UNITED STATES
 SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

(mark one)

x        Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2006

 

o           Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission file number 000-50856

 

NEUROMETRIX, INC.

(Exact name of registrant as specified in its charter)

Delaware		04-3308180
(State or other jurisdiction of incorporation or		(I.R.S. Employer Identification No.)
organization)
62 Fourth Avenue, Waltham, Massachusetts		02451
(Address of principal executive offices)		(Zip Code)

 

(781) 890-9989
 (Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve (12) months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past ninety (90) days.

Yes x    No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act (check one):

Large accelerated filer o   Accelerated filer x   Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o     No x

APPLICABLE ONLY TO CORPORATE ISSUERS

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date:

12,523,620 shares of common stock, par value $0.0001 per share, were outstanding as of August 4, 2006.

 

NEUROMETRIX, INC.

FORM 10-Q

INDEX

 

2

Part I
Financial Information

Item 1. Condensed Financial Statements

NeuroMetrix, Inc.

Balance Sheets

(Unaudited)

		June 30, 2006			December 31, 2005
Assets
Current assets:
Cash and cash equivalents		$	5,161,894		$	8,170,037
Short-term held-to-maturity investments		29,502,186			24,081,946
Accounts receivable, net of allowance for doubtful accounts of $525,000 and $400,000 at June 30, 2006 and December 31, 2005, respectively		6,320,363			4,543,339
Inventories, net		2,944,863			2,683,409
Prepaid expenses and other current assets		762,922			614,169
Current portion of deferred costs		280,724			223,009
Total current assets		44,972,952			40,315,909
Restricted cash		1,458,598			1,458,598
Fixed assets, net		973,746			875,551
Deferred costs		302,430			247,013
Total assets		$	47,707,726		$	42,897,071
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable		$	1,599,182		$	1,698,583
Accrued compensation		2,290,545			1,959,621
Other accrued expenses		1,146,041			1,213,928
Current portion of deferred revenue		1,012,268			760,613
Total current liabilities		6,048,036			5,632,745
Deferred revenue		1,118,714			885,354
Other long-term liabilities		101,818			130,909
Total liabilities		7,268,568			6,649,008
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $0.001 par value, 5,000,000 shares authorized, none outstanding		—			—
Common stock, $0.0001 par value; 50,000,000 shares authorized; 12,512,729 and 12,375,276 shares issued and outstanding at June 30, 2006 and December 31, 2005, respectively		1,251			1,238
Additional paid-in capital		95,579,515			93,212,368
Deferred compensation		(279,726		)	(425,623		)
Accumulated deficit		(54,861,882		)	(56,539,920		)
Total stockholders’ equity		40,439,158			36,248,063
Total liabilities and stockholders’ equity		$	47,707,726		$	42,897,071

 

The accompanying notes are an integral part of these financial statements.

3

 

NeuroMetrix, Inc.

Statements of Operations

(Unaudited)

		Three Months Ended						Six Months Ended
		June 30, 2006			June 30, 2005			June 30, 2006			June 30, 2005
Revenues:
Diagnostic device		$	1,933,594		$	960,513		$	3,475,031		$	1,772,913
Biosensor		12,036,456			7,106,993			22,318,294			13,084,357
Total revenues		13,970,050			8,067,506			25,793,325			14,857,270
Cost of revenues		3,377,466			2,090,064			6,257,379			3,907,789
Gross margin		10,592,584			5,977,442			19,535,946			10,949,481
Operating expenses:
Research and development(1)		1,268,545			1,029,070			2,527,153			1,933,274
Sales and marketing(1)		5,408,315			3,494,499			10,676,568			6,739,150
General and administrative(1)		2,690,772			1,678,480			5,246,021			3,272,520
Total operating expenses		9,367,632			6,202,049			18,449,742			11,944,944
Income (loss) from operations		1,224,952			(224,607		)	1,086,204			(995,463		)
Interest income		372,348			184,667			665,934			361,047
Interest expense		—			(204		)	—			(2,042		)
Income (loss) before provision for income taxes		1,597,300			(40,144		)	1,752,138			(636,458		)
Provision for income taxes		66,600			—			74,100			—
Net income (loss)		$	1,530,700		$	(40,144	)	$	1,678,038		$	(636,458	)
Net income (loss) per common share
Basic		$	0.12		$	(0.00	)	$	0.13		$	(0.05	)
Diluted		$	0.12		$	(0.00	)	$	0.13		$	(0.05	)
Weighted average shares used to compute net income (loss) per common share
Basic		12,485,205			12,085,448			12,450,037			12,064,393
Diluted		13,137,867			12,085,448			13,136,868			12,064,393

(1)             Non-cash stock-based compensation expense included in these amounts is as follows:

Research and development		$	76,967		$	19,162		$	295,718		$	39,042
Sales and marketing		200,147			33,501			391,055			69,770
General and administrative		349,654			19,253			677,208			39,079

 

The accompanying notes are an integral part of these financial statements.

4

 

NeuroMetrix, Inc.

