarket sales of peripherals and supplies. Service revenue consists of revenue from extended service contracts, non-warranty service visits and additional training.

Revenue for fiscal 2008 decreased by 22.2% to $30.0 million compared to $38.6 million in 2007 while operating expense for fiscal 2008 was $16.2 million, a decrease of 9.4% from $17.9 million in 2007. Fiscal 2008 net loss was $0.7 million, or $0.17 per diluted share, compared to fiscal 2007 net income of $1.1 million, or $0.24 per diluted share, for the same period. During fiscal 2008, the Company concluded its clinical trial program with its largest clinical research customer. As a result of this event, year-over-year revenues were adversely impacted by $5.4 million.

During the first half of fiscal 2008, the Company terminated the employment of 17 employees to allow better management of operating expense and, as a result, recorded severance charges of $369,000. For fiscal 2009, the Company expects these actions to decrease operating expense by approximately $1.5 million.

The following table contains selected information from our historical consolidated statements of operations, expressed as a percentage of revenue:

                                       2008       2007

Revenue                                 100.0 %    100.0 %
Cost of revenue                          48.5       49.5
Gross margin                             51.5       50.5

Selling and marketing expenses           28.8       26.2
General and administrative expenses      14.6       10.9
Research and development expenses         8.1        7.3
Amortization of intangibles               2.5        1.9
Total operating expenses                 54.0       46.3
Operating income (loss)                  (2.5 )      4.2
Interest income                           0.5        0.4
Provision for taxes                       0.3        1.9
Net income (loss)                        (2.3 %)     2.7 %

Fiscal 2008 total revenues decreased 22.2% to $30.0 million compared to $38.6 million in fiscal 2007. Domestic product revenues decreased by 21.9% to $20.1 in 2008 compared to 2007 revenues of $25.7 million. International product revenue decreased 35.5% to $6.1 million in 2008 compared to $9.4 million in 2007. Service revenues increased 11.3% to $3.8 million in 2008 compared to $3.5 million in 2007. Revenue from extended service contracts and non-warranty service visits increased in 2008 as the installed customer base increased as a result of higher sales in fiscal 2007, as well as non-warranty service visits for clinical research customers in the first three quarters of fiscal 2008.

The Company sold cardiorespiratory diagnostic systems and services to its large clinical research customer that were used in conducting safety and efficacy clinical trials both in the United States and internationally. This customer accounted for 4.1% of revenues in fiscal 2008 compared to 17.3% in fiscal 2007. The Company completed its contract with this customer in the third quarter of 2008 and expects minimal revenue from this relationship in the future. Excluding sales to this customer, revenue for 2008 decreased by $3.2 million, or 9.8%, compared to 2007.

Gross margin percentage for 2008 increased to 51.5% of revenues compared to 50.5% in fiscal 2007. In 2008, the Company reported an increase in higher margin service revenues in both total dollars and as a percentage of revenue. In addition, the 2007 gross margin was adversely impacted by price discounts negotiated by our large clinical research customer.

During fiscal 2008, due to a change in accounting estimate, the inventory obsolescence reserve increased by $499,000 which negatively impacted gross margin. Excluding this impact, the Company's gross margin percentage would have increased to 53.2%. See note 3, "Inventories", in the consolidated financial statements for further discussion.

Selling and marketing expenses for fiscal 2008 decreased by 14.5% to $8.6 million compared to $10.1 million for fiscal 2007.

Selling and marketing expenses related to sales and sales support personnel, travel and customer support expenses decreased by 15.6%, or $870,000, for 2008 compared to 2007. The change is a result of the Company decreasing the number of personnel as a response to the slowing sales environment. Partially offsetting this decrease were expenses related to the representative branch office in Milan, Italy that increased by $113,000 in 2008 as the Company added additional headcount to assist in the delivery of marketing and technical support to the Company's European distribution partners. Finally, commission expenses decreased by $478,000 in 2008 compared to 2007 corresponding to the previously mentioned decrease in revenue.

General and administrative expenses for 2008 increased by 4.0%, or $170,000, to $4.4 million compared to $4.2 million in 2007.

