This document contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as "may," "expect," "believe," "anticipate" or "estimate" identify such forward-looking statements. These statements by their nature involve substantial risks and uncertainties, and actual results may differ materially from those expressed in such forward-looking statements. The factors that could cause such material differences are identified in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2008. We undertake no obligation to correct or update any forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any future disclosures we make on related subjects in future filings with the SEC.
Executive Overview
ATS Medical, Inc. (hereinafter the "Company", "ATS", "we", "us" or "our") develops, manufactures, and markets medical devices. Our primary interest lies with devices for the treatment of structural heart disease used by cardiovascular surgeons in the cardiac surgery operating theater. Currently, we participate in the markets for heart valve therapy including mechanical bileaflet replacement heart valves, tissue heart valves and valve repair products and the surgical treatment of cardiac arrhythmias, primarily the treatment of atrial fibrillation. Additionally, a small portion of our business is surgical tools and accessories used by the cardiac surgeon.
In 1990, we licensed a patented and partially developed mechanical heart valve from CarboMedics, Inc. Under the terms of the license, we would complete the development of the valve and agreed to purchase carbon components from CarboMedics. As a result, ATS now holds an exclusive, royalty-free, worldwide license to an open pivot, bileaflet mechanical heart valve design owned by CarboMedics. In addition, we have an exclusive, worldwide right and license to use CarboMedics' pyrolytic carbon technology to manufacture components for the ATS mechanical heart valve. We commenced selling the ATS mechanical heart valve in international markets in 1992. In late 2000, we received U.S. Food and Drug Administration ("FDA") approval to sell the ATS Open Pivot mechanical heart valve and commenced sales and marketing of our valve in the United States. During 2002, we reorganized the Company and began the process of rebuilding our sales and marketing teams, both in the United States and internationally. This rebuilding has been a significant factor in our operating expense levels since 2002. During 2004 and 2005, we developed and implemented a plan to ramp-up our own manufacturing facility for pyrolytic carbon. By the end of 2005, this process was substantially complete.
During 2004, we made our first investments outside the mechanical heart valve market. We completed a global partnership agreement with CryoCath Technologies, Inc. ("CryoCath") to market CryoCath's surgical cryotherapy products for the ablation of cardiac arrhythmias. CryoCath developed a portfolio of novel products marketed under the SurgiFrost® and FrostByte® trade names which are used by cardiac surgeons to treat cardiac arrhythmias. Treatment is accomplished through the creation of an intricate pattern of lesions on the surface of the heart to block inappropriate electrical conduction circuits which cause the heart to be less effective when pumping blood and can lead to stroke, heart failure and death. Unique to this technology is the use of cryothermy (cold) to create lesions. The agreement with CryoCath has resulted in revenues for ATS since 2005.
During 2005, we continued to expand our business outside the mechanical heart valve market. We entered into an exclusive development, supply and distribution agreement with Genesee BioMedical, Inc. ("GBI") under which GBI develops, supplies and manufactures cardiac surgical products to include annuloplasty repair rings and bands and accessories, and we have exclusive worldwide rights to market and sell such products. Our agreement with GBI has produced revenues for us since 2006.
In 2006, we completed the acquisition of all the voting and non-voting stock of 3F Therapeutics, Inc. ("3F"), an early stage privately-held medical device company at the forefront of the emerging field of minimally invasive open- and closed-chest tissue valve replacement. The acquisition of 3F was a major step in the execution of our long-standing vision of obtaining a leadership position in the major segments of the cardiac surgery market. The acquisition was consummated pursuant to an agreement and plan of merger, as amended ("the Merger Agreement"). Under the terms of the Merger Agreement, upon closing, we paid each 3F stockholder its pro-rata portion of an initial payment of 9,000,000 shares of our common stock, subject to certain adjustments. In addition to the initial closing payment, we are obligated to make additional contingent payments to 3F stockholders of up to 10,000,000 shares of our common stock with shares issuable upon obtaining each of the CE mark and FDA approval of certain future key products on or prior to December 31, 2013. Milestone share payments may be accelerated upon completion of certain transactions involving these future key products. Our current first generation tissue valve, the ATS 3f Aortic Bioprosthesis, has received the CE mark and is available for sale in Europe and certain other international markets. In the United States, we received FDA approval of this product in October 2008.

Also in 2006, we entered into an exclusive distribution agreement with Novare Surgical Systems, Inc. ("Novare"). Novare is the owner of the Enclose II® cardiac anastomosis assist device, which is a device used by cardiac surgeons to attach a bypass vessel to the aorta during coronary artery bypass graft surgery. Under the terms of the agreement, we hold the exclusive right to market, sell and distribute the Enclose II product in the United States, Germany, France and the United Kingdom. We discontinued selling the Enclose II device on August 1, 2009.
In June 2007, we acquired the cryoablation surgical device business of CryoCath. The acquisition included the SurgiFrost, FrostByte and SurgiFrost XL family of products for which we served as CryoCath's exclusive agent in the United States and distributor in certain international markets. Under the acquisition agreement, we paid CryoCath $22.0 million upon closing of the transaction (reduced by $0.9 million subsequent to closing) and $2.0 million during 2008 upon the achievement of certain manufacturing transition milestones. We also paid $2.0 million in June 2009 (two years after closing) and agreed to pay up to $4.0 million in contingent payments based on future sales of Surgifrost XL, an FDA cleared and CE Marked product designed to enable less-evasive ablations. Based on the results of extensive bench and pre-clinical testing as well as human feasibility studies, the Company discontinued development of the SurgiFrost XL product in late 2008. The Company continues to develop less invasive procedures utilizing its existing set of tools. The acquisition of the cryoablation surgical device business of CryoCath enables us to leverage our current operating infrastructure and allows us to better address the rapidly growing cardiac arrhythmia market within cardiac surgery. The transaction was financed with a portion of the proceeds of an $8.6 million senior secured Term Loan from Silicon Valley Bank and the private placement of 9,800,000 shares of our common stock to Alta Partners VIII, L.P., a life sciences venture capital firm.
Critical Accounting Policies and Estimates We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Management's discussion and analysis of financial condition and results of operations are based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect (1) the reported amounts of assets, liabilities, revenues and expenses; and (2) the related disclosure of contingent assets and liabilities. At each balance sheet date, we evaluate our estimates and judgments. The critical accounting policies that are most important to fully understanding and evaluating our financial condition and results of operations are discussed in our most recent Annual Report on Form 10-K on file with the SEC.
See Notes 9 and 10 of "Notes to Consolidated Financial Statements" in Item 1 of this Form 10-Q for information on recently issued accounting pronouncements which will or could affect our accounting policies and estimates.

Results of Operations
The following table provides the dollar and percentage change in the Statements
of Operations for the three and nine month periods ended October 3, 2009 and
September 27, 2008.

                                   Three months ended                                                Nine months ended
                                October 3 (September 27)                                          October 3 (September 27)
                                                 Increase (Decrease)                                               Increase (Decrease)
(in thousands)      2009          2008             $               %                 2009          2008              $               %
Net sales         $ 18,827      $ 16,044      $     2,783          17.3 %          $ 57,011      $  47,789      $     9,222          19.3 %
Cost of goods
sold                 6,983         6,570              413           6.3 %            20,153         19,077            1,076           5.6 %

Gross profit        11,844         9,474            2,370          25.0 %            36,858         28,712            8,146          28.4 %

Operating
expenses:
Sales and
marketing            6,950         7,059             (109 )        (1.5 )%           21,976         20,693            1,283           6.2 %
Research and
development          2,226         1,843              383          20.8 %             6,087          6,351             (264 )        (4.2 )%
General and
administrative       2,438         2,431                7           0.3 %             7,345          8,199             (854 )       (10.4 )%
Amortization
of intangibles         812           891              (79 )        (8.9 )%            2,412          2,672             (260 )        (9.7 )%

Total
operating
expenses            12,426        12,224              202           1.7 %            37,820         37,915              (95 )        (0.3 )%

Operating loss        (582 )      (2,750 )         (2,186 )       (78.8 )%             (962 )       (9,203 )         (8,241 )       (89.5 )%

Net interest
expense               (644 )        (700 )            (56 )        (8.0 )%           (2,057 )       (1,976 )             81           4.1 %
Other income
(expense), net         383          (241 )            624         258.9 %               501            637             (136 )       (21.4 )%


Net loss
before income
taxes                 (843 )      (3,691 )         (2,848 )       (77.2 )%           (2,518 )      (10,542 )         (8,024 )       (76.1 )%
Income tax
expense               (132 )         (55 )             77         140.0 %              (314 )         (284 )             30          10.6 %


Net loss          $   (975 )    $ (3,746 )    $    (2,771 )       (74.0 )%         $ (2,832 )    $ (10,826 )    $    (7,994 )       (73.8 )%

The following table presents the Statements of Operations as a percentage of net sales for the three and nine month periods ended October 3, 2009 and September 27, 2008.

                                             Three months ended                     Nine months ended
                                          October 3 (September 27)              October 3 (September 27)
                                           2009                2008              2009                2008
Net sales                                     100.0 %            100.0 %             100.0 %           100.0 %
Cost of goods sold                             37.1 %             40.9 %              35.3 %            39.9 %

Gross profit                                   62.9 %             59.1 %              64.7 %            60.1 %
Operating expenses:
Sales and marketing                            36.9 %             44.0 %              38.5 %            43.3 %
Research and development                       11.8 %             11.5 %              10.7 %            13.3 %
General and administrative                     12.9 %             15.2 %              12.9 %            17.2 %
Amortization of intangibles                     4.3 %              5.6 %               4.2 %             5.6 %

Total operating expenses                       66.0 %             76.2 %              66.3 %            79.3 %

Operating loss                                 (3.1 )%           (17.1 )%             (1.7 )%          (19.3 )%

Net interest income (expense)                  (3.4 )%            (4.4 )%             (3.6 )%           (4.1 )%
Other income (expense), net                     2.0 %             (1.5 )%              0.9 %             1.3 %


Net loss before income taxes                   (4.5 )%           (23.0 )%             (4.4 )%          (22.1 )%
Income tax expense                             (0.7 )%            (0.3 )%             (0.6 )%           (0.6 )%


Net loss                                       (5.2 )%           (23.3 )%             (5.0 )%          (22.7 )%

Net Sales. The following table provides the dollar and percentage change in net sales inside and outside the United States for the three and nine month periods ended October 3, 2009 and September 27, 2008.

                                              Three months ended                                       Nine months ended
                                           October 3 (September 27)                                October 3 (September 27)
                                                                 Increase                                                Increase
(in thousands)                    2009          2008           $           %              2009          2008           $           %
United States                   $  7,040      $  5,847      $ 1,193        20.4 %       $ 22,553      $ 18,274      $ 4,279        23.4 %

Outside United States             11,787        10,197        1,590        15.6 %         34,458        29,515        4,943        16.7 %


Total                           $ 18,827      $ 16,044      $ 2,783        17.3 %       $ 57,011      $ 47,789      $ 9,222        19.3 %

The following table provides net sales inside and outside the United States as a percentage of total net sales for the three and nine month periods ended October 3, 2009 and September 27, 2008.

                                Three months ended                 Nine months ended
                             October 3 (September 27)          October 3 (September 27)
                                2009              2008            2009              2008
   United States                     37.4 %         36.4 %             39.6 %         38.2 %

   Outside United States             62.6 %         63.6 %             60.4 %         61.8 %


   Total                            100.0 %        100.0 %            100.0 %        100.0 %

The following table provides net sales by product group for the three and nine month periods ended October 3, 2009 and September 27, 2008.

                                                   Three months ended                                              Nine months ended
                                                October 3 (September 27)                                        October 3 (September 27)
                                                                Increase (Decrease)                                             Increase (Decrease)
(in thousands)                      2009          2008            $               %                 2009          2008            $               %
Heart valve therapy               $ 14,163      $ 11,755      $    2,408          20.5 %          $ 42,144      $ 34,529      $    7,615          22.1 %

Surgical arrhythmia                  4,491         4,011             480          12.0 %            14,117        12,245           1,872          15.3 %

Surgical tools and accessories         173           278            (105 )       (37.8 )%              750         1,015            (265 )       (26.1 )%


Total                             $ 18,827      $ 16,044      $    2,783          17.3 %          $ 57,011      $ 47,789      $    9,222          19.3 %

Total net sales in the third quarter and first nine months of 2009 increased 17% and 19%, respectively, over the same periods in 2008. Our net sales increases in the third quarter and first nine months of 2009 were negatively impacted (approximately 210 and 370 basis points, respectively) by lower foreign currency exchange rates against the U.S. dollar during 2009. Approximately 20% of our total sales for the first nine months of 2009 were invoiced in Euros or other local currencies in European markets where we sell our products directly to hospitals.
Heart valve therapy sales, our largest product group, consists of mechanical and tissue heart valves and heart valve repair products. Our mechanical heart valve products continue to be our primary product line and comprised approximately 60% of our total worldwide sales for the first nine months of 2009, compared to 65% for the same period in 2008. Surgical arrhythmia therapy products consist of cryotherapy products for the ablation of cardiac arrhythmias. We acquired this business from CryoCath in 2007. Surgical tools and accessories consist primarily of cardiac anastomosis assist devices and thoracic port systems. Effective August 1, 2009, we ceased distribution of anastomotic assist devices, which represented approximately $0.5 million and $0.8 million of sales in the first nine months of 2009 and 2008, respectively.

Worldwide mechanical heart valve revenue for the three and nine months ended October 3, 2009 increased 10% and 11% from the same periods in 2008, respectively, due to stronger mechanical heart valve sales in Asia and certain developing markets. Tissue heart valve revenue increased 375% in the third quarter of 2009 to $1.4 million, and increased 312% in the first nine months of 2009 to $4.1 million compared to the same periods in 2008, driven primarily by the limited commercial launch of the Company's first generation U.S. tissue valve product, the ATS 3f Aortic Bioprosthesis, approved by the FDA in October 2008. U.S. tissue valve revenue comprised more than 50% of total tissue valve revenue for the first nine months of 2009. Heart valve repair revenue increased 29% for the third quarter of 2009 to $1.2 million, and increased 51% to $3.6 million for the first nine months of 2009, compared to the same periods in 2008, due to the introduction of our semi-rigid line of repair rings in the first quarter of 2008 as well as to continued sales growth of our existing repair ring products.
Surgical arrhythmia therapy revenue in the third quarter and first nine months of 2009 increased 12% and 15%, respectively, compared to the same periods in the prior year. Cryotherapy products in general and CryoMaze procedural growth in particular has benefited from the overall growth of the surgical ablation market and increased market acceptance of cryo-energy (cold) as a preferred technology to perform Cox-Maze lesion sets.
Cost of Goods Sold and Gross Profit. Our third quarter and first nine months 2009 gross profit percentages of net sales improved to 62.9% and 64.7% from 59.1% and 60.1% for the same periods in the prior year, respectively. Our third quarter and year-to-date 2009 gross profit has benefited significantly from lower product manufacturing costs, particularly for mechanical heart valves. The cost declines are attributable primarily to higher manufacturing volumes as a result of increased demand. Lower product costs increased our third quarter and first nine months 2009 gross profit percentages of net sales by approximately 550 and 830 basis points, respectively, compared to the comparable periods of 2008. Also contributing to the higher third quarter and first nine months 2009 gross profit percentages were higher U.S. average selling prices, attributable in large part to tissue valves, which increased both our third quarter and first nine months 2009 gross profit percentages of net sales by approximately 200 basis points compared to the same periods in the prior year. Partially offsetting the improved 2009 gross profit percentages of net sales were (1) shifts in the overall product mix to lower margin products, which decreased our third quarter and first nine months 2009 gross profit percentages of net sales by approximately 50 and 300 basis points, respectively, compared to comparable periods of 2008 and (2) lower international selling prices due to foreign currency exchange rate changes and geographical sales mix shifts resulting from higher sales growth in lower-margin countries, which had a net unfavorable impact on our third quarter and first nine months 2009 gross profit percentages of net sales of approximately 320 and 280 basis points, respectively, compared to the comparable periods in the prior year.
Sales and Marketing. In the United States, our sales and marketing costs for the third quarter and first nine months of 2009 increased approximately 1.5% and 12.5%, respectively, over the comparable periods in the prior year, to $4.4 million and $14.2 million, respectively. The increases reflect higher marketing program costs, particularly for our tissue heart valve and cryoablation businesses, as well as additional marketing personnel costs. Field selling costs in the United States were 10.0% higher in the first nine months of 2009 compared to the same period in the prior year, reflecting primarily hospital sales program costs as well as higher independent sales agent commissions connected with increased 2009 sales in the United States. Internationally, our sales and marketing costs for the third quarter and first nine months of 2009 decreased approximately 6.4% and 3.6% over the comparable periods in the prior year to $2.5 million and $7.8 million, respectively. The decreases are attributable to the impact of lower Euro-to-U.S. dollar foreign exchange rates during 2009 than 2008 (more than 75% of our international sales and marketing costs are denominated in Euros) partially offset by higher costs associated with our continuing investment in international markets, evidenced by the establishment of a European support office in Belgium during the second half of 2008 to continue the support and expansion of our direct sales operations in Europe.
Research and Development. Research and development ("R & D") expenses for the third quarter of 2009 increased 20.8% over the comparable period in the prior year to $2.2 million. The increase reflects higher clinical program costs related to headcount additions and the timing of clinical trial submissions for tissue valves, partially offset by lower direct tissue valve R & D expenses after FDA approval of our first generation tissue valve in October 2008 and prior year development and start-up costs for surgical cryoablation manufacturing.
R & D expenses for the first nine months of 2009 decreased 4.2% over the comparable period in the prior year to $6.1 million. The decrease reflects lower direct tissue valve R & D expenses, lower clinical program costs for tissue valves and lower bonus accruals, partially offset by the allocation of stock compensation expense to R & D beginning in 2009. R & D expense fluctuations are generally related to the timing and stages of individual projects and programs.

