We believe the allegations are without merit and intend to defend them vigorously. Defending these lawsuits will require additional legal expenses to defend, may make fundraising more difficult if not impossible and will distract certain members of management from day-to-day operations.

Moreover, our insurance carrier has previously denied coverage for the plaintiffs’ claims and, accordingly, has indicated it will not cover the costs of defending the claims and will not pay any resulting damages we may suffer if the plaintiffs are successful. We have retained insurance counsel to advise us in this matter, which is in its early stages.

Finally, under our bylaws and contractual agreements we are required to indemnify our current and former officers and directors who are parties to the litigation by providing legal defense through our attorneys (or reimbursing them for their own attorneys) and covering all damages they may suffer if the plaintiffs are successful.

All of these financial impacts may have an adverse impact on the value of our common stock.

Ongoing Investigations by the SEC and U.S. Attorney are causing us to incur significant legal expenses, which if they continue, could adversely affect our working capital and shareholder value.

Both the Securities and Exchange Commission (“SEC”) and the U.S. Attorney’s Office for the Southern District of New York (“Attorney’s Office”) are conducting investigations involving possible violations of proscriptions on insider trading by our Chairman and Chief Executive Officer. While the Company is not a target of the investigations, the Company is incurring substantial legal expenses in responding to requests for information and documents from the SEC and Attorney’s Office, preparing for and attending depositions by the Company’s officers, conducting investigations of our own affairs, and advancing legal fee on behalf of officers who are or may be entitled to indemnification in connection with the se investigations. To date, in compliance with these requests, we have incurred expenses of approximately $650,000. The expenses we have incurred to date have substantially and adversely affected our working capital. As of the date of this document, the investigations are ongoing; and the expenses we may incur in the future could substantially and adversely affect our working capital, distract management from day-to-day operations and retard capital formation, which may result in us having to materially reduce or terminate our operations.

We have limited revenues from operations and may never have substantial revenue from operations.

With limited exceptions, our products have not been used in commercial applications and there is no assurance that the market will accept our products in sufficient volume to assure profitability. From inception on June 10, 1987 to June 30, 2003, we have recorded $3.4 million in revenue, $2.6 million from the sale of medical products and $800,000 from the sale of industrial products and test services. We have also recorded $93.7 million in operating expenses, resulting in aggregate accumulated operating losses as of June 30, 2003 of $92.8 million. We recorded revenues of approximately $1.5 million, $900,000 and $700,000 for the fiscal years ended June 30, 2003, 2002 and 2001, respectively. Failure to generate a profit could adversely affect shareholder value.

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Failure to obtain insurance reimbursement codes for our BCS 2100 may make the BCS 2100 unmarketable, thereby adversely affecting shareholder value.

Most healthcare providers, insurance companies and other third-party payers will not use or pay for the use of a medical device or a procedure unless it is has an accompanying reimbursement code. In December 2001, we applied to the American Medical Association for an Emerging Technology Code, which is the first step in obtaining Medicare, Medicaid and private insurance reimbursement for procedures performed using our BCS 2100. Our application will not be acted upon unless and until we receive FDA approval for the BCS 2100. There can be no assurance that we will receive these codes, that Medicare, Medicaid or private insurers will provide reimbursement under these codes, or that our customers will find the reimbursements sufficient to warrant the use of our BCS 2100. If our customers cannot obtain adequate insurance reimbursement for their services, the market for our BCS 2100 would be reduced and this would have a material adverse effect on us and our shareholders.

We expect to continue to incur losses, deficits, and deficiencies in liquidity that could impair our ability to grow.

We must develop clinical applications, obtain regulatory approvals, market our BCS 2100 and develop further applications and markets for our other products in order to become profitable. There is no assurance that we will be able to accomplish these objectives. We have incurred substantial losses in the past and expect to continue to incur losses, deficits and deficiencies in liquidity due to the significant costs associated with the continuing development and commercialization of our products. Such losses and deficiencies could have a material adverse impact on us and our shareholders. From June 10, 1987 until June 30, 2003, we incurred accumulated losses of $94.2 million. We recorded accumulated losses of $11.7, $21.7 and $26.1 million for the fiscal years ended June 2003, 2002 and 2001 respectively.

We may sell assets or reduce activities to fund operations, which could adversely affect shareholder value.

If we are unable to secure adequate capital through the sales of securities, or as part of a funding arrangement, we may continue to seek raising capital by selling all or part of our intellectual property and know-how, enter into license agreements for all or part of our intellectual property rights (which might include manufacturing licenses) to third parties for certain territories or business segments, terminate operations in any of our business segments to reduce expenditures, or reduce our operations in any or all of our business segments to preserve the business until funding is available. There can be no guarantee that we will be successful in these efforts. If we are not successful, we may have to severely reduce or terminate all or some of our operations, either of which could severely reduce or completely eliminate any shareholder value.

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The recent volatility in the market price of our shares could continue and adversely affect shareholder value.

The market price of our stock may continue to experience wide fluctuations, as it has in the recent past, which could be unrelated to our financial and operating results. Such volatility could result in a material loss in the value of an investment in our shares. Our stock price fluctuated between $4.97 and $1.44 during the year ended June 30, 2001, fluctuated between $4.05 and $.56 during the year ended June 30, 2002 and fluctuated between $1.29 and $0.09 during the year ended June 30, 2003. The price at which our common stock trades has been and will likely continue to be highly volatile and fluctuate substantially due to factors such as the following:

We could issue preferred stock and this could harm your interests.

We have authorized 3 million shares of preferred stock, par value $5.00 per share, none of which are outstanding. The preferred stock, if issued, could have preferential voting, dividend and liquidation rights which could adversely affect the rights of our common shareholders. Our authority to issue preferred stock without shareholder approval could discourage potential takeover attempts and could delay or prevent a change in control through merger, tender offer, proxy contest or otherwise by making such attempts more difficult and costly. The inability of a third party to enter into such a transaction may reduce the value of our shares. In connection with our efforts to raise capital, we could sell preferred stock to an investor. While we cannot quantify the impact at this time from any such issuance, this stock could offer conversion, dividend or other rights that could significantly dilute current shareholders of our common stock.

We rely on third parties in the development and manufacture of key components for our products. If they fail to perform, FDA approvals, product development, and/or production could be substantially delayed.

We depend upon third parties to assist us with clinical studies, product development and to supply product components. Our products are highly specialized and have component parts developed and manufactured according to unique specifications. Although there may be more than one developer or manufacturer for these components, failure to develop or manufacture in a timely manner could result in a loss of business and further result in substantial delays in FDA approvals and/or commercialization of our products. Such delays could adversely affect our operations and shareholder value.

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If we are unsuccessful in preventing others from using our intellectual property, we could lose a competitive advantage.

Our success will depend, in part, on our ability to use and prevent others from using our trademarks and other intellectual property. We currently hold three patents and have submitted seven patent applications. There can be no assurance that the steps we have taken to protect our property will protect our rights. Defense of our intellectual property could be expensive and time consuming, and parties that misappropriate our intellectual property could have significantly more financial resources than the Company, making it financially impossible to protect our rights.

We do not have product liability insurance.

The manufacture and sale of medical imaging systems may entail significant risk of product liability claims. There can be no assurance that we can obtain insurance coverage with limits adequate to protect us from any liability that might arise in connection with the sale of our products. Without such insurance, we may have to pay claims with Company funds, thereby making it impossible to maintain operations.

ITEM 2.      PROPERTIES

We lease facilities under various operating leases requiring fixed monthly payments, adjusted periodically over their term as follows:

Lake Oswego, Oregon Lease Agreement. Until March 1, 2003, we leased approximately 7,388 square feet of executive office space through August 14, 2006 with respect to 2,088 square feet and August 15, 2005 with respect to the remaining 5,300 square feet. Pursuant to the agreement, monthly lease payments were $15,700, plus operating expenses and property taxes. This space was used as our headquarters and housed our administrative, financial, executive, and marketing employees.  On March 1, 2003, as part of our general reduction in our operating expenses, we vacated these premises and moved into approximately 1,800 square feet of executive office space. The lease for that space is through June 2003 and thereafter runs on a month-to-month basis at $2,100 per month. The landlord for the space we vacated has filed a lawsuit against us for the remaining rent owed under that lease. See “Legal Proceedings.” On July 31, 2003 we consolidated our Oregon Office into the Ogden Utah office.

Ogden, Utah Lease Agreement. We lease approximately 7,660 square feet of manufacturing space in Ogden, Utah, through June 30, 2003. Monthly payments under the lease are $6,361. Our corporate, manufacturing, regulatory, quality assurance and clinical development departments use this space. We intend to continue consolidated operations in this facility and may, pursuant to the lease, continue occupying the space on a month-to-month basis for 110% of current monthly rents.

We believe that our offices are adequate for our present needs and that suitable space will be available for our future needs.

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See the description above in “Risk Factors.”

Salah Al-Hasawi Advisory Services Claim

On March 29, 2000, Salah Al-Hasawi (“Plaintiff”), a citizen and resident of Kuwait, filed an action in the United States District Court for the Southern District of New York, against us and our former Chief Executive Officer, alleging violations under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, for commissions allegedly due to Plaintiff in connection with the private placement of our securities. Shortly thereafter, the Plaintiff’s lawsuit was dismissed without prejudice and on April 12, 2000 the Plaintiff filed a similar complaint in the United States District Court for the District of Utah. Plaintiff seeks specified damages of $15.5 million, attorney fees and unspecified damages pursuant to five separate causes of action including breach of contract, fraud and unjust enrichment.

