UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-QSB
 
(Mark One)
x QUARTERLY REPORT UNDER SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: March 31, 2006

or

o TRANSITION REPORT UNDER SECTION 13 OR 15 (d) OF THE
EXCHANGE ACT
For the transition period from _______to________

Commission File Number: 0-26520

NEOPROBE CORPORATION
(Exact name of small business issuer as specified in its charter)

Delaware
31-1080091
(State or other jurisdiction of
(I.R.S. employer identification no.)
incorporation or organization)
  

425 Metro Place North, Suite 300, Dublin, Ohio 43017
(Address of principal executive offices)

614-793-7500
(Issuer's telephone number)

58,691,046 shares of common stock, par value $.001 per share
(Number of shares of issuer’s common equity outstanding as of the close of business on May 5, 2006)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 such filing requirements for the past 90 days. Yes x    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 x

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: 58,691,046 shares of common stock, par value $.001 per share (as of the close of business on May 5, 2006).

Transitional Small Business Disclosure Format (check one) Yes o    No x
 
Back to Table of Contents

NEOPROBE CORPORATION and SUBSIDIARIES

INDEX
     
3
 
3
 
5
 
6
 
7
     
14
 
14
 
14
 
16
 
17
 
18
 
19
 
21
     
22
     
23
 
 
-2-
 
PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

Neoprobe Corporation and Subsidiaries
Consolidated Balance Sheets
           
ASSETS
  
March 31,
2006
(unaudited)
  
December 31,
2005
  
Current assets:
          
Cash and cash equivalents
  
$
5,658,771
  
$
4,940,946
  
Available-for-sale securities
    
54,853
    
1,529,259
  
Accounts receivable, net
    
710,820
    
673,008
  
Inventory
    
800,910
    
803,703
  
Prepaid expenses and other
    
307,340
    
501,557
  
Total current assets
    
7,532,694
    
8,448,473
  
               
Property and equipment
   
2,065,528
    
2,051,793
  
Less accumulated depreciation and amortization
    
1,785,645
    
1,768,558
  
     
279,883
    
283,235
  
               
Patents and trademarks
    
3,170,333
    
3,162,547
  
Acquired technology
   
237,271
    
237,271
  
     
3,407,604
    
3,399,818
  
Less accumulated amortization
    
1,365,875
    
1,300,908
  
               
     
2,041,729
    
2,098,910
  
               
Other assets
    
685,703
    
739,823
  
Total assets
  
$
10,540,009
  
$
11,570,441
  
 
 
Continued
 
-3-

Neoprobe Corporation and Subsidiaries
Consolidated Balance Sheets, continued
           
LIABILITIES AND STOCKHOLDERS’ EQUITY
  
March 31,
2006
(unaudited)
  
December 31,
2005
  
Current liabilities:
          
Accounts payable
  
$
423,037
  
$
207,824
  
Accrued liabilities and other
    
348,737
    
821,781
  
Capital lease obligations, current
    
19,401
    
19,530
  
Deferred revenue, current
    
249,898
    
252,494
  
Notes payable to finance companies
    
132,299
    
200,054
  
Total current liabilities
    
1,173,372
    
1,501,683
  
               
Capital lease obligations
    
27,302
    
31,855
  
Deferred revenue
    
31,944
    
41,132
  
Notes payable to CEO, net of discounts of $24,568 and $26,249, respectively
    
75,432
    
73,751
  
Notes payable to investors, net of discounts of $1,965,435 and $2,099,898, respectively
    
6,034,565
    
5,900,102
  
Other liabilities
    
4,510
    
5,122
  
Total liabilities
    
7,347,125
    
7,553,645
  
               
Commitments and contingencies
              
               
Stockholders’ equity:
              
Preferred stock; $.001 par value; 5,000,000 shares
              
authorized at March 31, 2006 and December 31, 2005;
             
none issued and outstanding
   
—
    
—
  
Common stock; $.001 par value; 150,000,000 shares
             
authorized; 58,690,046 shares issued and outstanding
              
at March 31, 2006; 58,622,059 shares issued and
             
outstanding at December 31, 2005
    
58,690
    
58,622
  
Additional paid-in capital
    
135,008,954
    
134,903,259
  
Accumulated deficit
    
(131,874,705
)
  
(130,947,103
)
Accumulated other comprehensive (loss) income
    
(55
)
  
2,018
  
Total stockholders’ equity
   
3,192,884
    
4,016,796
  
Total liabilities and stockholders’ equity
 
$
10,540,009
  
$
11,570,441
  
 
 
See accompanying notes to the consolidated financial statements
 
-4-
 
Neoprobe Corporation and Subsidiaries
Consolidated Statements of Operations
(unaudited)
       
 
Three Months Ended
March 31,
  
   
2006
  
2005
  
         
Net sales
 
$
1,787,918
  
$
1,465,887
  
Cost of goods sold
    
737,220
    
563,323
  
Gross profit
    
1,050,698
    
902,564
  
               
Operating expenses:
              
Research and development
    
834,183
    
638,445
  
Selling, general and administrative
    
852,483
    
836,115
  
Total operating expenses
    
1,686,666
    
1,474,560
  
               
Loss from operations
    
(635,968
)
  
(571,996
)
               
Other income (expenses):
              
Interest income
    
66,203
    
40,963
  
Interest expense
    
(356,534
)
  
(327,573
)
Increase in warrant liability
    
—
    
(142,427
)
Other
    
(1,303
)
  
(1,738
)
Total other expenses
    
(291,634
)
  
(430,775
)
Net loss
  
$
(927,602
)
$
(1,002,771
)
               
Net loss per common share:
              
Basic
  
$
(0.02
)
$
(0.02
)
Diluted
  
$
(0.02
)
$
(0.02
)
               
Weighted average shares outstanding:
              
Basic
    
58,510,944
    
58,317,098
  
Diluted
    
58,510,944
    
58,317,098
  
 
 
See accompanying notes to the consolidated financial statements.
 
