Natus®, AABR®, ABaer®, ALGO®, AOAE®, AuDX®, Balance Manager®, Balance Master®, Biliband®, Bio-logic®, Ceegraph®, CHAMP®, Cochlea Scan®, Cool Cap®, Ear Couplers®, Echo Screen®, EquiTest®, Fischer-Zoth®, Flexicoupler®, MASTER®, Navigator®, neoBLUE®, NeuroWorks®, Oxydome®, Sleepscan®, Smart Scale®, Traveler®, Warmette® and VAC PAC® are registered trademarks of Natus Medical Incorporated. Accuscreen™, Bili-Lite Pad™, Bili-Lite™, Biomark™, Circumstraint™, Coherence™, Deltamed™, inVision™, MiniMuffs™, Neometrics™ and Smartpack™ are non-registered trademarks of Natus. Solutions for Newborn CareSM is a non-registered service mark of Natus. Xltek®, Neuromax® and Sleeprite® are registered trademarks of Excel Tech Ltd.

Overview

The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") supplements the MD&A in the Annual Report on Form 10-K for the year ended December 31, 2008 of Natus Medical Incorporated ("Natus," "we," "us," or "our Company"), and presumes that readers have read or have access to the discussion and analysis in our Annual Report. Management's discussion and analysis should be read in conjunction with our condensed consolidated financial statements and accompanying footnotes, the discussion of certain risks and uncertainties contained in Part II, Item 1A of this report, and the cautionary information regarding forward-looking statements at the end of this section. MD&A includes the following sections:

• Our Business. A general description of our business;

• 2009 Third Quarter Overview. A summary of key information concerning the financial results for the three months ended September 30, 2009;

• Application of Critical Accounting Policies. A discussion of the accounting policies that are most important to the portrayal of our financial condition and results of operations and that require significant estimates, assumptions, and judgments;

• Results of Operations. An analysis of our results of operations for the periods presented in the financial statements;

• Liquidity and Capital Resources. An analysis of capital resources, sources and uses of cash, investing and financing activities, off-balance sheet arrangements, contractual obligations and interest rate hedging;

• Recent Accounting Pronouncements. See Note 1 to our Condensed Consolidated Financial Statements for a discussion of new accounting pronouncements that affect us; and

• Cautionary Information Regarding Forward-Looking Statements. Cautionary information about forward-looking statements.

Our Business

Natus is a leading provider of healthcare products used for the screening, detection, treatment, monitoring and tracking of common medical ailments in newborn care, hearing impairment, neurological dysfunction, epilepsy, sleep disorders, and balance and mobility disorders. Product offerings include computerized neurodiagnostic systems for audiology, neurology, polysomnography, and neonatalogy, as well as newborn care products such as hearing screening systems, phototherapy devices for the treatment of newborn jaundice, head-cooling products for the treatment of brain injury in newborns, and software systems for managing and tracking disorders and diseases for public health laboratories.

We have completed a number of acquisitions since 2003, consisting of either the purchase of a company, substantially all of the assets of a company, or individual products or product lines. The businesses we have acquired include Neometrics in 2003, Fischer-Zoth in 2004, Bio-logic, Deltamed, and Olympic in 2006, Xltek in 2007, Sonamed Corporation, Schwarzer Neurology, a division of Schwarzer GmbH, and Neurocom International, Inc. in 2008 and Hawaii Medical and Alpine Biomed in 2009.

Product Families

We categorize our products into the following product families, which are more fully described in our Annual Report on Form 10-K for the year ended December 31 2008:

• Hearing - Includes products for newborn hearing screening and diagnostic hearing assessment.

• Newborn Care - Includes products for the treatment of brain injury and jaundice in newborns.

Segment and Geographic Information

We operate in one reportable segment in which we provide healthcare products used for the screening, detection, treatment, monitoring and tracking of common medical ailments in newborn care, hearing impairment, neurological dysfunction, epilepsy, sleep disorders and balance and mobility disorders.

Our end-user customer base includes hospitals, clinics, laboratories, physicians, nurses, audiologists, and governmental agencies. Most of our international sales are to distributors who resell our products to end-users or sub-distributors.

Information regarding our sales and long-lived assets in the U.S. and in countries outside the U.S. is contained in Note 11 - Segment, Customer and Geographic Information of our condensed consolidated financial statements included in this report.