We have denied all of Plaintiff’s claims and have affirmatively alleged that all amounts due have been paid in full. We are currently engaged in discovery and no trial date has yet been set.

SEC and Department of Justice Investigations

In December 2002, the Company was requested to provide certain documents to the U.S. Securities and Exchange Commission and the U.S. Attorney for the Southern District of New York in connection with possible violations of the insider trading prohibitions found in the federal securities laws by our Chairman and Chief Executive Officer. To date, we have incurred approximately $650,000 in legal costs in complying with these requests. The Company also may be required to indemnify its officers and directors in connection with fees incurred in connection with these investigations. For the year ended June 30, 2003 and 2004, such indemnification obligations have totaled approximately $131,000 and $24,000 respectively.

St. Paul Properties, Inc. vs. Computerized Thermal Imaging, Inc.

On April 11, 2003, St. Paul Properties, Inc. (the “Landlord”) filed suit against us in the Circuit Court for Clackamas County. The Landlord alleges that we have breached our prior corporate office lease by failing to pay the rent specified under the lease. The Landlord seeks damages of approximately $667,000 plus interest and attorneys and other fees. The Company has filed an answer and affirmative defenses alleging that St. Paul Properties failed to use reasonable efforts to mitigate its damages. In addition, we are aware that much of the vacant space has been relet to a third party tenant, substantially reducing the damage claim. The Company has offered the sum of $40,000 to settle the matter. That offer was rejected by the landlord, with no counter offer made by the landlord. The Company intends to continue efforts to settle the matter.

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PART II

Our common stock trades on the American Stock Exchange under the symbol “CIO.”

Price Range of Our Common Stock

The following table summarizes the quarterly low and high bid prices per share for our common stock. The bid prices reflect inter-dealer prices, without retail markup, markdown, or commission and may not represent actual transactions.

On September 1, 2003, the closing price of our common stock as reported on the American Stock Exchange was $0.37 per share. On September 1, 2003, we had approximately 21,000 beneficial shareholders of our common stock and approximately 113 million shares of our common stock outstanding.

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Forward-Looking Statements Concerning Our Business

The following discussion should be read in conjunction with the Consolidated Financial Statements, the Notes thereto and the other information included in this Report. Certain statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” are forward-looking statements. When used in this document, the words “expects,” “anticipates,” “intends,” “plans,” “may,” “believes,” “seeks,” “estimates,” and similar expressions generally identify forward-looking statements. The forward-looking statements contained herein are based on current expectations and entail various risks and uncertainties that could cause actual results to differ materially from those expressed in such forward-looking statements. For a more detailed discussion of these and other business risks, see “Risk Factors.”

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Overview

Our mission is to improve the quality of life by continuously raising the performance standards of infrared thermal imaging technology for both the medical device and industrial markets. We design, manufacture and market thermal imaging devices and services used for clinical diagnosis, pain management and industrial non-destructive testing. We provide inspection services and design and build non-destructive test systems for industrial customers.

Our current products are the BCS 2100, Photonic Stimulator, TIP, and our TBIS. We market our products with an internal sales force and through independent distributors. To date, revenues have been generated from the sale of our Photonic Stimulator, TIP, TBIS and services provided in connection with our TBIS.

Critical Accounting Policies

The preparation of financial statements requires the Company to estimate the effect of various matters that are inherently uncertain as of the date of the financial statements. Each of these required estimates varies in regard to the level of judgment involved and its potential impact on the Company’s reported financial results. Estimates are deemed critical when a different estimate could have reasonably been used or where changes in the estimate are reasonably likely to occur from period to period, and would materially impact the Company’s financial condition, changes in financial condition or results of operations. The Company’s significant accounting policies are discussed in Note 1 of the Notes to Consolidated Financial Statements; critical estimates inherent in these accounting policies are discussed in the following paragraphs. The Company’s management has discussed the development and selection of these critical accounting policies with the Audit Committee of the Company’s Board of Directors.

Revenue Recognition—Although we believe revenues recognized to date have been immaterial to our financial statements, we also believe revenue recognition is a significant business process that requires management to make estimates and assumptions. We recognize revenue from product sales after shipment when persuasive evidence of an agreement exists, delivery of the product has occurred, no significant obligations remain, the price or fee is fixed or determinable, and collectibility is probable. If these conditions are not met, revenue is deferred until such obligations and conditions are fulfilled.

Our standard domestic terms for our medical products to end-user customers are net 30 days and our standard international terms for our medical products are cash or a letter of credit before shipment. On occasion, we offer extended payment terms beyond our normal business practices, usually in connection with providing an initial order of demonstration equipment to a new domestic distributor. We consider fees on these extended terms agreements to not be fixed and collectibility to be less than probable. Accordingly, we defer the revenue until receipt of payment. We sell separate extended warranty contracts for our TIP and Photonic Stimulator and recognize revenue from those arrangements ratably over the contract life. The Company does not offer rights or return privileges in sales agreements.

Industrial sales are made pursuant to individually negotiated commercial contracts which specify payment terms that have ranged from 60 to 90 days from shipment or service completion. With industrial products, even if delivery and payment have occurred, we may retain a significant ongoing obligation under a sales arrangement for the delivery of components or customized software and customer testing, and we defer recognizing revenue until all the multiple elements of the sale are completed

Inventory Valuation—The Company values its inventory at lower of cost or market. Inventory values are determined using standard purchase quantities and prices agreed with our vendors. If purchase costs decrease, any difference is recorded to cost of revenues and the carrying value of inventory is reduced. The Company has not experienced significant material cost increases for any production part.

Inventory Reserves—The Company reserves for excess and obsolete inventory by comparing inventory on hand to estimated consumption during the next 12 months. Consumption is estimated by annualizing trailing three or six month trailing sales volumes, adjusting those volumes for known activities and trends and then comparing forecast consumption to quantity on hand. Any difference between inventory on hand greater and estimated consumption is recorded to cost of revenues and an excess and obsolete reserve which is included as an element of net inventory reported on our Balance Sheet. Amounts charged into the inventory reserves are not reversed to income until the reserved inventory is sold or otherwise disposed.

Impairment of Long-Lived Assets—The Company follows the provisions of the Financial Accounting Standards Board (“FASB”) SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, which requires that if the sum of the future undiscounted cash flows expected to result from the assets is less than the carrying value of the assets, then the asset is not recoverable and the company must recognize an impairment. The amount of impairment to be recognized is the excess of the carrying value of the assets over the fair value of those assets and is recorded as a component of impairment loss on our consolidated statement of operations. In estimating impairments, management makes assumptions about future cash flows, the likelihood of those cash flows occurring and fair values of the related assets based on estimates that may differ from actual results.

Stock-Based Compensation—The Company measures compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board (“APB”) Opinion 25, Accounting for Stock Issued to Employees and FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation—an interpretation of Accounting Principles Board (APB) Opinion No. 25 (“FIN 44”).

Pursuant to the prescribed guidelines, the Company has recorded adjustments (see Stock-Based Compensation in Management’s Discussion and Analysis) from changing the exercise price of employee stock options, extending the exercise period of employee stock options, issuing stock options at a strike price lower than the then Company stock price and from issuing stock to directors or stock to an employee.

During 2001, we modified the price of some executives and managers’ stock options in connection with concluding severance agreements or to align the interests of executives, managers and shareholders. As a result, these options became subject to variable accounting. Variable accounting requires the Company to adjust compensation expense for the increases or decreases in the intrinsic value of the modified awards in subsequent periods until the award is exercised, is forfeited, or expires unexercised.

The Company follows SFAS 123, Accounting for Stock-Based Compensation, for non-employee stock options and warrants granted. Values have been estimated at the date of grant and beginning of the period respectively, using a Black-Scholes security pricing model. In determining values under the Black-Scholes pricing model, the Company makes estimates and assumptions regarding the Company’s volatility, risk-free lending rate and the expected life of the security, which materially impact the security’s value.

The board of directors authorizes all stock option and warrant grants, and must approve any changes to option or warrant terms.

Results of Operation

Fiscal Years Ended June 30, 2003 and 2002

Revenue

Total revenues for the fiscal year ended June 30, 2003, were $1.539 million compared to $ 878 thousand for the fiscal year ended June 30, 2002, an increase of $661 thousand, or 75.28%. Revenues for 2003 include $420 thousand in deferred revenues for products shipped during the year ended June 30, 2002.

Our medical segment revenues were $1.0 million and $750 thousand for the fiscal years 2003 and 2002, respectively. The $250 thousand, or 33% increase, results from increased shipments of TIP units and Photonic Stimulators (“PS”). The price of TIP units sold increased 6% and the quantity of units sold increased 138% during the fiscal year 2003. The price of PS units sold decreased 51% while the quantity of units sold increased 150% during 2003.

