Valuation of Intangible Assets

We assess the impairment of intangible assets when events or changes in circumstances indicate that the carrying value of the assets or the asset grouping may not be recoverable. Factors that we consider in deciding when to perform an impairment review include significant under-performance of a product line in relation to expectations, significant negative industry or economic trends, and significant changes or planned changes in our use of the assets. Recoverability of intangible assets that will continue to be used in our operations is measured by comparing the carrying amount of the asset grouping to our estimate of the related total future net cash flows. If an asset grouping’s carrying value is not recoverable through the related cash flows, the asset grouping is considered to be impaired. The impairment is measured by the difference between the asset grouping’s carrying amount and its fair value, based on the best information available, including market prices or discounted cash flow analysis. Impairments of intangible assets are determined for groups of assets related to the lowest level of identifiable independent cash flows. Due to our limited operating history and the early stage of development of some of our intangible assets, we must make subjective judgments in determining the independent cash flows that can be related to specific asset groupings. To date we have not recognized impairments on any of our intangible assets related to the Safety Sponge™ System.

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Stock-Based Compensation

We have adopted the provisions of SFAS No. 123(R), Share-Based Payment. The fair value of each option grant, nonvested stock award and shares issued under the employee stock purchase plan were estimated on the date of grant using the Black-Scholes option pricing model and various inputs to the model. Expected volatilities were based on historical volatility of our stock. The expected term represents the period of time that grants and awards are expected to be outstanding. The risk-free interest rate approximates the U.S. treasury rate corresponding to the expected term of the option, and dividends were assumed to be zero. These inputs are based on our assumptions, which include complex and subjective variables. Other reasonable assumptions could result in different fair values for our stock-based awards.

Stock-based compensation expense, as determined using the Black-Scholes option pricing model, is recognized on a straight line basis over the service period, net of estimated forfeitures. Forfeiture estimates are based on historical data. To the extent actual results or revised estimates differ from the estimates used, such amounts will be recorded as a cumulative adjustment in the period that estimates are revised.

New Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 does not require new fair value measurements but rather defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We adopted SFAS 157 on January 1, 2008 and in connection with its adoption, there was no impact on our consolidated financial statements, and the resulting fair values calculated under SFAS No. 157 after adoption were not significantly different than the fair values that would have been calculated under previous guidance.

 

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment to FASB Statement No. 115 (“SFAS 159”). This statement permits companies to choose to measure many financial instruments and other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This statement is expected to expand the use of fair value measurement of accounting for financial instruments. The fair value option established by this statement permits all entities to measure eligible items at fair value at specified election dates with the resulting unrealized gains and losses, if any, reported in earnings. We adopted SFAS 159 on January 1, 2008 and in connection with its adoption, there was no impact on our consolidated financial statements.

Staff Accounting Bulletin 110 (“SAB 110”) issued by the SEC was effective for us beginning in the first quarter of 2008. SAB 110 amends the SEC’s views discussed in Staff Accounting Bulletin 107 (“SAB 107”) regarding the use of the simplified method in developing estimates of the expected lives of share options in accordance with SFAS No. 123(R), Share-Based Payment. We will continue to use the simplified method until we have the historical data necessary to provide reasonable estimates of expected lives in accordance with SAB 107, as amended by SAB 110.

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In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141(R), Business Combinations (“SFAS 141(R)”). This statement requires the acquiring entity in a business combination to record all assets acquired and liabilities assumed at their respective acquisition-date fair values, changes the recognition of assets acquired and liabilities assumed arising from contingencies, changes the recognition and measurement of contingent consideration, and requires the expensing of acquisition-related costs as incurred. SFAS 141(R) also requires additional disclosure of information surrounding a business combination, such that users of the entity's financial statements can fully understand the nature and financial impact of the business combination. We will implement SFAS No. 141(R) on January 1, 2009 and will apply prospectively to business combinations completed on or after that date.

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160, Noncontrolling Interests in Consolidated Financial Statements an amendment of ARB 51 (“SFAS 160”). SFAS 160 establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent's ownership interest and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. SFAS 160 also established reporting requirements that provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owner. We will implement SFAS No. 160 on January 1, 2009. As of May 20, 2009, we did not have any minority interests. Therefore, we do not expect the adoption of this standard to have a material impact on our income statement, financial position or cash flows.

