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 surgical devices, surgical equipment and consumables of the highest quality in order to assist and enable surgeons who perform surgery around the world to provide a better quality of life for their patients. The Company's primary focus is on the surgical disciplines of ophthalmology (vitreoretinal) 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 disposable and reusable devices, surgical equipment, procedural kits and the delivery of laser energy, ultrasound, electrosurgery, aspiration, illumination and irrigation, often delivered in multiple combinations. Enterprise-wide sales information is included in Note 14 to the consolidated audited financial statements.

Demand Trends

The Company's sales increased 7.8 percent during the fiscal year ended July 31, 2012 (including $1.5 million of deferred revenue recognized) compared with the previous fiscal year. The two most significant factors impacting this increase were a $693,000 increase in ophthalmic sales and a $4.5 million increase in OEM sales. The increased sales were partially offset by an $853,000 decrease in our other sales due to the transition of the majority of our direct neurosurgery product sales to our marketing partners. Currently, disposable product sales account for approximately 81.5 percent of our total products sales. Overall sales of our disposable products grew $4.0 million, or 8.8 percent, in fiscal 2012 as compared to fiscal 2011. Sales of capital equipment declined by approximately $267,000, or 2.7 percent, in fiscal 2012 as compared to fiscal 2011, due to continued weak demand for capital equipment given a more cautious capital spending environment.

A study performed by Market Scope in February 2011 predicts a steady growth of 3.6 percent per year in retinal procedures worldwide driven by an increase in the elderly population worldwide, an increase in the number of surgeons, an increase in the number of diseases treated with vitrectomy and an increase in frequency of diabetic complications due to the obesity epidemic. On a dollar basis, we estimate that the vitreoretinal market will grow approximately seven percent to $997 million in 2012.

Neurosurgical procedures on a global basis continue to rise at an estimated 1 to 3 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. Based upon this growth in procedures, sales of neurosurgical products worldwide are forecasted to increase by approximately 4 percent.

In addition, the Company believes that the demand for high quality, innovative products and new technologies consistent with the Company's devices and disposables will continue to favorably impact procedure growth in the ophthalmic and neurosurgical markets. Strong orders from the emerging markets of Brazil, Russia and India offset weakness in other international markets which faced continued economic challenges and competitive factors in the third and fourth quarters of this fiscal year.

Pricing Trends

The Company has generally been able to maintain the average selling prices for its products in the face of downward pricing pressure in the healthcare industry. However, increased competition in the Company's capital equipment market segments, in combination with customer budget constraints, capital scarcity and the transition of procedures to the ambulatory surgery center, has the potential to negatively impact the Company's selling prices on these devices. The Company has no major domestic group purchasing agreements.

Economic Trends

Economic conditions may continue to negatively impact capital expenditures at the hospital, ambulatory surgical center and physician level. Further, global economic conditions continue to negatively impact the volume and average selling price of the Company's products in its European markets.

Regulatory Developments

In March 2010, significant U.S. healthcare reform legislation, the Patient Protection and Affordable Care Act along with the Health Care and Education Reconciliation Act of 2010, was enacted into law. As a U.S. headquartered company with significant sales in the United States, this new law will likely have a material impact on our results of operations. A number of provisions of the new health care reform legislation is not yet finalized and effective, and as such, we are unable to predict the full impact of the laws and regulations promulgated thereunder.

Among other matters, the law imposes a 2.3 percent excise tax on all U.S. medical device sales beginning in January 2013. Approximately 73% of our consolidated fiscal 2012 sales were in the U.S. If we are unable to offset the taxes that will be levied on these sales, such as through the increase of efficiencies through our lean manufacturing initiatives, we expect that the new tax will materially and adversely affect our business, cash flows and results of operations.

The law also focuses on a number of Medicare provisions aimed at improving quality and decreasing costs and include provisions such as value-based payment programs and increased funding of comparative research. Furthermore, the law includes a reduction in the annual rate of inflation for hospitals that began in 2011 and the establishment of an independent payment advisory board to recommend ways of reducing the rate of growth in Medicare spending beginning in 2014. We cannot predict what healthcare programs and regulations will be ultimately implemented at the federal or state level, or the effect of any future legislation or regulation. However, any changes that lower reimbursement for our products or reduce medical procedure volumes could adversely affect our business and results of operations.