Industrial segment revenues, primarily from the recognition of a deferred sale of a TBIS to Alstom, were $539 thousand and $128 thousand for the fiscal years ended June 30, 2003 and 2002, respectively. We shipped a TBIS to Alstom during the second quarter of 2002; however, due to existing commitments and obligations requiring us to repair and correct all defects in material, workmanship including software updates for a one-year period subsequent to customer acceptance requirements, we deferred the revenue until we fulfilled our outstanding obligations regarding this sale.

As of June 30, 2003, we do not have a backlog of industrial orders for our TBIS and industrial products compared to a backlog of approximately $425 thousand in industrial backlog as of June 30, 2002. We have no backlog for pain management products, which are shipped immediately upon receipt of an order. Reported backlog represents the actual value of purchase orders issued to the Company for delivery of goods in the future. In our relatively short sales history, backorder cancellations are approximately 15% of total backorders recorded principally because one customer, Alstom, elected to purchase accessories and additional testing software for the first unit shipped, rather than purchase a second unit.

Expenses

Gross Margins and Cost of Revenues. Total gross margin for 2003 were approximately $215 thousand compared to $269 thousand for 2002, a decrease of 20%. This decrease is primarily attributable to an inventory reserve adjustments for excess and obsolete inventory of $394 thousand offset by increased sales in medical and industrial products. Total cost of goods sold for 2003 were $1.3 million compared to $609 thousand in 2002.

Gross margins for our medical products segment were approximately ($40 thousand) and $168 thousand for 2003 and 2002, respectively. Although medical sales were up 33% compared to 2002, gross margin decreased (124%). This decrease was due primarily to an increase in the inventory reserve of $394 thousand, which we incurred during the third quarter of 2003 due to our estimates and projections of future sales compared to quantities on hand at the time. This decrease was partially offset by increased sales volume. Our medical segment costs of revenues were approximately $1.040 million in 2003 and $582 thousand in 2002. 

We do not believe gross margins for the year ended June 30, 2003, are indicative of gross margins for future periods. We expect that unit prices for our TIP products will decline as a prerequisite to increasing unit volumes and as a result of competition. We expect prices to decline faster than we are able to reduce manufacturing costs; therefore, our gross margins as a percent of sales for our pain management products excluding impairments will most likely decline. However, if we are able to gain market acceptance and increase volume, total gross margin dollars may improve. Demand for our pain management products and resulting revenues and gross margins are dependant upon general economic conditions, insurance reimbursements, insurance coverage offered by medical plans and our ability to aggressively market and promote our products.

Gross margins and cost of revenues as a percentage of sales are:

Gross margins for the industrial segment were $255 thousand and $101 thousand for 2003 and 2002, respectively, an increase of $154 thousand, or 152%, while cost of revenues were $284 thousand and $27 thousand for the same periods, an increase of $257 thousand, or 952%. The increase in the gross margin was primarily attributable to the recognition of the Alstom TBIS that we shipped in the second quarter of 2002.

Industrial gross margins are unpredictable because of the custom content of each unit, the relatively poor condition of the power turbine and aerospace industries and general economic conditions. In April 2003, we consolidated our Walnut Creek, California operation into our Ogden, Utah facility to decrease operating expenses.

Operating General and Administrative. Operating general and administrative expenses for the year ended June 30, 2003 were $2.919 million compared to $1.356 million for the year ended June 30, 2002. Excluding a stock-based compensation expense of $7 thousand in 2003 and a benefit or recovery of $2.914 million during the year ended June 30, 2002, resulting from variable accounting for certain employee stock options operating general and administrative expenses decreased by $1.358 million or 32%. If we can obtain FDA approval or funding to facilitate the steps suggested by the FDA, our expense level will increase in connection with hiring the people needed to build the administrative infrastructure required to manufacture and market our BCS 2100. Operating general and administrative expenses, excluding stock based compensation, are:

In 2003, operating general and administrative expenses contain a $7 thousand deferred compensation expense related to repricing stock options at a price below the fair value on the date of modification. In 2002, the operating general and administrative stock-based compensation adjustments contain a net benefit, or expense recovery, of approximately $2.914 million due to the decrease in the Company’s stock price during the year (see Stock-based Compensation below for a more detailed description).

Operating general and administrative expenses decreased from 2003 to 2002, excluding stock-based compensation, were primarily attributable to: 1) a $626 thousand decrease in wages and related expenses; 2) a $156 thousand decrease in professional services expense excluding legal expenses; 3) a $162 thousand decrease in overhead expenses, primarily insurance and rent; 4) a $13 thousand decrease in temporary services; 5) a $529 thousand decrease in other expenses, which includes travel, equipment, supplies, bad debt recoveries, and miscellaneous accrued expenses. The decreases were partially offset by increases in expenses attributable to: 6) a $90 thousand increase in legal expenses, and 8) a $38 thousand increase to stockholder services.

The decrease in wages is primarily due to a material decrease in the number of administrative employees and salary reductions. Professional services decreased primarily due to decreasing the number of service providers and the activities performed. Overhead and other expenses decreased primarily due to our efforts to consolidate offices, terminate services and reduce travel expenses along with other general cost containment efforts. Legal expenses increased during 2003 due to a request by the U.S. Securities and Exchange Commission and the U.S. Attorney for the Southern District of New York to provide certain documents in connection with possible violations of the insider trading prohibitions found in the federal securities laws. To date, we have incurred approximately $650 thousand in legal costs in complying with these requests and in conducting related internal investigations. The Company also may be required to indemnify its officers and directors in connection with fees incurred in connection with these investigations. For the year ended June 30, 2004, such indemnification obligations have totaled approximately $24,000. If we can obtain FDA approval or funding to facilitate the steps suggested by the FDA, our expense level for general and administrative expenses will increase as we add people and build infrastructure to bring the BCS 2100 to market. Our legal expenses will be determined in large part by our ability to obtain insurance coverage for the shareholder securities litigation, our success in defending that litigation and obtaining insurance coverage, the cost of complying with the SEC and US Attorney investigations, the cost of preparing and filing any securities registrations, and our ability to avoid additional significant litigation.

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Operating general and administrative expenses are allocated to segments using budgeted levels of various activities; e.g., headcount, square feet occupied and fixed assets. Comparative expenses allocated to these segments were affected by the factors discussed above.

Research and Development. Research and development expenses for the year ended June 30, 2003, were $3.765 million compared to $6.141 million for 2002. Excluding a stock-based compensation benefit resulting from variable accounting for certain employee stock options of $209 thousand during the year ended June 30, 2002, research and development expenses decreased by $2.585 million, or 41%.

The stock-based compensation adjustment recorded as research and development expense during 2002 contains a benefit or recapture to expense of approximately $209 thousand due to the decrease in Company’s stock price during the fiscal year related to repricing company executive stock options in 2001 (see Stock-based Compensation below for a more detailed description). Excluding stock-based compensation, research and development expenses are:

           Excluding stock-based compensation, the decrease in research and development expense was primarily a result of: 1) $1.228 million decrease in wages and related expenses; 2) $325 thousand decrease in consulting services associated with the development of our BCS 2100 and FDA PMA application; 3) $165 thousand decrease in clinical trial expenses; 4) a $470 thousand decrease in engineering costs associated with product design, developments and enhancements; 5) a $73 thousand decrease in staffing services; 6) a $170 decrease in overhead, primarily rents and insurance; 7) a $188 thousand decrease in other costs, primarily travel, supplies and miscellaneous costs; and 8) a $32 thousand decrease to benefits. This reduction in expenses was partially offset by: 9) a $66 thousand increase in patent protection expenses.

The decrease of research and development expenses overall primarily relates to our efforts to increase cash flow and decrease in costs. We have significantly reduced our medical and industrial research and development personnel and have scaled back capital intensive projects. Our remaining research and development personnel now devote more time and attention to replying to technical questions from FDA regarding our PMA and refining existing products.

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Research and development spending is highly dependant upon our ability to secure FDA approval, and any conditions that might be attached to that approval. If we are unable to obtain FDA approval through negotiation or the FDA appeal process, the FDA’s non-approvable letter dated January 2003, describes additional steps to obtain approval including more clinical trials and further research. However, we cannot guarantee whether or when our negotiations or appeal with the FDA might be concluded, the outcome of those negotiations or appeal or the outcome of new clinical trial and research.

Medical research and development expenses were approximately $3.047 million and $5.089 million for 2003 and 2002, respectively. Excluding stock-based compensation, as discussed above, research and development expenses decreased approximately $2.251 million, or 42%. This decrease in research and development expenses from 2002 to 2003 is attributable to our cost reduction and consolidation efforts discussed above. If we can obtain FDA approval or FDA approval with modest conditions, research and development expenses will remain approximately constant. However, if we are unable to obtain FDA approval, or if the FDA approval contains significant conditions, and we can obtain funding to facilitate the steps suggested by the FDA, research and development expenses will increase to conduct more clinical trials and further research into the BSC 2100.

Industrial research and development expenses were approximately $718 thousand and $1.052 million for the fiscal years 2003 and 2002, respectively. This decrease in research and development expense is attributable consolidating the Walnut Creek office into our Ogden Utah office, materially decreasing industrial research and development personnel and suspending research and development activities. We are still providing industrial services and products, but at a much lower level. We will adjust our industrial research and development expenses based upon our perception of the condition of the aerospace and commercial power generation markets and our existing customers’ requirements. If we can obtain sufficient additional funding and the market conditions warrant industrial expansion, we will consider expanding our industrial capability.