In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, Disclosures about Derivative Instruments and Hedging Activities—an amendment of FASB Statement No. 133 (“SFAS No. 161”). The standard requires additional quantitative disclosures (provided in tabular form) and qualitative disclosures for derivative instruments. The required disclosures include how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows; relative volume of derivative activity; the objectives and strategies for using derivative instruments; the accounting treatment for those derivative instruments formally designated as the hedging instrument in a hedge relationship; and the existence and nature of credit-related contingent features for derivatives. SFAS No. 161 does not change the accounting treatment for derivative instruments. SFAS No. 161 is effective for us in the first quarter of fiscal year 2009.

Financial Condition, Liquidity and Capital Resources

Our cash and cash equivalents balance was $156,000 at March 31, 2008, versus $405,000 at December 31, 2007. Total current liabilities were $3,216,000 at March 31, 2008, versus $2,402,000 at December 31, 2007. As of March 31, 2008 we had a working capital deficit of approximately $2,839,000. Since we continue to have recurring losses, we have relied upon private placements of equity and debt securities. Our existing cash and cash equivalents balance is not sufficient to meet our anticipated funding requirements during 2008, and the Company is currently seeking additional financing.

2007 private placements

During 2007 we sold to accredited investors in our private placements, as reflected below, $5,280,000 in equity securities.

Between January 29, 2007 and June 8, 2007, we entered into various subscription agreements with accredited investors in private placements exempt from the registration requirements of the Securities Act. We issued and sold to these accredited investors an aggregate of 2,952,000 shares of our common stock and warrants to purchase an additional 1,376,000 shares of our common stock. The warrants are exercisable for a period of three to five years with an exercise price equal to $2.00. These issuances resulted in aggregate gross proceeds to us of $3,690,000, of which $3,190,000 was in cash and $500,000 was in product which we will receive over the course of a twelve (12) month period. We used the net proceeds from these private placement transactions primarily for general corporate purposes and repayment of existing liabilities

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On October 17, 2007, we entered into a securities purchase agreement with Francis Capital Management, LLC (“Francis Capital”), an accredited investor, in a private placement exempt from the registration requirements of the Securities Act. We issued and sold to Francis Capital an aggregate of 1,270,000 shares of our common stock and warrants to purchase an additional 763,000 shares of our common stock. The warrants are exercisable for a period of five years at an exercise price equal to $1.40 per share. These issuances resulted in aggregate gross proceeds to us of $1,500,000 in cash and the extinguishment of $90,000 in existing debt owed to Francis Capital by us. Pursuant to the terms of the securities purchase agreement, the Company may sell up to an aggregate of $3,000,000 in common stock and warrants under the securities purchase agreement by no later than November 16, 2007. We used the net proceeds from this private placement transaction primarily for general corporate purposes and repayment of existing liabilities.

Promissory notes

In addition to our private placements, we have also received a significant amount of funding from Ault Glazer Capital Partners, LLC (the “Fund”). AG Management is the managing member of the Fund. The managing member of AG Management is The Ault Glazer Group, Inc. (“The AG Group”). The Company’s former Chairman and former Chief Executive Officer, Milton “Todd” Ault, III, is Chairman, Chief Executive Officer and President of The AG Group. At March 31, 2008 the outstanding principal balance of the loan that we entered into with the Fund was $2,531,000.

At March 31, 2008 we also had outstanding promissory notes in the aggregate principal amount of $1,571,000. Between February 28, 2008 and March 20, 2008, Catalysis Offshore, Ltd. and Catalysis Partners, LLC (collectively “Catalysis”), related parties, loaned us an aggregate of $500,000. As consideration for the loans, we issued Catalysis promissory notes in the aggregate principal amount of $500,000 (the “Catalysis Notes”). The Catalysis Notes accrue interest at the rate of 8% per annum and have maturity dates of May 31, 2008. The other outstanding promissory notes were entered into during 2006.

During the period from June 29, 2007 to August 13, 2007, Automotive Services Group sold all the assets held by ASG thereby completing the liquidation of Automotive Services Group. We received net proceeds, after expenses of the sales, of $3,178,000 which resulted in a gain of $10,000. The majority of the proceeds from the sales were used to repay existing debt. By selling these assets the Company has positioned itself to aggressively pursue the market for surgical sponges in the United States and Europe, which we believe represents a market opportunity equal to or in excess of $650 million in annual sales.

Management is currently seeking additional financing and believes that it will be successful. However, in the event management is not successful in obtaining additional financing, existing cash resources, together with proceeds from investments and anticipated revenues from operations, may not be adequate to fund our operations for the twelve months subsequent to March 31, 2008. However, ultimately long-term liquidity is dependent on our ability to attain future profitable operations. We intend to undertake additional debt or equity financings to better enable us to grow and meet future operating and capital requirements.

