Overview

The following "Management's Discussion and Analysis of Financial Condition and Results of Operations," commonly referred to as MD&A, is intended to help the reader understand Synergetics USA, its operations and its

business environment. MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated audited financial statements and accompanying notes. This overview summarizes the MD&A, which includes the following sections:

• Our Business - a general description of the key drivers that affect our business and the industries in which we operate.

• Our Business Strategy - a description of the strategic initiatives on which we focus and the goals we seek to achieve.

• Results of Operations - an analysis of the Company's results of operations for the three years presented in our financial statements.

• Liquidity and Capital Resources - an analysis of cash flows, sources and uses of cash, currency exchange and an overview of our financial position.

• Contractual Obligations - an analysis of contracts entered into in the normal course of business that will require future payments.

• Use of Estimates and Critical Accounting Policies - a description of critical accounting policies including those that affect the more significant judgments and estimates used in the preparation of our consolidated financial statements.

Our Business

The Company is a medical device company. Through continuous improvement and development of our people, our mission is to design, manufacture and market innovative microsurgical instruments and consumables of the highest quality in order to assist and enable surgeons who perform microsurgery around the world to provide a better quality of life for their patients. The Company's primary focus is on the microsurgical disciplines of ophthalmology and neurosurgery. Our distribution channels include a combination of direct and independent sales organizations and important strategic alliances with market leaders. The Company's product lines focus upon precision engineered, microsurgical, hand-held instruments and the microscopic delivery of laser energy, ultrasound, electrosurgery, aspiration, illumination and irrigation, often delivered in multiple combinations. Enterprise-wide information is included in Note 16 to the consolidated audited financial statements.

New Product Sales

The Company's business strategy has been, and is expected to continue to be, the development, manufacture and marketing of new technologies for microsurgery applications including the ophthalmic and neurosurgical markets. New products, which management defines as products first available for sale within the prior 24-month period, accounted for approximately 6.8 percent of total sales for the Company for fiscal 2009, or approximately $3.6 million. For fiscal 2008, new products accounted for approximately 17.2 percent of total sales for the Company, or approximately $8.6 million. This continued growth was primarily in our capital equipment and disposable products both in the ophthalmic and neurosurgical markets. The Company's past revenue growth has been closely aligned with the adoption by surgeons of new technologies introduced by the Company. Since August 1, 2008, the Company has introduced 18 new catalogue items to the ophthalmic and neurosurgical markets. We expect adoption rates for the Company's new products in the future to have a positive effect on its operating performance.

Growth in Minimally Invasive Surgery Procedures

Minimally invasive surgery is surgery performed without making a major incision or opening. Minimally invasive surgery generally results in less patient trauma, decreased likelihood of complications related to the incision and a shorter recovery time. A growing number of surgical procedures are performed using minimally invasive techniques, creating a multi-billion dollar market for the specialized devices used in the procedures. Based on our micro-instrumentation capability, we believe we are ideally positioned to take advantage of this growing market. The Company has developed scissors having a single activating shaft as small as 30 gauge (0.012 inch, 0.3 millimeter in diameter). We also believe that we are the world leader in small-fiber illumination technology as our Photontm and Photontm II light sources can transmit more light through a fiber of 300 micron diameter or smaller

than any other light source in the world. This product was developed for ophthalmology but has wide ranging minimally invasive surgical applications. The Company's Malis® line of electrosurgical bipolar generators is the market share leader in neurosurgical generators worldwide. These generators produce a unique and patented waveform that has been developed and refined over many decades and has proven to cause less collateral tissue damage as compared to other competing generators. The Omni® power ultrasound system technology provides a new method for the minimally invasive removal of soft and fibrotic tissue, as well as bone removal. This technology is in its infancy, and we anticipate that, once fully developed, it will become a standard of care in multiple minimally invasive surgical applications. The Company has benefited from the overall growth in this market and expects to continue to benefit as it continues to introduce new and improved technologies targeting this market.

