UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-QSB

(Mark One)

þ		QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

o		TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission file number: 0-31641

2839 Charter Street, Columbus, Ohio 43228

(Address of principal executive offices, including zip code)

(614) 486-0261

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

     Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for at least the past 90 days. YES  þ  NO  o

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES  o  NO  þ

     State the number of shares outstanding of each of the registrant’s classes of common equity, as of the latest practicable date: 3,427,915 shares of Common Stock, without par value, were outstanding at October 31, 2006.

     Transitional Small Business Disclosure Format (Check one): YES  o  NO  þ

 

 

FORM 10-QSB

SUPERCONDUCTIVE COMPONENTS, INC.

								Page No.
PART I. FINANCIAL INFORMATION
		Item 1.				Financial Statements
						Balance Sheets as of September 30, 2006 (unaudited) and December 31, 2005			3
						Statements of Operations For the Three Months and Nine Months Ended September 30, 2006 and 2005 (unaudited)			5
						Statements of Cash Flows For the Nine Months Ended September 30, 2006 and 2005 (unaudited)			6
						Notes to Financial Statements (unaudited)			8
		Item 2.				Management’s Discussion and Analysis of Financial Condition and Results of Operations			15
		Item 3.				Controls and Procedures			22
PART II. OTHER INFORMATION
		Item 1.				Legal Proceedings			N/A
		Item 2.				Changes in Securities and Small Business Issuer Purchases of Equity Securities			N/A
		Item 3.				Defaults Upon Senior Securities			N/A
		Item 4.				Submission of Matters to a Vote of Security Holders			N/A
		Item 5.				Other Information			N/A
		Item 6.				Exhibits			22
		Signatures							22
EX-31.1
EX-31.2
EX-32.1
EX-32.2
EX-99.1

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SUPERCONDUCTIVE COMPONENTS, INC.

BALANCE SHEETS

		September 30,				December 31,
		2006				2005
		(UNAUDITED)
ASSETS
CURRENT ASSETS
Cash		$	1,368,743				1,161,369
Accounts receivable
Trade, less allowance for doubtful accounts of $25,000			388,783				243,130
Contract			52,760				50,710
Other			2,074				13,749
Inventories			675,713				584,140
Prepaid expenses			33,872				11,748
Total current assets			2,521,945				2,064,846
PROPERTY AND EQUIPMENT, AT COST
Machinery and equipment			2,599,148				2,221,298
Furniture and fixtures			23,643				23,643
Leasehold improvements			290,979				284,072
Construction in progress			741				101,075
			2,914,511				2,630,088
Less accumulated depreciation			(1,956,484	)			(1,814,959	)
			958,027				815,129
OTHER ASSETS
Deposits			15,031				10,765
Intangibles			31,666				33,982
Total other assets			46,697				44,747
TOTAL ASSETS		$	3,526,669				2,924,722

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

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

SUPERCONDUCTIVE COMPONENTS, INC.
NOTES TO FINANCIAL STATEMENTS

Note 1. Business Organization and Purpose

Superconductive Components, Inc. (the “Company”) is an Ohio corporation that was incorporated in May 1987. The Company was formed to develop, manufacture and sell materials using superconductive principles. Operations have since been expanded to include the manufacture and sale of non-superconductive materials. The Company’s domestic and international customer base is primarily in the thin film battery, high temperature superconductor, photonics and optical coatings industries.

Note 2. Summary of Significant Accounting Policies

The accompanying unaudited financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with instructions to Form 10-QSB and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments considered necessary for fair presentation of the results of operations for the periods presented have been included. The financial statements should be read in conjunction with the audited financial statements and the notes thereto for the year ended December 31, 2005. Interim results are not necessarily indicative of results for the full year.