As of March 31, 2008, other than our office lease and employment agreements with key executive officers, we had no commitments as liabilities not reflected in our consolidated financial statements.

Cash decreased by $250,000 to $156,000 during the three months ended March 31, 2008, compared to an increase of $1,407,000 during the three months ended March 31, 2007.

 

Operating activities used $746,000 of cash during the three months ended March 31, 2008, compared to $971,000 during the three months ended March 31, 2007.

 

Operating activities for the three months ended March 31, 2008, exclusive of changes in operating assets and liabilities, used $1,152,000 of cash, as the Company's net cash used in operating activities of $746,000 included non-cash charges for depreciation and amortization of $158,000 and stock based compensation of $201,000. For the three months ended March 31, 2007, operating activities, exclusive of changes in operating assets and liabilities, used $860,000 of cash, as the Company's net cash used in operating activities of $971,000 included non-cash charges for depreciation and amortization of $113,000, debt discount of $169,000 and stock based compensation of $312,000.

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Changes in operating assets and liabilities provided cash of $406,000 during the three months ended March 31, 2008, principally due to increases in the level of accounts payable and accrued liabilities which was partially offset by an increase in accounts receivable. Changes in operating assets and liabilities used cash of $111,000 during the three months ended March 31, 2007, principally due to decreases in the level of accounts payable and an increase in accounts receivable which were partially offset by a decrease in accrued liabilities and prepaid expenses

The principal factor in the $117,000 of cash provided by investing activities during the three months ended March 31, 2008 was the sale of our undeveloped land in Alabama for $226,000. This was partially offset by capitalized costs of $128,000 related to the ongoing development of purchased software related to our Safety-Sponge System. The principal factor in the $79,000 of cash used in investing activities during the three months ended March 31, 2007 was the capitalized costs of $73,000 related to the ongoing development of software related to our Safety-Sponge System.

Cash provided by financing activities during the three months ended March 31, 2008 of $380,000 resulted from net proceeds from short-term debt financings of $500,000 offset by the repayment of a promissory note of $101,000 and the payment of preferred dividends of $19,000. Cash provided by financing activities during the three months ended March 31, 2007, of $2,457,000 resulted primarily from net proceeds from the issuance of common stock and warrants of $2,897,000 offset by the repayment of the Winstar Note of $450,000

Investments

Our financial condition is partially dependent on the success of our existing investments. On March 29, 2006 our Board of Directors directed us to liquidate all of our investments and other assets that do not relate to the patient safety medical products business. Some of our investments are subject to restrictions on resale under federal securities laws and otherwise are illiquid, which will make it difficult to dispose of the securities quickly. Since we will be forced to liquidate some or all of the investments on an accelerated timeline, the proceeds of such liquidation may be significantly less than the value at which we acquired the investments. The following is a discussion of our most significant investments at March 31, 2008.

Our long-term investment, also referred to as our non-core assets, is valued at $667,000. At March 31, 2008, our long-term investment included our investment in Alacra Corporation, our only significant investment security. Our non-core assets also consisted of certain real property located in Tennessee. The real property meets the “held for sale” criteria and is classified as such.

Alacra Corporation

At March 31, 2008, we had an investment in Alacra Corporation (“Alacra”), valued at $667,000, which represents 8.8% of our total assets. On April 20, 2000, we purchased $1,000,000 worth of Alacra Series F Convertible Preferred Stock. We have the right, subject to Alacra having the available cash, to have the preferred stock redeemed by Alacra over a period of three years for face value plus accrued dividends beginning on December 31, 2006. Pursuant to this right, in December 2006 we informed management of Alacra that we were exercising our right to put back one-third of our preferred stock. Alacra had a sufficient amount of cash to redeem our preferred stock and in December 2007 completed the initial redemption of one-third of our preferred stock. We received proceeds of $333,000 which accounted for the entire amount of the decrease in value of our Alacra investment. We continue to maintain our right to put back our remaining preferred stock to Alacra.

 

Real Estate Investments

At March 31, 2008, we had one real estate investment, valued at $90,000. The real estate investment, consisting of 0.61 acres of undeveloped land in Springfield, Tennessee, is currently being marketed for sale. In March 2008, we completed the sale of approximately 8.5 acres of undeveloped land in Heber Springs, Arkansas for net proceeds of $226,000, which resulted in a realized loss of $25,000. In March 2008 we wrote down the value of our one remaining parcel in Springfield, Tennessee to $90,000. We recognized an unrealized loss of $90,000 as a result of this write-down.