Our Business Strategy

The Company's key strategy is to enhance shareholder value through profitable revenue growth in ophthalmology and neurosurgery markets. This is accomplished through the identification and development of reusable and disposable devices and surgical equipment in conjunction with leading surgeons and marketing partners. We are committed to establishing a strong operational infrastructure and financial foundation within which growth opportunities can be prudently evaluated, financed and implemented. We will remain vigilant and sensitive to new challenges which may arise from changes in the definition and delivery of appropriate healthcare in our fields of interest. In fiscal 2012 and continuing through fiscal 2013, our strategic priorities are to drive the Company onto a higher growth trajectory and to continue to enhance the profitability of our operational platform by focusing on manufacturing efficiencies. Enterprise-wide sales information is included in Note 14 to the consolidated audited financial statements. For additional detail on the Company's Strategy, see Part I, Item 1, "Business - Strategy."

Results of Operations

Year Ended July 31, 2012 Compared to Year Ended July 31, 2011

Net Sales

The following table presents net sales by category (dollars in thousands):
                 Fiscal Year Ended July 31,
                2012          2011          %
Net Sales
Ophthalmic   $   35,240     $ 34,547         2.0 %
OEM (1)          23,973       19,456        23.2 %
Other (2)           801        1,654       (51.6 %)
Total        $   60,014     $ 55,657         7.8 %

(1) Revenues from OEM represent sales of electrosurgery generators, disposable bipolar forceps and related accessories and royalties from Codman, multi-channel generators, disposable ultrasonic tips and related accessories to Stryker and certain laser probes to Iridex. In addition, recognition of deferred revenues of $266,000 and $1.2 million from Codman and Alcon, respectively, are included in this category for the fiscal year ended July 31, 2012. Recognition of deferred revenues of $334,000 and $696,000 from Codman and Alcon, respectively, are included in this category for the fiscal year ended July 31, 2011.

(2) Revenues from Other represent direct neurosurgery revenues and other miscellaneous revenues.

Ophthalmic sales grew 2.0 percent in fiscal 2012 compared to fiscal 2011. Domestic ophthalmic sales increased 5.3 percent primarily due to sales of the Company's new disposable products. However, international ophthalmic sales decreased 1.8 percent primarily due to organic weakness in Europe and Canada. OEM sales increased by $4.5 million in fiscal 2012 as compared to fiscal 2011. Total OEM sales rose 23.2 percent to $24.0 million in fiscal 2012 (including $1.5 million of deferred revenue recognized) compared with $19.5 million in the fiscal 2011 (including $1.0 million of deferred revenue recognized). The increase was primarily due to strong volumes of disposable products sold to Stryker and new product sales to Mobius. Other sales decreased $853,000 in the fiscal 2012, or 51.6 percent, compared to the fiscal 2011. This decline in other sales was the result of the transition of the majority of our direct neurosurgery distribution to Codman and Stryker under marketing partner agreements.

Currently, disposable product sales account for approximately 81.5 percent of our total product sales. Overall sales of our disposable products grew $4.0 million, or 8.8 percent, in fiscal 2012 as compared to fiscal 2011. Sales of capital equipment declined by approximately $267,000 or 2.7 percent, in fiscal 2012 compared to fiscal 2011.

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

Fiscal Year Ended July 31,

                   2012           2011         %
Net Sales
Domestic        $   44,047      $ 38,997       12.9 %
International       15,967        16,660       (4.2 %)
Total           $   60,014      $ 55,657        7.8 %

Domestic sales increased 12.9 percent in fiscal 2012 due to increases in ophthalmic and OEM sales. All OEM sales are recorded as domestic sales. The decrease in international ophthalmology sales of 1.8 percent was exacerbated by the decline in international neurosurgery sales in fiscal 2012 due to the shift in sales from direct international neurosurgery sales to our marketing partners, as these sales are included in domestic revenue.