-5-
 
Neoprobe Corporation and Subsidiaries
Consolidated Statements of Cash Flows
(unaudited)
   
Three Months Ended
March 31,
  
 
2006
  
2005
  
Cash flows from operating activities:
          
Net loss
  
$
(927,602
)
$
(1,002,771
)
Adjustments to reconcile net loss to net cash
              
used in operating activities:
              
Depreciation and amortization
    
100,700
    
149,812
  
Amortization of debt discount and offering costs
    
190,264
    
161,391
  
Increase in warrant liability
    
—
    
142,427
  
Stock option expense
    
79,150
    
—
  
Other
    
26,521
    
(111
)
Changes in operating assets and liabilities:
              
Accounts receivable
    
(37,812
)
  
(500,245
)
Inventory
    
(16,658
)
  
(8,259
)
Prepaid expenses and other assets
    
196,217
    
87,532
  
Accounts payable
    
215,213
    
9,465
  
Accrued liabilities and other liabilities
    
(473,657
)
  
(74,761
)
Deferred revenue
    
(11,784
)
  
172,978
  
Net cash used in operating activities
    
(659,448
)
  
(862,542
)
               
Cash flows from investing activities:
              
Purchases of available-for-sale securities
    
—
    
(3,494,029
)
Maturities of available-for-sale securities
    
1,476,000
    
—
  
Purchases of property and equipment
    
(16,504
)
  
(24,748
)
Proceeds from sales of property and equipment
    
—
    
154
  
Patent and trademark costs
    
(7,786
)
  
(8,470
)
 
              
Net cash provided by (used in) investing activities
    
1,451,710
    
(3,527,093
)
               
Cash flows from financing activities:
              
Proceeds from issuance of common stock
    
—
    
57,922
  
Payment of debt issuance costs
    
(5,000
)
  
(9,635
)
Payment of notes payable
    
(64,755
)
  
(76,977
)
Payments under capital leases
    
(4,682
)
  
(3,181
)
Other
    
—
    
20
  
Net cash used in financing activities
    
(74,437
)
  
(31,851
)
               
Net increase (decrease) in cash and cash equivalents
    
717,825
    
(4,421,486
)
               
Cash and cash equivalents, beginning of period
    
4,940,946
    
9,842,658
  
Cash and cash equivalents, end of period
  
$
5,658,771
  
$
5,421,172
  
 
 
See accompanying notes to the consolidated financial statements.
 
-6-
 
Notes to the Consolidated Financial Statements
(unaudited)

1.
Basis of Presentation

The information presented as of March 31, 2006 and 2005 and for the three-month periods then ended is unaudited, but includes all adjustments (which consist only of normal recurring adjustments) that the management of Neoprobe Corporation (Neoprobe, the Company, or we) believes to be necessary for the fair presentation of results for the periods presented. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the U.S. Securities and Exchange Commission. The results for the interim periods are not necessarily indicative of results to be expected for the year. The consolidated financial statements should be read in conjunction with Neoprobe’s audited consolidated financial statements for the year ended December 31, 2005, which were included as part of our Annual Report on Form 10-KSB.

Our consolidated financial statements include the accounts of Neoprobe, our wholly-owned subsidiary, Cardiosonix Ltd. (Cardiosonix), and our 90%-owned subsidiary, Cira Biosciences, Inc. (Cira Bio). All significant inter-company accounts were eliminated in consolidation.

2.
Stock-Based Compensation

Effective January 1, 2006, we adopted Statement of Financial Accounting Standards (SFAS) No. 123(R), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their estimated fair values.

We are applying the modified prospective method for recognizing the expense over the remaining vesting period for awards that were outstanding but unvested as of January 1, 2006. Under the modified prospective method, we have not adjusted the financial statements for periods ending prior to January 1, 2006. Under the modified prospective method, the adoption of SFAS No. 123(R) applies to new awards and to awards modified, repurchased, or cancelled after December 31, 2005, as well as to the unvested portion of awards outstanding as of January 1, 2006.

We are continuing to use the Black-Scholes option pricing model to value share-based payments. Compensation cost arising from stock-based awards is recognized as expense using the straight-line method over the vesting period. As of March 31, 2006, there was approximately $291,000 of total unrecognized compensation cost related to unvested stock-based awards, which we expect to recognize over remaining weighted average vesting terms of 1.3 years. For the quarter ended March 31, 2006, our total stock-based compensation expense was $79,000. We have not recorded any income tax benefit related to stock-based compensation in either of the quarters ended March 31, 2006 and 2005.
 
-7-
 
As permitted by SFAS No. 123, prior to 2006 Neoprobe accounted for share-based payments to employees using APB Opinion No. 25’s intrinsic value method and, as such, generally recognized no compensation cost for employee stock options. The following table illustrates the effect on net loss and net loss per share for the quarter ended March 31, 2005 as if compensation cost for our stock-based compensation plans had been determined based on the fair value at the grant dates for awards under those plans consistent with SFAS No. 123.

 
Three Months Ended
March 31, 2005
  
     
Net loss, as reported
  
$
(1,002,771
)
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards
    
(214,301
)
Pro forma net loss
  
$
(1,217,072
)
         
Loss per common share:
        
As reported (basic and diluted)
  
$
(0.02
)
Pro forma (basic and diluted)
  
$
(0.02
)

During the first quarter of 2005, the Board of Directors granted options to directors and certain employees to purchase 335,000 shares of our common stock, exercisable at an average price of $0.68 per share, vesting over three years. No options were granted during the first quarter of 2006. As of March 31, 2006, we have 5.5 million options outstanding under three stock option plans. Of the outstanding options, 4.1 million options have vested as of March 31, 2006, at an average exercise price of $0.46 per share.

3.
Comprehensive Income (Loss)

Due to our net operating loss position, there are no income tax effects on comprehensive income (loss) components for the three-month periods ended March 31, 2006 and 2005.

   
Three Months Ended
March 31,
  
 
2006
  
2005
  
         
Net loss
  
$
(927,602
)
$
(1,002,771
)
Unrealized losses on securities
    
(2,073
)
  
(2,198
)
Other comprehensive loss
  
$
(929,675
)
$
(1,004,969
)
 
 
-8-
 
4.
Earnings Per Share

Basic earnings (loss) per share is calculated using the weighted average number of common shares outstanding during the periods. Diluted earnings (loss) per share is calculated using the weighted average number of common shares outstanding during the periods, adjusted for the effects of convertible securities, options and warrants, if dilutive.

   
Three Months Ended
March 31, 2006
  
Three Months Ended
March 31, 2005
  
 
Basic
Earnings
Per Share
  
Diluted
Earnings
Per Share
  
Basic
Earnings
Per Share
  
Diluted
Earnings
Per Share
  
Outstanding shares
    
58,690,046
    
58,690,046
    
58,585,008
    
58,585,008
  
Effect of weighting changes in outstanding shares
    
(49,102
)
  
(49,102
)
  
(137,910
)
  
(137,910
)
Contingently issuable shares
    
(130,000
)
  
(130,000
)
  
(130,000
)
  
(130,000
)
Adjusted shares
    
58,510,944
    
58,510,944
    
58,317,098
    
58,317,098
  
 
There is no difference in basic and diluted loss per share related to the three-month periods ended March 31, 2006 and 2005. The net loss per common share for these periods excludes 41,341,677 and 38,722,364, respectively, of common shares issuable upon exercise of outstanding stock options and warrants into our common stock or upon the conversion of convertible debt since such inclusion would be anti-dilutive.