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

      Equipment purchased with grant funding

In 2004, the Company received funds of $517,935 from the Ohio Department of Development’s Third Frontier Action Fund (TFAF) for the purpose of purchasing equipment related to the grant’s purpose. The Company elected to record the funds received as a liability; therefore, the equipment is not reflected in the Company’s financial statements. As equipment was purchased, the liability initially created when the cash was received was reduced with no revenue recognized or equipment recorded on the balance sheet. In 2005 the Company purchased equipment in the amount of $25,945 that was reimbursed by TFAF in the first quarter of 2006. As of September 30, 2006, the Company had disbursed the entire amount received. The grant provides that as long as the Company performs in compliance with the grant, the Company retains the rights to the equipment. Management anticipates that the Company will be in compliance with the requirements of the grant and, therefore, expects to retain the equipment at the end of the grant in 2007.

      Reclassification

Certain amounts in the prior year financial statements pertaining to research and development have been reclassified to conform to the current year presentation.

SUPERCONDUCTIVE COMPONENTS, INC.
NOTES TO FINANCIAL STATEMENTS

Note 2. Summary of Significant Accounting Policies (continued)

      Stock Based Compensation

During 2005 the Company accounted for stock based compensation using the intrinsic value method prescribed in APB Opinion No. 25, “Accounting for Stock Issued to Employees.” The Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard “Accounting for Stock Based Compensation” (SFAS 123), which established accounting and disclosure requirements using a fair value based methodology. SFAS 123 allowed the intrinsic value method to be used, and required disclosure of the impact to the financial statements of utilizing the intrinsic value versus the fair value based method on a pro forma basis, as set forth in the table below. For all periods prior to January 1, 2006, the Company utilized the fair value method as provided for in SFAS 123 to account for stock based compensation to non-employees.

The Company’s pro forma information for the nine months ended September 30, 2005, in accordance with the provisions of SFAS 123 is provided below. For purposes of pro forma disclosures, stock based compensation was amortized to expense on a straight-line basis over the vesting period.

For the nine months ended September 30, 2005, there was no stock based employee compensation cost included in the determination of net loss as reported.

Recently Issued Accounting Standards — In December 2004, the FASB issued SFAS 123 (Revised), “Shared Based Payment” (SFAS 123R). SFAS 123R replaced SFAS 123, and superseded APB Opinion No. 25. Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS 123R and related interpretations using the modified-prospective transition method. Under this method, compensation cost recognized in the first nine months of 2006 includes (a) compensation cost for all stock-based awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123 and (b) compensation cost for all stock-based awards granted on or subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. Stock based compensation expense recognized for the nine

SUPERCONDUCTIVE COMPONENTS, INC.
NOTES TO FINANCIAL STATEMENTS

Note 2. Summary of Significant Accounting Policies (continued)

months ended September 30, 2006 was $5,744, which is included in the operating expenses in the accompanying statements of operations.

In December 2005, the Board of Directors approved the acceleration of vesting of unvested stock options previously awarded to employees and officers of the Company. As a result of this action, options to purchase 149,500 shares of common stock that would otherwise have vested over the next one to five years became fully vested. The decision to accelerate the vesting of these options was considered to be in the best interest of the Company’s shareholders and was made primarily to reduce non-cash compensation expense that would have been recorded in future periods following the adoption of FAS 123R.

Note 3. Common Stock and Stock Options

The following stock options were granted under the 2006 Stock Option Plan during the nine months ended September 30, 2006:

The exercise prices for all outstanding stock options ranged from $1.00 to $4.00 at September 30, 2006. The weighted average option price for all options outstanding is $2.26 with a weighted average remaining contractual life of 6.5 years.

The weighted average fair values at date of grant for all options granted during 2006 and 2005 were $3.03 and $2.28, respectively, and were estimated using the Black-Scholes option valuation model with the following weighted average assumptions:

Due to minimal historical exercise data, the Company used the option contract term as the expected life. The approximate interest rate was based on the implied yield available on U.S. Treasury bills. The Company used the historical price volatility of the Company’s stock price beginning in 2000 for purposes of determining the expected volatility factor. The Company does not expect to pay dividends on its common stock; therefore, a dividend yield of zero was used in the model.

