Summary of SOMANETICS CORP

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS February 28, 2009 Forward-Looking Statements
You should read the following discussion and analysis of our financial condition and results of operations together with our financial statements and the related notes and other financial data included elsewhere in this report. Some of the information contained in this discussion and analysis or set forth elsewhere in this report, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. You should review the "Risk Factors" section of our Annual Report on Form 10-K for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. See also "Forward-Looking Statements" in Item 1A of our Annual Report on Form 10-K.
Overview
We develop, manufacture and market the INVOS System, a non-invasive patient monitoring system that continuously measures changes in the blood oxygen levels in the brain and elsewhere in the body in tissues beneath the sensor in patients with or at risk for restricted blood flow. We are currently expanding the use of our INVOS System in the pediatric and neonatal ICU's with the launch of our smaller sensor in the first half of fiscal 2008.
In November 2005, we received 510(k) clearance from the FDA to market our INVOS System to monitor changes in somatic tissue blood oxygen saturation in regions of the body other than the brain in patients with or at risk for restricted blood flow. In May 2008, we received 510(k) clearance from the FDA to market our INVOS System to monitor changes in blood oxygen saturation in any tissues beneath the sensor, not limited to brain and somatic tissue, in any individual. Our four-channel cerebral and somatic INVOS System monitor, which we launched in the second quarter of 2006, can display information from four disposable sensors. This feature allows for the simultaneous monitoring of changes in blood oxygen saturation in tissues beneath the sensor in four different places in the body in patients with or at risk for restricted blood flow, in somatic tissue.
In November 2008, we acquired substantially all of the assets of ICU Data Systems, Inc., a technology development company, for approximately $2,000,000 in cash plus the assumption of specified liabilities. ICU Data Systems has developed a patented technology that integrates data from a broad array of hospital bedside devices, such as physiological monitors, ventilators and infusion devices, into a single bedside display for comparison, data management and storage. We plan to further develop and launch our newly-acquired data integration technology as a stand-alone device in mid-2009. The INVOS System is one of many devices whose data can be integrated into the stand-alone device. To support the addition of the derived parameter features to the system, we will pursue a new FDA 510(k) clearance in 2009. In addition, we expect to invest to combine the ICU Data Systems and INVOS System technologies in a single product for launch expected in the second half of 2010. We also plan to pursue a new FDA 510(k) clearance for this integrated device in 2010.
Net Revenues and Cost of Sales
We derive our revenues primarily from sales of INVOS Systems to hospitals in the United States through our direct sales team and independent sales representative firms, although we expect to derive modest revenues in fiscal 2009 from our newly-acquired data integration technology, which we plan to launch as a stand-alone device in mid-2009 through our direct sales team. Outside the United States, we have distribution agreements with independent distributors for the INVOS System, including Covidien in Europe, Canada, the Middle East and South Africa, and Edwards Lifesciences Ltd. in Japan. Our cost of sales represent the cost of producing monitors and disposable sensors. Revenues from outside the United States contributed 22 percent to our first quarter fiscal 2009 net revenues. As a percentage of net revenues, the gross margins from our international sales are typically lower than gross margins from our U.S. sales, reflecting the difference between the prices we receive from distributors and from direct customers.

SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS February 28, 2009 We offer to our customers in the United States a no capital cost sales program whereby we ship the INVOS System monitor to the customer at no charge. Under this program, we do not recognize any revenue upon the shipment of the monitor. At the time of shipment of the monitor, we capitalize the monitor as an asset and depreciate this asset over five years, and this depreciation is included in cost of goods sold. We recognize sensor revenue when we receive purchase orders and ship the product to the customer.
Operating Expenses
Selling, general and administrative expenses generally consist of:

• salaries, wages and related expenses of our employees and consultants;

• sales and marketing expenses, such as employee sales commissions, commissions to independent sales representatives, travel, entertainment, advertising, education and training expenses, depreciation of demonstration monitors and attendance at selected medical conferences;

• clinical research expenses, such as costs of supporting clinical trials; and

• general and administrative expenses, such as the cost of corporate operations, professional services, stock compensation, insurance, warranty and royalty expenses, investor relations, depreciation and amortization, facilities expenses and other general operating expenses.