Revenue by Product Category

We generate our revenue either from sales of Devices and Systems, which are generally non-recurring, and from related Supplies and Services, which are generally recurring. The products that are attributable to these categories are described in our Annual Report on Form 10-K for the year ended December 31, 2008. Revenue from Devices and Systems and Supplies and Services, as a percent of total revenue for the three and nine months ended September 30, 2009 and 2008 is as follows:

                                  Three Months Ended          Nine Months Ended
                                     September 30,              September 30,
                                 2009            2008         2009           2008
        Devices and Systems          54 %            59 %         55 %         60 %
        Supplies and Services        44 %            39 %         43 %         38 %
        Other                         2 %             2 %          2 %          2 %

During the three and nine months ended September 30, 2009, no single customer or foreign country contributed to more than 10% of revenue, and revenue from services was less than 10% of revenue.

2009 Third Quarter Overview

Our revenue increased 6% to $44.3 million in the third quarter ended September 30, 2009, compared to $41.7 million reported in the comparable quarter of the previous year. Net income decreased 23% to $3.7 million, or $0.13 per diluted share, for the third quarter of 2009, compared with net income of $4.8 million, or $0.17 per diluted share, for the third quarter of 2008. The increase in revenue in 2009 compared to the same period in 2008 was primarily attributable to our recent acquisitions.

The severe worldwide economic downturn that started to impact our business in December 2008 continued to influence our results for the third quarter of 2009. In the quarter, hospitals in the United States reduced expenditures on capital equipment, but the decrease was less than in the first half of 2009. This impacted sales of all of our product lines except our newborn care products. We saw a small increase in capital equipment spending outside the United States. Revenue from our neurology, balance and mobility, hearing diagnostic, and newborn hearing equipment products were all down by at least 11% year over year, but increased sequentially over our 2009 second quarter.

We acquired Hawaii Medical on July 2, 2009 for $2.9 million in cash, with the potential for additional consideration depending upon the achievement of certain revenue targets. Hawaii Medical, which manufactures and markets single-use disposable products sold into the nursery and neonatal intensive care unit ("NICU") in hospitals.

We acquired Alpine Biomed on September 14, 2009, for $43.2 million in cash, with the potential for additional consideration depending upon the achievement of certain revenue targets. Alpine Biomed is a leader in the development, manufacturing, and sales of devices for the diagnosis of neurological disorders.

Please see Note 2 - Business Combinations, Goodwill, and Intangible Assets of our condensed consolidated financial statements included in this report for additional information regarding the terms of these acquisitions

Application of Critical Accounting Policies

We prepare our financial statements in accordance with accounting principles generally accepted in the United States of America ("GAAP"). In so doing, we must often make estimates and use assumptions that can be subjective, and, consequently, our actual results could differ from those estimates. For any given individual estimate or assumption we make, there may also be other estimates or assumptions that are reasonable.

We believe that the following critical accounting policies require the use of significant estimates, assumptions, and judgments. The use of different estimates, assumptions, or judgments could have a material affect on the reported amounts of assets, liabilities, revenue, expenses, and related disclosures as of the date of the financial statements and during the reporting period:

• Revenue recognition

• Allowance for doubtful accounts

• Inventory is carried at the lower of cost or market value

• Carrying value of intangible assets and goodwill

• Liability for product warranties

• Share-based compensation

These critical accounting policies are described in more detail in our Annual Report on Form 10-K for the year ended December 31, 2008, under Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations. There have been no changes to these policies during the three and nine months ended September 30, 2009.

Results of Operations

The following table sets forth, for the periods indicated, selected consolidated
statements of operations data as a percentage of total revenue. Our historical
operating results are not necessarily indicative of the results for any future
period.



                                                    Three Months Ended          Nine Months Ended
                                                      September 30,               September 30,
                                                   2009           2008          2009          2008
Revenue                                             100.0 %        100.0 %       100.0 %      100.0 %
Cost of revenue                                      39.4           38.0          39.1         38.2

Gross profit                                         60.6           62.0          60.9         61.8

Operating expenses:
Marketing and selling                                26.6           23.9          27.9         24.5
Research and development                              9.4            9.7          10.3         10.1
General and administrative                           12.9           11.8          14.3         12.8

Total operating expenses                             48.9           45.4          52.5         47.4

Income from operations                               11.7           16.6           8.4         14.4
Other income, net                                     0.2            1.4           0.5          0.8

Income before provision for income tax               11.9           18.0           8.9         15.2
Income tax provision                                  3.6            6.5           3.0          5.7

Net income                                            8.3 %         11.5 %         5.9 %        9.5 %

Certain reclassifications have been made to the prior period classification of revenue as devices and systems or supplies and services to conform to the current presentation.

