• When used as an indication of compromised cerebral oxygenation, interventions to return the patient's rSO2 to baseline using the INVOS System have been shown to improve outcomes after surgery.

• In neonates, infants and children, cerebral and somatic rSO2 provide noninvasive indications of oxygen changes in the cerebral and peripheral circulatory systems and may provide an early indication of oxygen deficits associated with impending shock states and anaerobiosis.

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 blood oxygen saturation in tissues beneath the sensor in four different places in the body in patients greater than 2.5 kilograms at risk for restricted or no blood flow, and also allows for the simultaneous monitoring of changes in blood oxygen saturation in four different places in the body in all individuals.
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,

• 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 have hired and 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.

• 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 Vital Sync System, 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 May 31, 2009 Compared to Three Months Ended May 31, 2008 Net Revenues. Our net revenues decreased $908,503, or seven percent, from $12,740,063 in the three-month period ended May 31, 2008 to $11,831,560 in the three-month period ended May 31, 2009. The decrease in net revenues is primarily attributable to a decrease in U.S. sales of $905,963, or nine percent, from $10,218,227 in the second quarter of fiscal 2008 to $9,312,264 in the second quarter of fiscal 2009. This decrease in U.S. sales was primarily due to a decrease in sales of the INVOS System monitor in the United States of $2,094,378, or 77%, primarily as a result of the current economic downturn in the United States that is affecting hospital budget spending and lengthening the sales cycle for our INVOS System monitor. The decrease in U.S. sales was partially offset by increased sales of our disposable sensors of $1,191,915, or 16%, primarily as a result of an 11% increase in sensor unit sales.
In the second quarter of fiscal 2009, international sales represented 21% of our net revenues, compared to 20% of our net revenues in the second quarter of fiscal 2008. Purchases by Covidien accounted for 11% of net revenues in the second quarter of fiscal 2009, compared to 12% in the same period of fiscal 2008.
We sold 79,624 disposable sensors in the United States and 41,640 internationally in the second quarter of fiscal 2009. We placed 111 INVOS System monitors in the United States and 136 internationally in the second quarter of fiscal 2009, and our installed base of INVOS System monitors in the United States was 2,711, in 751 hospitals, as of May 31, 2009.
Sales of our products as a percentage of net revenues were as follows:

                                          Three Months Ended May 31,
              Product                       2009                2008
              Sensors                           83 %                 68 %
              INVOS System Monitors             17 %                 32 %

We believe that the current economic downturn in the United States and abroad could continue to significantly lengthen the sales cycle for our products and reduce the growth in our net revenues in fiscal 2009. We expect international net revenues to increase beginning in February 2010 as a result of new prices negotiated as part of our distribution agreement extension with Covidien.
Gross Margin. Gross margin as a percentage of net revenues was 86% for the three months ended May 31, 2009 and 87% for the three months ended May 31, 2008. The decrease in our gross margin percentage is primarily attributable to decreased sales of the INVOS System monitor to pediatric hospitals in the United States

• a $93,357 increase in professional service fees, primarily due to increased legal and accounting fees associated with the establishment of Somanetics International BV and the related branches and operations;

• a $86,896 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; and

• a $62,025 increase in stock compensation expense due to stock compensation issued to our officers, employees, directors and one of our consultants in fiscal 2008 and 2009.

These increases were partially offset by a $245,226 decrease in commissions paid to our sales employees, and a $223,275 decrease in commissions paid to our independent sales representative firms as a result of lower second quarter 2009 sales and fewer independent sales representative firms in the second 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 sales and marketing expenses and increased stock compensation expenses.
Other Income. During the second quarter of fiscal 2009, interest income decreased to $328,836, from $700,685 in the second quarter of 2008, primarily due to the use of cash for the repurchase of common shares in 2008, decreased interest rates and decreased cash and cash equivalents balances, partially offset by our increased investment balances and cash provided by operating activities.
Income Taxes. During the second quarter of fiscal 2009 and 2008, we recognized income tax expense on our statement of operations at an estimated effective tax rate 38% and 36% respectively. We expect our effective tax rate for fiscal 2009 to approximate 37%.

• an increase in international sales of $1,158,097, or 31%, from $3,772,333 in the first six months of fiscal 2008 to $4,930,430 in the first six months 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 six months of fiscal 2009, international sales represented 21% of our net revenues, compared to 18% of our net revenues in the first six months of fiscal 2008. Purchases by Covidien accounted for 13% of net revenues in the first six months of fiscal 2009, compared to 10% of our net revenues in the same period of fiscal 2008.

