Summary of SOMANETICS CORP

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS August 31, 2009 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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 provides accurate, real-time blood oxygen measurements in the brain and elsewhere in the body in tissues beneath the sensor in patients greater than 2.5 kilograms, and continuously measures changes in blood oxygen levels for individuals of any weight. The INVOS System is the only commercially-available cerebral/somatic oximeter proven to improve outcomes.
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. In April 2009, we received 510(k) clearance from the FDA to expand the indications for use to reflect the INVOS System's ability to provide accurate, immediate blood oxygen saturation measurements in patients greater than 2.5 kilograms at risk for restricted or no blood flow, in addition to our previous FDA clearance to measure changes in blood oxygen saturation in any individual. In addition, this most recent 510(k) clearance expanded the labeling for our INVOS System to include the following new marketing claims:
• The measurement of regional cerebral oxygen saturation (rSO2) is an indication of whether oxygen delivery to the brain is adequate. Prolonged declines in rSO2are indicative of, or may result in, potential brain injury.

• 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.

SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS August 31, 2009 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 launched our newly-acquired data integration technology as a stand-alone device we call Vital Sync™ in the third quarter of fiscal 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, upon launching our Vital Sync System and gaining market experience with the stand-alone device, we expect to begin to invest to combine the ICU Data Systems and INVOS System technologies in a single product. Upon completion of development of a single product combining the Vital Sync System with our INVOS System technology, we also plan to pursue a new FDA 510(k) clearance for this integrated device.
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 Vital Sync System, which we launched as a stand-alone device in the third quarter of 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 20% to our first nine months of 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.
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 have hired and are planning to hire direct salespersons and clinical specialists in Europe to support Covidien. We expect selling, general and administrative expenses to increase in fiscal 2009, as a result of these hirings, and as a result of increased sales and marketing expenses and stock compensation expenses. In addition, we expect our selling, general and administrative expenses to increase in fiscal 2010, primarily as a

SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS August 31, 2009 result of the lease agreement that we have entered into for our new corporate headquarters and assembly and storage facility, and the patent infringement action that we have filed against CAS Medical Systems, Inc. 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 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 August 31, 2009 Compared to Three Months Ended August 31, 2008
Net Revenues. Our net revenues increased $145,147, or 1%, from $12,367,988 in the three-month period ended August 31, 2008 to $12,513,135 in the three-month period ended August 31, 2009. The increase in net revenues is primarily attributable to an increase in U.S. sales of $979,433, or 10%, from $9,399,612 in the third quarter of fiscal 2008 to $10,379,045 in the third quarter of fiscal 2009. This increase in U.S. sales was primarily due to an increase in sales of our disposable sensors of $1,017,245, or 13%, primarily as a result of a 10% increase in sensor unit sales.
The increase in U.S. sales was partially offset by a decrease in international sales of $834,286, or 28%, from $2,968,376 in the three month period ended August 31, 2008 to $2,134,090 in the three month period ended August 31, 2009. This decrease was primarily due to a $1,064,206, or 58%, decrease in sales of the INVOS System monitor, primarily to Covidien in Europe, as a result of the current economic downturn internationally that is affecting hospital budget spending and lengthening the sales cycle for our INVOS System monitor. This decrease was partially offset by a $229,920, or 20%, increase in sales of our disposable sensors, primarily to Covidien in Europe.
In the third quarter of fiscal 2009, international sales represented 17% of our net revenues, compared to 24% of our net revenues in the third quarter of fiscal 2008. Purchases by Covidien accounted for 12% of net revenues in the third quarter of fiscal 2009, compared to 19% in the same period of fiscal 2008.
We sold 83,540 disposable sensors in the United States and 48,590 internationally in the third quarter of fiscal 2009. We placed 89 INVOS System monitors in the United States and 87 internationally in the third quarter of fiscal 2009, and our installed base of INVOS System monitors in the United States was 2,800, in 765 hospitals, as of August 31, 2009.
Sales of our products as a percentage of net revenues were as follows:

                             SOMANETICS CORPORATION
               MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
                      CONDITION AND RESULTS OF OPERATIONS
                                August 31, 2009

                                         Three Months Ended August 31,
              Product                       2009                2008

              Sensors                           84 %                 75 %
              INVOS System Monitors             16 %                 25 %