5.
Available-for-Sale Securities

Available-for-sale securities are recorded at fair value. Unrealized holding gains and losses, net of the related tax effect, on available-for-sale securities are excluded from earnings and are reported as a separate component of other comprehensive income (loss) until realized. Realized gains and losses from the sale of available-for-sale securities are determined on a specific identification basis.

A decline in the market value of any available-for-sale security below cost that is deemed to be other than temporary results in a reduction in carrying amount to fair value. The impairment is charged to earnings and a new cost basis for the security is established. Premiums and discounts are amortized or accreted over the life of the related available-for-sale security as an adjustment to yield using the effective interest method. Dividend and interest income are recognized when earned.

Available-for-sale securities are classified as current based on our intent to use them to fund short-term working capital needs.

6.
Inventory

The components of inventory are as follows:

 
March 31,
2006
(unaudited)
  
December 31,
2005
  
         
Materials and component parts
  
$
380,956
  
$
461,218
  
Finished goods
    
419,954
    
342,485
  
Total
  
$
800,910
  
$
803,703
  
 
 
-9-
 
7.
Intangible Assets

The major classes of intangible assets are as follows:

       
March 31, 2006
  
December 31, 2005
  
   
Wtd Avg Life
  
Gross Carrying Amount
  
 
Accumulated Amortization
  
Gross Carrying Amount
  
 
Accumulated Amortization
  
                     
Patents and trademarks
    
10 yrs
  
$
3,170,333
  
$
1,221,303
  
$
3,162,547
  
$
1,164,763
  
Acquired technology
    
3 yrs
    
237,271
    
144,572
    
237,271
    
136,145
  
Total
        
$
3,407,604
  
$
1,365,875
  
$
3,399,818
  
$
1,300,908
  

The estimated future amortization expenses for the next five fiscal years are as follows:

 
Estimated Amortization Expense
  
     
For the year ended 12/31/2006
  
$
262,992
  
For the year ended 12/31/2007
    
226,830
  
For the year ended 12/31/2008
    
201,976
  
For the year ended 12/31/2009
    
168,267
  
For the year ended 12/31/2010
    
168,267
  

8.
Product Warranty

We warrant our products against defects in design, materials, and workmanship generally for a period of one year from the date of sale to the end customer except in cases where the product has a limited use as designed. Our accrual for warranty expenses is adjusted periodically to reflect actual experience. Our primary marketing partner, Ethicon Endo-Surgery, Inc. (EES), a Johnson & Johnson company, also reimburses us for a portion of warranty expense incurred based on end customer sales they make during a given fiscal year. Payments charged against the reserve are disclosed net of EES’ estimated reimbursement.

The activity in the warranty reserve account for the three-month periods ended March 31, 2006 and 2005 is as follows:

   
Three Months Ended
March 31,
  
   
2006
  
2005
  
         
Warranty reserve at beginning of period
  
$
41,185
  
$
66,000
  
Provision for warranty claims and changes in reserve for warranties
    
13,451
    
23,573
  
Payments charged against the reserve
    
(10,911
)
  
(23,073
)
Warranty reserve at end of period
  
$
43,725
  
$
66,500
  

9.
Notes Payable

In December 2004, we completed a private placement of four-year convertible promissory notes in an aggregate principal amount of $8.1 million with Biomedical Value Fund, L.P., Biomedical Offshore Value Fund, Ltd. and David C. Bupp (our President and CEO). Biomedical Value Fund, L.P. and Biomedical Offshore Value Fund, Ltd. are funds managed by Great Point Partners, LLC. The notes bear interest at 8% per annum, payable quarterly on each March 31, June 30, September 30 and December 31 of each year, and are freely convertible into shares of our common stock at a price of $0.40 per share. Neoprobe may force conversion of the notes prior to their stated maturity under certain circumstances. All of our material assets, except the intellectual property associated with our LymphoseekTM and RIGS® products under development, have been pledged as collateral for these notes.
 
-10-

In addition to the security interest in our assets, the notes carry substantial covenants that impose significant requirements on us, including, among others, requirements that: we pay all principal, interest and other charges on the notes when due; we use the proceeds from the sale of the notes only for permitted purposes such as Lymphoseek development and general corporate purposes; we nominate and recommend for election as a director a person designated by the holders of the notes (as of March 31, 2006, the holders of the notes have not designated a potential board member); we keep reserved out of our authorized shares of common stock sufficient shares to satisfy our obligation to issue shares on conversion of the notes and the exercise of the warrants issued in connection with the sale of the notes; we achieve annual revenues on a consolidated basis of at least $5.4 million in 2005, $6.5 million in 2006, and $9.0 million in each year thereafter; we maintain minimum cash balances of $4.5 million at the end of the first six months of 2005, $4.0 million at the end of the second six months of 2005, and $3.5 million at the end of each six-month period thereafter; and we indemnify the purchasers of the notes against certain liabilities. Additionally, with certain exceptions, the notes prohibit us from: amending our organizational or governing agreements and documents, entering into any merger or consolidation, dissolving the company or liquidating its assets, or acquiring all or any substantial part of the business or assets of any other person; engaging in transactions with any affiliate; entering into any agreement inconsistent with our obligations under the notes and related agreements; incurring any indebtedness, capital leases, or contingent obligations outside the ordinary course of business; granting or permitting liens against or security interests in our assets; making any material dispositions of our assets outside the ordinary course of business; declaring or paying any dividends or making any other restricted payments; or making any loans to or investments in other persons outside of the ordinary course of business.

As part of this transaction, we issued the investors 10,125,000 Series T warrants to purchase our common stock at an exercise price of $0.46, expiring in December 2009. The fair value of the warrants issued to the investors was $1,315,000 on the date of issuance and was determined by a third-party valuation expert using the Black-Scholes option pricing model with the following assumptions: an average risk-free interest rate of 3.4%, volatility of 50% and no expected dividend rate. In connection with this financing, we also issued 1,600,000 warrants to purchase our common stock to the placement agents, containing substantially the same terms as the warrants issued to the investors. The fair value of the warrants issued to the placement agents was $208,014 using the Black-Scholes option pricing model with the same assumptions used to determine the fair value of the warrants issued to the investors. The value of the beneficial conversion feature of the notes was estimated at $1,315,000 based on the effective conversion price at the date of issuance. The fair value of the warrants issued to the investors and the value of the beneficial conversion feature were recorded as discounts on the note and are being amortized over the term of the notes using an effective interest rate of 19.8%. The fair value of the warrants issued to the placement agents was recorded as a deferred debt issuance cost and is being amortized over the term of the notes. If we issue equity at prices below the conversion rate for the promissory notes (and for the warrants below the exercise price), then we would be required to reset the exercise and conversion prices for these securities. This provision results in a contingent beneficial conversion feature that may require us to estimate an additional debt discount if a reset occurs.