Statements of Cash Flows

(Unaudited)

		Six Months Ended
		June 30, 2006			June 30, 2005
Cash flows for operating activities:
Net income (loss)		$	1,678,038		$	(636,458	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization		174,314			131,052
Compensation expense associated with stock options		1,363,981			147,891
Provision for doubtful accounts		343,265			50,149
Amortization of premium on investments		102,115			249,417
Provision for income taxes		74,100			—
Changes in operating assets and liabilities:
Accounts receivable		(2,120,289		)	(647,549		)
Inventories		(261,454		)	(733,866		)
Prepaid expenses and other current assets		(119,053		)	14,229
Accounts payable		(99,401		)	594,692
Accrued compensation and other accrued expenses		263,037			490,440
Other long-term liabilities		(29,091		)	(29,091		)
Deferred revenue and deferred costs		371,883			244,890
Net cash provided by (used in) operating activities		1,741,445			(124,204		)
Cash flows for investing activities:
Purchases of investments		(23,752,079		)	(7,433,535		)
Maturities of investments		18,229,724			8,434,179
Purchases of fixed assets		(272,509		)	(245,209		)
Net cash provided by (used in) investing activities		(5,794,864		)	755,435
Cash flows from financing activities:
Proceeds from exercise of stock options		828,363			73,285
Proceeds from issuance of common stock under employee stock purchase plan		216,913			127,263
Net cash provided by financing activities		1,045,276			200,548
Net increase (decrease) in cash and cash equivalents		(3,008,143		)	831,779
Cash and cash equivalents, beginning of period		8,170,037			1,936,241
Cash and cash equivalents, end of period		$	5,161,894		$	2,768,020

 

The accompanying notes are an integral part of these financial statements.

5

 

NeuroMetrix, Inc.

Notes to Financial Statements

1.             Nature of the Business and Basis of Presentation

NeuroMetrix, Inc. (the “Company”), a Delaware corporation, was formed in June 1996. The Company designs, develops and sells proprietary medical devices used to diagnose neuropathies. Neuropathies are diseases of the peripheral nerves and parts of the spine that frequently are caused by or associated with diabetes, low back pain and carpal tunnel syndrome, as well as other clinical disorders. The Company operates in one business segment.

The accompanying unaudited balance sheet as of June 30, 2006 and unaudited statements of operations for the three and six month periods ended June 30, 2006 and 2005 and the unaudited statements of cash flows for the six month periods ended June 30, 2006 and 2005 have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair statement of the results of operations have been included. Operating results for the six month period ended June 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006 or any other period. These financial statements and notes should be read in conjunction with the financial statements for the year ended December 31, 2005 included in the Company’s Annual Report on Form 10-K (File No. 000-50856). The accompanying balance sheet as of December 31, 2005 has been derived from audited financial statements prepared at that date, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Recent Accounting Pronouncement

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 (“FIN No. 48”), which clarifies the accounting and disclosure for uncertainty in tax positions, as defined. FIN No. 48 seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement related to accounting for income taxes. This interpretation is effective for fiscal years beginning after December 15, 2006. The Company has not yet determined the impact this interpretation will have on our results from operations or financial position.

2.             Accounting for Stock-Based Compensation

In December 2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share Based Payment” (“SFAS No. 123(R)”), which requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. SFAS No. 123(R) revises SFAS No. 123 “Accounting for Stock-Based Compensation” (“SFAS No. 123”) and supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) and SFAS No. 148, “Accounting for Stock Based Compensation—Transition and Disclosure—an amendment of Financial Accounting Standards Board Statement No. 123”. As a result, beginning January 1, 2006, the Company adopted SFAS No. 123(R) using the modified prospective method and has begun reflecting the stock-based compensation expense determined under fair value based methods in statement of operations rather than as pro forma disclosure in the notes to the financial statements. Under this transition method, the compensation cost recognized beginning January 1, 2006 includes compensation cost for (i) all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123, and (ii) all share based payments granted subsequent to January 1, 2006 based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R). Compensation cost is generally recognized ratably over the requisite service period. Prior period amounts have not been restated. The Company uses the Black-Scholes option pricing model for determining the fair value of its stock options and amortizes its stock-based compensation expense using the straight-line method.

During 1996, the Company adopted the 1996 Stock Option/Restricted Stock Plan (the “1996 Stock Plan”). The 1996 Stock Plan provides for the granting of incentive and non-qualified stock options and stock bonus awards to officers, directors and employees of the Company. The maximum number of shares that may be issued pursuant to the 1996 Stock Plan is 156,250. All of the outstanding options under the 1996 Stock Plan are fully vested and terminate 10 years after the grant date, or earlier if the option holder is no longer an executive officer, employee, consultant, advisor or director, as applicable, of the Company. As of June 30, 2006, 6,250 shares were subject to outstanding options at a weighted average exercise price of $0.20 per share, 127,962 shares had been issued under the 1996 Stock Plan and no shares were available for future grant. If any options granted under the 1996 Stock Plan are forfeited, such shares are not available for future grant and revert back to the founder.

6

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During 1998, the Company adopted the 1998 Equity Incentive Plan (the “1998 Stock Plan”). The 1998 Stock Plan also provides for granting of incentive and nonqualified stock option and stock bonus awards to officers, consultants and employees of the Company. As of June 30, 2006, 1,250,000 shares of common stock were authorized for issuance under the 1998 Stock Plan, of which 487,709 shares had been issued and 682,812 shares were subject to outstanding options at a weighted average exercise price of $6.66 per share. Outstanding options under the 1998 Stock Plan generally vest over three or four years and terminate 10 years after the grant date, or earlier if the option holder is no longer an executive officer, employee, consultant, advisor or director, as applicable, of the Company. The 1998 Stock Plan was closed to any future grants at the time of the Company’s initial public offering and therefore we will not make any additional grants under the 1998 Stock Plan.