Gross Profit

Gross profit as a percentage of net sales was 57.5 percent in fiscal 2012, compared to 58.9 percent in fiscal 2011. Gross profit as a percentage of net sales for fiscal 2012 compared to fiscal 2011 decreased 1.4 percentage points due to the impact of an inventory write-down of approximately $367,000 in the third fiscal quarter and the impact of the mix of OEM sales, partially offset by the impact of the improved margins on our ophthalmology products and the recognition of deferred revenue from our OEM business. The Company continues to realize incremental savings from the lean manufacturing initiative and will continue to develop its internal resources to expand the lean initiative throughout the entire organization.

Operating Expenses (dollars in thousands)

                                          Fiscal Year Ended July 31,
                                       2012                         2011
                             Dollars      % of Sales      Dollars      % of Sales
R&D costs                    $  3,642             6.1 %   $  3,713             6.7 %
Sales and marketing            11,881             9.8 %     11,474            20.6 %
General and administrative     10,515            17.5 %      9,245            16.6 %

R&D costs decreased $71,000 to $3.6 million for fiscal 2012 when compared to fiscal 2011. As of July 31, 2012, there were 26 active projects in various stages of completion. The Company's R&D investment is driven by the opportunities to develop new products to meet the needs of its surgeon customers, and reflects the Company's R&D budget. This 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 5 to 7 percent of net sales.

Sales and marketing expenses, which consist of salaries, commissions and direct expenses, increased $407,000 to $11.9 million, or 19.8 percent of sales, for the fiscal year ended July 31, 2012, compared to $11.5 million, or 20.6 percent of net sales, for the fiscal year ended July 31, 2011. The decrease in sales and marketing as a percentage of net sales was primarily due to the impact of the mix of OEM sales.

General and administrative ("G&A") expenses increased by approximately $1.3 million during the fiscal year ended July 31, 2012 and as a percentage of net sales were 17.5 percent for the fiscal year ended July 31, 2012 as compared to 16.6 percent for the fiscal year ended July 31, 2011. The increase in G&A expenses was primarily due to stock compensation granted to directors, executive officers and senior managers of the organization and additional employees required to manage the implementation of our lean and quality improvement initiatives.

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 uses restricted stock to provide incentive compensation for its non-officer employees. As of July 31, 2012, the future compensation cost expected to be recognized is approximately $305,000 in fiscal 2013, $192,000 in fiscal 2014, $183,000 in fiscal 2015, $156,000 in fiscal 2016 and $59,000 in fiscal 2017. However, the major portion of our stock 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, 2012, there was approximately $1.2 million 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 four years, which is generally the vesting period.

Other Income/Expense

Other expense in fiscal 2012 decreased to $14,000 compared to $213,000 in fiscal 2011. The decrease was primarily due to lower interest expense on a reduced level of debt and the $99,000 loss on sale of product line which the Company experienced in fiscal 2011.

Operating Income, Income Taxes and Net Income

Operating income for fiscal 2012 was $8.5 million, as compared to operating income of $8.3 million in the comparable 2011 fiscal period. The increase in operating income was primarily the result of a 7.8 percent increase in net sales (including $1.5 million of deferred revenue recognized) partially offset by a 11.4 percent increase in cost of goods sold for a net increase in gross profit of $1.7 million. In addition, operating income was unfavorably impacted in fiscal 2011 by an increase of $1.3 million in G&A expenses and $407,000 in sales and marketing expenses offset by a $71,000 decrease in R&D costs, respectively.

For the fiscal year ended July 31, 2012, the Company recorded a $2.5 million income tax provision on a pre-tax income of $8.5 million, or 29.5 percent effective tax rate. For the fiscal year ended July 31, 2011, the Company recorded a $2.5 million income tax provision on pre-tax income of $8.1 million, or 30.3 percent effective tax rate. The Company's effective tax rate decreased for the fiscal year ended July 31, 2012 primarily due to the increase in the production deduction from 6.0 percent to 9.0 percent and the impact of the Company's state tax planning strategies, partially offset by the expiration of the research and development tax credit as of December 31, 2011.