For the year ended June 30, 2003 and all prior periods, we expensed all costs associated with process and systems development, including software code development, computer hardware and software purchases, and expenses related to the development of our BCS 2100.

Marketing. Marketing expenses for the year ended June 30, 2003, were $1.492 million compared to $2.993 million for the year ended June 30, 2002. Excluding a stock-based compensation recovery resulting from variable accounting for certain employee stock options of $378 thousand during the year ended June 30, 2002, marketing expenses decreased by $1.879 million, or 56%.

The stock-based compensation adjustment recorded as marketing expense during 2002 contains a recovery of expense of approximately $378 thousand due to the decrease in the Company’s stock price during the fiscal year related to repricing executive stock options in 2001 (see Stock-based Compensation below for a more detailed description). Excluding stock-based compensation, marketing expenses are:

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Marketing expense decreases, excluding stock-based compensation, were primarily a result of: 1) $366 thousand decrease in wages and related expenses from a material reduction in the number of sales and marketing employees; 2) $1.261 million decrease in marketing and tradeshows to develop a market for our products; 3) $53 thousand decrease in overhead expenses—principally, insurance, utilities, postage and miscellaneous expenses; and 4) $199 thousand decrease in other expenses, primarily, travel, equipment, supplies, and miscellaneous expenses.

Marketing expenses decreased primarily due to our efforts to reduce marketing activities including tradeshows and sales and marketing personnel. Subsequent to June 30, 2003, we consolidated our Portland, Oregon office to the Ogden, Utah facility. As a result of these significant reductions in workforce and curtailed marketing efforts since June 30, 2002, we expect these expenses to decline slightly for fiscal 2004. However, if we can obtain FDA approval for our BCS 2100, we expect our marketing expenses to increase significantly as we increase our sales force and commence actively marketing the BCS 2100.

Marketing expenses are allocated to segments using budgeted levels of various activities, e.g., headcount, square feet occupied and fixed assets. Comparative expenses allocated to these segments were affected by the factors discussed above.

Depreciation and Amortization. Depreciation and amortization expenses for the fiscal year ended June 30, 2003 were $440 thousand compared to $1.600 million for the year ended June 30, 2002. The $1.160 million, or 73%, decrease was primarily related to goodwill impairments recorded June 30, 2002, and to fixed asset impairments recorded during the year ended June 30, 2003.

Depreciation and amortization expenses are allocated to segments using budgeted levels of various activities, e.g., headcount, square feet occupied and fixed assets.

Stock-based Compensation. We have recorded stock-based compensation resulting from: 1) granting options with an exercise price below the market price of the Company’s common stock on the date of grant; 2) modifying the exercise price of outstanding employee stock options; 3) extending the exercise period of outstanding employee stock options; and 4) issuing common stock to employees and directors.

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During 2001, we modified the price of some executives’ and managers’ stock options in connection with concluding severance agreements or to align the interests of executives, managers and shareholders. As a result, these options became subject to variable accounting. Variable accounting requires the Company to adjust compensation expense for the increases of decreases in the intrinsic value of the modified awards in subsequent periods until the award is exercised, is forfeited, or expires unexercised.

During fiscal 2001, we issued 80,000 shares of restricted stock to our outside directors as compensation. These shares were valued at the closing price of our common stock on the date of grant. We also issued 50,000 shares of stock to our former CFO in connection with a severance agreement. The shares replaced 100,000 fixed incentive employee stock options and were valued at the closing price of our common stock on the date of the grant. We recorded compensation for these two transactions of $134 thousand and $137 thousand respectively.

Because our stock price decreased from $4.95 to $0.63 per common share from June 30, 2001 to June 30, 2002, we recorded an expense recovery (reduced expense) of approximately $3.501 million in 2002 in contrast to the expense we recorded in 2001 of $3.840 million when the price of the stock increased from the fair market price at the date of modification to $4.95 at June 30, 2001. In fiscal 2003, we recorded deferred compensation of approximately $7 thousand related to repricing options in 2001 at a strike price below the fair value.

Impairment Losses. Impairment losses consist of asset impairments of approximately $711 thousand and $8.717 million for 2003 and 2002, respectively. We evaluate our property, plant and equipment for impairment whenever indicators of impairment exist.

For the year ended June 2003, we reviewed our fixed assets and impaired them to their estimated fair value primarily because of our limited cash balances, history of sustained losses and the FDA’s decision to disapprove the BCS 2100. Accounting standards require that if the sum of the future cash flows expected to result from the assets, undiscounted and without interest charges, is less than a company’s reported value of the assets, then the asset is not recoverable and the company must recognize an impairment. The amount of impairment to be recognized is the excess of the reported value of the assets over the fair value of those assets and is recorded as an impairment expense on our statement of operations. In estimating impairments, management makes assumptions about future cash flows and fair value that are inherently uncertain, can significantly affect the results, and may differ from actual future results. The 2003 impaired assets consist of computers, furniture, equipment, leasehold improvements and software used in the medical and industrial segments.

During the year ended June 30, 2002, we evaluated the carrying value of our intangible assets and recorded a reduction of $8.717 million in goodwill and other intangible assets.

Operating Income/Loss

We recorded an operating loss of $9.112 million for the year ended June 30, 2003 compared to an operating loss of $22.138 million for the year ended June 30, 2002.

Medical segment losses were approximately $7.613 and $20.309 million for 2003 and 2002, respectively. Excluding stock-based compensation and the impairment losses, medical segment losses were approximately $7.064 and $14.187 million for 2003 and 2002, respectively. The improvement of approximately $7.123 million is related to reductions in staffing levels across the Company, clinical trial activities, research and development of our BCS 2100, product improvements and enhancements. If we can obtain FDA approval without condition or with relatively modest conditions, medical net losses will increase overall as we build infrastructure and incur marketing expenses until we can generate significant sales from our BCS 2100. If we receive FDA approval with significant conditions or if we cannot obtain FDA approval without completing the steps outlined in the January 2003 non-approval letter, medical segment losses will increase as we conduct more clinical trials, research into the BSC 2100 and continue our efforts to obtain approval.

Industrial segment losses were approximately $1.499 million and $1.829 million for 2003 and 2002, respectively. Excluding stock-based compensation, industrial segment lost approximately $1.329 million and $2.735 million for 2003 and 2002, respectively. The $1.406 million decrease in losses is primarily attributable to consolidating our Walnut Creek office into the Ogden Utah office, reducing staffing levels and suspending industrial research and development activities. We expect the industrial segment to remain unprofitable because of unfavorable conditions in the economy. We have deemphasized our industrial segment to reduce these losses, but if we can obtain sufficient funding and market conditions become favorable, we plan to invest in this segment and expect to incur losses until we are able to increase industrial revenues.

Net Interest Income/Expense

Interest income for the year ended June 30, 2003, was $165 thousand compared to $654 thousand for the year ended June 30, 2002. The $489 thousand, or 75%, decrease was primarily a result of decreased investments available for sale and lower interest rates. Interest income will continue to decease as we use investments available for sale to fund operations.

Interest expense for the fiscal year ended June 30, 2003 was $2.792 million compared to $219 thousand for the year ended June 30, 2002. Interest expense is comprised of: 1) $1.777 million related to reducing the conversion price of the Convertible Debenture and attached warrants; 2) $286 thousand related to penalty; and 3) $367 thousand related to the amortization of deferred finance costs; 4) $243 thousand related to the amortization of the beneficial conversion feature; and 5) $119 thousand of accrued interest at 7% per annum on the Convertible Debenture. Interest expense will decrease as we redeem the Convertible Debenture. The Company has paid periodic interest on the debenture in common stock.

Net Loss

We incurred a loss of $11.738 million, or $(.13) per share, for the year ended June 30, 2003 compared to a loss of $21.703 million, or $(0.26) per share, for the year ended June 30, 2002.

Fiscal Years Ended June 30, 2002 and 2001

Revenue

Total revenues for the fiscal year ended June 30, 2002, were $878 thousand compared to $674 thousand for the fiscal year ended June 30, 2001, an increase of $204 thousand or 30%. Revenues for 2002 and 2001 do not include $420 thousand in deferred revenues for products shipped during the year ended June 30, 2001, which will be recognized as revenues in future periods in accordance with GAAP.

Our medical segment revenues were $750 thousand and $566 thousand for the fiscal years 2002 and 2001 respectively. The $184 thousand, or 33% increase, results from increased shipments of TIP units and Photonic Stimulators (“PS”). The price of TIP units sold decreased 12% while the quantity of units sold increased 60% during the fiscal year 2002. The price of PS units sold decreased 18% while the quantity of units sold increased 2% during 2002.

Industrial segment revenues, primarily from the sale of test services and product analysis, were $128 thousand and $108 thousand for the fiscal years ended June 30, 2002 and 2001, respectively. The $20 thousand, or 19% increase, is from increased sales of turbine blade test services to Alstom, which ended when the Company shipped a TBIS to Alstom during the second quarter of 2002. Industrial revenues do not include deferred revenue from the shipment of the TBIS to Alstom, which will be recognized when we have concluded our outstanding commitments and obligations that require us to repair and correct all defects in material and workmanship for a one-year period after the customer acceptance requirements are complete. As of the date of this document, we have completed our ongoing commitments and will recognize revenue from this sale during the third quarter of 2003.