Note 4. Inventory

     Inventory is comprised of the following:

SUPERCONDUCTIVE COMPONENTS, INC.
NOTES TO FINANCIAL STATEMENTS

Note 5. Earnings Per Share

Basic income (loss) per share is calculated as income available to common stockholders divided by the weighted average of common shares outstanding. Diluted earnings per share is calculated as diluted income (loss) available to common stockholders divided by the diluted weighted average number of common shares. Diluted weighted average number of common shares has been calculated using the treasury stock method for Common Stock equivalents, which includes Common Stock issuable pursuant to stock options and Common Stock warrants. At September 30, 2005, all Common Stock options and warrants were anti-dilutive due to the net loss. The following is provided to reconcile the earnings per share calculations:

Note 6. Capital Requirements

The Company’s accumulated deficit since inception was $8,134,004 (unaudited) at September 30, 2006. The losses have been financed primarily from additional investments and loans by major shareholders and private offerings of common stock and warrants to purchase common stock. The Company cannot assure that it will be able to raise additional capital in the future to fund its operations.

As of September 30, 2006, cash on-hand was $1,368,743. Management believes, based on forecasted sales and expenses, that funding will be adequate to sustain operations at least through September 30, 2007. During 2005 the Company raised additional funds through offerings of debt and equity. The Company received debt financing of $300,000 in 2005. Of this $300,000 received, $100,000 was repaid to the lender and $200,000 was converted into shares of the Company’s common stock in 2005.

SUPERCONDUCTIVE COMPONENTS, INC.
NOTES TO FINANCIAL STATEMENTS

Note 6. Capital Requirements (continued)

In November of 2004 a director agreed to loan the Company up to $200,000 for working capital, to be drawn by the Company in increments of $50,000. The interest rate was Huntington National Bank’s prime rate plus 2%, which accrued and compounded monthly. The loan was secured by the Company’s assets and perfected by the filing of a UCC-1 financing statement. For each $50,000 increment drawn on the loan the director received 5,000 warrants to purchase the Company’s common stock, without par value, at a purchase price of $2.50 per share and exercisable until November 1, 2009. The loan was drawn on the following schedule: November 3, 2004, $100,000; January 7, 2005, $50,000; and April 1, 2005, $50,000. The loan balance (principal and accrued interest) was repaid in October 2005 and the UCC-1 financing statement was terminated.

In April of 2005, the same director who agreed to provide a loan to the Company in November 2004, agreed to provide an additional $200,000 convertible secured loan to the Company for working capital. The interest rate of 10% accrued and compounded monthly. The loan was drawn on the following schedule: April 14, 2005, $100,000; and May 20, 2005, $100,000. Because the Company completed equity financing of at least $500,000 during the fourth quarter of 2005, the principal and accrued interest totaling $209,110 automatically converted on the same basis as the new financing to 104,555 shares of common stock ($2.00 per share) and warrants to purchase an aggregate of 26,139 shares of the Company’s common stock at a purchase price of $3.00 per share exercisable until October 2010.

In the fourth quarter of 2005, the Company completed a private placement to accredited investors. The investors purchased 986,555 shares of common stock at a price of $2.00 per share and warrants to purchase an additional 246,639 shares of common stock at $3.00 per share until October 14, 2010. The Company received $1,386,000 in cash from certain investors for 693,000 shares of common stock and warrants to purchase 173,250 shares of Common Stock. Four other investors cancelled indebtedness owed by the Company in the aggregate amount of $587,110 in exchange for 293,555 shares of common stock and warrants to purchase 73,389 shares of common stock. The indebtedness cancelled was as follows: (i) the Estate of Edward R. Funk cancelled indebtedness of $188,411.71 in exchange for 94,000 shares of common stock, warrants to purchase 23,500 shares of common stock at $3.00 per share exercisable until October 2010, and payment of $411.71; (ii) the Estate of Ingeborg V. Funk cancelled $100,980.21 of indebtedness in exchange for 50,000 shares of common stock, warrants to purchase 12,500 shares of common stock at $3.00 per share exercisable until October 2010, and payment of $980.21; (iii) Porter, Wright, Morris & Arthur LLP (PWMA) cancelled $90,000 of indebtedness for legal fees in exchange for 45,000 shares of common stock and warrants to purchase an additional 11,250 shares of common stock at $3.00 per share exercisable until October 2010; and (iv) a director cancelled $209,110 of a secured loan in exchange for 104,555 shares of common stock and warrants to purchase an additional 26,139 shares of common stock at $3.00 per share exercisable until October 2010 (as described in preceding paragraph).