We acquired Neurocom in October 2008, Hawaii Medical in July 2009, and Alpine Biomed in September 2009. Where significant, we have noted the impact of these acquisitions on our results of operations for the three and nine months ended September 30, 2009, as compared to the same periods in 2008.

Three Months Ended September 30, 2009 and 2008

Revenue increased $2.5 million, or 6%, for the three month period ended September 30, 2009 from the comparable 2008 period. The increase was due primarily to the acquisition of NeuroCom, Hawaii Medical and Alpine Biomed which contributed to $6.1 million of revenue offset by a $3.6 million decrease in capital equipment revenue.

Device and systems revenue decreased $922,000, or 3.7%, to $23.8 million in the three months ended September 30, 2009 compared to $24.7 million in the same period in 2008. NeuroCom and Alpine Biomed contributed to $4.2 million of revenue from devices and systems offset by a $3.5 million decrease in revenue from other neurology products, and a $1.6 million decrease in revenue from other products. Revenue from devices and systems was 54% of consolidated revenue in the three months ended September 30, 2009 compared to 59% of consolidated revenue for the third quarter of 2008.

Supplies and services revenue increased 21.4%, or $3.5 million, to $19.7 million in the third quarter of 2009 compared to $16.2 million in the same period in 2008. In the 2009 third quarter, revenue from hearing screening and neurology supplies increased by $2.3 million and service fees increased by $1.2 million. Revenue from supplies and services was 44% of consolidated revenue in the three months ended September 30, 2009 compared to 39% of consolidated revenue for the third quarter of 2008.

Revenue from sales outside the U.S. increased $2.3 million, or 19.9%, to $14.1 million in the third quarter of 2009 compared to $11.8 million for the same period in 2008. Neurocom and Alpine Biomed contributed to $2.8 million of international revenue, offset by $500,000 decrease in revenue from other devices and systems.

Gross profit as a percentage of revenue was 60.6% for the three months ended September 30, 2009 compared to 62.0% for the respective period in 2008. The lower margin in the 2009 period reflects higher manufacturing overhead costs, primarily associated with the transfer of manufacturing operations of Hawaii Medical products to our Olympic facility in Seattle. We also accrued $460,000 of severance costs for production personnel at Xltek and at our corporate facility in San Carlos, California during the third quarter of 2009. These severance costs reflect our continued effort to outsource manufacturing to contract manufacturers. These severance costs reduced our third quarter 2009 gross profit by 1.0%.

Cost of revenue increased $1.6 million, or 10.2%, to $17.4 million in the three months ended September 30, 2009, from $15.8 million in 2008, reflecting lower margins on sales in the 2009 period. Gross profit increased $922,000, or 3.6%, to $26.8 million in the third quarter of 2009, from $25.9 million in the third quarter of 2008.

Total operating costs increased by $2.7 million or 14.2%, to $21.6 million in the three months ended September 30, 2009, compared to $18.9 million in the same period in 2008. Neurocom and Alpine Biomed contributed to $2.5 million of the increase.

Marketing and selling expenses increased $1.8 million, or 18.1%, to $11.8 million in the three months ended September 30, 2009 compared to $10.0 million in the same period in 2008. Neurocom and Alpine Biomed contributed to $1.4 million of marketing and selling expenses, while other marketing and selling expenses were approximately 4% higher in the third quarter of 2009 compared to the same period in 2008 reflecting higher salary and commission related expenses.

Research and development expenses increased $109,000, or 2.7%, to $4.2 million for the three months ended September 30, 2009 compared to $4.1 million in the same period of 2008. Neurocom and Alpine Biomed contributed to $334,000 of research and development expenses, while other research and development expenses were approximately 5% lower in the third quarter of 2009 compared to the same period in 2008. The reduction in research and development expenses exclusive of Neurocom and Alpine Biomed reflects the impact of our 2008 restructuring plan and lower outside service costs.