As of June 30, 2002, we had a backlog of industrial orders for our TBIS and industrial products of approximately $425 thousand that we expect to complete in the next fiscal year compared to $600 thousand in industrial backlog as of June 30, 2001. We have no backlog for pain management products, which are shipped immediately upon receipt of an order. Reported backlog represents the actual value of purchase orders issued to the Company for delivery of goods in the future. In our relatively short sales history, backorder cancellations are approximately 15% of total backorders recorded principally because one customer, Alstom, elected to purchase accessories and additional testing software for the first unit shipped, rather than purchase a second unit.

Expenses

Gross Margins and Cost of Revenues. Total gross margin for 2002 were approximately $269 thousand compared to $255 thousand for 2001, an increase of 5%. This increase is primarily attributable to increased sales in medical and industrial products offset by increased inventory reserve adjustments for excess and obsolete inventory and a decrease in the average sales price of medical products. Total cost of revenues for the 2002 was approximately $609 thousand compared to $419 thousand for the prior fiscal year, an increase of 45%.

Gross margins for our medical products segment were approximately $168 thousand and $185 thousand for 2002 and 2001, respectively. Although medical sales were up 33% compared to 2001, gross margin decreased 9%. This decrease was due primarily to an increase in inventory reserves of $94 thousand required because our sales did not increase as rapidly as we expected, decreases in our sales prices and increases in cost of revenues. This decrease was partially offset by increased sales volume. Our medical segment cost of revenues were approximately $582 thousand and $381 thousand, an increase of $201 thousand, for 2002 and 2001, respectively.

We expect that unit prices for our TIP and PS will continue to decline as a prerequisite to increasing market penetration strategies. We also expect prices to decline faster than we are able to reduce manufacturing costs; therefore, our gross margins as a percentage of sales for our pain management products will decline. However, if we are able to gain market acceptance and increase volume, total gross margin dollars may improve.

Gross margins and cost of revenues as a percentage of sales are:

Gross margins for the industrial segment were $101 thousand and $70 thousand for the 2002 and 2001, respectively, an increase of $31 thousand, or 44%, while cost of revenues were $27 thousand and $38 thousand for the same periods, a decrease of $11 thousand, or 29%. This was primarily attributable to a decrease in non-destructive test services after we shipped a TBIS to Alstom during the second quarter of 2002.

Industrial gross margins are unpredictable because of the custom content of each unit, the relatively poor condition of the power turbine and aerospace industries and general economic conditions. In April 2003, we consolidated our Walnut Creek, California operation into our Ogden, Utah facility to decrease operating expenses.

Operating General and Administrative. Operating general and administrative expenses for the year ended June 30, 2002 were $1.356 million compared to $11.345 million for the year ended June 30, 2001. Excluding a stock-based compensation benefit or recovery resulting from variable accounting for certain employee stock options of $2.914 million during the year ended June 30, 2002, and other stock-based compensation expenses of $5.140 million for the fiscal year ended June 30, 2001, operating general and administrative expenses decreased by $1.935 million or 31%. If we can obtain FDA approval or funding to facilitate the steps suggested by the FDA, our expense level will increase in connection with hiring the people needed to build the administrative infrastructure required to manufacture and market our BCS 2100.

In 2002, the operating general and administrative stock-based compensation adjustments contain a benefit, or recovery of expense, of approximately $2.914 million due to the decrease in the Company’s stock price during the year (see Stock-based Compensation below for a more detailed description). The stock-based compensation adjustment in 2001 contains an expense of approximately $5.140 million composed of 1) $3.047 million related to repricing employee stock options for the Company’s former president, current president and certain management employees 2) $1.687 million related to extending the life of stock options in connection with a severance agreement for the former CEO 3) $271 thousand related to issuing stock to the former CFO in connection with his severance agreement and to directors for services rendered and 4) $135 thousand related to issuing stock options as compensation to outside directors at a strike price below the Company’s common stock price on the day they were granted. Excluding stock-based compensation operating general and administrative expenses are:

Operating general and administrative expense decreases from 2001 to 2002, excluding stock-based compensation, were primarily attributable to: 1) a $593 thousand decrease in wages and related expenses; 2) an $627 thousand decrease in legal services expense; 3) a $64 thousand decrease in other professional services expense; 4) a $66 thousand decrease in shareholder service expense; 5) a $191 thousand decrease in overhead expenses, primarily insurance and rent; 6) a $103 thousand decrease in temporary services; 7) a $66 thousand decrease in employee benefits; and 8) a $225 thousand decrease in other expenses, which includes travel, equipment, supplies, bad debt, and miscellaneous accrued expenses.

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Operating general and administrative wages and related expenses, excluding severance payments of $250 thousand to executive employees during 2001, decreased by $343 thousand from 2001 to 2002. This decrease in wages is primarily due to a decrease in the number of administrative employees and the reassignment of administrative personnel to marketing and research departments. Legal expenses decreased during 2002 due to concluded lawsuits, decreased services related to registering our shares on a stock exchange and decreased fees related to Securities and Exchange Commission compliance services. Shareholder services expense decreased $66 thousand from a reduction in annual shareholder meeting and proxy printing expenses. The decrease in overhead, temporary services and other expense relate in part to allocating overhead to a larger number of growing departments while decreasing the size of the administrative department. If we can obtain FDA approval or funding to facilitate the steps suggested by the FDA, our expense level for general and administrative expenses will increase as we add people and build infrastructure to bring the BCS 2100 to market.

During 2002, we accrued $250 thousand in legal fees. This accrual represents our insurance deductible and expected obligations related to the shareholder securities litigation described above. Our current policy covers up to $10 million in potential claims. Our insurance carrier has previously denied coverage. If our insurance carrier continues to take the position that the claims are not covered by insurance and does not pay the claims associated with this lawsuit and if we are unable to defend the lawsuit successfully, we will incur significant legal fees and damages. Our legal expenses will be determined in large part by our ability to obtain insurance coverage for the shareholder securities litigation, our success in defending that litigation and obtaining insurance coverage, the cost of complying with the SEC and US Attorney investigations, the cost of preparing and filing any securities registrations, and our ability to avoid additional significant litigation.

Operating general and administrative expenses are allocated to segments using budgeted levels of various activities; e.g., headcount, square feet occupied and fixed assets. Comparative expenses allocated to these segments were affected by the factors discussed above.

Litigation Settlement. During the year ended June 30, 2002, we recorded $1.6 million in litigation settlement expense; $1.4 million related to concluding the Packer litigation and $200 thousand in connection with resolving litigation with a former consultant.

Research and Development. Research and development expenses for the year ended June 30, 2002, were $6.141 million compared to $8.703 million for 2001. Excluding a stock-based compensation benefit resulting from variable accounting for certain employee stock options of $209 thousand during the year ended June 30, 2002, and stock-based compensation expense of $216 thousand for the year ended June 30, 2001, research and development expenses decreased by $2.137 million, or 25%.

The stock-based compensation adjustment recorded as research and development expense during 2002 contains a benefit or recapture to expense of approximately $209 thousand due to the decrease in Company’s stock price during the fiscal year related to repricing company executive stock options in 2001 (see Stock-based Compensation below for a more detailed description). The stock-based compensation adjustment in 2001 contains an expense of approximately $216 thousand due to the increase in the Company’s stock price from the date of modification to June 30, 2001 related to repricing a manager’s stock options in 2001. Excluding stock-based compensation, research and development expenses are:

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Excluding stock-based compensation, the decrease in research and development expense was primarily a result of: 1) $2.867 million decrease in consulting services associated with the development of our BCS 2100 and FDA PMA application; 2) $310 thousand decrease in software license fees; 3) $707 thousand decrease in clinical trial expense; and 4) $8 thousand decrease in other miscellaneous expenses. This reduction in expense was partially offset by: 5) $796 thousand increase in salaries and related expenses as a result of an increase in the number of engineering, regulatory, and manufacturing support employees; 6) $491 thousand increase in administrative overhead costs; 7) $122 thousand increase in patent related expenditures; 8) $206 thousand increase in temporary labor services; and 9) $140 thousand increase in engineering and design costs. Research and development spending is highly dependant upon our ability to secure FDA approval, and any conditions that might be attached to that approval. If we are unable to obtain FDA approval through negotiation or the FDA appeal process, the FDA’s non-approvable letter dated January 2003, describes additional steps to obtain approval including more clinical trials and further research. However, we cannot guarantee whether or when our negotiations or appeal with the FDA might be concluded, the outcome of those negotiations or appeal or the outcome of new clinical trial and research.

Research and development expenses decreased during 2002 compared to 2001 as we concluded our clinical trials and completed Module 5 of our PMA application for the BCS 2100. The composition of these expenses and focus of our efforts also changed. Our research and development personnel now devote more time and attention to replying to technical questions from FDA regarding our PMA, refining existing products, and developing new applications for our products.