SUPERCONDUCTIVE COMPONENTS, INC.
NOTES TO FINANCIAL STATEMENTS

Note 6. Capital Requirements (continued)

The Company has incurred substantial operating losses through September 30, 2006, and numerous factors may make it necessary for the Company to seek additional capital. In order to support the initiatives envisioned in its business plan, the Company may need to raise additional funds through public or private financing, collaborative relationships or other arrangements. Its ability to raise additional financing depends on many factors beyond its control, including the state of capital markets, the market price of its common stock and the development or prospects for development of competitive products by others. Because the common stock is not listed on a major stock exchange, many investors may not be willing or allowed to purchase it or may demand steep discounts. The necessary additional financing may not be available or may be available only on terms that would result in further dilution to the current owners of the common stock.

Part I. Financial Information

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

     Executive Summary

For the three months ended September 30, 2006, the Company had revenues of $2,064,497. This was an increase of $1,043,286, or 102.2%, over the three months ended September 30, 2005. The third quarter revenue for 2006 was a record and the fifth consecutive quarter that product revenue exceeded $1,000,000.

For the nine months ended September 30, 2006, the Company had revenues of $4,423,554. This was an increase of $2,113,749, or 91.5%, over the same period in 2005.

For the nine months ended September 30, 2006, the Company recorded net income applicable to common shares of $8,463 compared to a net loss of $(319,595) for the same period in 2005. The Company adopted SFAS 123R effective January 1, 2006. SFAS 123R requires compensation costs related to share based payment transactions to be recognized in the financial statements. Included in expenses for 2006 is non-cash compensation expense to employees related to the granting of stock options. This expense totaled $5,744 through September 30, 2006. The net income applicable to common shares would have been $14,207 through September 30, 2006 without this expense. Earnings Before Interest, Taxes, Deprecation and Amortization (EBITDA) was $165,542 during the nine months ending September 30, 2006 versus $(80,662) during the same period last year.

Orders received in the third quarter of 2006 were $3,532,000, which was $2,528,000 or 251.8% more than the third quarter of 2005. Orders received in the first nine months of 2006 totaled $7,253,000, which was $4,769,000, or 192.0% higher than the same period in 2005. The orders received through September 2006 exceeded the amount of orders received for all of 2005, which was $3,459,000. The growth in orders is primarily due to increased demand from current customers coupled with business from new customers.

     RESULTS OF OPERATIONS

Nine months ended September 30, 2006 (unaudited) compared to nine months ended September 30, 2005 (unaudited):

      Revenues

Revenues for the nine months ended September 30, 2006 were $4,423,554, compared to $2,309,805, for the same period last year, an increase of $2,113,749 or 91.5%.

Product revenues for the nine months ended September 30, 2006 increased to $4,381,462, from $2,064,122 for the same period last year, or an increase of 112.3%. The increase in revenues for the first nine months of 2006 was due to the return of a major customer and the addition of another major customer following the receipt by the Company of ISO 9001:2000 certification in the second quarter of 2005. Also, the addition of other new customers since the third quarter of 2005 has contributed to increased revenues. Revenues included the ongoing purchase of commodities whose prices have historically experienced periods of significant fluctuation. These changes are regularly reflected in the Company’s selling prices.

Contract research revenues were $42,092 for the nine months ended September 30, 2006, as compared to $245,683 for the same period last year. The decrease was due to the completion of work performed on a Phase II Small Business Innovation Research grant for $523,612 from the United States Department of Energy that was awarded in 2003. This award was to develop an

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

advanced method to manufacture continuous reacted lengths of High Tc Superconductor: Bismuth Strontium Calcium Copper Oxide — 2212 Wire. The work on this contract was completed in 2005. Revenues of $0 and $231,738 from this grant were included in the first nine months of 2006 and 2005, respectively.