Total 100 % 100 %

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 88% for the three months ended August 31, 2009 and 86% for the three months ended August 31, 2008. The increase in our gross margin percentage is primarily attributable to decreased international sales, due to the lower margins we receive on sales to our international distributors. We expect international gross margin to increase beginning in February 2010 as a result of new prices negotiated as part of our distribution agreement extension with Covidien.
Research, Development and Engineering Expenses. Our research, development and engineering expenses increased $143,948, or 43%, from $332,236 in the third quarter of fiscal 2008 to $476,184 in the third quarter of fiscal 2009. The increase is primarily attributable to a $120,860 increase in salaries, primarily due to the addition of research and development personnel in fiscal 2008 and 2009, and $83,138 in development costs associated with our Contract Development Agreement with Shirley Research Corporation and the development of our Vital Sync System, partially offset by a $78,153 decrease in development cost associated with our INVOS System and disposable sensor. 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.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $1,122,347, or 18%, from $6,155,551 for the three months ended August 31, 2008 to $7,277,898 for the three months ended August 31, 2009, primarily due to:
• a $557,210 increase in salaries, wages and related expenses, primarily as a result of an increase in the number of employees, principally in sales and marketing (from an average of 105 employees for the three months ended August 31, 2008 to an average of 126 employees for the three months ended August 31, 2009) and an increase in employee insurance premiums;

• a $406,841 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, and legal fees associated with corporate and intellectual property matters;

• a $216,305 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, sales training and advertising expenses;

• a $86,797 increase in office and administrative expenses, primarily due to the addition of new employees during fiscal 2009 and the establishment of Somanetics International BV and the hiring of employees in the related branches and operations; and

SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS August 31, 2009 • a $35,516 increase in stock compensation expense due to stock compensation issued to our officers, employees, directors and one of our consultants in fiscal 2009.

These increases were partially offset by a $187,704 decrease in commissions paid to our sales employees, and a $62,698 decrease in commissions paid to our independent sales representative firms as a result of lower third quarter 2009 sales and fewer independent sales representative firms in the third 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. In addition, we expect our selling, general and administrative expenses to increase in fiscal 2010, primarily as a result of the lease agreement that we have entered into for our new corporate headquarters and assembly and storage facility, and the patent infringement action that we have filed against CAS Medical Systems, Inc.
Other Income. During the third quarter of fiscal 2009, interest income decreased to $312,271, from $562,178 in the third 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 third quarter of fiscal 2009 and 2008, we recognized income tax expense on our statement of operations at an estimated effective tax rate 37% and 36% respectively. During fiscal 2009, we have begun to recognize deferred tax assets related to the exercise of stock options in prior years. These assets have been recognized as an increase in additional paid in capital on our balance sheet because they were utilized and reduced current taxes payable. We expect our effective tax rate for fiscal 2009 to approximate 37%.
Nine Months Ended August 31, 2009 Compared to Nine Months Ended August 31, 2008
Net Revenues. Our net revenues increased $1,698,723, or 5%, from $33,801,326 in the nine-month period ended August 31, 2008 to $35,500,049 in the nine-month period ended August 31, 2009. The increase in net revenues is primarily attributable to:
• an increase in U.S. sales of $1,374,911, or 5%, from $27,060,617 in the first nine months of fiscal 2008 to $28,435,528 in the first nine months of fiscal 2009. The increase was primarily due to an increase in sales of the disposable sensors of $3,428,090, or 15%, primarily as a result of an 11% increase in sensor unit sales. This increase was partially offset by a decrease in sales of the INVOS System monitor in the United States of $2,011,502, or 42%, 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; and

• an increase in international sales of $323,812, or 5%, from $6,740,709 in the first nine months of fiscal 2008 to $7,064,521 in the first nine months of fiscal 2009. The increase in international sales was primarily due to increased sales of our disposable sensors of $837,600, or 29%, primarily as a result of purchases by Covidien in Europe. This increase was partially offset by a decrease in sales of the INVOS System monitor internationally of $513,788, or 13%, primarily due to reduced purchases by Covidien in Europe as a result of the current economic downturn internationally that is affecting hospital budget spending and lengthening the sales cycle for our INVOS System monitor. In the first nine months of fiscal 2009 and 2008, international sales represented 20% of our net revenues. Purchases by Covidien accounted for 13% of net revenues in the first nine months of fiscal 2009, compared to 14% of our net revenues in the same period of fiscal 2008.