Demand Trends

Increased international sales contributed to the majority of sales growth for the Company during the fiscal year ended July 31, 2009. A recent study performed for the Company by Market Scope LLC predicts a steady growth of 3.4 percent per year in vitrectomy surgery worldwide. Neurosurgical procedures volume on a global basis continues to rise at an estimated 5.0 percent growth rate driven by an aging global population, new technologies, advances in surgical techniques and a growing global market resulting from ongoing improvements in healthcare delivery in third world countries, among other factors. In addition, the demand for high quality products and new technologies, such as the Company's innovative instruments and disposables, to support growth in procedures volume continues to positively impact growth. The Company believes innovative surgical approaches will continue to significantly impact the ophthalmic and neurosurgical market.

Pricing Trends

Through its strategy of delivering new and higher quality technologies, the Company has generally been able to maintain the average selling prices for its products in the face of downward pressure in the healthcare industry. However, increased competition in the market for the Company's capital equipment market segments in combination with customer budget constraints and capital scarcity, has in some instances negatively impacted the Company's selling prices on these devices.

Economic Trends

Economic conditions may continue to negatively impact capital expenditures at the hospital or surgical center and doctor level. Further, economic conditions in the United States are negatively impacting the volume of the Company's capital equipment sales. Therefore, the Company only experienced a 5.8 percent increase in sales during the 2009 fiscal year as compared to a compound annual growth rate of approximately 10 percent in fiscal 2008.

Our Business Strategy

The Company's key strategy is to enhance shareholder value through profitable revenue growth in ophthalmology and neurosurgery markets through the identification and development of reusable and disposable instrumentation in conjunction with leading surgeons and marketing partners and to build out a strong operational infrastructure and financial foundation within which prudently financed growth opportunities can be realized and implemented. At the same time, we will maintain vigilance and sensitivity to new challenges which may arise from changes in the definition and delivery of appropriate healthcare in our fields of interest. For additional detail on the Company's Strategy, see

Results of Operations

Year Ended July 31, 2009 Compared to Year Ended July 31, 2008

Net Sales

The following table presents net sales by category (dollars in thousands):


                                                             Year Ended July 31,          % Increase
                                                             2009            2008         (Decrease)

Ophthalmic                                                $    29,981      $ 28,019               7.0 %
Neurosurgery                                                   13,968        12,925               8.1 %
Marketing partners (Codman, Stryker and Iridex)                 8,538         8,347               2.3 %
Other                                                             478           772             (38.1 )%

Total                                                     $    52,965      $ 50,063               5.8 %

Ophthalmic sales growth for fiscal 2009 was led by growth in sales of disposable products which includes illumination products, laser probes and sales of new disposable packs. When comparing neurosurgery, net sales during the fiscal year ended 2009 were 8.1 percent greater than 2008, primarily attributable to the sales of disposable products related to electrosurgical generators and power ultrasonic aspirators. Sales to our marketing partners were up 2.3 percent to $8.5 million for the fiscal year ending July 31, 2009 primarily due to disposable products sold to Codman and Iridex and sales of pain control generators to Stryker, partially offset by a decrease in capital equipment sold to Codman due to the current economic environment. The Company expects that the Vitratm laser and Malis® electrosurgical generator sales will improve as signs of an economic turnaround are beginning to take shape, and that the related disposables will continue to have a positive impact on net sales, in fiscal 2010.

The following table presents domestic and international net sales (dollars in thousands):

                                                             Year Ended July 31,
                                                             2009            2008        % Increase

United States (including sales to marketing partners)     $    36,047      $ 35,838              0.6 %
International (including Canada)                               16,918        14,225             18.9 %

Total                                                     $    52,965      $ 50,063              5.8 %

U.S. sales remained relatively flat as the increase in sales of the Company's disposable products were offset by decreased sales of its capital products due to the economic recession experienced in fiscal 2009. International sales grew 18.9 percent in the Company's core technology areas, including sales of ophthalmic products in direct sales markets, the ultrasonic aspirator, electrosurgical generator and their related disposables. Our international ophthalmic sales force at July 31, 2009 included 13 direct employees and approximately 47 non-U.S. distributors and independent sales representatives covering 60 countries. Our international neurosurgical sales force at July 31, 2009 included approximately 30 distributors covering 40 countries.