The Company received notification in 2005 from the United States Department of Energy of a Notice of Financial Assistance Award in the amount of $99,793. This award provided support for Phase I of an SBIR entitled “Feasibility of Cost Effective, Long Length, BSCCO 2212 Round Wires, for Very High Field Magnets Beyond 12 Tesla at 4.2 Kelvin.” The work on the contract has been completed. Revenues for this award of $42,092 were recognized during the first nine months of 2006 and $57,701 in revenues were recognized in the second half of 2005.

     Gross Margin

Total gross margin for the nine months ended September 30, 2006 was $1,022,520, or 23.1% of total revenue, compared to $640,497, or 27.7% of total revenue, for the same period of 2005. Gross margin on product revenue was 22.8% for the nine months ended September 30, 2006, versus 23.1% for the same period of 2005. The slight decline was due to product mix of higher value product with lower gross margin commodities. Gross margin on contract research revenue was 58.6% and 66.4% for the nine months ended September 30, 2006 and 2005, respectively. The decrease was due to the completion of the Phase II grant.

     Selling Expense

Selling expense for the nine months ended September 30, 2006 increased to $210,162, from $167,518 for the same period of 2005, an increase of 25.5%. The increase was due to the implementation of an incentive compensation program.

      General and Administrative Expense

General and administrative expense for the nine months ended September 30, 2006 increased to $667,013, from $560,487 for the same period of 2005, an increase of 19.0%. The increase was due to increased wages, higher public relations and legal expenses and implementation of an incentive compensation program.

     Research and Development Expense

Research and development expense for the nine months ended September 30, 2006 was $144,974, compared to $146,817 for the same period of 2005, a decrease of 1.3%. The slight decrease was due to a change in focus from R&D to manufacturing Photonics products.

     Interest Income and Expense

Interest income was $32,501 and $1,473 for the nine months ended September 30, 2006 and 2005, respectively. This was due to an increase in cash from the private equity placement in the fourth quarter of 2005 and also an increase in revenues during the fourth quarter of 2005 and the first nine months of 2006.

Interest expense was $10,367 and $67,402 for the nine months ended September 30, 2006 and 2005, respectively. Interest expense to related parties was $0 and $64,263 for the nine months ended September 30, 2006, and 2005, respectively. The decrease was due to the elimination of interest expense to related parties on a note that was repaid, and another note that converted to equity in October of 2005.

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

INCOME (LOSS) APPLICABLE TO COMMON SHARES

Income (loss) applicable to common shares was $8,463 and $(319,595) for the nine months ended September 30, 2006 and 2005, respectively. Net income (loss) per common share based on the income (loss) applicable to common shares for the nine months ended September 30, 2006 and 2005 was $0.00 and $(0.13), respectively. The income (loss) applicable to common shares includes the net income (loss) from operations and the accretion of Series B preferred stock dividends. The net income (loss) per common share before dividends on preferred stock was $.01 and $(0.12) for the nine months ended September 30, 2006 and 2005, respectively.

Dividends on the Series B preferred stock accrue at 10% annually on the outstanding shares. Accrued dividends on the Series B preferred stock totaled $18,888 and $18,889 for the nine months ended September 30, 2006 and 2005, respectively.

Basic earnings per common share for the nine months ended September 30, 2006 were $0.00 per share with 3,425,937 average common shares outstanding as compared to $(0.13) per share and 2,448,906 weighted average common shares outstanding for the nine months ended September 30, 2005.

Diluted earnings per common share for the nine months ended September 30, 2006 were $0.00 per share with 3,946,035 average common shares outstanding as compared to $(0.13) per share and 2,448,906 weighted average common shares outstanding for the nine months ended September 30, 2005. For the nine months ended September 30, 2005, all outstanding common stock equivalents were anti-dilutive due to the net loss.