                             SOMANETICS CORPORATION
               MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
                      CONDITION AND RESULTS OF OPERATIONS
                                August 31, 2009
   We sold 235,806 disposable sensors in the United States and 130,920
internationally in the first nine months of fiscal 2009. We placed 277 INVOS
System monitors in the United States and 360 internationally in the first nine
months of fiscal 2009.
   Sales of our products as a percentage of net revenues were as follows:

                                         Nine Months Ended August 31,
              Product                       2009                2008

              Sensors                           83 %                 74 %
              INVOS System Monitors             17 %                 26 %

Total 100 % 100 %

Gross Margin. Gross margin as a percentage of net revenues was 87% for the nine months ended August 31, 2009 and August 31, 2008. During the first nine months of fiscal 2009, we realized a 4% increase in the average selling price of disposable sensors in the United States as a result of increased sales of our pediatric sensor, which sells for a higher price than the adult sensor. The increase in average selling prices described above was offset by decreased sales of the INVOS System monitor to pediatric hospitals in the United States during the period.
Research, Development and Engineering Expenses. Our research, development and engineering expenses increased $501,352, or 56%, from $894,574 in the first three quarters of fiscal 2008 to $1,395,926 in the first three quarters of fiscal 2009. The increase is primarily attributable to a $295,674 increase in salaries, primarily due to the addition of research and development personnel in fiscal 2008 and 2009, and $203,431 in development costs and expenses associated with our Contract Development Agreement with Shirley Research Corporation and the development of our Vital Sync System, partially offset by a $36,987 decrease in development costs associated with our INVOS System and disposable sensor.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $2,342,272, or 12%, from $19,423,534 for the nine months ended August 31, 2008 to $21,765,806 for the nine months ended August 31, 2009, primarily due to:
• a $1,577,350 increase in salaries, wages and related expenses, primarily as a result of an increase in the number of employees, principally in sales and marketing (from an average of 102 employees for the nine months ended August 31, 2008 to an average of 121 employees for the nine months ended August 31, 2009) and an increase in employee insurance premiums;

• a $656,929 increase in travel, marketing and selling-related expenses as a result of our increased sales personnel and increased sales and marketing activities, including sales training, trade shows and advertising expenses;

• a $317,152 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, and legal fees associated with corporate and intellectual property matters;

• a $243,535 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;

• a $242,607 increase in office and administrative expenses, primarily due to the addition of new employees during fiscal 2009 and the establishment of Somanetics International BV and the hiring of employees in the related branches and operations, and costs associated with terminating our CorRestore license; and

• a $216,043 increase in recruiting and training, primarily as a result of an increase in the number of employees, principally in sales and marketing.

SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS August 31, 2009 These increases were partially offset by a $490,415 decrease in commissions paid to our sales employees, and a $463,213 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 nine months of fiscal 2009, interest income decreased to $912,493, from $2,197,280 in the first nine 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 nine months of fiscal 2009, 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. In addition, during fiscal 2009, we have begun to recognize deferred tax assets related to the exercise of stock options in prior years. These assets have been recognized as an increase in additional paid in capital on our balance sheet because they were utilized and reduced current taxes payable. During the first nine months of fiscal 2008, we recognized income tax expense at an estimated effective tax rate of 37%. 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 August 31, 2009, we did not have any outstanding or available debt financing arrangements, we had working capital of $59.7 million and our primary sources of liquidity were $20.7 million of cash and cash equivalents, $29.0 million of marketable securities and $28.0 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.
On August 7, 2009, Somanetics filed a patent infringement action against CAS Medical Systems, Inc. in the United States District Court for the Eastern District of Michigan. The complaint asserts that CAS Medical's FORE-SIGHT® Cerebral Oximeter willfully infringes upon one or more of Somanetics' patents. The complaint also asserts that CAS Medical has engaged in unfair competition and false advertising, by making false or misleading statements in connection with its advertising and promotion of FORE-SIGHT, and false or misleading statements related to Somanetics' products. The complaint seeks, among other things, compensation for damages and an injunction against CAS Medical from infringing upon Somanetics' patents. CAS Medical Systems, Inc.'s CEO has stated that he does not believe CAS Medical has infringed on these patents or engaged in unfair competition and that it intends to vigorously defend all of the claims. We expect our selling, general and administrative expenses to increase in fiscal 2010, in part as a result of this patent infringement action.
We believe that cash, cash equivalents, marketable securities and long-term investments on hand as of August 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 nine months of fiscal 2009 and 2008 was $7,930,407 and $11,192,542, respectively. In the first nine months of fiscal 2009, cash was provided primarily by:

SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL . . .