Summary of PATIENT SAFETY TECHNOLOGIES, INC

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated interim financial statements and the related notes thereto appearing elsewhere in this Form 10-Q and our audited consolidated financial statements and related notes thereto and the description of our business appearing in the Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. See "Cautionary Note Regarding Forward-Looking Statements." Known and unknown risks, uncertainties and other factors could cause our actual results to differ materially from those projected in any forward-looking statements. In evaluating these statements, you should specifically consider various factors, including, but not limited to, those set forth under the caption "Risk Factors" in the Form 10-K.

Overview

Patient Safety Technologies, Inc. is a Delaware corporation whose operations are conducted through its wholly-owned operating subsidiary, SurgiCount Medical, Inc., a California corporation. The use of the terms "we," "us," "our," and "our company" and other similar terms in this quarterly report on Form 10-Q means Patient Safety Technologies, Inc. and its consolidated subsidiary, SurgiCount Medical, Inc. unless the context requires otherwise.

We focus on the development, marketing and sales of products and services in the medical patient safety markets. Our Safety-SpongeTM System is a patented system of bar-coded surgical sponges, SurgiCounter™ scanners, and software applications integrated to form a comprehensive counting and documentation system. This system is designed to reduce the number of retained surgical sponges unintentionally left inside of patients during surgical procedures by allowing faster and more accurate counting of surgical sponges. We initially sell our SurgiCount Safety-SpongeTM System to hospitals and other institutions through our direct sales force, but rely on a distributor for the ongoing supply of our proprietary surgical sponge products, manufactured for us by an exclusive supplier, to hospitals and other institutions that have adopted our system. Our business model consists of selling our unique surgical sponge products on a recurring basis to those hospitals and institutions that have adopted our SurgiCount Safety-SpongeTM System.

We recently launched the SurgiCount indemnification program, whereby hospitals using the Safety-Sponge™ System in conjunction with our proprietary data manager, "Citadel™," are insured for up to $1 million per retained foreign object ("RFO") event. We believe that this has the potential to increase interest in, and accelerate adoption of, our Safety-SpongeTM System. As hospitals continue to embrace our solution to RFO's, we are actively expanding our sales and clinical presence in the marketplace to keep pace with our growing customer base.

Sources of Revenues and Expenses

Revenues

Surgical Sponge Revenues. We generate revenues primarily from the sale of our Safety-Sponge™ sponges to our exclusive distributor, who then sells directly to and through sub-distributors to hospitals and other institutions that have adopted our SurgiCount Safety-SpongeTM System. We expect hospitals and institutions that adopt our Safety-Sponge™ System to commit to its use and thus provide a recurring source of revenues from ongoing sales of supplies. We recognize revenues from the sale of surgical sponges in accordance with Staff Accounting Bulletin 104. Because most of our surgical sponges sales are to our distributor FOB shipping point, this means we generally recognize revenues upon shipment to our distributor.

Hardware, Software and Maintenance Agreement Revenues. We also generate revenues from the sale of related hardware and software to such hospitals and institutions. The sale of our SurgiCount Safety-SpongeTM System includes hardware (the SurgiCounter™ scanners), our proprietary software and an initial one-year maintenance agreement (which may be renewed). All of these items are considered to be separate deliverables within a multiple-element arrangement and, accordingly, we allocate the total price of this arrangement among each respective deliverable, and recognize revenue as each element is delivered. For the hardware and software elements of our SurgiCount Safety-SpongeTM System, we recognize revenues on delivery, which is the time of shipment (if terms are FOB shipping point) or upon receipt by the customer (if terms are FOB destination). Delivery with respect to our initial one-year maintenance agreements is considered to occur on a monthly basis over the term of the one-year period; we recognize revenues related to this element on a pro-rata basis during this period. Because of the change in our business model discussed below under "Factors Affecting Future Results," we do not expect for these sales to represent a significant portion of our revenues going forward.