The following schedule represents the outstanding common shares of the Company during the period of 2006 through 2016 assuming all outstanding stock options and stock warrants are exercised during the year of expiration. If each shareholder exercises his or her options or warrants, it could increase the Company’s common shares by 1,268,537 (37.0%) to 4,695,652 by December 31, 2016. Exercise prices for options and warrants range from $1.00 to $4.00 at September 30, 2006. Assuming all such options and warrants are exercised in the year of expiration, the effect on shares outstanding is illustrated as follows:

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

      LIQUIDITY AND WORKING CAPITAL

At September 30, 2006, working capital was $1,347,462 compared to $(337,744) at September 30, 2005. This was due to an increase in cash from the private equity placement in the fourth quarter of 2005, an increase in accounts receivable, and the elimination of obligations due to a note payable-shareholder in the fourth quarter of 2005. The Company provided cash from operations of approximately $466,000 for the nine months ended September 30, 2006. The Company used cash from operations of approximately $347,000 for the nine months ended September 30, 2005. Significant non-cash items including depreciation, accretion and amortization, stock based compensation expense, inventory reserve on excess and obsolete inventory, and allowance for doubtful accounts were approximately $166,000 and $155,000, for the nine months ended September 30, 2006 and 2005, respectively. Accounts receivable, inventory, prepaid expenses and other assets increased approximately $254,000 for the nine months ended September 30, 2006 compared to approximately $202,000 for the same period in 2005. Accounts payable, accrued expenses and deferred revenue increased approximately $527,000 for the nine months ended September 30, 2006 versus an increase of approximately $1,000 for the first nine months of 2005.

The Company used cash of approximately $164,000 and $43,000 for investing activities for the nine months ended September 30, 2006 and 2005, respectively. The amounts invested were used to purchase machinery and equipment for increased production capacity, new product lines and leasehold improvements for the new facility. Proceeds on sale of equipment totaled $0 and $250 for the nine months ended September 30, 2006 and 2005, respectively.

The Company used cash of approximately $95,000 for financing activities during the nine months ended September 30, 2006. Cash payments to third parties for capital lease obligations approximated $46,000. Cash payments for services provided for the registration of common stock were $50,131. Proceeds from the exercise of stock options were $1,200. The Company incurred new leases of $134,268 for a forklift and production equipment.

The Company provided cash of approximately $411,000 for financing activities for the nine months ended September 30, 2005. Cash payments to third parties for capital lease obligations approximated $25,000. Proceeds from notes payable totaled $300,000 and proceeds from the sale of common stock were $136,000.

During the third quarter of 2006, the Company met with the Development Financing Advisory Council (DFAC) of the Ohio Department of Development and applied for a loan from the Innovation Ohio Loan Fund. The DFAC has forwarded the Company’s request for a $631,687 loan at an interest rate of 7.5% plus certain fees over 7 years to the State Controlling Board and recommended the loan be approved at the November 13, 2006 State Controlling Board meeting.

While certain major shareholders of the Company have advanced funds in the form of secured debt, subordinated debt, accounts payable and guaranteeing bank debt in the past, there is no commitment by these individuals to continue funding the Company or guaranteeing bank debt in the future. The Company will continue to seek new debt or equity financing arrangements. However, the Company cannot be certain that it will be successful in efforts to raise additional funds.

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

In November 2004, a director agreed to loan the Company up to $200,000 for working capital, to be drawn by the Company in increments of $50,000. The interest rate was Huntington National Bank’s prime rate plus 2%, accruing and compounding monthly. The loan was secured by a first lien on substantially all of the Company’s assets. For each $50,000 increment drawn on the loan, the director received 5,000 warrants to purchase the Company’s common stock at a purchase price of $2.50 per share exercisable until November 1, 2009. The loan was drawn based on the following schedule: November 3, 2004, $100,000, January 7, 2005, $50,000; and April 1, 2005, $50,000. The entire loan balance (principal and accrued interest) was repaid in October 2005.

In April 2005, the same director who agreed to provide a secured loan for $200,000 to the Company in November 2004, agreed to provide an additional $200,000 secured loan to the Company for working capital. The interest rate was 10%, accruing and compounding monthly. On April 14, 2005, $100,000 was drawn on this loan. $100,000 was also drawn on the loan on May 20, 2005. By the terms of the loan, because the Company completed an equity financing of at least $500,000 during 2005, the principal and accrued interest on this loan totaling $209,110 automatically converted on the same basis as the new financing to 104,555 shares of common stock ($2.00 per share) and warrants to purchase an aggregate of 26,139 shares of the Company’s common stock at a purchase price of $3.00 per share exercisable until October 2010.