Overall 2008 general and administrative expense was impacted by an increase in non-cash stock-based compensation expense of $277,000 as compared to 2007. The Company adopted Statement of Financial Accounting Standard No. 123(R), Share-Based Payment ("SFAS 123(R)"), on November 1, 2006, but did not issue any options until the fourth quarter of fiscal 2007. As a result, general and administrative as well as other operating expense categories increased in 2008 compared to the prior year. The Company recognized only $50,000 in non-cash stock-based compensation expense during 2007 related to general and administrative expenses compared to $327,000 in 2008.

Research and development expenses for 2008 decreased by 13.5%, or $383,000, to $2.4 million compared to the same period in 2007.

Personnel-related costs decreased by $261,000 in 2008, compared to the same period in 2007 as the Company reduced headcount in the current year. In addition, project expenses associated with new product development decreased by $178,000 for 2008 compared to 2007. The Company introduced the Platinum EliteTM during the second quarter of 2008. Much of the spending on the testing of the Platinum EliteTM occurred during fiscal 2007. The Company still continues to focus on other new product development initiatives, including products targeted for cardiology, dietary, asthma, allergy and primary care physicians, health and fitness club professionals, as well as international markets. In addition, the Company is also developing new functionality and new technologies for use in existing products.

Amortization of developed technology was $728,000 for 2008 compared to $733,000 in 2007. As further described in note 9 to the consolidated financial statements, "Income Taxes," in this Form 10-K, as the Company utilizes pre-emergence bankruptcy net operating loss ("NOL") carry forwards, the Company will reduce the value of developed technology until the net carrying value is zero. To the extent that utilization of these NOLs reduces the value of developed technology, future amortization expense will be reduced.

Interest income for the year ended 2008 decreased to $163,000 from $182,000 in 2007. While there was an increase in excess cash balances available for short-term investment, the decrease in interest income is principally due to the negative impact of lower interest rates in fiscal 2008.

The Company is required to present the provision for taxes as if it were fully taxable in accordance with SOP 90-7. The Company has utilized its pre-emergence bankruptcy NOLs in the

The Company has financed its liquidity needs over the last several years through revenue generated by the operations of its wholly owned subsidiary, Medical Graphics Corporation.

The Company had cash and cash equivalents of $9.0 million and working capital of $15.0 million as of October 31, 2008. During 2008, the Company generated $2.3 million in cash from operating activities, primarily from the change in accounts receivable that resulted in a cash inflow of $2.5 million. The decrease in accounts receivable reflects a year-over-year revenue decline of over 22% for 2008. Days sales outstanding ("DSO"), which measures how quickly receivables are collected, increased by 15 days between 2008 and 2007, improving cash flow. Cash flow was also improved by removing the non-cash impact on net income of the increase in inventory obsolescence of $499,000. This was a result of a change in estimate of inventory obsolescence due to changing economic conditions and aging related to inventory items.

Partially offsetting these cash inflows were a decrease of $753,000 in employee compensation accruals due to the reduced 2008 bonus payouts and an increase of $332,000 in gross inventory balances that were an effect of the decrease in sales.

During 2008, the Company used $203,000 in cash for the purchase of property and equipment. The Company has no material commitments for capital expenditures for fiscal year 2009.

An immaterial amount of cash was generated from financing activities in 2008. In 2007, $1.9 million in cash was generated from the exercise of options and warrants to purchase the Company's common stock and issuance of common stock under our employee stock purchase plan. The Company also realized $374,000 in tax benefits from stock options exercised during 2007.

The Company believes that its liquidity and capital resource needs for fiscal year 2009 will be met through its current cash and cash equivalents and cash flows from operations.

Critical Accounting Policies

Significant accounting policies adopted and applied by the Company are summarized in note 2 to the consolidated financial statements, "Summary of Significant Accounting Policies," which is included in this Form 10-K. Some of the more critical policies include revenue recognition, allowance for doubtful accounts, income taxes, and impairment of long-lived assets. The following accounting policies are considered by management to be the most critical to the presentation of the consolidated financial statements because they require the most difficult, subjective and complex judgments.