During 2004, the Company adopted the 2004 Stock Option and Incentive Plan (the “2004 Stock Plan”). The 2004 Stock Plan also provides for granting of incentive and nonqualified stock option and stock bonus awards to officers, consultants and employees of the Company. Outstanding options under the 2004 Stock Plan generally vest over three or four years and terminate 10 years after the grant date, or earlier if the option holder is no longer an executive officer, employee, consultant, advisor or director, as applicable, of the Company. As of June 30, 2006, 1,946,022 shares of common stock were authorized for issuance under the 2004 Stock Plan, of which 71,559 shares had been issued, 613,066 shares were subject to outstanding options at a weighted average exercise price of $22.78 per share and 1,261,397 shares were available for future grant. In March 2006, the Company’s Board of Directors voted to discontinue the provision of the 2004 Stock Plan which automatically increased the number of options available for grant under the 2004 Stock Plan based on the net increase in the total number of outstanding shares of common stock during the year.

The exercise price of each stock option issued under the 1996 and 1998 Stock Plans was specified by the Board of Directors at the time of grant. However, incentive stock options may not be granted at less than the fair market value of the Company’s common stock as determined by the Board of Directors at the date of grant or for a term in excess of 10 years. The exercise price of stock options awarded under the 2004 Stock Plan may not be less than the fair market value of the common stock on the date of the option grant. For holders of more than 10% of the Company’s total combined voting power of all classes of stock, incentive stock options may not be granted at less than 110% of the fair market value of the Company’s common stock at the date of grant and for a term not to exceed five years.

In June 2004, the Company adopted the 2004 Employee Stock Purchase Plan (“ESPP”). All of our employees who have been employed by the Company for at least 60 days and whose customary employment is for more than 20 hours per week and for more than five months in any calendar year are eligible to participate. Any employee who owns 5% or more of the voting power or value of our stock is not eligible to participate and an employee may purchase no more than $25,000 worth of common stock, valued at the start of the purchase period, in any calendar year. The ESPP authorizes the issuance of up to a total of 375,000 shares of our common stock to participating employees.

Under the ESPP, participating employees can authorize the Company to withhold up to 10% of their earnings during consecutive six-month payment periods for the purchase of the shares. At the conclusion of each period, participating employees can purchase shares at 85% of the lower of their fair market value at the beginning or end of the period. The ESPP is regarded as a compensatory plan according to the provisions of SFAS No. 123(R). Under this plan, the Company has issued 41,911 shares of its common stock through June 30, 2006.

A summary of activity under the Company’s 1996, 1998 and 2004 Stock Plans for the six months ended June 30, 2006 is presented below:

		Number of Shares		Exercise Price Range			Weighted Average Exercise Price
Outstanding at December 31, 2005		1,120,619		$	0.200 - 37.230		$	8.3316
Granted at fair value		332,500		27.280 - 38.600			30.6666
Exercised		(87,860	)	0.400 - 11.470			6.2722
Forfeited		(41,152	)	2.250 - 35.040			19.3486
Outstanding at March 31, 2006		1,324,107		$	0.200 - 38.600		$	13.7345
Granted at fair value		20,800		26.630 - 38.960			33.2324
Exercised		(40,479	)	0.400 - 12.600			7.5839
Forfeited		(2,300	)	2.250 - 26.630			23.4500
Outstanding at June 30, 2006		1,302,128		$	0.200 - 38.960		$	14.2200

 

The aggregate intrinsic value of options exercised during the second quarter and first six months of 2006 was $841,800 and $3.4 million, respectively.

7

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The following table summarizes information about stock options outstanding at June 30, 2006:

Exercise Price		Number of  Options  Outstanding		Weighted Average  Remaining  Contractual  Life (Years)		Weighted  Average  Exercise Price
$0.20 — 1.35		24,131		3.2		$	0.6663
$2.25 — 2.25		131,523		6.9		$	2.2500
$4.48 — 8.00		525,751		8.0		$	7.9121
$8.25 — 9.92		189,652		8.5		$	9.5921
$10.00 — 14.76		48,871		8.6		$	11.2438
$17.34 — 29.65		92,500		9.4		$	26.8185
$30.10 — 38.96		289,700		9.5		$	31.7401
		1,302,128		8.3		$	14.2200

 

 The following table summarizes information about stock options exercisable at June 30, 2006:

Exercise Price		Number of  Options  Exercisable		Weighted  Average  Exercise Price
$0.20 — 1.35		24,131		$	0.6663
$2.25 — 2.25		66,794		$	2.2500
$4.48 — 8.00		263,552		$	7.8574
$8.25 — 9.92		29,116		$	9.3234
$10.00 — 14.76		9,197		$	10.5328
$17.34 — 29.65		750		$	18.0133
$30.10 — 38.96		—		N/A
		393,540		$	6.6551

 

The weighted average remaining contractual life for stock options exercisable at June 30, 2006 was 7.50 years. The aggregate intrinsic value for stock options outstanding and exercisable at June 30, 2006 was $21,581,400 and $9,368,200, respectively.