Income from continuing operations increased by $299,000 to $6.0 million for the fiscal year ended July 31, 2012 from $5.7 million for the same period in fiscal 2011. Basic and diluted earnings per share from continuing operations for the fiscal year ended July 31, 2012 increased to $0.24 from $0.23 when compared to the fiscal year ended July 31, 2011. Basic weighted average shares outstanding increased to 25,100,064 at July 31, 2012 from 24,901,832 at July 31, 2011.

The Company also experienced a $382,000 loss in fiscal 2012, or $0.02 basic and diluted earnings per share, from the discontinued operations of its plastic injection molding operations.

Net income was $5.6 million,, or $0.22 basic and diluted earnings per share for fiscal 2012.

Year Ended July 31, 2011 Compared to Year Ended July 31, 2010

Net Sales

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

                    Fiscal Year Ended July 31,
                2011          2010        % Increase
                                          (Decrease)
Net Sales
Ophthalmic   $   34,547     $ 31,689              9.0 %
OEM (1)          19,456       12,082             61.0 %
Other (2)         1,654        8,239            (79.9 %)
Total        $   55,657     $ 52,010              7.0 %

(1) Revenues from OEM represent sales of electrosurgery generators, disposable bipolar forceps and related accessories and royalties from Codman, multi-channel generators, disposable ultrasonic tips and related accessories to Stryker disposable bipolar forceps and certain laser probes to Iridex. In addition, recognition of deferred revenues of $334,000 and $696,000 from Codman and Alcon, respectively, are included in this category for the fiscal year ended July 31, 2011. There was no deferred revenue recorded in fiscal 2010.

(2) Revenues from Other represent direct neurosurgery revenues and other miscellaneous revenues.

Ophthalmic sales grew 9.0 percent in fiscal 2011 compared to fiscal 2010. Domestic ophthalmic sales increased 4.5 percent and international ophthalmic sales increased 14.6 percent primarily due to sales of disposable products.

OEM sales rose 61.0% to $19.5 million for fiscal year ended July 31, 2011 as compared to the fiscal year ended July 31, 2010 as a result of the transition of the majority of our direct neurosurgery product sales to Codman and Stryker under new marketing partner agreements during fiscal 2010. Other sales decreased as a result of the transition of the majority of our direct neurosurgery distribution to Codman and Stryker under marketing partner agreements.

Overall sales of our disposable products grew $5.0 million, or 12.6 percent, in fiscal 2011 as compared to fiscal 2010. Sales of capital equipment, including the sales of Omni® capital equipment, declined by approximately $2.3 million, or 19.0 percent, in fiscal 2011 compared to fiscal 2010. The downward trend, after excluding the loss of the Omni® ultrasonic aspirator sales, is a result of hospitals tightly controlling their capital budgets.

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

                   2011           2010       % Increase
                                             (Decrease)
Net Sales
Domestic        $   38,997      $ 35,352            10.3 %
International       16,660         6,658             0.0 %
Total           $   55,657      $ 52,010             7.0 %

Domestic sales increased 10.3 percent in fiscal 2011 due to increases in ophthalmic and OEM. The increase in international ophthalmology sales of 14.6 percent was offset by the decline in international neurosurgery sales in fiscal 2011 due to the shift in sales from direct international neurosurgery sales to our OEM markets.

Gross Profit

Gross profit as a percentage of net sales was 58.9 percent in fiscal 2011, compared to 57.6 percent in fiscal 2010. Gross profit as a percentage of net sales for fiscal 2011 compared to fiscal 2010 increased 1.3 percentage points due to the improved margins on our ophthalmology products and recognition of deferred revenue from our OEM partners, partially offset by the margin impact of the transition of the majority of our direct neurosurgery sales to our marketing partners.