Gross Profit

Gross profit as a percentage of net sales was 55.5 percent in fiscal 2009, compared to 59.8 percent in fiscal 2008. The decrease in gross profit as a percentage of net sales from fiscal 2009 to fiscal 2008 was attributable primarily to an increase in sales of 5.8 percent compared to a cost of goods sold increase of 17.2 percent. Gross profit as a percentage of net sales from fiscal 2008 to fiscal 2009 decreased by approximately four percentage points primarily due to the change in mix toward our international products, reduced absorption of both labor and overhead on our capital equipment product lines and a $975,000 fourth quarter write-off primarily due to excess and discontinued inventory which was either contributed to a charitable organization or was discarded.

Operating Expenses

R&D costs as a percentage of net sales were 5.7 percent and 5.3 percent for the fiscal years ended July 31, 2009 and 2008, respectively. R&D costs increased approximately $344,000 to $3.0 million in 2009 compared to

$2.7 million in 2008. The increase in R&D costs was primarily due to the direct costs associated with 39 active, major projects in various stages of completion at July 31, 2009. The Company's R&D investment is driven by the opportunities to develop new products to meet the needs of its surgeon customers, and reflecting the need to keep such spending in line with what the Company can afford to spend, results in an investment rate that is comparable to such spending by other medical device companies. The Company expects over the next few years to invest in R&D at a rate of approximately 4 percent to 6 percent of net sales.

Selling expenses, which consist of salaries, commissions and direct expenses, increased approximately $1.7 million to $14.3 million, or 26.9 percent of sales, for the fiscal year ended July 31, 2009, compared to $12.6 million, or 25.2 percent of net sales, for the fiscal year ended July 31, 2008. The increase in sales expenses as a percentage of net sales was primarily due to commissions paid on a 6.5 percent increase in commissionable sales which excludes sales to our marketing partners. In March 2009, the Company eliminated two positions within sales and marketing. In July 2009, the Company completed a reduction in personnel of approximately 10 percent of our workforce including most of our direct neurosurgical sales force. This realignment was designed to position the Company to attain increased profitability through the elimination of a substantial portion of our commercial expenses associated with direct distribution of the neurosurgical products.

General and administrative expenses ("G&A") decreased by approximately $469,000 during the fiscal year ended July 31, 2009 and as a percentage of net sales were 17.0 percent for the fiscal year ended July 31, 2009 as compared to 19.0 percent for the fiscal year ended July 31, 2008. The Company experienced a decrease of approximately $388,000 in outside consulting costs on its Sarbanes-Oxley compliance efforts, primarily due to efforts to further internalize documentation processes and procedures. The Company also experienced a decrease of approximately $100,000 in audit costs, as its external auditors were not required to attest to the Company's internal control over financial reporting due to the Company's qualification as a smaller reporting company. The Company's legal expenses increased by $331,000 during the fiscal year ended July 31, 2009 compared to the fiscal year ended July 31, 2008 primarily due to the cost associated with the Alcon patent and trademark infringement lawsuit. Directors' fees increased $176,000 due to each independent director serving as the principal executive officer of the Company on a weekly rotating basis for the first six months of the fiscal year while the Board was conducting a search for a new CEO. In addition, the directors serving as the principal executive officer also caused salaries and benefits to decrease by approximately $150,000.

Stock-based compensation cost is measured at the grant date, based on the fair value of the award calculated using the Black-Scholes option pricing model, and is recognized over the directors' and employees' requisite service period. The Company will continue to grant options to its independent directors and officers but has begun to use restricted stock to provide incentive compensation for its non-officer employees. As of July 31, 2009, the future compensation cost expected to be recognized under Statement of Financial Accounting Standards ("SFAS") No. 123(R) is approximately $26,000 in fiscal 2010, $13,000 in fiscal 2011 and $3,000 in fiscal 2012. However, the major portion of our compensation cost arises from our stock option grants to our directors, which is recognized pro-ratably over the year as the options vest. As of July 31, 2009, there was approximately $235,000 of total unrecognized compensation cost related to non-vested restricted-stock based compensation arrangements granted under a stock option plan adopted by Valley Forge in 2001. The cost is expected to be recognized over a weighted average period of five years, which is generally the vesting period.

Other Expense

Other expense for the 2009 fiscal year decreased 31.7 percent to $755,000 from $1.1 million for the fiscal year ended July 31, 2008. The decrease was primarily due to decreased interest expense for the decreased borrowings on the Company's working capital line during the year partially offset by the annual interest expense associated with the Iridex settlement.