Prior to January 1, 2006, the Company accounted for stock-based compensation plans in accordance with the provisions of APB No. 25, as permitted by SFAS No. 123, and accordingly did not recognize compensation expense for the issuance of options with an exercise price equal to or greater than the market price at the date of grant. Had the fair value based method as prescribed by SFAS No. 123 been applied by the Company, the effect on net loss and net loss per common share for the second quarter and first six months of 2005 would have been as follows:

		Three months ended			Six months ended
		June 30, 2005			June 30, 2005
Net loss, as reported		$	(40,144	)	$	(636,458	)
Add employee stock-based compensation expense included in reported net loss		71,916			147,891
Less employee stock-based compensation expense determined under fair value method		(350,630		)	(679,663		)
Net loss — pro forma		(318,858		)	(1,168,230		)
Net loss per common share (basic and diluted)
As reported		$	(0.00	)	$	(0.05	)
Pro forma		$	(0.03	)	$	(0.10	)

 

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The weighted average grant date fair value used in the calculation of stock-based compensation expense in the accompanying statement of operations for the second quarter and first six months of 2006 and the pro forma net income (loss) and earnings (loss) per common share information presented above has been calculated using the Black-Scholes option pricing model with the following weighted average assumptions:

		Three Months Ended						Six months ended
		June 30, 2006			June 30, 2005			June 30, 2006			June 30, 2005
Risk-free interest rate		4.8%-5.2		%	3.5%-4.1		%	4.3%-5.2		%	3.5%-4.3		%
Expected dividend yield		—			¾			—			¾
Expected option term		5 years			5 years			5 years			5 years
Volatility		50.0		%	63.7		%	50.0		%	60.0		%
Weighted average fair value of options granted		$	16.41		$	7.56		$	14.96		$	5.51

 

The expected option term of five years was estimated based on an analysis of actual option exercises and a review of comparable medical device companies. The risk-free interest rate assumption was based on the United States Treasury’s constant maturity’s rate for a five year term (corresponding to the expected option term) on the date the option was granted. The volatility assumption was based on weekly historical volatility during the time period that corresponds to the expected option term and a review of comparable medical device companies. The assumed dividend yield was based on the Company’s expectation of future dividend payouts. The post-vesting forfeiture rate is based on the historical and projected average turnover rate using four classifications of employees. These assumptions will be evaluated and revised as necessary based on changes in market conditions and historical experience.

The Company recorded stock-based compensation expense for the second quarter and first six months of 2006 of approximately $626,800 and $1.4 million, respectively. Included in the stock-based compensation expense recorded by the Company in the second quarter and first six months of 2006 is (a) $579,200 and $1.1 million, respectively, in compensation expense relating to stock-options granted to employees subsequent to the Company’s July 2004 initial public offering (“IPO”) that are accounted for according to the provisions of SFAS No. 123(R); (b) a $52,300 reduction of compensation expense and $49,000 in compensation expense related to stock options granted to non-employees that are accounted for according to the provisions of Emerging Issues Task Force (“EITF”) Issue No. 96-18 “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” (“EITF No. 96-18”); (c) $38,000 and $75,900, respectively, in compensation expense related to the ESPP and accounted for under the provisions of SFAS No. 123(R) and (d) $61,800 and $125,900, respectively, in compensation expense relating to stock options granted to employees prior to the Company’s initial public offering that are being accounted for using the intrinsic value method according to the provisions of SFAS No. 123(R).

Stock options granted to non-employees are recorded at fair value and adjusted to market over the vesting period according to the provisions of EITF No. 96-18. The Company determines fair value using the Black-Scholes option pricing model, an expected term equal to the remaining vesting period, a risk-free interest rate corresponding to the expected term, an expected volatility of 50% and a dividend yield of zero.

Deferred compensation was recorded in connection with stock option grants made prior to the Company’s IPO. The deferred compensation represents the difference between the estimated market value of common stock on the date of grant and the exercise price associated with the stock options. The deferred compensation is amortized to expense over the vesting period of the related stock options. The unamortized balance of deferred compensation as of June 30, 2006 is approximately $279,700.

Total unrecognized stock-based compensation costs related to non-vested stock options was approximately $7,087,300 as of June 30, 2006 which related to approximately 908,600 shares with a per share weighted fair value of $7.81. This unrecognized cost is expected to be recognized over a weighted average period of approximately 2.3 years.

The Company has no tax windfall or shortfall as of June 30, 2006 as a result of having a 100% valuation allowance established against deferred tax assets.

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3.             Net Income (Loss) Per Common Share

The Company accounts for and discloses net income (loss) per common share in accordance with SFAS No. 128, “Earnings Per Share”. Basic net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of common shares outstanding. Diluted net income (loss) per common share is computed by dividing net income (loss) by the weighted average number of common shares and dilutive potential common shares then outstanding. Potential common shares consist of shares issuable upon the exercise of stock options (using the treasury stock method).

		Three Months Ended						Six Months Ended
		June 30, 2006			June 30, 2005			June 30, 2006			June 30, 2005
Basic:
Net income (loss) available to common stockholders		$	1,530,700		$	(40,144	)	$	1,678,038		$	(636,458	)
Weighted average shares		12,485,205			12,085,448			12,450,037			12,064,393
Basic income (loss) per common share		$	0.12		$	(0.00	)	$	0.13		$	(0.05	)
Diluted:
Net income (loss) available to common stockholders		$	1,530,700		$	(40,144	)	$	1,678,038		$	(636,458	)
Weighted average shares		12,485,205			12,085,448			12,450,037			12,064,393
Effect of stock options		652,662			—			686,831			—
Weighted average shares, as adjusted		13,137,867			12,085,448			13,136,868			12,064,393
Diluted income (loss) per common share		$	0.12		$	(0.00	)	$	0.13		$	(0.05	)

 