Revenue Recognition. In accordance with the SEC's Staff Accounting Bulletin No. 104, "Revenue Recognition," the Company recognizes revenue when persuasive evidence of an arrangement exists, transfer of title has occurred or services have been rendered, the selling price is fixed or determinable and collectability is reasonably assured. The Company's products are sold for cash or on

Service contract revenue is based on a stated contractual rate and is deferred and recognized ratably over the service period, which is typically from one to four years. In accordance with Emerging Issues Task Force Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables," the Company applies Financial Accounting Standards Board ("FASB") Technical Bulletin No. 90-1 for service contract revenue. Deferred income associated with service contracts and supplies was $2,005,000 and $2,120,000 as of October 31, 2008 and 2007, respectively. Revenue from installation and training services provided to domestic customers is deferred until the service has been performed. The amount of deferred installation and training revenue was $223,000 and $365,000 at October 31, 2008 and 2007, respectively.

When a sale involves multiple deliverables, such as equipment, installation services and training, the amount of the consideration from an arrangement is allocated to each respective element based on the residual method and recognized as revenue when revenue recognition criteria for each element is met. Consideration allocated to delivered equipment is equal to the total arrangement consideration less the fair value of installation and training. The fair value of installation and training services is based on specific objective evidence, including third-party invoices. The assumptions used in allocating the amount of consideration to each deliverable represent management's best estimates, but these estimates involve inherent uncertainties and the application of management judgment.

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

Allowance for Doubtful Accounts. The Company establishes estimates of the uncollectibility of accounts receivable. Management analyzes accounts receivable, historical write-offs of bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. The Company maintains an allowance for doubtful accounts at an amount that it estimates to be sufficient to provide adequate protection against losses resulting from collecting less than full payment on receivables. A considerable amount of judgment is required when assessing the realizability of receivables, including assessing the probability of collection and the current credit-worthiness of each customer. If the financial condition of the Company's customers were to deteriorate, resulting in an impairment of their ability to make payments, an additional provision for doubtful accounts might be required. For the year ended October 31, 2008, the allowance for doubtful accounts increased by $198,000 from the prior year end.

Income Taxes. The Company utilizes the asset and liability method of accounting for income taxes. The Company recognizes deferred tax assets or liabilities for the expected future tax consequences of temporary differences between the book and tax bases of assets and liabilities. Each quarter, the Company assesses the likelihood that its deferred tax assets will be recovered from future taxable income. The analysis to determine the amount of the valuation allowance is highly judgmental and requires weighing positive and negative evidence including historical and projected future taxable income and ongoing tax planning strategies. While the Company was profitable for nine consecutive quarters through

The Company believes more historical data is needed before the valuation allowance should be reduced. Based upon management's assessment of all available evidence, the Company determined that it is more likely than not as of October 31, 2008 that none of its deferred tax assets will be realized. Therefore, at October 31, 2008, a full valuation allowance of $7.8 million has been established against the net deferred tax asset. If the Company determines that it has become more likely than not that part of or all its deferred tax assets will be realized, the Company will be required to partially or fully reduce this valuation allowance. If the Company reduces the valuation allowance, it will be required to allocate this reduction between pre and post bankruptcy deferred tax assets in the following manner:

• Under the application of AICPA SOP 90-7, when the valuation allowance relating to pre-emergence bankruptcy net operating loss and other deferred tax assets is reversed, tax benefits aggregating $4.7 million will be credited first to identifiable intangible assets arising from the bankruptcy and then to additional paid-in capital.

• The valuation allowance related to post bankruptcy net operating losses and other deferred tax assets is approximately $3.1 million. An aggregate of $2.3 million of the $3.1 million will first affect earnings as a reduction in the provision for taxes and thereafter, the remaining $0.8 million will increase additional paid-in capital as these deferred tax assets represent employee stock-based compensation tax deductions included in the Company's net operating losses.

The allocation of the benefits realized from the reduction in the valuation allowance for deferred tax assets in interim and annual periods will require significant judgment to attribute the reduction to pre and post bankruptcy deferred tax assets. This may result in significant fluctuations in the provision for taxes for financial reporting purposes in future interim or annual periods.

Stock-Based Compensation. On November 1, 2006, we adopted the fair value recognition provisions of SFAS 123(R). We apply the provision of SFAS 123(R) to new stock option grants. Compensation expense calculated under SFAS 123(R) is amortized to compensation expense on a straight-line basis over the vesting period of the underlying stock option grants.