Operating Income, Income Taxes and Net Income

Operating income for fiscal 2009 was $3.1 million, as compared to an operating income of $5.2 million in fiscal 2008. The decrease in operating income was primarily the result of a decrease in gross profit margin of approximately four percentage points on 5.8 percent more net sales, and an increase in R&D expenses and selling

costs of $344,000 and $1.7 million, respectively, which was partially offset by a $469,000 decrease in G&A expenses.

For the fiscal year ended July 31, 2009, the Company recorded a $775,000 provision on a pre-tax income of $2.4 million, or 32.7 percent effective tax rate. For the fiscal year ended July 31, 2008, the Company recorded a $1.4 million provision on pre-tax income of $4.1 million, or 35.1 percent effective tax rate. The Company's effective tax rate decreased for the fiscal year ended July 31, 2009 due to the decrease in pre-tax income, causing the relative portion of the provision that is made up by the research and experimentation credit and the manufacturing deduction to increase.

Net income decreased by $1.1 million to $1.6 million for the fiscal year ended July 31, 2009, from $2.7 million for the same period in fiscal 2008. Basic and diluted earnings per share for the fiscal year ended July 31, 2009 decreased to $0.07, respectively, from $0.11, respectively, for the fiscal year ended July 31, 2008. Basic weighted average shares outstanding increased from 24,321,713 at July 31, 2008 to 24,459,749 at July 31, 2009.

Year Ended July 31, 2008 Compared to Year Ended July 31, 2007

Net Sales

The following table presents net sales by category (dollars in thousands):


                                                             Year Ended July 31,          % Increase
                                                             2008            2007         (Decrease)

Ophthalmic                                                $    28,019      $ 24,522              14.3 %
Neurosurgery                                                   12,925        10,241              26.2 %
Marketing partners (Codman, Stryker and Iridex)                 8,347        10,266             (18.7 )%
Other                                                             772           916             (15.7 )%

Total                                                     $    50,063      $ 45,945               9.0 %

Ophthalmic sales growth was led by growth in sales of the products in our core technology areas including increased sales of vitreoretinal instruments, laser probes and sales of new disposable packs. When comparing neurosurgery, net sales during the fiscal year ended 2008 were 26.2 percent greater than 2007 sales, primarily attributable to the sales of disposables related to electrosurgical generators and power ultrasonic aspirators. Sales to our marketing partners were down 18.7 percent to $8.3 million for the fiscal year ended July 31, 2008 compared to $10.3 million for the prior year because sales to Stryker declined by 33.9 percent to $2.0 million for the fiscal year ended July 31, 2008 compared to $3.0 million for the prior year due to Stryker's model change completed during fiscal 2008 which resulted in lower sales.

The following table presents domestic and international net sales (dollars in thousands):

                                                             Year Ended July 31,
                                                             2008            2007        % Increase

United States (including sales to marketing partners)     $    35,838      $ 35,214              0.2 %
International (including Canada)                               14,225        10,731             32.5 %

Total                                                     $    50,063      $ 45,945              9.0 %

U.S. sales were primarily flat with the sales of the Company's core technology products offsetting weak sales to our marketing partners. International sales grew 32.5 percent in the Company's core technology areas including sales of ophthalmic products in direct sales markets, the ultrasonic aspirator, electrosurgical generator and their related disposables. The Malis® Advantagetm received the CE mark during the fourth quarter of our 2006 fiscal year thus allowing the Company to begin selling these medical devices internationally. During fiscal 2008, the Company continued adding distributors to its international neurosurgical sales force due to the addition of the Omni® and the Malis® Advantagetm. As of July 31, 2008, the Company had 30 international distributors covering 40 countries.