The following potentially dilutive common shares were excluded from the calculation of diluted net income (loss) per common share because their effect was antidilutive for each of the periods presented:

		Three Months Ended				Six Months Ended
		June 30, 2006		June 30, 2005		June 30, 2006		June 30, 2005
Options outstanding		375,200		1,278,780		396,700		1,278,780

 

4.             Inventories

Inventories consist of the following:

		June 30, 2006			December 31, 2005
Purchased components		$	287,898		$	276,167
Finished goods		2,656,965			2,407,242
		$	2,944,863		$	2,683,409

 

5.             Other Balance Sheet Items

Accrued expenses consist of the following:

		June 30, 2006			December 31, 2005
Professional services		$	291,289		$	438,519
Other		854,752			775,409
		$	1,146,041		$	1,213,928

 

10

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Product Warranty Costs

The Company accrues estimated product warranty costs at the time of sale which are included in cost of sales in the statements of operations. The amount of the accrued warranty liability is based on historical information such as past experience, product failure rates, number of units repaired and estimated cost of material and labor. The liability for product warranty costs is included in accrued expenses in the balance sheet.

The following is a rollforward of the Company’s accrued warranty liability for the three and six month periods ended June 30, 2006 and 2005:

		Three Months Ended						Six Months Ended
		June 30, 2006			June 30, 2005			June 30, 2006			June 30, 2005
Balance at beginning of period		$	53,162		$	64,182		$	64,122		$	59,876
Accrual for warranties		130,316			79,622			223,844			139,316
Settlements made		(138,351		)	(72,451		)	(242,839		)	(127,839		)
Balance at end of period		$	45,127		$	71,353		$	45,127		$	71,353

 

There have been no adjustments to the amounts disclosed above for prior periods.

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Item 2.      Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion of our financial condition and results of operations in conjunction with our condensed financial statements and the accompanying notes to those financial statements included elsewhere in this Quarterly Report on Form 10-Q. This discussion contains forward-looking statements that involve risks and uncertainties. For a description of factors that may cause our actual results to differ materially from those anticipated in these forward looking statements, please refer to the section of this Quarterly Report on Form 10-Q titled “Cautionary Note Regarding Forward-Looking Statements.”

Overview

NeuroMetrix was founded in June 1996. We design, develop and sell proprietary medical devices used to diagnose neuropathies. Our proprietary technology provides physicians with an in-office diagnostic system, the NC-stat System, which enables physicians to make rapid and accurate diagnoses of neuropathies, including carpal tunnel syndrome, low back and leg pain and diabetic peripheral neuropathy. The NC-stat System is comprised of: (1) disposable single use NC-stat biosensors that are placed on the patient’s body; (2) the NC-stat monitor and related components; and (3) the NC-stat docking station, an optional device that enables the physician’s office to transmit data to our onCall Information System. Each component of the NC-stat System is also sold separately. The sensitivity of the nervous system to metabolic and mechanical damage, compounded by its limited regenerative ability, creates a market opportunity for a medical device that can assist in point-of-service diagnoses of neuropathies in a manner that is cost-effective for the patient and third-party payer. We believe the ease of use, accuracy and convenience provided by the NC-stat System position it to become a standard of care for the assessment of neuropathies at the point-of-service.

We derive our revenues from the sale of NC-stat biosensors, monitors and docking stations directly to end users, which are generally physician practice groups. Our NC-stat biosensors are disposable products that are used once and inactivated after use. The NC-stat monitor is an electronic instrument that is used with the NC-stat biosensors to perform nerve conduction studies for the purpose of diagnosing neuropathies. The NC-stat monitor displays the pertinent results of nerve conduction studies on an LCD screen immediately at the conclusion of each study. The NC-stat docking station is an optional device that is used to transmit to the onCall Information System data generated by the nerve conduction study performed with the NC-stat monitor. The onCall Information System formulates the data it receives for each test into a detailed report that is provided to the customer through facsimile or e-mail.

Reimbursement from third-party payers is an important element of success for medical products companies. Generally, we believe that the nerve conduction studies performed by our customers with the NC-stat System have been satisfactorily covered by third-party payers. As our presence in the market expands and the use of the NC-stat System increases, we have experienced and are likely to continue to experience an increased focus from third-party payers and governmental agencies regarding the reimbursement of nerve conduction studies performed using the NC-stat System and an increased focus from these organizations regarding the professional requirements for performing nerve conduction studies in general. At any point in time, a number of third-party payors may take the position of not reimbursing our customers for their use of the NC-stat System. Widespread adoption of the NC-stat System by the medical community is unlikely to occur if physicians do not receive satisfactory reimbursement from third-party payers for procedures performed with the NC-stat System. One of the primary challenges we face in our business is successfully expanding the market for nerve conduction studies. A successful market expansion will depend upon, in part, our targeting of primary care and specialty physicians who traditionally have not been targeted by companies selling equipment used to perform nerve conduction studies and our ability to alter physicians’ practices relating to the diagnosis of neuropathies. In order to successfully implement this growth strategy, we have increased our sales force to 50 employees, including 46 regional sales managers, as of June 30, 2006. We have also expanded the network of independent sales agents we use to generate sales leads for our regional sales managers through the signing of an agreement with Physician Sales & Service (“PSS”). PSS has a direct sales force of nearly 700 representatives. As a result we now have over 1,000 independent sales agents assisting us in our efforts to penetrate the market of primary care and specialty care physicians. We also will participate in various industry conferences in order to accelerate the market awareness and adoption of our products. These efforts, as well as the overall expansion of our business, will provide challenges to our organization and may increase the burden on our management and operations. We plan to monitor our business as it grows and appropriately acquire and allocate resources to address these issues, with a goal of sustaining profitable growth.