We have increased the size of our direct sales team and expect to increase the size of our U.S. direct sales team in fiscal 2009. In addition we are planning to hire direct salespersons and clinical specialists in Europe to support Covidien. We also expect increased sales and marketing expenses and increased stock compensation expenses in fiscal 2009. As a result, we expect selling, general and administrative expenses to increase in fiscal 2009.
Research, development and engineering expenses consist of:

• salaries, wages and related expenses of our research and development personnel and consultants;

• costs of various development projects; and

• costs of preparing and processing applications for FDA clearance of new products.

We expect our research, development and engineering expenses to increase in fiscal 2009 primarily as a result of development costs associated with development of our newly-acquired data integration technology as a stand-alone device, development of a single product combining the data integration technology with our INVOS System technology, development costs associated with advances to the design and performance features of the INVOS System, including the disposable sensor, development costs associated with our Contract Development Agreement with Shirley Research Corporation and the hiring of additional research and development personnel. Results of Operations
Three Months Ended February 28, 2009 Compared to Three Months Ended February 29, 2008
Net Revenues. Our net revenues increased $2,462,080, or 28 percent, from $8,693,274 in the three-month period ended February 29, 2008 to $11,155,354 in the three-month period ended February 28, 2009. The increase in net revenues is primarily attributable to:
• an increase in U.S. sales of $1,301,442, or 17 percent, from $7,442,777 in the first quarter of fiscal 2008 to $8,744,219 in the first quarter of fiscal 2009. This increase was primarily due to an increase in sales of the disposable sensor of $1,218,930, or 18 percent, primarily as a result of a 13 percent increase in sensor unit

SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS February 28, 2009 sales. In addition, sales of the INVOS System Monitor in the United States increased $102,188, or 13 percent, primarily as a result of increased purchases by pediatric hospitals.

• an increase in international sales of $1,160,638, or 93 percent, from $1,250,497 in the first quarter of fiscal 2008 to $2,411,135 in the first quarter of fiscal 2009. The increase in international sales was primarily due to increased purchases of our INVOS System monitor and disposable sensors by Covidien in Europe. In the first quarter of fiscal 2009, international sales represented 22 percent of our net revenues, compared to 14 percent of our net revenues in the first quarter of fiscal 2008. Purchases by Covidien accounted for 15 percent of net revenues in the first quarter of fiscal 2009.

We sold 72,642 disposable sensors in the United States and 40,690 internationally in the first quarter of fiscal 2009. We placed 77 INVOS System monitors in the United States and 137 internationally in the first quarter of fiscal 2009, and our installed base of INVOS System monitors in the United States was 2,600, in 725 hospitals, as of February 28, 2009.
Sales of our products as a percentage of net revenues were as follows:

                                              Three Months Ended
          Product                  February 28, 2009       February 29, 2008

          Sensors                              81 %                      83 %
          INVOS System Monitors                19 %                      17 %

          Total                               100 %                     100 %

We believe that the current economic downturn in the Untied States and abroad could significantly lengthen the sales cycle for our products and reduce the growth in our net revenues in fiscal 2009.
Gross Margin. Gross margin as a percentage of net revenues was 86 percent for the three months ended February 28, 2009 and 88 percent for the three months ended February 29, 2008. The decrease in our gross margin percentage is primarily attributable to increased international sales, due to lower margins we receive on sales to our international distributors. This decrease was partially offset by a five percent increase in the average selling price of disposable sensors in the United States, which is attributable to increased sales of our pediatric sensors, which sell for a higher price than the adult sensor.
Research, Development and Engineering Expenses. Our research, development and engineering expenses increased $92,725, or 28 percent, from $330,436 in the first quarter of fiscal 2008 to $423,161 in the first quarter of fiscal 2009. The increase is primarily attributable to an increase in salaries due to the addition of research and development personnel in fiscal 2008 and 2009. We expect our research, development and engineering expenses to increase in fiscal 2009 primarily as a result of development costs associated with development of our newly-acquired data integration technology as a stand-alone device, development of a single product combining the data integration technology with our INVOS System technology, development costs associated with advances to the design and performance features of the INVOS System, including the disposable sensor, development costs associated with our Contract Development Agreement with Shirley Research Corporation and the hiring of additional research and development personnel.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $816,551, or 13 percent, from $6,498,148 for the three months ended February 29, 2008 to $7,314,699 for the three months ended February 28, 2009, primarily due to:

SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS February 28, 2009 • a $371,629 increase in salaries, wages, commissions and related expenses, primarily as a result of an increase in the number of employees, principally in sales and marketing (from an average of 99 employees for the three months ended February 29, 2008 to an average of 115 employees for the three months ended February 28, 2009) and an increase in employee insurance premiums;

• a $350,119 increase in travel, marketing and selling-related expenses as a result of our increased sales personnel and increased sales and marketing activities, including trade shows and sales training;

• a $145,993 increase in stock compensation expense due to stock compensation issued to our officers, employees, directors and one of our consultants in fiscal 2007 and 2008;

• a $128,412 increase in recruiting and training, primarily as a result of an increase in the number of employees, principally in sales and marketing;

• a $111,791 increase in office and administrative expenses, due to increased employees and costs associated with terminating our CorRestore license; and

• a $58,121 increase in accrued incentive compensation expense due to our year-to-date 2009 financial performance, primarily increased sales and operating income in accordance with the 2009 incentive compensation plans.

These increases were partially offset by a $183,046 decrease in professional service fees due to decreased auditing, tax, and legal fees and a $177,240 decrease in commissions paid to our independent sales representative firms as a result of fewer independent sales representative firms in the first quarter of 2009.
We expect our selling, general and administrative expenses to increase in fiscal 2009, primarily as a result of our hiring additional direct sales personnel in fiscal 2008 and 2009, increased employee sales commissions payable as a result of increased sales, increased sales and marketing expenses and increased stock compensation expenses.
Other Income. During the first quarter of fiscal 2009, interest income decreased to $271,386, from $934,418 in the first quarter of 2008, primarily due to decreased interest rates and the use of cash for the repurchase of common shares in fiscal 2008, partially offset by our increased investment balances and our cash provided by operating activities.
Income Taxes. During the first quarter of fiscal 2009 and 2008, we recognized income tax expense on our statement of operations at an estimated effective tax rate of 38 percent and 42 percent, respectively, as a result of certain additional state tax expenses recorded in the quarter. We expect our effective tax rate for fiscal 2009 to approximate 37 percent. Liquidity and Capital Resources
General
Our principal sources of operating funds have been the proceeds from sales of our common shares and cash provided by operating activities.
As of February 28, 2009, we did not have any outstanding or available debt financing arrangements, we had working capital of $53.2 million and our primary sources of liquidity were $23.9 million of cash and cash equivalents, $20.0 million of marketable securities and $27.6 million of long-term investments. Marketable securities and long-term investments consist of Aaa-rated United States Government agency bonds and treasury bills, and cash and cash equivalents are currently invested in bank savings accounts and money market accounts, pending their ultimate use.

SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS February 28, 2009 We believe that cash, cash equivalents, marketable securities and long-term investments on hand at February 28, 2009 will be adequate to satisfy our operating and capital requirements for more than the next twelve months.
Cash Flows From Operating Activities
Net cash provided by operations during the first quarter of fiscal 2009 and 2008 was $1,704,128 and $3,040,071, respectively. In the first quarter of fiscal 2009, cash was provided primarily by:
• $2,678,839 of income before income taxes and non-cash depreciation, amortization and stock compensation expense; and

• a $674,461 decrease in accounts receivable, primarily as a result of lower first quarter sales in fiscal 2009 than in the fourth quarter of fiscal 2008, partially offset by increased international sales in the first quarter of 2009 which have longer payment terms, and less timely collections.