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Results of Operations

We account for our operations under accounting principles generally accepted in the United States. The principal measure of our financial performance is captioned “Loss available to common shareholders,” which is comprised of the following:

	§	"Revenues," which is the amount we receive from sales of our products;
	§	“Operating expenses,” which are the related costs and expenses of operating our business;
	§	“Interest, dividend income and other, net,” which is the amount we receive from interest and dividends from our short term investments and money market accounts;
	§	“Realized gains (losses) on investments, net,” which is the difference between the proceeds received from dispositions of investments and their stated cost; and
	§	“Unrealized gains (losses) on marketable securities, net,” which is the net change in the fair value of our marketable securities, net of any (decrease) increase in deferred income taxes that would become payable if the unrealized appreciation were realized through the sale or other disposition of the investment portfolio.

Revenues

We recognized revenues of $500,000 and $307,000 during the three months ended March 31, 2008 and 2007, respectively. Revenues during the three months ended March 31, 2008 consisted of sales from the Safety-Sponge of $413,000 and sales from hardware and supplies of $87,000, whereas, revenues during the three months ended March 31, 2007 consisted of sales from the Safety-Sponge of $201,000 and sales from hardware and supplies of $106,000. Although hardware sales are not considered a recurring item, we expect that once an institution adopts our system, they will be committed to its use and therefore provide a recurring source of revenues for sales of the safety sponge.

We attribute a significant amount of the increase in sales generated by our Safety-Sponge System to increased product awareness and demand. The Safety-Sponge System is currently being evaluated by more than 10 medical institutions, the adoption by any one of which would have a material impact on our revenues. We expect that small medical institutions which adopt the Safety-Sponge System will represent approximately $100,000 in annual revenue whereas the larger institutions could represent annual recurring revenues of $600,000 or more. We expect that current demand will begin to accelerate.

On November 14, 2006, SurgiCount entered into a Supply Agreement with Cardinal Health 200, Inc., a Delaware corporation ("Cardinal"). Pursuant to the agreement, Cardinal shall act as the exclusive distributor of SurgiCount's products in the United States, with the exception that SurgiCount may sell its products to one other hospital supply company, named in the agreement, solely for the sale and distribution to its hospital customers. The term of the agreement is 36 months, unless earlier terminated as set forth therein. Otherwise, the agreement automatically renews for successive 12 month periods. Although we cannot reasonably predict or estimate the financial impact of the agreement with Cardinal we believe it has and will continue to have a material impact on our results of operations due to the coordination of our sales efforts with Cardinal and their significant presence in the major medical institutions.

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Expenses

Operating expenses were $1,531,000 and $1,195,000 for the three months ended March 31, 2008 and 2007, respectively.

The increase in operating expenses of $335,000, for the three months ended March 31, 2008 when compared to the three months ended March 31, 2007, was primarily the result of salaries and employee benefits, which increased by $125,000. Our Compensation Committee, currently comprised of two independent directors, determines and recommends to our Board the cash and stock based compensation to be paid to our executive officers and also reviews the amount of salary and bonus for each of our other officers and employees.

For the three months ended March 31, 2008, we recorded $199,000 related to grants of nonqualified stock options and $2,000 related to restricted stock awards to our employees and non-employee directors. During the three months ended March 31, 2007, we recorded $58,000 related to grants of nonqualified stock options and $192,000 related to restricted stock awards to our employees and non-employee directors. The issuance of stock options and restricted stock awards to our employees and non-employee directors resulted in a decrease in stock based compensation expense of $49,000 for the three months ended March 31, 2008 compared to the three months ended March 31, 2007. Therefore, excluding stock based compensation, salaries and employee benefits increased by $174,000.

At March 31, 2008, three of our executives were covered under employment agreements. Our Chief Executive Officer, William B. Horne, was covered under a two year employment agreement with annual base compensation of $250,000; our Chief Executive Officer of SurgiCount Medical, Inc., Bill Adams, was covered under a three year employment agreement with annual base compensation of $300,000 and; our President of Sales and Marketing of SurgiCount Medical, Inc., Richard Bertran, was covered under a three year employment agreement with annual base compensation of $250,000. None of our other executives are currently covered under an employment agreement, therefore, we are under no financial obligation, other than monthly salaries, for our other executive officers. Currently, monthly gross salaries for all of our employees are $156,000. Conversely, during the three months ended March 31, 2007 we significantly increased our sales and administrative staff thereby increasing the amount of our monthly gross salaries to $135,000 at March 31, 2007. We believe, as with all our operating expenses, that our existing cash resources, together with proceeds from investments, anticipated financings and expected revenues from our operations, should be adequate to fund our salary obligations

The increase in cost of sales of $179,000 reflects an increase in sales of our Safety-Sponge^TM System. During the three months ended March 31, 2008, our gross margin percentage decreased as compared to the three months ended March 31, 2007 primarily as a result of discounts provided in connection with hardware sales.