Our financial objective is to grow our business through the sale of the NC-stat System and additional products that may be commercialized for the diagnosis and treatment of neuropathies and to achieve sustainable profitability. Our efforts in the remainder of 2006 will continue to focus primarily on sales of the NC-stat System and continuing our ongoing program of making enhancements and improvements to the NC-stat System, with the goal of increasing our market penetration. During the first six months of 2006, we continued efforts on improvements to our biosensors, on the development of new biosensors, on the development of products to diagnose additional neuropathies, and on the development of a third generation neurodiagnostic system. We are also in the early stages of designing a drug delivery system for the minimally invasive treatment of neuropathies by both primary care and specialist physicians. We believe that the accomplishment of these goals will have a positive impact on our progress toward the objective of growing the business and achieving sustainable profitability.

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Effective January 1, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share Based Payment” (“SFAS No. 123(R)”), which requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. SFAS No. 123(R) is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”) and supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) and SFAS No. 148, “Accounting for Stock Based Compensation—Transition and Disclosure—an amendment of Financial Accounting Standards Board Statement No. 123” (“SFAS No. 148”). This statement establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all entities to apply a fair value based measurement method in accounting for share-based payment transactions with employees except for equity instruments held by employee share ownership plans. As a result, beginning January 1, 2006, we adopted SFAS No. 123(R) using the modified prospective method and have begun reflecting the stock-based compensation expense determined under fair value based methods in the income statement rather than as pro forma disclosure in the notes to the financial statements. Prior period results have not been restated. We use the Black-Scholes option pricing model for determining the fair value of its stock options and amortize our stock-based compensation expense using the straight-line method. During the first six months of 2006, we recorded stock-based compensation of approximately $1.4 million. We expect stock-based compensation expense recognized in accordance with the provisions of SFAS 123(R) in each of the remaining quarters of 2006 to be relatively consistent with the amount recognized in the first six months of 2006, but this amount could increase if there are additional stock options granted. The stock-based compensation expense recognized in accordance with Emerging Issues Task Force Issue No. 96-18 “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” for option grants to non-employees may vary significantly based on the performance of the Company’s stock price since these grants are valued at the end of each reporting period.

Results of Operations

The following table presents certain statement of operations information stated as a percentage of total revenues:

		Three Months Ended June 30,				Six Months Ended June 30,
		2006		2005		2006		2005
Revenues:
Diagnostic device		13.8	%	11.9	%	13.5	%	11.9	%
Biosensor		86.2		88.1		86.5		88.1
Total revenues		100.0		100.0		100.0		100.0
Cost of revenues		24.2		25.9		24.3		26.3
Gross margins		75.8		74.1		75.7		73.7
Operating expenses:
Research and development		9.1		12.8		9.8		13.0
Sales and marketing		38.7		43.3		41.4		45.4
General and administrative		19.3		20.8		20.3		22.0
Total operating expenses		67.1		76.9		71.5		80.4
Income (loss) from operations		8.8		-2.8		4.2		-6.7
Interest income (expense), net		2.7		2.3		2.6		2.4
Income (loss) before provision for income taxes		11.4		-0.5		6.8		-4.3
Provision for income taxes		0.5		—		0.3		—
Net income (loss)		11.0	%	-0.5	%	6.5	%	-4.3	%

 

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Comparison of Three Months Ended June 30, 2006 and June 30, 2005

Revenues

The following tables present a breakdown of our customers, biosensor units used and revenues:

		12-Month Period Ended June 30,
		2006		2005		Change		% Change
Customers		4,068		2,696		1,372		50.9	%

 

		Three Months Ended June 30,
		2006		2005		Change		% Change
Biosensor units used		287,200		173,100		114,100		65.9	%

 

		($ in thousands)
Revenues:
Diagnostic device		$	1,933.6		$	960.5		$	973.1		101.3
Biosensor		12,036.5			7,107.0			4,929.5			69.4
Total revenues		$	13,970.1		$	8,067.5		$	5,902.5		73.2	%

 

Diagnostic device revenues were $1.9 million and $960,500 for the three months ended June 30, 2006 and June 30, 2005, respectively, representing a year-over-year increase for the comparative periods of $973,100, or 101.3%. Of this increase, approximately $777,900 is attributable to a greater number of units sold, primarily as a result of an increase in the number of regional sales managers. In addition, approximately $195,100 of this increase is attributable to an increase in the list price of our NC-stat monitors and docking stations from $4,000 to $5,000 effective January 1, 2006, which resulted in a higher average selling price during the three months ended June 30, 2006 as compared to the same period in 2005. Diagnostic device revenues accounted for 13.8% and 11.9% of our total revenues for the three months ended June 30, 2006 and June 30, 2005, respectively.

Biosensor revenues were $12.0 million and $7.1 million for the three months ended June 30, 2006 and June 30, 2005, respectively, representing a year-over-year increase for the comparative periods of $4.9 million, or 69.4%. The increase was primarily due to an increased customer base for our biosensors and increased frequency of testing by our customers. Biosensor revenues accounted for 86.2% and 88.1% of our total revenues for the three months ended June 30, 2006 and June 30, 2005, respectively.