General and Administrative. General and administrative ("G & A") expenses were flat for the third quarter of 2009 and decreased 10.4% for the first nine months of 2009 compared to the same periods in 2008. The primary driver behind these results was significantly lower legal fees ($0.2 million for the third quarter of 2009 and $1.4 million for the first nine months of 2009) after the fourth quarter 2008 settlement of the litigation with CarboMedics. Offsetting the lower legal fees in the third quarter of 2009 was higher consulting costs. In the third quarters of 2009 and 2008, we recognized total stock compensation expense of $0.7 million and $0.4 million, respectively. In the first nine months of 2009 and 2008, we recognized total stock compensation expense of $1.9 million and $1.2 million, respectively. Stock compensation expense has been allocated to cost of goods sold, sales and marketing, R & D and G & A expenses as indicated above in Note 2 of "Notes to Consolidated Financial Statements" in this Form 10-Q. The increase in stock compensation expense is attributable primarily to new equity grants and awards and to fewer forfeitures.
Amortization of Intangibles. Amortization expense for the third quarter and first nine months of 2009 decreased $0.1 million and $0.3 million, respectively, over the comparable periods in 2008, attributable primarily to certain trademark intangibles becoming fully amortized in the third quarter of 2008. Amortization expense for both 2009 and 2008 primarily consists of amortization of our pyrolytic carbon technology license with CarboMedics as well as amortization of definite-lived intangible assets acquired in connection with our 2006 acquisition of 3F and our 2007 acquisition of the surgical cryoablation business of CryoCath. We estimate total amortization expense for full year 2009 will be approximately $3.2 million.
Net Interest Expense. Net interest expense for the third quarter of 2009 declined 8% from the same period in 2008 due to lower interest on the declining principal balance of our loan with Silicon Valley bank, the cessation of imputed interest expense on the $2.0 million acquisition payment made to CryoCath in June 2009, and lower interest income on cash and investment balances. Net interest expense for the first nine months of 2009 increased approximately 4% over the comparable period in 2008, reflecting lower interest income on cash and investment balances and interest expense related to the June 2008 Credit Agreement and Credit Facility with Theodore C. Skokos, offset in part by lower interest on the declining principal balance of our loan with Silicon Valley bank.
Net interest expense includes (1) commitment fee and deferred financing costs related to the 2008 Credit Agreement and Credit Facility with Theodore C. Skokos
(2) interest on the $8.6 million Term Loan with Silicon Valley Bank obtained in connection with the 2007 acquisition of the surgical cryoablation business of CryoCath, and (3) interest on the $22.4 million aggregate principal amount of 6% Convertible Senior Notes issued in 2005. Interest expense on the Notes includes amortization of (a) financing costs, (b) the discount related to the implied value of common stock warrants sold with the Notes, and (c) the discounts . . .