Operating Expenses (dollars in thousands)

                                          Fiscal Year Ended July 31,
                                       2011                         2010
                             Dollars      % of Sales      Dollars      % of Sales
R&D costs                    $  3,713             6.7 %   $  3,008             5.8 %
Sales and marketing            11,474            20.6 %     11,958            23.0 %
General and administrative      9,245            16.6 %      8,903            17.1 %

R&D costs increased $705,000 to $3.7 million for fiscal 2011 when compared to fiscal 2010. As of July 31, 2011, there were 28 active, major projects in various stages of completion.

Sales and marketing expenses, which consist of salaries, commissions and direct expenses, decreased $484,000 to $11.5 million, or 20.6 percent of sales, for the fiscal year ended July 31, 2011, compared to $12.0 million, or 23.0 percent of net sales, for the fiscal year ended July 31, 2010. The decrease in sales and marketing as a percentage of net sales was primarily due to the elimination of our neurosurgery sales force as of July 31, 2009 as the residual cost was eliminated throughout fiscal 2010.

G&A expenses increased by $342,000 during the fiscal year ended July 31, 2011 and as a percentage of net sales were 16.6 percent for the fiscal year ended July 31, 2011 as compared to 17.1 percent for the fiscal year ended July 31, 2010. The increase in G&A expenses was primarily due to additional employees required to manage the implementation of our lean manufacturing initiative and quality improvement initiatives.

Other Income/Expense

Other expense in fiscal 2011 increased to $213,000 compared to income of $2.8 million in fiscal 2010. The increase was primarily due to the one-time impact of the $817,000 gain from sale of the Omni® product line to Stryker and the $2.4 million in settlement gain from Alcon which both occurred in fiscal 2010. Interest expense decreased to $202,000 in fiscal 2011 as the Company was able to pay off the remaining bond on the O'Fallon, Missouri facility and further reduce its other debt. In addition, the Company recorded a $99,000 loss on the sale of the Omni® product line to Stryker as certain receivables were deemed to be uncollectible due to the change in the distribution model.

Operating Income, Income Taxes and Net Income

Operating income for fiscal 2011 was $8.3 million, as compared to operating income of $6.1 million in the comparable 2010 fiscal period. The increase in operating income was primarily the result of a 7.0 percent increase in net sales (including $1.0 million of deferred revenue recognized) partially offset by a 3.7 percent increase in cost of goods sold for a net increase in gross profit of $2.8 million. In addition, operating income was favorably impacted in fiscal 2011 by a decrease of $484,000 in sales and marketing expenses offset by a $705,000 and $342,000 increase in R&D and G&A costs, respectively.

For the fiscal year ended July 31, 2011, the Company recorded a $2.5 million income tax provision on a pre-tax income of $8.1 million, or 30.3 percent effective tax rate. For the fiscal year ended July 31, 2010, the Company recorded a $3.1 million income tax provision on pre-tax income of $8.9 million, or 35.0 percent effective tax rate. The Company's effective tax rate decreased for the fiscal year ended July 31, 2011 due to the re-enactment of the R&D tax credit, the increase in the domestic production deduction from 6 percent to 9 percent and approximately $100,000 of R&D tax credit from the prior year as this credit was re-enacted during the second quarter of fiscal 2011. The R&D credit from the prior year was for the period that the credit was expired (i.e. from January 1, 2010 through July 31, 2010), and the Company could not accrue the benefits the credit afforded.

Net income decreased by $100,000 to $5.6 million for the fiscal year ended July 31, 2011 from $5.7 million for the same period in fiscal 2010. Basic and diluted earnings per share for the fiscal year ended July 31, 2011 remained flat at $0.23 when compared to the fiscal year ended July 31, 2010. Basic weighted average shares outstanding increased to 24,901,832 at July 31, 2011 from 24,618,403 at July 31, 2010.

Liquidity and Capital Resources

The Company had $12.7 million in cash and cash equivalents and no interest-bearing debt as of July 31, 2012.

Working capital, including the management of inventory and accounts receivable, is a management focus. At July 31, 2012, the Company had an average of 72 days of sales outstanding ("DSO") in accounts receivable. The 72 days of DSO at July 31, 2012 was one day favorable when compared to July 31, 2011 and nine days unfavorable when compared to July 31, 2010 utilizing the trailing twelve months . . .