General and administrative expenses increased $775,000, or 15.8%, to $5.7 million in the three months ended September 30, 2009 compared to $4.9 million in the same period in 2008. During the third quarter 2009 Neurocom and Alpine Biomed contributed to $627,000 of general and administrative expenses for which we had no such costs in the 2009 period. We also recorded $460,000 of direct acquisition costs associated with the acquisitions of Hawaii Medical and Alpine Biomed in the third quarter 2009. Other general and administrative expense exclusive of those associated with Neurocom and Alpine, and the referenced acquisition costs, were $312,000 less in the 2009 third quarter compared to the same period in 2008, which resulted primarily from a reduction in outside consulting expenses.

We adopted an integration and restructuring plan in February 2008 that was designed to reduce redundant costs resulting from prior acquisitions and to improve efficiencies in operations. These actions were phased in during the first nine months of 2008. Costs under the plan, which were primarily for severance benefits, stay bonuses, and duplicative salaries, totaled approximately $700,000. We accrued $460,000 and $64,000 of employee termination benefits in the three months ended September 30, 2009 and 2008, respectively.

Other income, net consists of investment income from our investment portfolio, interest expense, net currency exchange gains and losses, and other miscellaneous income and expenses. We reported other income, net of $71,000 in the three months ended September 30, 2009, compared to $567,000 in the same period in 2008, due primarily to lower rates of interest earned on our investment portfolio; however we expect this trend will continue, even if interest rates rise, as our investment portfolio has decreased as a result of our recent acquisitions.

We recorded income tax expense of $1.6 million in the three months ended September 30, 2009, compared to $2.7 million in the same period in 2008. Our effective tax rate in the third quarter of 2009 was 30.0% compared to an effective rate of 36.1% in the third quarter of 2008 and 38.0% for the first six months of 2009. Our effective tax rate was lower in the third quarter 2009 than in previous quarters because of a number of discrete adjustments to the tax provision, including primarily the impact of foreign currency fluctuations on deferred taxes of our Xltek subsidiary. Because the functional currency of Xltek became the U.S. Dollar on January 1, 2009, deferred tax assets and liabilities of Xltek are revalued to the Canadian Dollar and the net change in value is reported as a component of our tax provision. We expect that this revaluation will increase the volatility in our effective tax rate in the future.

Nine Months Ended September 30, 2009 and 2008

Revenue decreased $3.6 million, or 3.0%, for the nine month period ended September 30, 2009 from the comparable 2008 period. The decrease was due primarily to lower capital equipment sales across all of our product lines. We believe that these lower sales resulted from weakness in demand due to the current economic recession and not a loss of market share. Neurocom, Hawaii Medical and Alpine Biomed contributed to $9.7 million of revenue offset by a $13.3 million decrease in revenue from our other capital equipment products.

Device and systems revenue decreased $8.0 million, or 10.9%, to $63.6 million in the nine months ended September 30, 2009 compared to $71.6 million in the same period in 2008. Neurocom and Alpine Biomed contributed to $7.8 million of revenue from devices and systems offset by a $10.8 million decrease in revenue from other neurology and sleep diagnostics products, a $3.7 million decrease in revenue from hearing products, and a $1.2 million decrease in revenue from newborn care and other products. Revenue from devices and systems was 55.4% of consolidated revenue in the nine months ended September 30, 2009 compared to 60.4% of consolidated revenue for the same period in 2008.

Supplies and services revenue increased $4.5 million, or 10.2%, to $49.0 million in the nine months ended September 30, 2009 compared to $44.5 million in the same period in 2008. NeuroCom, Hawaii Medical and Alpine Biomed contributed to $2.4 million of revenue from supplies and services and sales of Neurology supplies increased by $2.1 million. Revenue from supplies and services was 42.7% of consolidated revenue in the nine months ended September 30, 2009 compared to 37.6% of consolidated revenue for the nine months ended September 30, 2008.

Revenue from sales outside the U.S. increased $855,000, or 1.7%, to $36.1 million in the nine months ended September 30, 2009 compared to $35.2 million for the same period in 2008. Neurocom and Alpine Biomed contributed to $4.0 million of international revenue. International device and systems revenue decreased $2.8 million, reflecting the impact of the economic recession in international markets, while international hearing and newborn care supplies revenue increased $1.5 million during the 2009 period.

Gross profit as a percentage of revenue was 60.9% for the nine months ended September 30, 2009 compared to 61.8% for the respective period in 2008. The lower margin reflects higher materials and manufacturing overhead costs in the 2009 period included the $460,000 of severance costs recorded in the third quarter of 2009. These severance costs reduced our third quarter 2009 gross profit by 0.5%.