U.S. generally accepted accounting principles also required us to classify the warrants issued in connection with the placement as a liability due to penalty provisions contained in the securities purchase agreement. The penalty provisions could have required us to pay a penalty of 0.0667% per day of the total debt amount if we failed to meet certain registration deadlines, or if our stock was suspended from trading for more than 30 days. As a liability, the warrants were considered a derivative instrument that were required to be periodically “marked to market” on our consolidated balance sheet. We estimated the fair value of the warrants at December 31, 2004 using the Black-Scholes option pricing model with the following assumptions: an average risk-free interest rate of 3.4%, volatility of 50% and no expected dividend rate. On February 16, 2005, Neoprobe and the investors confirmed in writing their intention that the penalty provisions which led to this accounting treatment were intended to apply only to the $8.1 million principal balance of the promissory notes and underlying conversion shares and not to the warrant shares. Because the value of our stock increased $0.02 per share from $0.59 per share at December 31, 2004 to $0.61 per share at February 16, 2005, the effect of marking the warrant liability to “market” resulted in an increase in the estimated fair value of the warrant liability of $142,427 which was recorded as non-cash expense during the first quarter of 2005. The estimated fair value of the warrant liability was then reclassified to additional paid-in capital during the first quarter of 2005.
 
-11-

10.
Stock Warrants

During the first quarter of 2005, 143,278 of our Series R and 63,587 of our Series S warrants that were issued in October 2003 were exercised and we realized proceeds of $57,922. No warrants were exercised during the first quarter of 2006.

At March 31, 2006, there are 17.0 million warrants outstanding to purchase our common stock. The warrants are exercisable at prices ranging from $0.13 to $0.75 per share with a weighted average exercise price of $0.40 per share.

11.
Segment and Subsidiary Information

We report information about our operating segments using the “management approach” in accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. This information is based on the way management organizes and reports the segments within the enterprise for making operating decisions and assessing performance. Our reportable segments are identified based on differences in products, services and markets served. There were no inter-segment sales. We own or have rights to intellectual property involving two primary types of medical device products, including gamma detection instruments currently used primarily in the application of intraoperative lymphatic mapping (ILM), and blood flow measurement devices. We also own or have rights to intellectual property related to several drug and therapy products.

The information in the following table is derived directly from each reportable segment’s financial reporting.
 
($ amounts in thousands)
Three Months Ended March 31, 2006
  
Gamma Detection Devices
  
Blood Flow
Devices
  
Drug and Therapy Products
  
Corporate
  
Total
  
                       
Net sales:
                      
United States1
  
$
1,479
  
$
35
  
$
—
  
$
—
  
$
1,514
  
International
    
95
    
179
    
—
    
—
    
274
  
Research and development expenses
    
112
    
257
    
465
    
—
    
834
  
Selling, general and administrative expenses, excluding depreciation and amortization2
    
—
    
—
    
—
    
751
    
751
  
Depreciation and amortization
    
28
    
59
    
—
    
14
    
101
  
Income (loss) from operations3
    
793
    
(199
)
  
(465
)
  
(765
)
  
(636
)
Other income (expenses)4
    
—
    
—
    
—
    
(292
)
  
(292
)
                                 
Total assets, net of depreciation and amortization:
                                
United States operations
    
986
    
565
    
36
    
6,778
    
8,365
  
Israeli operations (Cardiosonix Ltd.)
    
—
    
2,175
    
—
    
—
    
2,175
  
Capital expenditures
    
—
    
1
    
—
    
16
    
17
  
                                 
 
 
-12-
 
($ amounts in thousands)
Three Months Ended March 31, 2005
  
Gamma Detection Devices
  
Blood Flow Devices
  
Drug and Therapy Products
  
Corporate
  
Total
  
                       
Net sales:
                      
United States1
  
$
1,354
  
$
56
  
$
—
  
$
—
  
$
1,410
  
International
    
42
    
14
    
—
    
—
    
56
  
Research and development expenses
    
38
    
350
    
250
    
—
    
638
  
Selling, general and administrative expenses, excluding depreciation and amortization2
    
—
    
—
    
—
    
686
    
686
  
Depreciation and amortization
    
34
    
101
    
—
    
15
    
150
  
Income (loss) from operations3
    
793
    
(414
)
  
(250
)
  
(701
)
  
(572
)
Other income (expenses)4
    
—
    
—
    
—
    
(431
)
  
(431
)
                                 
Total assets, net of depreciation and amortization:
                                
United States operations
    
1,590
    
171
    
7
    
10,186
    
11,954
  
Israeli operations (Cardiosonix Ltd.)
    
—
    
2,766
    
—
    
—
    
2,766
  
Capital expenditures
    
—
    
16
    
1
    
8
    
25
  
                                 
1
All sales to EES are made in the United States. EES distributes the product globally through its international affiliates.
2
Selling, general and administrative expenses, excluding depreciation and amortization, represent expenses that relate to the general administration of the Company and as such are not currently allocated to our individual reportable segments.
3
Income (loss) from operations does not reflect the allocation of selling, general and administrative expenses to the operating segments.
4
Amounts consist primarily of interest income and interest expense which are not currently allocated to our individual reportable segments.

12.
Supplemental Disclosure for Statements of Cash Flows:

During the first quarter of 2005 and 2004, we paid interest aggregating $166,000 and $180,000, respectively. During the first quarter of 2005, we purchased equipment under capital leases totaling $20,000.
 
-13-

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

The Company

Neoprobe Corporation is a biomedical technology company that provides innovative surgical and diagnostic products that enhance patient care by meeting the critical decision-making needs of physicians. The December 2001 acquisition of Cardiosonix Ltd. (Cardiosonix) expanded our potential product offerings beyond the neo2000® gamma detection device, which is marketed in the oncology arena, into the area of blood flow measurement and cardiac care. Cardiosonix has received marketing clearance for two of its products, Quantix/ND™ and Quantix/OR™, in the U.S. and in Europe. Neoprobe is commercializing the proprietary Cardiosonix blood flow monitoring devices for a variety of diagnostic and surgical applications. In addition to our medical device products, we have two radiopharmaceutical products, Lymphoseek™ and RIGScan® CR, in the advanced phases of clinical development. In January 2005 we also formed a majority-owned (90%) subsidiary, Cira Biosciences, Inc. (Cira Bio) to advance our activated cellular therapy (ACT) platform.

Overview

This Overview section contains a number of forward-looking statements, all of which are based on current expectations. Actual results may differ materially from the anticipated results discussed herein. Our financial performance is highly dependent on our ability to continue to generate income and cash flow from our gamma device product line and on our ability to successfully commercialize the blood flow products of Cardiosonix. We cannot assure you that we will achieve the volume of sales anticipated, or if achieved, that the margin on such sales will be adequate to produce positive operating cash flow. We continue to be optimistic about the longer-term potential for our other proprietary, procedural-based technologies such as Lymphoseek, RIGS® (radioimmunoguided surgery) and ACT; however, these technologies are not anticipated to generate any significant revenue for us during 2006. In addition, we cannot assure you that these products will ever obtain marketing clearance from the appropriate regulatory bodies.

Our revenue for the first quarter of 2006 was somewhat higher than our original expectations due to slightly higher unit sales of our gamma detection devices and accessories offset by declines in unit prices of our base neo2000 system. Our sales of Quantix® blood flow devices for the first quarter of 2006 represent a combination of demonstration and customer unit sales. We expect that net sales of gamma detection devices for 2006 will be consistent to slightly higher than 2005, but that the effect of increased unit sales may be offset if we continue to experience price declines or if unfavorable foreign currency exchange rates occur. We continue to expect that our sales of blood flow measurement devices for 2006 will exceed 2005 by a significant percentage. However, future sales of Quantix devices are still highly dependent upon physician response to the products and our ability to train our distributors.

Our operating expenses during the first quarter of 2006 were focused primarily on support of Lymphoseek product development. In addition, we continued to invest in our Quantix blood flow measurement line, RIGScan CR, Cira Bio’s ACT technology and our neo2000 gamma detection device line. We expect our development expenses to increase over the remainder of 2006 as we conclude certain drug manufacturing and validation activities and conduct multi-center clinical evaluation of Lymphoseek. We expect to continue to incur development expenses to support and to innovate our device product lines as well as move our other product initiatives forward. We will also continue to invest in marketing and clinical development support for our blood flow products during the remainder of 2006 as we work with our distribution partners to expand market penetration of our Quantix product lines.

Our efforts thus far in 2006 have resulted in the following milestone achievements:

·      
Received notification of the renewal of our Marketing and Distribution agreement with our primary gamma detection device marketing partner, Ethicon Endo-Surgery, Inc. (EES), a Johnson & Johnson company, through December 2008;
 
 
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·      
Completed a submission to the U.S. Food and Drug Administration (FDA) to respond to information requested by FDA regarding both preclinical toxicity studies and the chemistry, manufacturing and control (CMC) issues surrounding the commercial production of Lymphoseek;
·      
Authorized by FDA to commence patient enrollment in a Phase II clinical study of Lymphoseek;
·      
Reviewed Phase II Lymphoseek protocol and clinical program with clinical investigators at the Society of Surgical Oncology meeting;
·      
Completed Investigational New Drug amendment submission for RIGScan CR; and
·      
Received first commercial production of Quantix devices from U.S.-based contract manufacturer.

In September 2005, Neoprobe received a letter from FDA confirming feedback from recent discussions regarding our Investigational New Drug (IND) application for Lymphoseek. The letter formalized FDA’s feedback and was consistent with the information that the agency had provided in the first quarter of 2005. In its feedback, FDA formalized a very stringent non-clinical template for drug safety involving a total of seven tests. All seven non-clinical tests, including repeat dose studies, were completed and we received the final reports. The final reports were submitted to FDA in late December 2005. Based on a review of the information from all of these tests, we are not aware of any drug-related adverse results. FDA’s September 2005 letter also confirmed that we will be required to use commercial drug, produced under commercial conditions, in the conduct of the Phase II trial, rather than the laboratory grade material produced by the University of California, San Diego, as originally planned. The additional non-clinical tests and the requirement to use commercial drug resulted in delays to the start of multi-center studies of Lymphoseek. However, we believe that use of commercially produced drug will help in FDA’s review of the New Drug Application (NDA) regarding efficacy from the pivotal (i.e., Phase III) trial and will ultimately put us in a much stronger regulatory position once the NDA is filed.

Our drug manufacturing partners, Reliable Biopharmaceuticals and Cardinal Health, have completed their development and validation work and have provided responses to the CMC questions raised by FDA, which, along with the previously completed non-clinical testing results, were submitted to FDA for review. Cardinal Health is entering the final stages of commercial drug production and is expected to have the commercial-quality drug packaged and labeled and available for clinical trial use at roughly the same time as the Phase II institutional sites are expected to complete their final reviews of the FDA-approved clinical protocol and are ready to commence enrollment of patients. However, even though commercial drug is expected to be available, it may still not be marketed for sale until the appropriate regulatory clearances have been obtained. We cannot assure you that such regulatory clearances will be obtained on a timely basis, if at all.

The effects of these changes required us to adjust our original timelines and expectations for Lymphoseek over the last several months. However, we were notified on May 10, 2006 by FDA that they have completed their review of our recent submissions and that we have been released from clinical hold and may commence patient enrollment for a Phase II clinical study of Lymphoseek. We have distributed the FDA-approved clinical protocol to the selected investigational sites for their institutional review process including Institutional Review Board approvals. As a result, we currently expect to begin patient enrollment in the Phase II trial during June 2006 and to be in a position to report preliminary results approximately 90 days after enrollment commences; however, we do not expect enrollment in the Phase II trial to be completed until sometime during the second half of 2006. This will likely mean that the pivotal trial will start sometime in late 2006, at the earliest, or in early 2007 pending obtaining appropriate regulatory and clinical site clearances. Our goal is now to file the NDA by the middle of 2007; however, we believe that strenuously following the guidance we are receiving from FDA will ultimately pay dividends in the review process for the NDA as we remain highly confident in the clinical benefit and market potential of Lymphoseek. We believe that Lymphoseek can be commercialized by early 2008 and, if approved, should provide a significant positive financial contribution to Neoprobe yet in 2008. As a result of these activities, we expect our development expenses related to Lymphoseek to increase over the remainder of 2006 and into 2007. As a result of the delays we have experienced and modifications made to the number of patients we expect to enroll as well as revisions in our regulatory pathway have increased our current estimate of total out-of-pocket development costs to now total approximately $6 million.

With respect to our RIGS initiative, our current efforts are focused on preparing a Special Protocol Assessment (SPA) request related to RIGS which we believe will be important in attracting a potential development partner. With the establishment of a corporate IND, responsibility for the clinical and commercial development of this humanized version of RIGScan CR has now been officially transferred from a physician-sponsored IND to Neoprobe. Neoprobe’s contract statisticians have also concluded, based on data published in 2005 on adjuvant post-operative chemotherapies for colorectal cancer, that it will be necessary to increase the number of patients in a proposed pivotal trial for RIGScan CR to approximately 2,300 in order to show a statistically valid differential in time to recurrence between patients treated using RIGScan CR versus other more traditional methods. We expect the increase in patients will cause an increase in the development cost; however, we expect that the effect on the development timeline, once a partner is secured and development commences, will be less than six months. It remains our intent to seek a development partner to assist in or take full responsibility for funding of RIGScan CR development. In the meantime, until a partner is secured, we are moving forward with our plans to submit to FDA a request for a SPA related to RIGS; however, we do not expect to incur any significant additional expenses related to RIGS until a partner is secured.
 
-15-

Our efforts to raise capital to support the development activities of our subsidiary, Cira Bio, have thus far been unsuccessful due, we believe, to recent developmental failures by potential competitors to Cira Bio’s ACT technology. We are evaluating alternative strategies to determine the appropriate way to enhance shareholder value by financing a reduced clinical development strategy for Cira Bio.

We anticipate generating a net profit from the sale of our gamma detection devices in 2006; however, we expect that our blood flow device product line will operate at a net loss for 2006 due to increased marketing and administrative support costs that are still required to commercialize the product line. Currently, we expect the loss on blood flow products for 2006 to be less than the loss incurred in 2005. However, this expectation is based to a large degree on our anticipation that we will achieve the level of commercial sales we expect from our Quantix/OR product during the remainder of 2006.

Our overall operating results for 2006 will be significantly affected by the amount of development costs associated with the radiopharmaceutical products. If we are unsuccessful in achieving significant commercial sales of the Quantix/OR product in 2006, or if we decide to carry out RIGS development internally, our estimates and our business plan will likely need to be modified. As a result of our decision to fund Lymphoseek development internally, we do not expect to achieve operating profit during 2006. In addition, our net loss and net loss per share will likely be significantly impacted by the non-cash interest expense we expect to record related to the accounting treatment for the beneficial conversion feature of the convertible debt and for the warrants issued in connection with the private placement we completed in December 2004. Also, we cannot assure you that our current or potential new products will be successfully commercialized, that we will achieve significant product revenues, or that we will achieve or be able to sustain profitability in the future.

Results of Operations

Revenue for the first quarter of 2006 increased $322,000, or 22%, to $1.8 million from $1.5 million for the same period in 2005. Major expense categories as a percentage of net sales fluctuated from the first quarter of 2005 to the same period in 2006 due to increased net sales as well as increased development expenses related to our gamma detection radiopharmaceutical products. Research and development expenses, as a percentage of net sales, increased to 47% during the first quarter of 2006 from 44% during the same period in 2005. Selling, general and administrative expenses, as a percentage of net sales, decreased to 48% during the first quarter of 2006 from 57% during the same period in 2005. Due to the ongoing development activities of the Company, research and development expenses are expected to be higher as a percentage of sales in 2006 than they were in 2005. In addition, should we be successful in our ongoing commercialization activities related to the Quantix product line, selling, general and administrative expenses as a percentage of sales are expected to decrease in 2006 over 2005.

Three Months Ended March 31, 2006 and 2005

Net Sales and Margins. Net sales, primarily of our gamma detection systems, increased $322,000, or 22%, to $1.8 million during the first quarter of 2006 from $1.5 million during the same period in 2005. Gross margins on net sales decreased to 59% of net sales for the first quarter of 2006 compared to 62% of net sales for the same period in 2005. The increase in net sales was the combined result of increases of $179,000 in gamma detection device sales, $144,000 in blood flow device sales and $28,000 in gamma detection device extended service contract revenue, offset by a decrease of $29,000 in gamma device service revenue. The decrease in gross margins on net product sales was primarily due to the decrease in gamma detection device prices coupled with a decrease in gamma detection device service revenue which generally generates higher margins than sales of our devices, offset by decreased warranty expenses related to the blood flow devices.
 
-16-

Research and Development Expenses. Research and development expenses increased $196,000 or 31% to $834,000 during the first quarter of 2006 from $638,000 during the same period in 2005. Research and development expenses in the first quarter of 2006 included approximately $465,000 in drug and therapy product development costs, $257,000 in product design activities for the Quantix/OR system and $112,000 in gamma detection device development costs. This compares to expenses of $250,000, $350,000 and $38,000 in these relative segment categories during the same period in 2005. The changes in each category were primarily due to (i) efforts to move our development of Lymphoseek forward, (ii) the costs of product refinement and manufacturing transfer activities related to the Quantix/OR, and (iii) development activities related to updated versions of our gamma detection devices, respectively.

Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $16,000 or 2% to $852,000 during the first quarter of 2006 from $836,000 during the same period in 2005. Increases in base compensation, including $58,000 of stock option compensation required to be expensed under SFAS No. 123(R), coupled with increases in marketing, recruiting and facilities expenses were offset by decreases in amortization of intangible assets, professional services, investor relations and insurance.

Other Income (Expenses). Other expenses decreased $139,000 to $292,000 during the first quarter of 2006 from $431,000 during the same period in 2005. The primary reason for the decrease was the first quarter 2005 increase in warrant liability of $142,000 resulting from the accounting treatment for the warrants we issued in connection with the private placement of convertible debt we completed in December 2004. In addition, we recorded an increase of $25,000 in interest income resulting from higher interest rates on our cash and investments during the first quarter of 2006 compared to the same period in 2005. These decreases were offset by an increase of $29,000 in interest expense on debt financings we entered into during 2004 and 2003. Of this interest expense, $190,000 and $161,000 in the first quarter of 2006 and 2005, respectively, was non-cash in nature related to the amortization of debt issuance costs and discounts resulting from the warrants and beneficial conversion features of the convertible debt.

Liquidity and Capital Resources

Operating Activities. Cash used in operations decreased $203,000 to $659,000 during the first quarter of 2006 compared to $863,000 during the same period in 2005. Working capital decreased $587,000 to $6.4 million at March 31, 2006 as compared to $6.9 million at December 31, 2005. The current ratio increased to 6.4:1 at March 31, 2006 from 5.6:1 at December 31, 2005. The increase in working capital was primarily related to a decrease in accrued liabilities.

Cash and investment balances decreased to $5.7 million at March 31, 2006 from $6.5 million at December 31, 2005, primarily as a result of cash used to fund operating activities and service our debt during the first quarter of 2006.

Accounts receivable increased to $711,000 at March 31, 2006 from $673,000 at December 31, 2005. The increase was primarily a result of increased sales of blood flow measurement devices coupled with normal fluctuations of timing of purchases and payments by EES. We expect overall receivable levels will continue to fluctuate during 2006 depending on the timing of purchases and payments by EES. However, on average, we expect accounts receivable balances will start to increase commensurate with anticipated increases in sales of blood flow products to our distributors, many of whom are foreign-domiciled entities who typically pay at a slower rate than domestic companies. Such increases, if any, will require the increased use of our cash resources over time.
 
-17-
 
Inventory levels decreased slightly to $801,000 at March 31, 2006 as compared to $804,000 at December 31, 2005. We expect inventory levels to increase during 2006 as we ramp up our blood flow device business and reassess our gamma detection and blood flow measurement device safety stock levels.

Investing Activities. Investing activities provided $1.5 million during the first quarter of 2006 versus $3.5 million used during the same period in 2005. Available-for-sale securities of $1.5 million matured during the first quarter of 2006. We purchased $3.5 million of available-for-sale securities during the first quarter of 2005. Capital expenditures during the first quarter of 2006 were primarily for software. Capital expenditures during the first quarter of 2005 were split between purchases of office equipment and production tools and equipment. Capital needs for 2006 are expected to increase over 2005 as we start up blood flow product production at our contract manufacturers.

Financing Activities. Cash used in financing activities increased $43,000 to $74,000 during the first quarter of 2006 from $32,000 during the same period in 2005. Proceeds from the issuance of common stock were $58,000 during the first quarter of 2005. Payments of notes payable were $65,000 and $77,000 during the first quarter of 2006 and 2005, respectively.

During the first quarter of 2005, certain investors and placement agents who received warrants to purchase our common stock in connection with a November 2003 financing exercised a total of 206,865 warrants in exchange for 206,865 shares of our common stock, resulting in net proceeds of $57,922.

In December 2004, we completed a private placement of Convertible Promissory Notes in an aggregate principal amount of $8.1 million with Biomedical Value Fund, L.P., Biomedical Offshore Value Fund, Ltd. and David C. Bupp (our President and CEO). Biomedical Value Fund, L.P. and Biomedical Offshore Value Fund, Ltd. are funds managed by Great Point Partners, LLC. The notes bear interest at 8% per annum and are freely convertible into shares of our common stock at a price of $0.40 per share. Neoprobe may force conversion of the notes prior to their stated maturity under certain circumstances. The conversion price represents the ten-day volume weighted average trading price of our common stock through December 10, 2004. As part of this transaction, we issued the investors 10,125,000 Series T warrants to purchase our common stock at an exercise price of $0.46, expiring in December 2009. In connection with this financing, we also issued 1,600,000 warrants to purchase our common stock to the placement agents, containing substantially identical terms to the warrants issued to the investors.

Our future liquidity and capital requirements will depend on a number of factors, including our ability to raise additional capital in a timely manner through additional investment, expanded market acceptance of our current products, our ability to complete the commercialization of new products, our ability to monetize our investment in non-core technologies, our ability to obtain milestone or development funds from potential development and distribution partners, regulatory actions by FDA and international regulatory bodies, and intellectual property protection. We believe we now have adequate capital to assure that we can properly support our current business goals and objectives for 2006. Our near-term priorities are to commence multi-center trials for our Lymphoseek product, support the launch of the reengineered version of the Quantix/OR products, identify a development and commercialization partner for our RIGS technology, identify funding sources for our ACT technology and continue to innovate our gamma detection product line. We cannot assure you that we will be able to achieve significant product revenues from our current or potential new products. We also cannot assure you that we will achieve profitability again.

Recent Accounting Developments

In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments - An Amendment of FASB Statements No. 133 and 140 (SFAS No. 155). SFAS No. 155 amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. SFAS No. 155 (a) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (b) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133, (c) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, (d) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and (e) amends SFAS No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006 and is required to be adopted by Neoprobe beginning January 1, 2007. We do not expect the adoption of SFAS No. 155 to have a material impact on our consolidated results of operations and financial condition.
 
-18-

In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets - An Amendment of FASB Statement No. 140 (SFAS No. 156). SFAS No. 156 amends SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. SFAS No. 156 (a) requires recognition of a servicing asset or servicing liability each time an obligation to service a financial asset is undertaken by entering into a servicing contract in certain circumstances, (b) requires measurement at fair value of all separately recognized servicing assets and servicing liabilities, (c) permits the use of either the amortization method or the fair value measurement method for each class of separately recognized servicing assets and servicing liabilities, (d) permits a one-time reclassification of available-for-sale securities to trading securities at initial adoption, and (e) requires separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position and additional disclosures for all separately recognized servicing assets and servicing liabilities. SFAS No. 156 is effective for fiscal years beginning after September 15, 2006, and is required to be adopted by Neoprobe beginning January 1, 2007. We are currently evaluating the effect that the adoption of SFAS No. 156 will have on our consolidated results of operations and financial condition but do not expect it to have a material impact.

Critical Accounting Policies

The following accounting policies are considered by us to be critical to our results of operations and financial condition.

Revenue Recognition Related to Net Sales. We currently generate revenue primarily from sales of our gamma detection products; however, sales of blood flow products constituted approximately 12% of total revenues for the first quarter of 2006 and are expected to increase in the future. Our standard shipping terms are FOB shipping point, and title and risk of loss passes to the customer upon shipment. We generally recognize sales revenue related to sales of our products when the products are shipped and the earnings process has been completed. However, in cases where product is shipped but the earnings process is not yet completed, revenue is deferred until it has been determined that the earnings process has been completed. Our customers have no right to return products purchased in the ordinary course of business.

The prices we charge our primary customer, EES, related to sales of products are subject to retroactive annual adjustment based on a fixed percentage of the actual sales prices achieved by EES on sales to end customers made during each fiscal year. To the extent that we can reasonably estimate the end-customer prices received by EES, we record sales to EES based upon these estimates. If we are unable to reasonably estimate end customer sales prices related to certain products sold to EES, we record revenue related to these product sales at the minimum (i.e., floor) price provided for under our distribution agreement with EES.

We also generate revenue from the service and repair of out-of-warranty products. Fees charged for service and repair on products not covered by an extended service agreement are recognized on completion of the service process when the serviced or repaired product has been returned to the customer. Fees charged for service or repair of products covered by an extended warranty agreement are deferred and recognized as revenue ratably over the life of the extended service agreement.
 