Cash provided by operations in the first quarter of fiscal 2009 was partially offset by:
• a $1,028,800 decrease in accrued liabilities, primarily as a result of the payment of year-end 2008 accruals, including incentive compensation and sales commissions;

• a $391,424 increase in inventories, primarily due to the acquisition of components associated with our disposable sensors and our INVOS System monitor due to anticipated sales; inventories on our balance sheet increased less because we capitalized INVOS System monitors to property and equipment that are being used as demonstration units and no capital cost sales equipment, as described below; and

• a $200,288 decrease in accounts payable, primarily as a result of timing of payments made to vendors.

We expect our working capital requirements to increase as sales increase.

The increase in inventories described above is greater than shown on our balance sheet because it includes INVOS System monitors that we capitalized because they are being used as demonstration units and no capital cost sales equipment. We capitalized $151,493 of costs from inventory for INVOS System monitors being used as demonstration units and no capital cost sales equipment at customers during the first quarter of fiscal 2009, compared to $107,889 in the first quarter of fiscal 2008. As of February 28, 2009, we have capitalized $4,037,213 in costs for INVOS System monitors being used as demonstration and no capital cost sales equipment, and these assets have a net book value of $1,810,407. We depreciate these assets over five years.
Cash Flows From Investing Activities
Net cash used in investing activities in the first quarter of fiscal 2009 was $14,923,469 and net cash provided by investing activities in the first quarter of 2008 was $19,073,602. In the first quarter of fiscal 2009, net cash used in investing activities was primarily for investments in marketable securities and long-term investments, net of proceeds of maturities, of $14,819,555.
Cash Flows From Financing Activities
No net cash was provided by financing activities in the first quarter of fiscal 2009, and $219,043 was provided in the first quarter of fiscal 2008 as a result of the exercise of stock options.

SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS February 28, 2009 Contractual Obligations
As of February 28, 2009, there have been no material changes outside the ordinary course of business in the contractual obligations disclosed in our Annual Report on Form 10-K for the fiscal year ended November 30, 2008 under the caption "Contractual Obligations."
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements or financing activities. Critical Accounting Policies
We believe our most significant accounting policies relate to our accounting treatment of stock compensation of employees, our accounting treatment for income taxes, our revenue recognition associated with our no capital cost sales program and our recognition of a technology acquisition cost intangible asset and goodwill.
Stock Compensation
For the first quarter of fiscal 2009, we have recorded stock compensation expense of $384,430 as a result of stock options and restricted common shares granted to our officers, employees, directors and one of our consultants during fiscal 2008, fiscal 2007 and fiscal 2006. For the first quarter of fiscal 2008, we recorded stock compensation expense of $238,437. During the first quarter of fiscal 2009, no stock options were granted and we issued 8,588 restricted common shares to our employees with a market price of $16.31 per share on the date of grant. During the first quarter of fiscal 2008, we issued 5,273 restricted common shares to our employees with a market price of $21.81 per share on the date of grant.
As of February 28, 2009, there was $5,003,431 of total unrecognized compensation cost related to nonvested share-based compensation awards granted under the 2005 Plan. That cost is expected to be recognized over a weighted average period of approximately 4 years. No modifications were made to any share awards that required an accounting charge, and no cash was paid for share-based liabilities during the first quarter of fiscal 2009 or during the first quarter of fiscal 2008.
The fair value of the stock option grants was estimated on the date of grant using the Black-Scholes option-pricing model with assumptions regarding expected volatility (the measure by which the stock price has fluctuated or is expected to fluctuate during the period), risk-free interest rate (approximate U.S. Treasury yield in effect at the time of grant), expected lives and dividend yields. The fair value of the restricted common shares was estimated based on the market value of the common shares on the date of issuance. Different assumptions could significantly change the calculated grant date fair value, and, therefore, the amount of stock compensation expense we recognize over the vesting period of the awards. We believe, however, that our estimates are appropriate.
Income Taxes
We have performed the required assessment of positive and negative evidence regarding realization of our deferred tax assets in accordance with SFAS No. 109, including our past operating results, the existence of cumulative losses over our history up to the most recent six fiscal years, and our forecast for future net income. Our assessment of our deferred tax assets included making assumptions about the growth of our net revenues and pre-tax income in future years, making allowance for the uncertainties regarding, among other things, our future rate of growth in net revenues, the rate of adoption of our products in the marketplace, and the potential for competition to enter the marketplace. As of February 28, 2009, we have also concluded that it is more likely than not that approximately $1,753,000 of such assets will be realized.

SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS February 28, 2009 Given the assumptions inherent in our financial plans, it is possible to calculate a different value for our deferred tax asset by changing one or more of the variables in our assessment. However, we believe that our evaluation of our financial plans was reasonable, and that the judgments and assumptions that we made at the time of developing the plan were appropriate.
During the first quarter of fiscal 2009, we recorded income tax expense on our statement of operations at an estimated effective tax rate of 38 percent as a result of certain additional state tax expenses recorded in the quarter. We expect our effective tax rate for fiscal 2009 to approximate 37 percent.
No Capital Cost Sales Revenue Recognition We offer to our customers in the United States a no capital cost sales program whereby we ship the INVOS System monitor to the customer at no charge. Under this program, we do not recognize any revenue upon the shipment of the INVOS System monitor. We recognize sensor revenue when we receive purchase orders and ship the product to the customer. At the time of shipment of the monitor, we capitalize the INVOS System monitor as an asset and depreciate this asset over five years. We believe this is consistent with our stated revenue recognition policy, which is compliant with Staff Accounting Bulletin No. 104, and we have considered Emerging Issues Task Force No. 00-21, "Revenue Arrangements with Multiple Deliverables." Technology Acquisition Costs Intangible Asset and Goodwill Technology acquisition costs and goodwill are related to our November 2008 acquisition of substantially all of the assets of ICU Data Systems, Inc., a technology development company, for approximately $2,000,000 in cash plus the assumption of specified liabilities. Goodwill represents the amount by which the purchase price of the acquired business exceeds the estimated fair value of the net tangible and separately identifiable intangible assets of the acquired business, in addition to transaction costs recorded at cost. Goodwill is not amortized, but is tested at least annually for impairment. The technology acquisition costs intangible asset has an estimated useful life of 20 years, based on several patents that we have filed related to the technology, and will be amortized on a straight-line basis over the estimated useful life. Intangible assets and goodwill are reviewed annually for impairment at the end of our fiscal year, and whenever events or changes in circumstances indicate that the carrying value of the asset may not be recovered. We evaluate impairment by comparing the fair value of the intangible asset, determined using a cash flow method, with its carrying value.
We estimated the value of the technology acquisition costs intangible asset based on a valuation model that included estimating the future cash flows of the technology and discounting the net cash flows back to their present value using an appropriate risk-adjusted rate of return (discount rate). The discount rate used was determined at the time of the acquisition in accordance with accepted valuation methods. Our assessment of the estimated fair value included making assumptions about the expected net revenues and operating income related to the acquired technology in future years, making allowance for the uncertainties regarding, among other things, the time and cost associated with the further advancement of the design and performance of the technology to ready it for market launch, the rate of adoption of the technology once it is launched into the marketplace, and the potential for competition related to the launched technology. As of February 28, 2009, the carrying value of the technology acquisition costs intangible asset was $243,239 and the carrying value of the goodwill was $1,679,713.
Given the assumptions inherent in our valuation model, it is possible to calculate a different value for our technology acquisition costs intangible asset by changing one or more of the variables within our model. However, we believe that our evaluation of our valuation model was reasonable, and that the judgments and assumptions that we made at the time of developing the model upon acquisition of ICU Data Systems, Inc. were appropriate.