Cost of revenues

Our cost of revenues consists of direct product costs of our sponges from our contract manufacturers and a reserve expense for obsolete and slow moving inventory. We also include the travel and salary expenses relating to the software upgrades performed on our scanners under maintenance agreements in cost of revenues. In addition, when we provide (rather than sell) scanners to hospitals and institutions, we include the depreciation expense in cost of revenues over the life of the hardware, estimated to be three years. However, when we sell the scanners to hospitals and institutions, our costs of revenues includes the full product cost when shipped.

Research and development expenses

Our research and development expenses consist of costs associated with the design, development, testing and enhancement of our products. We also include salaries and related employee benefits, research-related overhead expenses and fees paid to external service providers in our research and development expenses.

Sales and marketing expenses

Our sales and marketing expenses consist primarily of salaries and related employee benefits, sales commissions and support cost, professional service fees, travel, education, trade show and marketing costs.

General and administrative expenses

Our general and administrative expenses consist primarily of salaries and related employee benefits, professional service fees, legal costs, expenses related to being a public entity, depreciation and amortization expense.

Total other income (expense)

Our total other income (expense) primarily reflects changes in the fair value of warrants classified as derivative liabilities. Under applicable accounting rules (discussed below under "Critical Accounting Policies-Warrant Derivative Liability"), we are required to make estimates of the fair value of our warrants each quarter, and "mark to market." As a result, changes in our stock price from period to period result in other income (when our stock price decreases) or other expense (when our stock price increases) on our income statement. We also record realized gain (loss) on assets held for sale and unrealized loss on assets held for sale in total other income (expense).

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures in the financial statements. Critical accounting policies are those accounting policies that may be material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, and that have a material impact on financial condition or operating performance. While we base our estimates and judgments on our experience and on various other factors that we believe to be reasonable under the circumstances, actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies used in the preparation of our financial statements require significant judgments and estimates. For additional information relating to these and other accounting policies, see Note 3 to our consolidated financial statements, appearing in Item 1 of this quarterly report on Form 10-Q.

Warrant Derivative Liability

We account for warrants issued in connection with financing arrangements in accordance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 815-40 Derivatives and Hedging - Contracts in Entity's Own Equity (which covers former Emerging Issues Task Fork ("EITF") Issue No 07-5, Determining whether an Instrument (or Embedded Feature) is indexed to an Entity's own Stock and the former EITF Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock). In applying ASC Topic 815-40, we must estimate the fair value of warrants classified as derivative liabilities. Although we use the Black-Scholes option pricing model to estimate such fair value, this model requires the use of numerous assumptions, including, among others, the expected life (turnover), volatility of the underlying equity security, a risk free interest rate and expected dividends. The use of different assumptions by management in the Black Scholes option pricing model could produce substantially different results. Because we record changes in the fair value of warrants classified as derivative liabilities in total other income (expense), materially different results could have a material effect on our results of operations.

Goodwill

Our goodwill represents the excess of the purchase price over the estimated fair values of the net tangible and intangible assets of SurgiCount Medical, Inc. acquired in February 2005. We review goodwill for impairment at least annually in the fourth quarter, as well as whenever events or changes in circumstances indicate its carrying value may not be recoverable in accordance with ASC Topic 350-10 (previously Statement of Financial Accounting Standards ("SFAS") No. 142, Goodwill and Other Intangible Assets). ASC Topic 350-10 requires that a two-step impairment test be performed on goodwill. In the first step, we will compare the fair value to its carrying value. If the fair value exceeds the carrying value, goodwill will not be considered impaired and we are not required to perform further testing. If the carrying value exceeds the fair value, then we must perform the second step of the impairment test in order to determine the implied fair value of goodwill and record an impairment loss equal to the difference. Determining the implied fair value involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, future economic and market conditions and determination of appropriate market comparables. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates. To the extent additional events or changes in circumstances occur, we may conclude that a non-cash goodwill impairment charge against earnings is required, which could have an adverse effect on our financial position and results of operations.