Our customers used 287,200 biosensor units in the three months ended June 30, 2006, compared to 173,100 units for the same period in 2005, an increase for the comparative periods of 114,100 units, or 65.9%. This increase in biosensor usage is primarily the result of the increase in the customer base and increased usage per customer.

Our total revenues were $14.0 million and $8.1 million for the three months ended June 30, 2006 and June 30, 2005 respectively, representing a year-over-year increase for the comparative periods of $5.9 million, or 73.2%. During the 12-month period ending June 30, 2006, a total of 4,068 customers used our NC-stat System compared to 2,696 customers for the same period ending June 30, 2005. This represents a 50.9% year-over-year increase in the number of customers that used our NC-stat System.

We expect revenues to continue to increase in 2006 as a result of the recent expansion of our sales force, which grew from 36 employees as of December 31, 2005 to 50 employees at the end of the second quarter of 2006, and as a result of the expansion of our network of independent sales agents, with the addition of PSS and their nearly 700 sales representatives. However, our revenues could be negatively impacted by a variety of factors, including the level of demand for nerve conduction studies, potential for changes in third-party reimbursement for nerve conduction studies, the overall economy, competitive factors and the factors described in the section of this Quarterly Report on Form 10-Q titled “Cautionary Note Regarding Forward-Looking Statements.”

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Costs and expenses

The following table presents our costs and expenses and net income (loss):

		Three Months Ended  June 30,
		2006			2005			Change			% Change
		($ in thousands)
Cost of revenues:
Diagnostic device		$	358.8		$	259.8		$	99.0		38.1	%
Biosensor		3,018.7			1,830.3			1,188.4			64.9
Total costs of revenues		3,377.5			2,090.1			1,287.4			61.6
Gross Margin:
Diagnostic device		1,574.8			700.7			874.1			124.7
Biosensor		9,017.8			5,276.7			3,741.0			70.9
Total gross margin		10,592.6			5,977.4			4,615.1			77.2
Gross Margin %:
Diagnostic device		81.4		%	73.0		%
Biosensor		74.9			74.2
Total gross margin %		75.8			74.1
Operating Expenses:
Research and development(1)		1,268.5			1,029.1			239.5			23.3
Sales and marketing(1)		5,408.3			3,494.5			1,913.8			54.8
General and administrative(1)		2,690.8			1,678.5			1,012.3			60.3
Total operating expenses		9,367.6			6,202.0			3,165.6			51.0
Income (loss) from operations		1,225.0			(224.6		)	1,449.6			-645.4
Interest income		372.3			184.7			187.7			101.6
Interest expense		—			(0.2		)	0.2			-100.0
Income (loss) before provision for income taxes		1,597.3			(40.1		)	1,637.4			-4,078.9
Provision for income taxes		66.6			—			66.6			N/A
Net income (loss)		$	1,530.7		$	(40.1	)	$	1,570.8		-3,913.0

(1)             Includes non-cash stock-based compensation expense of:

Research and development		$	77.0		$	19.2
Sales and marketing		200.1			33.5
General and administrative		349.7			19.3

 

Gross Margin

Diagnostic device gross margin increased to $1.6 million, or 81.4% of revenues, for the three months ended June 30, 2006 from $700,700, or 73.0% of revenues, for the same period in 2005. The increase in the gross margin percentage is primarily attributable to an increase in the list price of our NC-stat System from $4,000 to $5,000 effective January 1, 2006.

Biosensor gross margin increased to $9.0 million, or 74.9% of revenues, for the three months ended June 30, 2006 from $5.3 million, or 74.2% of revenues, for the same period in 2005. The increase in the biosensor gross margin percentage is primarily due to manufacturing price reductions realized for several of our biosensors during the second half of 2005 and the first quarter of 2006 partially offset by a change in the mix of biosensors sold.

Our overall gross margin was $10.6 million, or 75.8% of revenues, for the three months ended June 30, 2006 compared to $6.0 million, or 74.1% of revenues, for the same period in 2005.

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Research and Development

Our research and development, or R&D, expenses include expenses associated with our research, product development, clinical, regulatory and quality assurance departments.

R&D expenses increased $239,500, or 23.3%, to $1.3 million for the three months ended June 30, 2006 from $1.0 million for the same period in 2005. As a percentage of revenues, R&D expenses were 9.1% and 12.8% for the three months ended June 30, 2006 and June 30, 2005, respectively. The increase in expenses was primarily due to an increase of $198,400 in personnel costs resulting from the hiring of additional employees in our R&D department and increases in employee compensation. Also contributing to the increase was an increase of $57,800 in stock-based compensation expense due to the adoption of the provisions of SFAS No. 123(R).

We expect our spending on R&D will increase during the remainder of 2006 due to additional consulting services and the hiring of several additional employees to support product development efforts as well as increased clinical study costs. We expect R&D expenses, as a percentage of total revenues, to continue to decrease slightly due to an expected increase in revenue. This percentage may vary, however, depending primarily on our revenues for the remainder of 2006.

Sales and Marketing

Our sales and marketing expenses include expenses from the marketing, field sales, sales administration and reimbursement departments.