-19-

Use of Estimates. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We base these estimates and assumptions upon historical experience and existing, known circumstances. Actual results could differ from those estimates. Specifically, management may make significant estimates in the following areas:

·      
Stock-Based Compensation. Effective January 1, 2006, we adopted SFAS No. 123(R), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their estimated fair values. Compensation cost arising from stock-based awards is recognized as expense using the straight-line method over the vesting period. We used the modified prospective application method in adopting SFAS No. 123 (R). We use the Black-Scholes option pricing model to value share-based payments. The valuation assumptions used have not changed from those used under SFAS No. 123. Prior to the adoption of SFAS No. 123(R), we followed the guidance in APB No. 25 which resulted in disclosure only of the financial impact of stock options. Financial statements of the Company for periods prior to January 1, 2006 do not reflect any recorded stock-based compensation expense. In adopting SFAS No. 123(R), we made no modifications to outstanding stock options, nor do we have any other outstanding share-based payment instruments subject to SFAS No. 123(R). Based in part on the anticipated adoption of SFAS No. 123(R), the Company generally reduced number of stock options issued by individual in 2005 and shortened the vesting periods, with a portion of the options vesting immediately and the remainder vesting over a two-year period as compared to our previous practice of issuing stock options that vested over a three-year period. We will continue to evaluate compensation trends and may further revise our option granting practices in future years.

·      
Allowance for Doubtful Accounts. We maintain an allowance for doubtful accounts receivable to cover estimated losses resulting from the inability of our customers to make required payments. We determine the adequacy of this allowance by regularly reviewing our accounts receivable aging and evaluating individual customer receivables, considering customers’ credit and financial condition, payment history and relevant economic conditions. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances for doubtful accounts may be required.

·      
Inventory Valuation. We value our inventory at the lower of cost (first-in, first-out method) or market. Our valuation reflects our estimates of excess, slow moving and obsolete inventory as well as inventory with a carrying value in excess of its net realizable value. Write-offs are recorded when product is removed from saleable inventory. We review inventory on hand at least quarterly and record provisions for excess and obsolete inventory based on several factors, including current assessment of future product demand, anticipated release of new products into the market, historical experience and product expiration. Our industry is characterized by rapid product development and frequent new product introductions. Uncertain timing of product approvals, variability in product launch strategies, product recalls and variation in product utilization all impact the estimates related to excess and obsolete inventory.

·      
Impairment or Disposal of Long-Lived Assets. We account for long-lived assets in accordance with the provisions of SFAS No. 144. This Statement requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. As of March 31, 2006, the most significant long-lived assets on our balance sheet relate to assets recorded in connection with the acquisition of Cardiosonix and gamma detection device patents related to ILM. The recoverability of these assets is based on the financial projections and models related to the future sales success of Cardiosonix’ products and the continuing success of our gamma detection product line. As such, these assets could be subject to significant adjustment should the Cardiosonix technology not be successfully commercialized or the sales amounts in our current projections not be realized.
 
 
-20-
 
·      
Product Warranty. We warrant our products against defects in design, materials, and workmanship generally for a period of one year from the date of sale to the end customer. Our accrual for warranty expenses is adjusted periodically to reflect actual experience. EES also reimburses us for a portion of warranty expense incurred based on end customer sales they make during a given fiscal year.

·      
Fair Value of Warrant Liability. U.S. generally accepted accounting principles required us to classify the warrants issued in connection with our December 2004 placement of convertible promissory notes as a liability due to penalty provisions contained in the underlying securities purchase agreement. The penalty provisions could have required us to pay a penalty of 0.0667% per day of the total debt amount if we failed to meet certain registration deadlines, or if our stock was suspended from trading for more than 30 days. As a liability, the warrants were considered derivative instruments that were required to be periodically “marked to market” on our balance sheet. We estimated the fair value of the warrants at December 31, 2004 using the Black-Scholes option pricing model. On February 16, 2005, Neoprobe and the investors confirmed in writing their intention that the penalty provisions which led to this accounting treatment were intended to apply only to the $8.1 million principal balance of the promissory notes and underlying conversion shares and not to the warrant shares. Because the value of our stock increased $0.19 per share from $0.40 per share at the closing date of the financing on December 14, 2004 to $0.59 per share at December 31, 2004, our year end, the effect of marking the warrant liability to “market” at December 31, 2004 resulted in an increase in the estimated fair value of the warrant liability of $1.2 million which was recorded as non-cash expense during the fourth quarter of 2004. Subsequently, the value of our stock increased $0.02 per share from $0.59 at December 31, 2004 to $0.61 per share at February 16, 2005, such that marking the warrant liability to “market” at February 16, 2005 resulted in an increase in the estimated fair value of the warrant liability of $142,427 which was recorded as non-cash expense during the first quarter of 2005. The estimated fair value of the warrant liability was then reclassified to additional paid-in capital during the first quarter of 2005.

Forward-Looking Statements

The Private Securities Litigation Reform Act of 1995 (the Act) provides a safe harbor for forward-looking statements made by or on behalf of our company. From time to time, our representatives and we may make written or verbal forward-looking statements, including statements contained in this report and other company filings with the SEC and in our reports to stockholders. Statements that relate to other than strictly historical facts, such as statements about our plans and strategies, expectations for future financial performance, new and existing products and technologies, anticipated clinical and regulatory pathways, and markets for our products are forward-looking statements within the meaning of the Act. Generally, the words “believe,” “expect,” “intend,” “estimate,” “anticipate,” “will” and other similar expressions identify forward-looking statements. The forward-looking statements are and will be based on our then-current views and assumptions regarding future events and operating performance, and speak only as of their dates. Investors are cautioned that such statements involve risks and uncertainties that could cause actual results to differ materially from historical or anticipated results due to many factors including, but not limited to, our continuing operating losses, uncertainty of market acceptance of our products, reliance on third party manufacturers, accumulated deficit, future capital needs, uncertainty of capital funding, dependence on limited product line and distribution channels, competition, limited marketing and manufacturing experience, risks of development of new products, regulatory risks, and other risks detailed in our most recent Annual Report on Form 10-KSB and other SEC filings. We undertake no obligation to publicly update or revise any forward-looking statements.
 
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Item 3. Controls and Procedures

Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the Exchange Act)). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are adequately designed to ensure that the information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, possessed, summarized and reported, within the time periods specified in the applicable rules and forms. During the last fiscal quarter covered by this Annual Report on Form 10-KSB, there was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) identified in connection with the evaluation required by paragraph (d) of Rule 13a-15 that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
 
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PART II - OTHER INFORMATION

Item 6. Exhibits

 
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*

 
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*

 
Certification of Chief Executive Officer of Periodic Financial Reports pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.*

 
Certification of Chief Financial Officer of Periodic Financial Reports pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.*
     
*
Filed herewith.
 
Items 4 and 5 are not applicable and have been omitted.
 


SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


NEOPROBE CORPORATION
(the Company)
Dated: May 15, 2006
 
By:  /s/ David C. Bupp
David C. Bupp
President and Chief Executive Officer
(duly authorized officer; principal executive officer)
 
 
By:  /s/ Brent L. Larson
Brent L. Larson
Vice President, Finance and Chief Financial Officer
(principal financial and accounting officer)
 
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