Stock-Based Compensation

We recognize compensation expense, under the provisions of ASC Topic 505-50 (previously SFAS No. 123 (R), Share-Based Payment). As a result, we recognize compensation expense in an amount equal to the estimated fair value of each option grant, non-vested stock award and shares issued under the employee stock purchase plan over the estimated period of service and vesting. This estimation of the fair value of each stock-based grant or issuance on the date of grant involves numerous assumptions by management. Although we calculate the fair value under the Black Scholes option pricing model, which is a standard option pricing model, this model still requires the use of numerous assumptions, including, among others, the expected life (turnover), volatility of the underlying equity security, a risk free interest rate and expected dividends. The model and assumptions also attempt to account for changing employee behavior as the stock price changes and capture the observed pattern of increasing rates of exercise as the stock price increases. The use of different assumptions other than those used by management in the Black Scholes option pricing model could produce substantially different results.

Impairment of Long-Lived Assets and Identifiable Intangible Assets

We evaluate long-lived assets and identifiable intangible assets with finite useful lives under the provisions of ASC Topic 360-10 (previously SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets), and accordingly, management reviews our long-lived assets and identifiable intangible assets with finite useful lives for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. We recognize an impairment loss when the sum of the future undiscounted net cash flows expected to be realized from the asset is less than its carrying amount. If an asset is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value. Considerable judgment is necessary to estimate the fair value of the assets and accordingly, actual results could vary significantly from such estimates. Our most significant estimates and judgments relating to the long-lived asset impairments include the timing and amount of projected future cash flows.

Accounting for Income Taxes

Deferred income taxes result primarily from temporary differences between financial and tax reporting. Deferred tax assets and liabilities are determined based on the difference between the financial statement basis and tax basis of assets and liabilities using enacted tax rates. Future tax benefits are subject to a valuation allowance when management is unable to conclude that our deferred tax assets will more likely than not be realized from the results of operations. Our estimate for the valuation allowance for deferred tax assets requires management to make significant estimates and judgments about projected future operating results. If actual results differ from these projections or if management's expectations of future results change, it may be necessary to adjust the valuation allowance.

Effective January 1, 2007, we began to measure and record uncertain tax positions in accordance with ASC Topic 740-10 (previously FASB Interpretation No. ("FIN") 48, Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109). ASC Topic 740-10 prescribes a threshold for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Only tax positions meeting the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized upon adoption of this Interpretation. ASC Topic 740-10 also provides guidance on accounting for de-recognition, interest and penalties, and classification and disclosure of matters related to uncertainty in income taxes. Accounting for uncertainties in income tax positions under ASC Topic 740-10 involves significant judgments by management. If actual results differ from these judgments, it may be necessary to adjust the provision for income taxes.

Recent Accounting Pronouncements

On July 1, 2009, the FASB released the FASB Accounting Standards Codification,™ sometimes referred to as the "Codification" or "ASC." For us, this means that instead of following the rules in a particular SFAS or FIN, we now following the guidance in the corresponding ASC Topic. In other words, instead of applying SFAS No. 133, Accounting for Derivatives and Hedging Activities, we will now follow the guidance in Topic 815, Derivatives and Hedging. The Codification does not change how we account for our transactions or the nature of related disclosures made. However, when referring to guidance issued by the FASB, we now refer to topics in the ASC rather than SFAS or FIN. The above change was made effective by the FASB for periods ending on or after September 15, 2009 and accordingly, we have updated references in this quarterly report on Form 10-Q to reflect the Codification Topics as applicable.

For additional discussion regarding this, and other accounting pronouncements, see Note 3 to our consolidated financial statements, appearing in Item 1 of this quarterly report on Form 10-Q.

Internal Control Over Financial Reporting

In connection with the audit for the year ended December 31, 2008, our independent registered public accounting firm identified significant deficiencies in our internal control over financial reporting that are material weaknesses. These material weaknesses included an ineffective general control environment, an ineffective risk assessment processes, and ineffective internal control policies and procedures relating to equity transactions and share-based payments, the proper reporting of income and accounting for payroll taxes, and the integrity of spreadsheets and other "off system" work papers used in the financial reporting process.

To address the weaknesses identified in our general control environment, our board of directors hired a new Chief Executive Officer and restructured the board to include two directors who meet the requirements of an audit committee financial expert and have significant corporate governance experience, both of whom are independent directors. To address the weaknesses identified relating to equity transactions, we implemented a software program specifically designed to track and account for share-based payments and equity transactions. In addition, we engaged an internal control specialist to design and help implement effective risk assessment processes.

For information regarding our evaluation of the effectiveness of our disclosure controls and procedures as well as any changes in our internal control over financial reporting, see Item 4T "Controls and Procedures" of this quarterly report on Form 10-Q.

Factors Affecting Future Results

Cardinal Health Supply Agreement. Our exclusive Supply Agreement with Cardinal Health, which acts as the main distributor of our surgical sponges used in our Safety-Sponge™ System in the United States, terminated on November 14, 2009 in accordance with its terms. As we are currently in discussions with Cardinal Health relating to the negotiation of a successor agreement, we and Cardinal Health have orally agreed to continue under the terms of our terminated Supply Agreement while discussions continue. We are optimistic that we will enter into a successor agreement; however, if our negotiations do not result in our executing such an agreement with Cardinal Health, the absence of such an agreement could adversely impact our results of operations and have a material adverse effect on our business and financial condition.

Effect of Stocking Sales and Backlog on Revenues. Our revenues reflect primarily the sale of surgical sponges to our main distributor. Because we recognize revenues when we ship product, the timing of orders by our main distributor and the management of its inventory may affect the comparability of revenues between periods. Additionally, because we primarily recognize revenues when we ship our products to our main distributor, to the extent there is a backlog in receipt of products from our exclusive supplier of our surgical sponges, we may not always be able to recognize revenues in the same period in which a product order is received. In addition, our main distributor may be required to sell down its inventory more than it anticipated, which could result in a larger than normal product order. Thus, certain changes in our revenues between periods are not necessarily reflective of hospital or institutional demand for our surgical sponge products.

Reduction in Hardware Sales - Effect on Revenues and Cost of Revenues. Prior to the third quarter of 2009, our business model included the sale of our SurgiCounter™ scanners and related software used in our SurgiCount Safety-SpongeTM System to most hospitals and institutions that adopted our system. Beginning with the third quarter of 2009, we modified our business model and began to provide our SurgiCounter™ scanners and related software to certain hospitals and institutions at no cost to certain customers when they adopt our SurgiCount Safety-SpongeTM System. Because we now engage only in limited SurgiCounter™ scanner sales, we do not expect such sales to continue to represent sizable revenues. Notably, in the third quarter of 2009, Safety-SpongeTM sales accounted for 99% of our revenues, and sales of hardware accounted for 1%, compared to 83% and 8% for the same period in 2008, respectively. In addition to the effect on our revenues, this change in our business model also affected our costs of revenues because rather than recognizing the full product cost for all SurgiCounter™ scanners at the time of shipment in our cost of revenues, we now recognize only the depreciation expense for those SurgiCounter™ scanners that we have provided to certain hospitals and institutions at cost. This business model change is expected to lead to a significant improvement in our gross margin based on the shift in product mix resulting in a significantly higher percentage of surgical sponge sales which are sold at a higher margin than our SurgiCounter™ scanners included in our costs of revenues.

Results of Operations

Three Months Ended September 30, 2009 Compared to Three Months Ended September 30, 2008

Revenues

We had revenues of $978 thousand for the three months ended September 30, 2009, an increase of 11% compared to $880 thousand for the same period in 2008. In the three months ended September 30, 2009, Safety-SpongeTM sales accounted for 99% of revenues, and sales of hardware accounted for 1%, compared to 83% and 8% for the same period in 2008, respectively. The primary reason for the increase in revenues was an increase in Safety-SpongeTM sales as more hospital systems select and implement our system to reduce the number of retained sponges in surgeries. This growth more than offset the decline in revenues from scanner sales as a result of the shift in our business model.

Cost of revenues

Cost of revenues decreased by $78 thousand or 13%, to $540 thousand for the three months ended September 30, 2009 from $622 thousand for the same period in 2008. The primary reason for the decrease is the change in our business model with respect to the provision of our SurgiCounter™ scanners, which resulted in approximately $144 thousand of cost now being depreciated and recognized over the life of the hardware. This change in business model more than offset other increases in cost of revenues during the quarter.

Gross profit

We had gross profit of $438 thousand for the three months ended September 30, 2009, an increase of $180 thousand, or 69%, compared to $258 thousand in the same period in 2008. The primary reason for the increase in gross profit during the third quarter of 2009 was the higher revenue growth achieved combined with the shift in product mix resulting in a significantly higher percentage of surgical sponge sales, which are sold at a higher margin than our SurgiCounter™ scanners. We had gross margin of 44% for the three months ended September 30, 2009, compared to 29% for the same period in 2008, which improvement is attributable to our change in business model.

Operating expenses

We had total operating expenses of $1.9 million for the three months ended September 30, 2009, an increase of $229 thousand, or 13%, compared to $1.7 million in the same period in 2008. The primary reason for the increase in operating expenses was the significant increase in our general and administrative expenses, which reflected increased costs associated with being a public company, the reclassification of the warrant costs from additional paid in capital offset by a decrease in personnel costs, which more than offset the decreases in our research and development expenses and sales and marketing expenses.

Research and development expenses

We had research and development expenses of $69 thousand for the three months ended September 30, 2009, a decrease of $18 thousand, or 21%, compared to $87 thousand in the same period in 2008. The primary reason for the decrease in research and development expenses was a decrease in personnel and associated compensation costs.

Sales and marketing expenses

We had sales and marketing expenses of $610 thousand for the three months ended September 30, 2009, a decrease of $52 thousand, or 8%, compared to $662 thousand in the same period in 2008. The primary reason for the decrease in sales and marketing expenses was decrease in personnel and associated compensation costs.

General and administrative expenses

We had general and administrative expenses of $1.3 million for the three months ended September 30, 2009, an increase of $300 thousand, or 31%, compared to $958 thousand in the same period in 2008. The primary reason for the increase is a reclass of the warrant costs from additional paid in capital offset by a decrease in personnel costs.

Total other income (expense)

We had total other expense of $1.9 million for the three months ended September 30, 2009, compared to total other income of $1.6 million in the same period in 2008. The primary reason for the change was a significant increase in the fair value of our warrant derivative liability, which resulted in expense of $1.8 million in the three months ended September 30, 2009, compared to income of $1.7 million in the same period in 2008. This liability, and the related expense, increases and decreases as a direct result of fluctuations in the price of our common stock, which trades on the over the counter market.

Net income (loss)

For the foregoing reasons, we had a net loss of $3.4 million for the three months ended September 30, 2009 compared to net income of $205 thousand for the three months ended September 30, 2008.

Nine Months Ended September 30, 2009 Compared to Nine Months Ended September 30, 2008

Revenues

We had revenues of $2.9 million for the nine months ended September 30, 2009, an increase of 52% compared to $1.9 million for the same period in 2008. In the nine months ended September 30, 2009, Safety-SpongeTM sales accounted for 88% of revenues, and sales of hardware accounted for 7% compared to 83% and 8% for the same period in 2008, respectively. The primary reason for the increase in revenues was an increase in Safety-SpongeTM sales as more hospital systems select and implement our system to reduce the number of retained sponges in surgeries

Cost of revenues

Cost of revenues increased by $366 thousand, or 27%, to $1.7 million for the nine months ended September 30, 2009 from $1.3 million for the same period in 2008. This increase is primarily attributable to higher volume of Safety-SpongeTM sales and an allowance for slow moving inventory, which was only partially offset by the change in our business model with respect to the provision of our SurgiCounter™ scanners.

Gross profit

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