General and administrative expenses experienced an increase of $232,000 during the three months ended March 31, 2008 over the three months ended March 31, 2007. During the three months ended March 31, 2008, we invested a significant amount of capital in our advertising and marketing activities, which resulted in an increase of $106,000. The only other significant increase in general and administrative expenses is depreciation expense which reflected an increase of $45,000 and is due to the larger amount of fixed assets being depreciated. The remaining increase in general and administrative expenses are comprised of a combination of several types of expenses, none of which are significant individually.

Realized gains (losses) on investments, net

During the three months ended March 31, 2008 we realized a net loss of $25,000 compared to a loss of nil during the three months ended March 31, 2007. Realized loss during the three months ended March 31, 2008 reflects the sale of certain non-operating assets, specifically, the sale of approximately 8.5 acres of undeveloped land in Heber Springs, Arkansas.

Interest expense

We had interest expense of $87,000 and $268,000 for the three months ended March 31, 2008 and 2007, respectively.

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The decrease in interest expense for the three months ended March 31, 2008 when compared to March 31, 2007 is primarily attributable to the non-cash interest charges incurred as a result of the debt discount amortization associated with our short-term debt financings. During the three months ended March 31, 2008 and 2007, we recorded nil and $169,000, respectively, in non-cash interest charges. These charges resulted from the issuance of debt that either had conversion prices on the date of issuance that was below the fair market value of the underlying common stock or required the issuance of warrants to purchase shares of our common stock, which required us to record an expense based on the estimated fair value of the warrant.

Loss from discontinued car wash segment

During the three months ended March 31, 2007, we recorded a loss from our discontinued car wash segment of $89,000. Consistent with our decision to focus our business exclusively on the patient safety medical products field, we completed the divestiture of ASG in August 2007. Thus, we did not incur a loss from the discontinued car wash segment during the three months ended March 31, 2008.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Our business activities contain elements of market risk. We consider a principal type of market risk to be valuation risk. Investments and other assets are valued at fair value as determined in good faith by our Board of Directors.

We have invested a portion of our assets in a private, development stage, company. Private businesses tend to be thinly capitalized, unproven, small companies that lack management depth and have not attained profitability or have no history of operations. Because of the speculative nature and the lack of public market for these types of investments, there is significantly greater risk of loss than is the case with traditional investment securities. Our private investment may result in a complete loss or will be unprofitable despite appearing to be likely to become successful.

Because there is no public market for the equity interests in the small company in which we have invested, the valuation of such the equity interests is subject to the estimate of our Board of Directors. In making its determination, the Board may consider valuation information provided by an independent third party or the portfolio company itself. In the absence of a readily ascertainable market value, the estimated value of our equity investments may differ significantly from the values that would be placed on them if a liquid market for the equity interests existed. Any changes in valuation are recorded in our consolidated statements of operations as either "Unrealized losses on marketable securities, net” or “Other comprehensive income."

Item 4T. Controls and Procedures.

Limitations on the Effectiveness of Controls

We seek to improve and strengthen our control processes to ensure that all of our controls and procedures are adequate and effective. We believe that a control system, no matter how well designed and operated, can only provide reasonable, not absolute, assurance that the objectives of the controls system are met. In reaching a reasonable level of assurance, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. In addition, the design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, a control may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. No evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company will be detected.  As set forth below, our Chief Executive Officer and our Chief Financial Officer have concluded, based on their evaluation as of the end of the period covered by this report, that our disclosure controls and procedures were sufficiently effective to provide reasonable assurance that the objectives of our disclosure control system were met.

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Evaluation of Effectiveness of Disclosure Controls and Procedures

As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our principal executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15(b) of the Exchange Act.  Based upon that evaluation, our chief executive officer and chief financial officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective at the reasonable assurance level discussed above.

Changes in Internal Control over Financial Reporting

There were no changes in our internal controls over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during the last quarter that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting.

PART II – OTHER INFORMATION

Item 1. Legal Proceedings.

As of the date this report was filed, there have been no material developments in the legal proceedings previously reported in our annual report on Form 10-K for the fiscal year ended December 31, 2007, which was filed with the Securities and Exchange Commission on April 15, 2008.

Item 1A. Risk Factors.

There have been no material changes from risk factors previously disclosed in Item 1A included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which was filed with the SEC on April 15, 2008.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None