We sold 152,266 disposable sensors in the United States and 82,330 internationally in the first six months of fiscal 2009. We placed 188 INVOS System monitors in the United States and 273 internationally in the first six months of fiscal 2009.
Sales of our products as a percentage of net revenues were as follows:

                                           Six Months Ended May 31,
               Product                      2009               2008
               Sensors                          82 %                74 %
               INVOS System Monitors            18 %                26 %

Gross Margin. Gross margin as a percentage of net revenues was 86% for the six months ended May 31, 2009 and 87% for the six months ended May 31, 2008. The decrease in our gross margin percentage is primarily attributable to increased international sales, due to the lower margins we receive on sales to our international distributors, and decreased sales of the INVOS System monitor to pediatric hospitals in the United States during the six month period. 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 sensors.
Research, Development and Engineering Expenses. Our research, development and engineering expenses increased $357,405, or 64%, from $562,337 in the first two quarters of fiscal 2008 to $919,742 in the first two quarters of fiscal 2009. The increase is primarily attributable to a $174,814 increase in salaries primarily due to the addition of research and development personnel in fiscal 2008 and 2009, $57,321 in development costs associated with our Contract Development Agreement with Shirley Research Corporation, $46,872 in development costs associated with our Vital Sync System, and $41,166 in development costs associated with our INVOS System and disposable sensor.

• a $440,624 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 $208,018 increase in stock compensation expense due to stock compensation issued to our officers, employees, directors and one of our consultants in fiscal 2008 and 2009; and

• a $201,031 increase in recruiting and training, primarily as a result of an increase in the number of employees, principally in sales and marketing.

These increases were partially offset by a $302,711 decrease in commissions paid to our sales employees, and a $400,515 decrease in commissions paid to our independent sales representative firms as a result of lower fiscal 2009 sales and fewer independent sales representative firms in 2009.
Other Income. During the first six months of fiscal 2009, interest income decreased to $600,221, from $1,635,102 in the first six months of 2008, primarily due to the use of cash for the repurchase of common shares in 2008, decreased interest rates and decreased cash and cash equivalents balances, partially offset by our increased investment balances and cash provided by operating activities.
Income Taxes. During the first six months of fiscal 2009 and 2008, we recognized income tax expense on our statement of operations at an estimated effective tax rate of 38% as a result of certain additional state tax expenses recorded in the first quarter.
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 May 31, 2009, we did not have any outstanding or available debt financing arrangements, we had working capital of $49.9 million and our primary sources of liquidity were $9.5 million of cash and cash equivalents, $30.4 million of marketable securities and $34.1 million of long-term investments. Marketable securities and long-term investments consist of Aaa-rated United States Government agency bonds, and cash and cash equivalents are currently invested in bank savings accounts and money market accounts, pending their ultimate use.
We believe that cash, cash equivalents, marketable securities and long-term investments on hand at May 31, 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 six months of fiscal 2009 and 2008 was $4,162,779 and $6,375,687, respectively. In the first six months of fiscal 2009, cash was provided primarily by:

• a $261,456 decrease in prepaid expenses, primarily due to the amortization of prepaid insurance payments paid in fiscal 2008; and

• a $106,405 decrease in accounts receivable, primarily as a result of lower second quarter sales in fiscal 2009 than in the fourth quarter of fiscal 2008, partially offset by less timely collections in the second quarter of 2009.

Cash provided by operations in the first six months of fiscal 2009 was partially offset by:
• an $839,528 increase in inventories, primarily due to the acquisition of components associated with our disposable sensors and our INVOS System monitor due to anticipated sales, and increased current inventory levels as a result of lower than expected second quarter 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;

• an $852,304 decrease in accrued liabilities, primarily as a result of the payment of year-end 2008 accruals, including incentive compensation and sales commissions, partially offset by accruals in fiscal 2009 for incentive compensation and sales commissions as a result of year to date financial performance;

• a $350,546 decrease in accounts payable, primarily as a result of timing of payments made to vendors, partially offset by increased inventories and operating expenses;

• a $158,450 increase in accrued interest income, primarily due to our increased marketable securities and long-term investment balances partially offset by decreased interest rates; and

• an $85,000 increase in deferred income tax benefits as a result of payments made for estimated alternative minimum tax that we expect will result in future tax credits when we use our net operating loss carryforwards.

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 $356,536 of costs from inventory for INVOS System monitors being used as demonstration units and no capital cost sales equipment at customers during the first six months of fiscal 2009, compared to $240,636 in the first six months of fiscal 2008. As of May 31, 2009, we have capitalized $4,151,736 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 $1,848,713. We depreciate these assets over five years.
Cash Flows From Investing Activities
Net cash used in investing activities in the first six months of 2009 was $31,911,424 and net cash provided by investing activities in the first six months of fiscal 2008 was $22,927,868. In the first six months of fiscal 2009, these expenditures were primarily for investments in marketable securities and long-term investments of $56,462,735, partially offset by maturities of marketable securities and long-term investments of $24,784,312.
Cash Flows From Financing Activities
Net cash provided by financing activities in the first six months of fiscal 2009 was $125,118 and net cash used in financing activities in the first six months of fiscal 2008 was $18,640,616. During the first six months of fiscal 2009, we issued 37,300 common shares as a result of the exercise of stock options by our employees, directors and an officer, for proceeds of $125,118.

. . .