Determining the appropriate fair value model and calculating the fair value of share-based payment awards requires the input of highly subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. We use the Black-Scholes option-pricing model to value our stock option awards. The assumptions used in calculating the fair value of share-based payment awards represent management's best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and management uses different assumptions, share-based compensation expense could be materially different in the future. We are required to estimate the expected term and forfeiture rate and only recognize expense for those shares expected to vest. If the actual forfeiture rate is materially different from the estimate, share-based compensation expense could be significantly different from what has been recorded in the current period.

Impairment of Long-Lived Assets. The Company assesses the recoverability of long-lived assets whenever events or changes in circumstances indicate that expected future undiscounted cash flows might not be sufficient to support the carrying value of an asset. Recoverability of assets to be held and used is measured by a comparison of the carrying value of an asset to future net cash flows expected to be generated by the asset. If these assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying value of the assets exceeds the fair value of the assets.

Foreign Currency Exchange Risk

All sales made by the Company's Medical Graphics subsidiary are denominated in U.S. dollars. The Company does not currently and does not intend in the future to utilize derivative financial instruments for trading or hedging purposes.

The Company's foreign subsidiaries located in Germany are not operating currently and are being liquidated. Balances remaining with these subsidiaries are currently minimal and the corresponding exposure to foreign exchange rate fluctuations is likewise minimal.

Recently Issued Accounting Standards

In May 2008, the FASB issued FASB Staff Position (FSP) Financial Accounting Standard (FAS) 142-3, Determination of the Useful Life of Intangible Assets, which is effective for fiscal years beginning after December 15, 2008 and for interim periods within those years. FSP FAS 142-3 provides guidance on the renewal or extension assumptions used in the determination of the useful life of a recognized intangible asset. The intent of FSP FAS 142-3 is to better match the useful life of the recognized intangible asset to the period of the expected cash flows used to measure its fair value. The Company does not expect FSP FAS 142-3 to have a material effect on its consolidated financial statements.

In May 2008, the FASB issued Statements of Financial Standards No. 162 (SFAS 162), The Hierarchy of Generally Accepted Accounting Principles. SFAS 162 is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with U.S. generally accepted accounting principles (GAAP) for nongovernmental entities.

Prior to the issuance of SFAS 162, GAAP hierarchy was defined in the American Institute of Certified Public Accountants (AICPA) Statement on Auditing Standards No. 69 (SAS 69), The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles.SAS 69 has been criticized because it is directed to the auditor rather than the entity. SFAS 162 addresses these issues by establishing that the GAAP hierarchy should be directed to entities because it is the entity (not its auditor) that is responsible for selecting accounting principles for financial statements that are presented in conformity with GAAP.

SFAS 162 is effective 60 days following the SEC's approval of the Public Company Accounting Oversight Board Auditing amendments to AU Section 411, "The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles." The Company does not expect SFAS 162 to have a material effect on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements ("SFAS No. 157"), which is effective for fiscal years beginning after November 15, 2007 and for interim periods within those years. This statement defines fair value, establishes a framework for measuring fair value and expands the related disclosure requirements. The Company is currently evaluating the impact of SFAS No. 157 on its consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141 (revised 2007) Business Combinations (SFAS No. 141(R)). SFAS No. 141(R) retains the fundamental requirements of the original pronouncement requiring that the purchase method be used for all business combinations. SFAS No. 141(R) defines the acquirer as the entity that obtains control of one or more businesses in the business combination, establishes the acquisition date as the date that the acquirer achieves control and requires the acquirer to recognize the assets acquired, liabilities assumed and any noncontrolling interest at their fair values as of the acquisition date. SFAS No. 141(R) also requires that acquisition-related costs be recognized separately from the acquisition. SFAS No. 141(R) is effective for fiscal years beginning on or after December 15, 2008. The Company is currently assessing the impact of SFAS No. 141(R) on its consolidated financial statements.

In July 2006, the Financial Accounting Standards Board issued FASB Interpretation 48, Accounting for Uncertainty in Income Taxes: an interpretation of FASB Statement No. 109. Interpretation 48, which clarifies Statement 109, Accounting for Income Taxes, establishes the criterion that an individual tax . . .