Medical research and development expenses were approximately $5.089 million and $7.937 million for 2002 and 2001, respectively. Excluding stock-based compensation, as discussed above, research and development expenses decreased approximately $2.423 million, or 31%. This decrease in research and development expenses from 2001 to 2002 is attributable to concluding clinical trials for the BCS 2100 and a resulting decrease in consulting expense, headcount, travel and other expenses. If we can obtain FDA approval or FDA approval with modest conditions, research and development expenses will remain approximately constant. However, if we are unable to obtain FDA approval, or if the FDA approval contains significant conditions, and we can obtain funding to facilitate the steps suggested by the FDA, research and development expenses will increase to conduct more clinical trials and further research into the BSC 2100.

Industrial research and development expenses were approximately $1.052 million and $766 thousand for the fiscal years 2002 and 2001, respectively. This increase in research and development expense is attributable to building an industrial research and development infrastructure, hiring personnel and expanding research and development activities into non-destructive thermal imaging and testing. We will adjust our industrial research and development expenses based upon our perception of the condition of the aerospace and commercial power generation markets and our existing customers’ requirements. We have consolidated our industrial facility into our Ogden, Utah operation and have suspended industrial research activities to conserve cash. If we can obtain sufficient additional funding and the market conditions warrant industrial expansion, we will consider expanding our industrial capability.

For the year ended June 30, 2002 and all prior periods, we expensed all costs associated with process and systems development, including software code development, computer hardware and software purchases, and expenses related to the development of our BCS 2100.

Marketing. Marketing expenses for the year ended June 30, 2002, were $2.993 million compared to $3.101 million for the year ended June 30, 2001. Excluding a stock-based compensation recovery resulting from variable accounting for certain employee stock options of $378 thousand during the year ended June 30, 2002, and stock-based compensation expense of $577 thousand for the year ended June 30, 2001, marketing expenses increased by $847 thousand, or 34%.

The stock-based compensation adjustment recorded as marketing expense during 2002 contains a recovery of expense of approximately $378 thousand due to the decrease in the Company’s stock price during the fiscal year related to repricing executive stock options in 2001 (see Stock-based Compensation below for a more detailed description). The stock-based compensation adjustment in 2001 contains an expense of approximately $577 thousand due to modification of certain executives’ stock options and an increase in the Company’s stock price that occurred from the time the options were re-priced and the end of 2001. Excluding stock-based compensation, marketing expenses are:

Marketing expense increases, excluding stock-based compensation, were primarily a result of: 1) $408 thousand increase in wages and related expenses from an increase in the number of sales and marketing employees; 2) $74 thousand increase in marketing and tradeshows to develop a market for our products; 3) $154 thousand increase in overhead expenses—principally, insurance, utilities, supplies, postage and miscellaneous expenses; 4) $43 thousand increase in employee benefits; and 5) $168 thousand increase in other expenses—primarily, travel, equipment, supplies, and miscellaneous expenses.

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Marketing expenses increased primarily due to developing and expanding this department. As a result of significant reductions in workforce and curtailed marketing efforts since June 30, 2002, we expect these expenses to decline significantly in the coming months and for fiscal 2003. However, if we can obtain FDA approval for our BCS 2100, we expect our marketing expenses to increase significantly as we increase our sales force and commence actively marketing the BCS 2100.

Marketing expenses are allocated to segments using budgeted levels of various activities, e.g., headcount, square feet occupied and fixed assets. Comparative expenses allocated to these segments were affected by the factors discussed above.

Depreciation and Amortization. Depreciation and amortization expenses for the fiscal year ended June 30, 2002 were $1.600 million compared to $2.258 million for the year ended June 30, 2001. The $658 thousand, or 29%, decrease was primarily related to fixed asset impairments recorded during the year ended June 30, 2001.

Stock-based Compensation. We have recorded stock-based compensation resulting from: 1) granting options with an exercise price below the market price of the Company’s common stock on the date of grant; 2) modifying the exercise price of outstanding employee stock options; 3) extending the exercise period of outstanding employee stock options; and 4) issuing common stock to employees and directors.

During 2001, we modified the price of some executives’ and managers’ stock options in connection with concluding severance agreements or to align the interests of executives, managers and shareholders. As a result, these options became subject to variable accounting. Variable accounting requires the Company to adjust compensation expense for the increases of decreases in the intrinsic value of the modified awards in subsequent periods until the award is exercised, is forfeited, or expires unexercised.

During fiscal 2001, we issued 80,000 shares of restricted stock to our outside directors as compensation. These shares were valued at the closing price of our common stock on the date of grant. We also issued 50,000 shares of stock to our former CFO in connection with a severance agreement. The shares replaced 100,000 fixed incentive employee stock options and were valued at the closing price of our common stock on the date of the grant. We recorded compensation for these two transactions of $134 thousand and $137 thousand respectively.

Because our stock price decreased from $4.95 to $0.63 per common share from June 30, 2001 to June 30, 2002, we recorded an expense recovery (reduced expense) of approximately $3.501 million in 2001 in contrast to the expense we recorded in 2001 of $3.840 million when the price of the stock increased from the fair market price at the date of modification to $4.95 at June 30, 2001. In addition to expenses resulting from variable accounting during 2001, we incurred expenses of approximately 1) $1.687 million related to extending the life of stock options in connection with a severance agreement for the former CEO, 2) $271 thousand related to issuing stock to the former CFO in connection with his severance agreement and to directors for services rendered, and 3) $135 thousand related to issuing stock options at a strike price below the Company’s common stock price to directors as compensation.

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Impairment Losses. Impairment losses consist of asset impairments of approximately $8.717 million and $2.894 million for 2002 and 2001, respectively. During the year ended June 30, 2002, we evaluated the carrying value of our goodwill and intangible assets and recorded a reduction of $8.717 million in goodwill and other intangible assets. During the year ended June 30, 2001, we abandoned our database management project. In connection therewith, we reduced the capitalized value of the software to zero, incurring a charge of approximately $2.740 million. We also wrote-off other tangible and intangible assets, with a net book value of approximately $154 thousand in connection with relocating our Layton, Utah, operations to our Ogden, Utah manufacturing facility.

Operating Income/Loss

We recorded an operating loss of $22.138 million for the year ended June 30, 2002 compared to an operating loss of $28.047 million for the year ended June 30, 2001.

Medical segment losses were approximately $20.309 million and $24.589 million for 2002 and 2001, respectively. Excluding stock-based compensation and the impairment losses, medical segment losses were approximately $14.187 million and $16.849 million for 2002 and 2001, respectively. The improvement of approximately $2.662 million is related to a reduction in clinical trials and BCS 2100 PMA preparation expenses resulting from filing the fifth and final module of our PMA application during June 2001. This reduction was partially offset by the settlement of two lawsuits for $1.6 million. If we can obtain FDA approval without condition or with relatively modest conditions, medical net losses will increase overall as we build infrastructure and incur marketing expenses until we can generate significant sales from our BCS 2100. If we receive FDA approval with significant conditions or if we cannot obtain FDA approval without completing the steps outlined in the January 2003 non-approvable letter, medical segment losses will increase as we conduct more clinical trials and research into the BSC 2100.

Industrial segment losses were approximately $1.829 million and $3.457 million for 2002 and 2001, respectively. Excluding stock-based compensation, industrial segment lost approximately $2.735 million and $2.370 million for 2002 and 2001, respectively. The $365 thousand increase in losses is primarily attributable to 1) building infrastructure in marketing and research and development, and 2) expanding research and development activities into non-destructive thermal imaging and testing. We expect the industrial segment to remain unprofitable because of unfavorable conditions in the economy. However, with the recognition of revenue from the Alstom and other sales we expect to significantly reduce reported losses during 2003. We have deemphasized our industrial segment to reduce these losses, but if we can obtain sufficient funding and market conditions become favorable, we plan to invest in this segment and expect to incur losses until we are able to increase industrial revenues.

Net Interest Income/Expense

Interest income for the year ended June 30, 2002, was $654 thousand compared to $1.921 million for the year ended June 30, 2001. The $1.267 million, or 66%, decrease was primarily a result of lower interest rates and decreased investments available for sale. Interest income will continue to decease as we use investments available for sale to fund operations.

Interest expense for the fiscal year ended June 30, 2002 was $219 thousand. This amount includes coupon interest computed at 7% per annum on the $2.5 million convertible debenture and the amortization of deferred finance costs and debt discount. Interest expense will continue to increase as we record accelerated amortization of finance charges related to the convertible debenture. The Company anticipates paying periodic interest on the debenture in common stock

Net Loss

We incurred a loss of $21.703 million, or $(.26) per share, for the year ended June 30, 2002 compared to a loss of $26.113 million, or $(0.32) per share, for the year ended June 30, 2001.

Unaudited Quarterly Results of Operations

The following table summarizes our results of operations for each of the four quarters in the years ended June 30, 2003 and 2002. This information was derived from unaudited interim consolidated financial statements that, in the opinion of management, have been prepared on a basis consistent with the audited consolidated financial statements contained elsewhere in this report and includes all adjustments necessary for fair statement of such information when read in conjunction with the audited consolidated financial statements and notes thereto.

Period-to-period comparisons of our historical operating results are not necessarily indicative of future performance.

Operating expenses have fluctuated from quarter-to-quarter primarily due to impairment losses, litigation settlements, convertible debenture price modifications and variable option accounting (see stock-based compensation above for a detailed explanation).

The financial results for the first quarter of 2002 were affected by variable option accounting in which we recorded an expense recovery of approximately $3.346 million.

The financial results for the fourth quarter of 2002 were affected by a goodwill impairment loss of approximately $8.7 million and a settlement charge of $1.6 million. This impairment loss approximated 60 percent of the total net loss while the settlement charge approximates 11 percent of the total net loss for the quarter ended June 30, 2002.

The financial results for the second quarter of 2003 were affected by an operating assets impairment loss of $711 thousand, which approximates 21 percent of the total net loss.

The financial results for the third quarter of 2003 were affected by a modification to our exercise price of our Convertible Debenture from $1.44 to $.0.084 a share and the exercise price of the attached warrant from $1.50 to $.084 a share. In connection with this modification, we took an interest charge of approximately $1.78 million.

For the quarter ended December 31, 2001, our net loss is restated by $9 thousand to $3.896 million to reflect an increase to operating general and administrative expenses. For the quarter ended March 31, 2002, the net loss is adjusted $11 thousand to $3,657 thousand to reflect a $5 thousand increase in general and administrative expense and a $6 thousand increase in interest expense. These stock-based expenses increased from an adjustment to the volatility computations applied in the Black-Scholes equation we used to calculate the fair value of options and warrants issued to consultants and Beach Boulevard, LLC.

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Sources of Liquidity

From inception through June 30, 2003, we have generated $92.8 million of losses from operations.

Our cash requirements include general corporate expenses including salaries and benefits, lease payments for office space, technology acquisition, software license and maintenance contract payments, legal and accounting fees, clinical trial and technical support, FDA consulting, marketing, and expenses associated with the private placement of our equity securities. Capital resources needed to meet our past and planned expenditures have been financed and are likely to continue to be primarily from the sale of equity securities.

As of June 30, 2003, we believed that we had sufficient liquidity to sustain current operations for six to eight months. From June 20, 2003 to July 31, 2003, we have received $1 million in private financing from an investor and $660 thousand from our licensing agreement with Nanda. To restore operations to former levels, we must secure additional funding. As of June 30, 2003, our current monthly cash outlay rate was approximately $400 thousand; our cash monthly outlay at our former full operation rate was approximately $1.1 million. We plan to continue to reduce our monthly cash outlay to approximately $300 thousand through further office consolidation, staffing reduction and scaled back research and development activities. As of June 30, 2003, we still owe our Investor approximately $157 thousand in connection with the Convertible Debenture, which has subsequently been redeemed. Unless we are able to secure additional funding from a third party, we do not have sufficient working capital to sustain our current operations through the end of fiscal 2004.

The following table summarizes the Company’s contractual obligations and commitments to make future payments as of June 30, 2002:

The operating lease obligation represents the continued obligation of the St. Paul Properties lease, which we abandoned late in fiscal 2003 (see Legal Proceedings).

The debenture obligation represents the remaining portion of the redeemable balance attributable to the penalty from the trigger event (see Agreement with Beach Boulevard, LLC).

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Agreement with Beach Boulevard, LLC.

On December 31, 2001, we reached a financing agreement (the “Agreement”) with Beach Boulevard, LLC (the “Investor”), pursuant to which the we issued a 7% convertible debenture in the amount of $2.5 million (the “Debenture Offering”) and secured an equity line of credit (the “Equity Line”) for $20 million that allows the us to sell up to $20 million in common stock to the Investor at 94% of the market price, as defined by the Agreement. The Convertible Debenture was originally due on December 31, 2004. The terms of the Agreement permit the Investor to convert the Convertible Debenture into 2,100,694 shares of common stock at a conversion price of $1.44 per share at any time during the term of the Agreement. Interest on the Convertible Debenture is due on the conversion date and is payable, at the option of the Company, in cash or common stock.

In connection with the agreement, we entered into a registration rights agreement and subsequently filed an effective registration statement with the SEC, which was declared effective on March 18, 2002 (Registration No. 333-82016). Prior to completing this financing agreement, we terminated our 1999 agreement with Beach Boulevard to purchase up to $7 million of our common shares of stock. The Investor may require us to redeem all or a portion of the Convertible Debenture if the average closing bid price of the our common stock for the 90 consecutive trading days after the effective date of the registration statement is less than $1.44 (a “Trigger Event”). The amount redeemable is equal to 111% of the principal balance of the Convertible Debenture and accrued interest (the “Redeemable Balance”). If a Trigger Event occurs, the Investor is required to provide notice to us of its election to force redemption and to specify the date (the “Redemption Due Date”) on which the Redeemable Balance is to be paid. If we do not pay the Redeemable Balance in full by the Redemption Due Date, we are required to issue registered unrestricted shares of common stock pursuant to a series of put notices consistent with the terms of the Equity Line. If the registration statement is not currently effective, the conversion price of 94% would be reduced to 75% of the three lowest bid prices from the 10 trading days after a put is issued. The maximum put we can issue is equal to the lesser of $500 thousand or 125% percent of the weighted average volume of our common stock for the 20 trading days immediately preceding the put date. Because of this volume restriction, we cannot redeem the entire debenture at one time, but have to redeem the debenture in numerous puts. If the Redeemable Balance is not satisfied through the mandatory puts within six months of the Investor’s notice to force redemption, the unpaid portion of the Redeemable Balance is required to be paid immediately in cash. If the Company does not comply with the cash payment, the Company will be in default of its Debenture obligation.

The Equity Line allows for the sale of up to $20 million of common stock subject to a maximum put amount, as described above, at 94% of the three lowest bid stock prices during the 10 trading days preceding a put date. We believe our availability under the Equity Line will be significantly less than $20 million because availability is contingent upon a) our common stock price and b) our daily trading volume both of which have declined since we entered into the financing arrangement and because we are using the Equity Line to redeem the debenture as described above.

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In connection with the Agreement, we issued the Investor warrants for the purchase of 260,417 shares of common stock at $2.03 a share and 641,026 shares of common stock at $1.95 a share, which expire December 31, 2004 and December 31, 2007, respectively. The proceeds from the Debenture Offering were allocated between the Convertible Debenture, the beneficial conversion feature and the warrants issued to the Investor. We also issued separate warrants to an investment bank for the purchase of 100,000 shares of common stock at $1.87 per share. The fair market value of these warrants and other related financing costs have been recorded as deferred financing costs and were originally being amortized over the three-year term of the Agreement. However, because of the Trigger Event discussed in the preceding paragraph, the deferred financing costs and beneficial conversion feature, going forward, have been amortized over the six-month period ending January 25, 2003.

On July 25, 2002, the Investor notified us that a Trigger Event had occurred. On the date of the Trigger Event, the Redeemable Balance was approximately $2.9 million, which includes principal of $2.5 million, $111 thousand of accrued interest and $287 thousand of penalty. We elected to satisfy the Redeemable Balance through a series of put notices based on the terms of the Equity Line. The terms of the Equity Line provide for one mandatory put per month and a maximum put amount equal to the lesser of $500 thousand or 125% of the weighted average volume for the 20 days immediately preceding the date of the put notice. During the mandatory put period, we may still draw down the Equity Line and issue puts for general operating funds.

In connection with the terms of the Agreement (see Note 2), the Company issued 5,009,083 shares of common stock pursuant to a series of mandatory put notices during the period July 1, 2002 through January 29, 2003. The proceeds were applied to redeem approximately $685,000 of the Convertible Debenture and to pay accrued interest and penalties totaling $176,000 and $95,000, respectively.

On January 29, 2003, the Company received a Holder Redemption Notice (the “Notice”) from the Investor. The Notice, referencing the Agreement, stated that the Investor demanded payment of the Redeemable Balance. Pursuant to the Agreement, the Company had five days to pay the balance in cash. Because the Company did not pay the Redeemable Balance as requested by the Investor, the Company was considered to be in default based on the terms of the Agreement.

On February 5, 2003, the Company received approximately $210,000 from the issuance of 2,234,043 of common stock pursuant to the terms of the Equity Line. The proceeds were used to redeem approximately $183,000 of the Convertible Debenture and to pay accrued interest and penalties totaling $6,000 and $21,000, respectively.

On or about February 21, 2003, the Company and the Investor entered into an agreement which was formalized on March 19, 2003, (“Amendment Agreement”) whereby the Company agreed to reduce the conversion price in the Convertible Debenture from $1.44 per share to an amount equal to the lower of (a) $1.44 (the “Fixed Conversion Price”) or (b) ninety-four percent (94%) of the average of the lowest closing bid prices (not necessarily consecutive) for any three trading days during the ten trading days period immediately preceding the conversion date. The Company also agreed to reduce the exercise price of the warrants that were issued to the Investor in connection with the Agreement to $0.087733 per share, which was the average of the lowest closing bid prices for any of the three trading days during the ten trading days period immediately preceding the Amendment Agreement. Pursuant to the Amendment Agreement, the Investor exercised warrants to purchase 260,417 shares of common stock at an agreed-upon exercise price of $0.087733 per share and (2) converted approximately $86,000 in principal of the Convertible Debenture into 977,244 shares common stock at the agreed-upon conversion price of $0.087733 per share. The proceeds from the exercise of the warrants totaling approximately $23,000 were applied to redeem approximately $20,000 of the Convertible Debenture and to pay accrued interest of approximately $2,000. In connection with the modification of the conversion terms of the Convertible Debenture, which was considered to be an inducement to convert the Convertible Debenture, and the reduction of the exercise price of the Investor’s warrants, the Company recorded an interest expense totaling approximately $1,770,000 during the quarter ended March 31, 2003.

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The Company issued 1,212,956 shares of common stock pursuant to a mandatory put notice on February 21, 2003. The proceeds were applied to redeem approximately $91,000 of the Convertible Debenture and to pay accrued interest and penalties totaling $5,000 and $11,000, respectively. On March 19, 2003, the Company entered into an agreement with the Investor (the “Amendment Agreement”) that formalized the terms reached in the February 21, 2003 agreement. In connection with the Amendment Agreement, the Investor also agreed to defer its demand for immediate payment of the full amount due under the Notice for at least 90 days and agreed to not file suit against the Company, its officers, employees, partners or agents for a period of 90 days. Upon execution of the Amendment Agreement, the Investor converted $272,000 in principal of the Convertible Debenture, including $7,000 of interest, into 3,224,146 shares of common stock.

During the period March 20, 2003 through May 19, 2003, the Investor converted approximately $1,181,000 of the remaining Redeemable Balance, including interest of $11,000, into 9,805,161 shares of common stock. As of June 30, 2003, the Company still owes the Investor approximately $157,000 of the Redeemable Balance, which consists of the unpaid portion of the penalty. In July 2003, we issued approximately 200,000 shares of common stock to redeem the remaining Redeemable Balance.

Capital Requirements/Plan of Operation

Our capital requirements may vary from our estimates and depend upon numerous factors including 1) time and costs involved in obtaining regulatory approvals for the BCS 2100, 2) results of pre-clinical and clinical testing, 3) costs of technology, 4) progress in our research and development programs, 5) costs of filing, defending and enforcing any patent claims and other intellectual property rights, 6) the economic impact of developments in competing technology and our markets, 7) competing technological and market developments, 8) the terms of any new collaborative, licensing and other arrangements that we may establish, 9) litigation costs, and 10) market acceptance of our products and the cost of obtaining acceptance.

As of June 30, 2003, we estimate that we will require approximately $4 million in net cash to meet our financial obligations based on our current operating level for the remainder of the year ending June 30, 2004. Our current operating level consists of a significantly reduced staffing, minimal services, halted production and consolidated facilities. Since December, 2002, we have significantly cut back on our expenses to maintain solvency and continue negotiations with the FDA to obtain approval or conditioned approval. Since June 30, 2002, the Company has reduced its monthly cash outlays from $1.1 million to approximately $400 thousand by: a) reducing staff from 72 to 22 and eliminating certain benefit programs, resulting in a monthly cost reduction of $340 thousand; b) eliminating regional trade shows and related marketing expenses, resulting in a monthly cost reduction of $110 thousand; c) consolidated the Bales Scientific facility into the Ogden, Utah facility, resulting in a monthly cost reduction of $50 thousand; d) decreasing research and development activities resulting in a decrease of $120 thousand; and e) decreasing manufacturing and production expenditures resulting in monthly cash savings of approximately $80,000.

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In 2002, five different lawsuits were filed against us in the United States District Court in Oregon. The lawsuits, which were consolidated into a single class action, alleged that the Company violated Section 10(b) of the Securities Exchange Act of 1934, as amended, and accompanying regulations by misleading shareholders regarding such things as FDA approval and other matters, which the plaintiffs believe caused significant damage to the shareholders holding shares of our common stock at the time of these alleged misrepresentations and omissions.

On April 17, 2003, this litigation was dismissed without prejudice by the United States District Court. In a written opinion, the U.S. District Judge concluded that the statements made by the Company, that plaintiff’s alleged were misleading to investors, were either not material, not misleading, or not plead by plaintiffs with sufficient particularity to constitute a claim. The Court gave the plaintiffs until May 8, 2003 to replead three of the nine claims. On May 8, 2003, the plaintiffs informed Company counsel that they would not replead any claims. Instead, plaintiffs expressed their intention to appeal the court’s ruling following entry of the court’s dismissal order. That order was filed May 13, 2003 On May 22, 2003, the plaintiffs filed for appeal and on September 3, 2003 the plaintiffs filed their memorandum in support of their appeal. We have thirty days to respond. We do not expect to receive a decision from the appellate court for at least one year.  

The Company believes the allegations are without merit and intends to defend them vigorously. However, defending this lawsuit has required, and in the future may require, significant additional legal expenses, may make fundraising more difficult if not impossible and will distract certain members of management from day-to-day operations.

Moreover, our insurance carrier has previously denied there is insurance coverage for the plaintiff’s claims and, accordingly, has indicated it will not cover the costs of defending the claims and will not pay any resulting damages we may suffer if the plaintiff’s are successful.

Finally, under our bylaws and contractual agreements we are required to indemnify our current and former officers and directors who are a party to the litigation by providing legal defense through our attorneys (or reimbursing them for their own attorneys) and covering all damages they may suffer if the plaintiffs are successful. For the year ended June 30, 2004, such indemnification obligations have totaled approximately $24,000.

We do not have sufficient capital to cover the expected costs or potential damages of the shareholder litigation if there is no coverage under our insurance policies or to fund our business plans over the next year.

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In addition, the Company has been requested to provide certain documents to the U.S. Securities and Exchange Commission and the U.S. Attorney for the Southern District of New York in connection with possible violations of the insider trading prohibitions found in the federal securities laws. To date, we have incurred approximately $650 thousand in legal costs in complying with these requests and in conducting related internal investigations. We expect these legal costs to exceed $680 thousand by the time the investigations are complete. The Company also may be required to indemnify its officers and directors in connection with fees incurred in connection with these investigations. In 2003, such indemnification obligations totaled approximately $131,000.

Given our need to raise capital to fund our operations, history of losses ($94.2 million since inception), the foregoing litigation risk, and our reliance upon securing FDA approval for our primary product, our independent auditor’s opinion dated September 25, 2003, contains a paragraph expressing its substantial doubt about the Company’s ability to continue as a going concern. Our efforts to raise additional funds to date have been only marginally successful. Since December 2002 after the FDA did not grant us approval, we have raised $500 thousand in advances under the equity line of credit with Beach Boulevard, $1 million through a private issuance of restricted stock and $660 thousand from a $1.2 million manufacturing and licensing agreement of our TIP and Photonic Stimulator products. If possible, we will obtain additional capital through further capital contributions from private investors or by selling or licensing our intellectual property. We believe that if we can obtain FDA approval or conditioned approval, we will be able to secure the additional financing needed to execute our operating plans, which will include more clinical trials, research and development of the BCS 2100, marketing and manufacturing our products.

However, there is no guarantee that will be successful in obtaining FDA approval, conditioned approval or securing additional capital. Our discussions with potential investors are in an early stage and we cannot guarantee that we will be able to successfully conclude any transaction.

Recent Accounting Pronouncements

In January 2003, the FASB issued FIN 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The Company does not believe that the adoption of FIN 46 will have a material impact on the Company’s financial position or results of operations.

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In November 2002, the FASB issued Emerging Issues Task Force, or EITF, Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 addresses certain aspects of the accounting by a company for arrangements under which it will perform multiple revenue-generating activities. EITF Issue No. 00-21 addresses when and how an arrangement involving multiple deliverables should be divided into separate units of accounting. EITF Issue No. 00-21 provides guidance with respect to the effect of certain customer rights due to company nonperformance on the recognition of revenue allocated to delivered units of accounting. EITF Issue No. 00-21 also addresses the impact on the measurement and/or allocation of arrangement consideration of customer cancellation provisions and consideration that varies as a result of future actions of the customer or the company. Finally, EITF Issue No. 00-21 provides guidance with respect to the recognition of the cost of certain deliverables that are excluded from the revenue accounting for an arrangement. The provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The provisions of EITF Issue No. 00-21 will adopted in the third quarter of fiscal 2003 and is not expected to have a material impact on the consolidated financial statements.

In December 2002, the FASB issued Statement of SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, which amends Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation and requires more prominent and more frequent disclosures in the financial statements of the effects of stock-based compensation. The provisions of SFAS No. 148 are effective for fiscal years ending after December 15, 2002 and the interim disclosure provisions are effective for interim periods beginning after December 15, 2002.

In April 2003, the FASB issued SFAS No. 149, Amendments of Statement 133 On Derivative Instruments and Hedging Activities. SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. The Company believes the adoption of SFAS No. 149 will not have a material effect on the Company’s consolidated financial position or results of operations.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, which is effective the first interim period beginning after June 15, 2003. SFAS No. 150 establishes standards for how the Company classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. The Company believes the adoption of SFAS No. 150 will not have a material effect on the Company’s consolidated financial position or results of operations.

We are a development stage enterprise. We currently believe we are not subject to market risks beyond ordinary economic risks, such as interest rate fluctuation and inflation. As we begin to market our products, we become exposed to the opportunities and risks usually associated with marketing and manufacturing novel products, including staff recruiting and retention, market acceptance, product warranty, bad debts, and inventory obsolescence.

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COMPUTERIZED THERMAL IMAGING, INC.
(A Development Stage Company)

F-1