Gross Profit

Gross profit as a percentage of net sales was 59.8 percent in fiscal 2008, compared to 58.8 percent in fiscal 2007. The increase in gross profit as a percentage of net sales in fiscal 2008 from fiscal 2007 was attributable primarily to an increase in sales of 9.0 percent compared to a cost of goods sold increase of 6.1 percent. Gross profit as a percentage of net sales from fiscal 2007 to fiscal 2008 increased one percentage point, primarily due to the change in mix toward higher disposable product sales and as a result of the cost savings initiatives implemented by the Company. Beginning in June of 2007, the Company implemented a program to aggressively pursue cost savings and has subsequently had a reduction in force, implemented an incentive-based buyer's program for its purchasing department and gained additional control over its use of manufacturing supplies. The Company's incentive-based buyer's program is a bonus program for our purchasing employees, who are awarded a bonus based upon how much cost they can save from new or existing suppliers.

Operating Expenses

R&D costs as a percentage of net sales were 5.3 percent and 5.6 percent for the fiscal years ended July 31, 2008 and 2007, respectively. R&D costs remained relatively flat in 2008 compared to 2007. The Company's product development pipeline included over 36 active, major projects in various stages of completion at July 31, 2008.

Selling expenses, which consist of salaries, commissions and direct expenses, increased approximately $1.5 million to $12.6 million, or 25.2 percent of sales, for the fiscal year ended July 31, 2008, compared to $11.1 million, or 24.2 percent of net sales, for the fiscal year ended July 31, 2007. This increase was primarily due to the increase in head count as the Company in fiscal 2008 continued to increase its territory coverage of the United States and expand its international sales force. Additionally, as sales to our marketing partners did not increase as quickly as core product sales increased, this led to a significant increase in commissionable sales on a percentage basis. Commissionable sales increased from 77.7 percent of sales during the fiscal year ended July 31, 2007 to 83.3 percent in the fiscal year ended July 31, 2008.

G&A expenses decreased by $2.3 million during the fiscal year ended July 31, 2008 and as a percentage of net sales were 19.0 percent for the fiscal year ended July 31, 2008 as compared to 25.6 percent for the fiscal year ended July 31, 2007. The Company's legal expenses decreased by $2.3 million during the fiscal year ended July 31, 2008 compared to the fiscal year ended July 31, 2007 as the cost associated primarily with the Iridex lawsuit and subsequent settlement are no longer a significant factor. The Company also experienced a decrease of approximately $261,000 in outside consulting costs on the Company's Sarbanes-Oxley compliance efforts primarily due to the completion of documentation and testing of the former Valley Forge location in fiscal 2007 and the Company's efforts to internalize a portion of the documentation procedures. The Company instituted a cost savings initiative in June of 2007, which targeted selling, general and administrative ("SG&A") costs. The additional SG&A costs savings were offset by head count increases and the increase in amortization expense associated with the Iridex settlement.

Other Expense

Other expense for the 2008 fiscal year increased 17.0 percent to $1.1 million from $945,000 for the fiscal year ended July 31, 2007. The increase was due primarily to increased interest expense for the increased borrowings on the Company's working capital line due to working capital needs during the year and the additional expense associated with the Iridex settlement, as the fiscal year ended July 31, 2008 included the expense for the full twelve months and the fiscal year ended July 31, 2007 only included the expense for three months on the remaining $2.7 million obligation to Iridex.

Operating Income, Income Taxes and Net Income

Operating income for fiscal 2008 was $5.2 million, as compared to an operating income of $1.5 million in fiscal 2007. The increase in operating income was primarily the result of a one percentage point increase in gross profit margin on 9.0 percent more net sales, R&D expenses remaining relatively flat and a decrease of $2.3 million in G&A expenses primarily related to reductions in legal costs, partially offset by an additional $1.5 million in selling costs.

For the fiscal year ended July 31, 2008, the Company recorded a $1.4 million provision on a pre-tax income of $4.1 million, or 35.1 percent effective tax rate. For the fiscal year ended July 31, 2007, the Company recorded an $189,000 provision on pre-tax income of $573,000, or 33.0 percent effective tax rate, excluding a $461,000 research and experimentation credit for the 2007 fiscal year. The Company's effective tax rate increased for the fiscal year ended July 31, 2008 due to the substantial increase in pre-tax income, causing the relative portion of the provision that is made up by the research and experimentation credit and the manufacturing deduction to decrease.

Net income increased by $1.8 million to $2.7 million for the fiscal year ended July 31, 2008, from $845,000 for the same period in fiscal 2007. Basic and diluted earnings per share for the fiscal year ended July 31, 2008 increased to . . .