In the fourth quarter of 2005, the Company completed a private placement to accredited investors. The investors purchased 986,555 shares of common stock at a price of $2.00 per share and warrants to purchase an additional 246,639 shares of common stock at $3.00 per share until October 14, 2010. The Company received $1,386,000 in cash from certain investors for 693,000 shares of common stock and warrants to purchase 173,250 shares of Common Stock. Four other investors cancelled indebtedness owed by the Company in the aggregate amount of $587,110 in exchange for 293,555 shares of common stock and warrants to purchase 73,389 shares of common stock. The indebtedness cancelled was as follows: (i) the Estate of Edward R. Funk cancelled indebtedness of $188,411.71 in exchange for 94,000 shares of common stock, warrants to purchase 23,500 shares of common stock at $3.00 per share exercisable until October 2010, and payment of $411.71; (ii) the Estate of Ingeborg V. Funk cancelled $100,980.21 of indebtedness in exchange for 50,000 shares of common stock, warrants to purchase 12,500 shares of common stock at $3.00 per share exercisable until October 2010, and payment of $980.21; (iii) Porter, Wright, Morris & Arthur LLP (PWMA) cancelled $90,000 of indebtedness for legal fees in exchange for 45,000 shares of common stock and warrants to purchase an additional 11,250 shares of common stock at $3.00 per share exercisable until October 2010; and (iv) a director cancelled $209,110 of a secured loan in exchange for 104,555 shares of common stock and warrants to purchase an additional 26,139 shares of common stock at $3.00 per share exercisable until October 2010 (as described in preceding paragraph).

     Risk Factors

The Company desires to take advantage of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. The following factors, as well as the factors listed under the caption “Risk Factors” in the Company’s Form 10-KSB filed with the Securities and Exchange Commission on March 27, 2006, have affected or could affect the Company’s actual results and could cause such results to differ materially from those expressed in any forward-looking

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

statements made by the Company. Investors should consider carefully these risks and speculative factors inherent in and affecting the business of the Company and an investment in the Company’s common stock.

We have experienced significant operating losses in the past and may continue to do so in the future.

We commenced business in May of 1987. Our accumulated deficit since inception was $8,134,004 (unaudited) at September 30, 2006.

We have financed the losses primarily from additional investments and loans by our major shareholders and private offerings of common stock and warrants to purchase common stock in 2004 and 2005. We cannot assure you, however, that we will be able to raise additional capital in the future to fund our operations.

     Critical Accounting Policies

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make judgments, assumptions and estimates that affect the amounts reported in the Financial Statements and accompanying notes . Note 2 to the Financial Statements in the Annual Report on Form 10-KSB for the year ended December 31, 2005 describes the significant accounting policies and methods used in the preparation of the Financial Statements. Estimates are used for, but not limited to, accounting for the allowance for doubtful accounts, inventory allowances, property and equipment depreciable lives, patents and licenses useful lives, and assessing changes in which impairment of certain long-lived assets may occur. Actual results could differ from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the Financial Statements. The allowance for doubtful accounts is based on our assessment of the collectibility of specific customer accounts and the aging of the accounts receivable. If there is a deterioration of a major customer’s credit worthiness or actual defaults are higher than our historical experience, our estimates of the recoverability of amounts due us could be adversely affected. Inventory purchases and commitments are based upon future demand forecasts. If there is a sudden and significant decrease in demand for our products or there is a higher risk of inventory obsolescence because of rapidly changing technology and customer requirements, we may be required to increase our inventory allowances and our gross margin could be adversely affected. Depreciable and useful lives estimated for property and equipment, licenses and patents are based on initial expectations of the period of time these assets and intangibles will provide benefit to our Company. Changes in circumstances related to a change in our business, change in technology or other factors could result in these assets becoming impaired, which could adversely affect the value of these assets.

     Off Balance Sheet Arrangements

The Company has no off balance sheet arrangements including special purpose entities.