Sales and marketing expenses increased $1.9 million, or 54.8%, to $5.4 million for the three months ended June 30, 2006 from $3.5 million for the same period in 2005. As a percentage of revenues, sales and marketing expenses were 38.7% and 43.3% for the three months ended June 30, 2006 and June 30, 2005, respectively. The change in expenses was primarily due to an increase of $1.0 million in employee compensation and benefit costs, including sales commissions paid to our regional sales managers. This increase is due to the expansion of the sales force and higher revenues in the second quarter of 2006 compared to the second quarter of 2005. Also contributing to the change in expenses was an increase of $401,600 in sales commissions paid to our independent regional sales agencies, which were related to our higher revenues in the second quarter of 2006, an increase in stock-based compensation expense of $166,600 due to the adoption of the provisions of SFAS No. 123(R) and an increase of $161,900 in travel expenses due to the expansion of the sales force. The change in expenses was also partially due to an increase of $71,300 in costs for new promotional materials.

We have increased our sales force to 50 employees, including 46 regional sales managers, as of the end of the second quarter of 2006. For the remainder of 2006, we expect sales and marketing expenses, as a percentage of total revenues, to decrease slightly from the level experienced in 2005. This percentage may vary, however, depending primarily on our revenues for the remainder of 2006.

General and Administrative

Our general and administrative expenses include expenses from the executive, finance, administrative, customer service and information technology departments.

General and administrative expenses increased $1.0 million, or 60.3%, to $2.7 million for the three months ended June 30, 2006 from $1.7 million for the same period in 2005. As a percentage of revenues, general and administrative expenses were 19.3% and 20.8% for the three months ended June 30, 2006 and June 30, 2005, respectively. The increase in expenses was primarily due to (a) an increase in stock-based compensation expense of $330,400 due to the adoption of the provisions of SFAS No. 123(R); (b) an increase of $185,000 in bad debt expense; (c) an increase of $165,300 in professional fees for legal services and accounting and audit services; (d) an increase of $70,100 in recruiting costs associated with new hires; (e) an increase in credit card and bank fees of $61,200 related to increased customer transactions; and (f) an increase in printing costs of $40,500 related to the Company’s annual report and proxy statement.

We expect our general and administrative expenses to increase during the remainder of 2006 as a result of our expected growth and the expected hiring of additional general and administrative staff to support this growth. Total general and administrative expenses, as a percentage of total revenues, are expected to decrease in 2006, in spite of the anticipated need to hire additional staff. This percentage may vary, however, depending primarily on our revenues for 2006. We expect to be able to leverage existing resources such that the growth in general and administrative expenses is anticipated to be less than the growth in our revenues. Furthermore, while we experienced an increase in professional fees in 2005 largely due to the effect of the first year of compliance with the provisions of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley 404”), we do not expect the costs associated with Sarbanes-Oxley 404 to increase in 2006.

Interest Income and Expense

Interest income was $372,300 and $184,700 during the three months ended June 30, 2006 and June 30, 2005, respectively. Interest income was earned from investments in cash equivalents, short-term investments and long-term investments. Interest income increased during the three months ended June 30, 2006 compared to the same period in 2005 because of increased yields on invested funds in 2006. Interest expense was immaterial for all periods presented.

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Comparison of Six Months Ended June 30, 2006 and June 30, 2005

Revenues

The following tables present a breakdown of our customers, biosensor units used and revenues:

		12-Month Period Ended June 30,
		2006		2005		Change		% Change
Customers		4,068		2,696		1,372		50.9	%

 

		Six Months Ended June 30,
		2006		2005		Change		% Change
Biosensor units used		542,800		310,700		232,100		74.7	%

 

		($ in thousands)
Revenues:
Diagnostic device		$	3,475.0		$	1,772.9		$	1,702.1		96.0
Biosensor		22,318.3			13,084.4			9,233.9			70.6
Total revenues		$	25,793.3		$	14,857.3		$	10,936.1		73.6	%

 

Diagnostic device revenues were $3.5 million and $1.8 million for the six months ended June 30, 2006 and June 30, 2005, respectively, representing a year-over-year increase for the comparative periods of $1.7 million or 96.0%. Of this increase, approximately $1.4 million is attributable to a greater number of units sold, primarily as a result of an increase in the number of regional sales managers. In addition, approximately $319,700 of this increase is attributable to an increase in the list price of our NC-stat monitors and docking stations from $4,000 to $5,000 effective January 1, 2006, which resulted in a higher average selling price during the six months ended June 30, 2006 as compared to the same period in 2005. Diagnostic device revenues accounted for 13.5% and 11.9% of our total revenues for the six months ended June 30, 2006 and June 30, 2005, respectively.

Biosensor revenues were $22.3 million and $13.1 million for the six months ended June 30, 2006 and June 30, 2005, respectively, representing a year-over-year increase for the comparative periods of $9.2 million, or 70.6%. The increase was primarily due to an increased customer base for our biosensors and increased frequency of testing by our customers. Biosensor revenues accounted for 86.5% and 88.1% of our total revenues for the six months ended June 30, 2006 and June 30, 2005, respectively.

Our customers used 542,800 biosensor units in the six months ended June 30, 2006, compared to 310,700 units for the same period in 2005, an increase for the comparative periods of 232,100 units, or 74.7%. This increase in biosensor usage is primarily the result of the increase in the customer base and increased usage per customer.

Our total revenues were $25.8 million and $14.9 million for the six months ended June 30, 2006 and June 30, 2005 respectively, representing a year-over-year increase for the comparative periods of $10.9 million, or 73.6%. During the 12-month period ending June 30, 2006, a total of 4,068 customers used our NC-stat System compared to 2,696 customers for the same period ending June 30, 2005. This represents a 50.9% year-over-year increase in the number of customers that used our NC-stat System.

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