Total operating costs increased by $4.1 million or 7.3%, to $60.3 million in the nine months ended September 30, 2009, compared to $56.2 million in the same period in 2008. Neurocom and Alpine Biomed contributed to $4.8 million of total operating costs, while other operating costs were approximately 1.2% lower in the nine months ended September 30, 2009 compared to the same period in 2008. The reduction in operating expenses exclusive of Neurocom and Alpine Biomed reflects the impact of our 2008 restructuring plan and the implementation of tighter cost controls.

Marketing and selling expenses increased $3.0 million, or 10.3%, to $32.0 million in the nine months ended September 30, 2009 compared to $29.0 million in the same period in 2008. Neurocom and Alpine Biomed contributed to $3.4 million of marketing and selling expenses, while other marketing and selling expenses were approximately 1% lower in the nine months ended September 30, 2009 compared to the same period in 2008.

Research and development expenses decreased $122,000, or 1.0%, to $11.8 million for in the nine months ended September 30, 2009 compared to $12.0 million in the same period of 2008. Neurocom and Alpine Biomed contributed to $715,000 of research and development expenses, while other research and development expenses were approximately 7% lower in the nine months ended September 30, 2009 compared to the same period in 2008. The reduction in research and development expenses exclusive of Neurocom and Alpine Biomed reflects the impact of our 2008 restructuring plan.

General and administrative expenses increased $1.3 million, or 8.2%, to $16.5 million in the nine months ended September 30, 2009 compared to $15.2 million in the same period in 2008. During the third quarter 2009 Neurocom and Alpine Biomed contributed to $902,000 of general and administrative expenses, and the direct costs of acquiring Hawaii Medical and Alpine Biomed totaling $460,000 were expensed.

We adopted an integration and restructuring plan in February 2008 that was designed to reduce redundant costs resulting from prior acquisitions and to improve efficiencies in operations. These actions were phased in during the first nine months of 2008. Costs under the plan, which were primarily for severance benefits, stay bonuses, and duplicative salaries, totaled approximately $700,000. Pursuant to the plan, we accrued $460,000 and $301,000 of employee termination benefits in the nine months ended September 30, 2009 and 2008, respectively.

Other income, net consists of investment income from our investment portfolio, interest expense, net currency exchange gains and losses, and other miscellaneous income and expenses. We reported net other income of $584,000 in the nine months ended September 30, 2009, compared to $954,000 in the same period in 2008 due primarily to lower exchange gains and lower investment income offset by reduced interest expense in 2009 compared to the same period in 2008.

We recorded income tax expense of $3.5 million in the nine months ended September 30, 2009, compared to $6.8 million in the same period in 2008. Our effective tax rate in the first nine months of 2009 was 33.9% compared to an effective rate of 37.8% in the same period in 2008. Our tax rate was lower in the 2009 period because of the impact of foreign currency changes on deferred taxes at our Xltek subsidiary and because more of our income is taxed in foreign jurisdictions with lower tax rates than our consolidated effective tax rate.

Liquidity and Capital Resources

Liquidity is our ability to generate sufficient cash flows from operating activities to meet our obligations and commitments. In addition, liquidity includes the ability to obtain appropriate financing or to raise capital. Therefore, liquidity cannot be considered separately from capital resources that consist of our current funds and the potential to increase those funds in the future. We plan to use our capital resources in meeting our commitments and in achieving our business objectives.

As of September 30, 2009, we had cash and cash equivalents of $28.7 million, short-term investments of $944,000, stockholders' equity of $238.3 million, and working capital of $73.7 million, compared with cash and cash equivalents of $56.9 million, stockholders' equity of $226.5 million, and working capital of $102.3 million as of December 31, 2008.

We believe that our current cash, cash equivalents, and short-term balances, including cash generated from operations, will be sufficient to meet our ongoing operating and capital requirements for the foreseeable future. We completed two acquisitions in 2009, three acquisitions in 2008, one in 2007, and three in 2006. We intend to continue to acquire additional technologies, products or businesses, and these acquisitions could be significant. These actions will likely affect our future capital requirements and the adequacy of our available funds. We may be required to raise additional funds through public or private financings, strategic relationships, or other arrangements. Any equity financing may be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants and increase our cost of capital.

On September 2, 2008, we executed a second amendment to our Amended and Restated . . .