**SECURITIES
AND EXCHANGE COMMISSION**
 **WASHINGTON,
D.C. 20549**
  
 **FORM
10-Q**
 
 **(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, 2005********OR** ̈
    **TRANSITION
      REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE
ACT**
 
 **Commission
file number 0-19567**
 
 **CARDIAC
SCIENCE, INC.**
 **(Exact
name of Registrant as specified in its charter)**
 
 **DELAWARE**
    **33-0465681****(State
      or other jurisdiction of**
      **incorporation
      or organization)**
    **(I.R.S.
      Employer**
      **Identification
      No.)**
 
 **1900
Main Street, Suite 700, Irvine, California, 92614**
 **(Address
of principal executive offices)**
 
 Registrant’s
telephone number, including area code: (949) 797-3800
 
 Check
whether the registrant (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  ̈
 
 Indicate
by check mark if the registrant is an accelerated filer (as defined in Exchange
Act Rule 12b-2).    Yes x No  ̈
 
 The
number of shares of the Common Stock of the registrant outstanding as of May 6,
2005 was 85,945,368.
 
 
    **INDEX
TO FORM 10-Q**
  **PART
I. FINANCIAL INFORMATION**
 
 **Page
      No.**Item 1.
    Unaudited
      Financial Statements:Consolidated
      Condensed Balance Sheets as of March 31, 2005 and December 31,
      2004
    1Consolidated
      Condensed Statements of Operations for the three months ended March 31,
      2005 and 2004
    2Consolidated
      Condensed Statements of Comprehensive Loss for the three months ended
      March 31, 2005 and 2004
    3Consolidated
      Condensed Statements of Cash Flows for the three months ended March 31,
      2005 and 2004
    4Notes
      to Consolidated Condensed Financial Statements
    5Item 2.
    Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
    14Item 3.
    Quantitative
      and Qualitative Disclosures About Market Risk
    24Item 4.
    Controls
      and Procedures
    24**PART
      II. OTHER INFORMATION**Item 1.
    Legal
      Proceedings
    25Item 2.
    Unregistered
      Sales of Equity Securities and Use of Proceeds
    26Item 3.
    Defaults
      Upon Senior Securities
    26Item 4.
    Submission
      of Matters to a Vote of Security Holders
    26Item 5.
    Other
      Information
    26Item 6.
    Exhibits
    26Signatures
    27
 
 
 **PART
I. FINANCIAL INFORMATION**
 
 **Item
1.**  **Unaudited
Financial Statements**
 
 **CARDIAC
SCIENCE, INC.**
 
 **CONSOLIDATED
CONDENSED BALANCE SHEETS**
 **(Unaudited)**
 **(In
thousands, except share data)**
 
 **March
      31,**
      **2005**
    
    **December
      31,**
      **2004****ASSETS**Current
      assets:Cash
      and cash equivalents
    
    $
    9,624
    
    $
    13,913Accounts
      receivable, net of allowance for doubtful accounts of $3,862 at March 31,
      2005 and $3,611 at December 31, 2004
    
    
    13,623
    
    
    17,978Inventories,
      net
    
    
    12,180
    
    
    9,680Prepaid
      expenses and other current assets
    
    
    4,323
    
    
    2,517Total
      current assets
    
    
    39,750
    
    
    44,088Property
      and equipment, net
    
    
    4,816
    
    
    4,932Goodwill
    
    
    92,268
    
    
    140,544Intangibles,
      net
    
    
    9,178
    
    
    9,677Other
      assets
    
    
    6,559
    
    
    4,093$
    152,571
    
    $
    203,334**LIABILITIES
      AND STOCKHOLDERS’ EQUITY**Current
      liabilities:Accounts
      payable
    
    $
    8,629
    
    $
    8,266Accrued
      expenses
    
    
    5,920
    
    
    6,820Deferred
      revenue
    
    
    1,375
    
    
    1,940Current
      portion of long term debt
    
    
    12
    
    
    16Total
      current liabilities
    
    
    15,936
    
    
    17,042Deferred
      revenue
    
    
    657
    
    
    697Senior
      secured promissory notes
    
    
    54,113
    
    
    52,623Other
      long term debt
    
    
    21
    
    
    25Other
      liabilities
    
    
    32
    
    
    32Total
      liabilities
    
    
    70,759
    
    
    70,419Commitments
      and contingencies (Note 8 )Stockholders’
      equity:Preferred
      stock—$.001 par value; 1,000,000 shares authorized, none issued or
      outstanding
    
    
    —
    
    
    —Common
      stock—$.001 par value; 160,000,000 shares authorized, 85,945,368 and
      86,258,913 shares issued at March 31, 2005 and December 31, 2004,
      respectively; and 85,945,368 and 85,981,231 shares outstanding at March
      31, 2005 and December 31, 2004, respectively
    
    
    86
    
    
    86Additional
      paid-in capital
    
    
    259,950
    
    
    257,211Accumulated
      other comprehensive loss
    
    
    (25
    )
    
    (25
    )Accumulated
      deficit
    
    
    (178,199
    )
    
    (124,357
    )Total
      stockholders’ equity
    
    
    81,812
    
    
    132,915$
    152,571
    
    $
    203,334
 
 The
accompanying notes are an integral part of these unaudited financial
statements.
  1
 **CARDIAC
SCIENCE, INC.**
  **CONSOLIDATED
CONDENSED STATEMENTS OF OPERATIONS**
 **(Unaudited)**
 **(In
thousands, except share and per share data)**
 
 
 **Three
      Months Ended****March
      31,**
      **2005**
    
    **March
      31,**
      **2004**Net
      revenue
    
    $
    15,011
    
    $
    15,604Cost
      of revenue
    
    
    6,267
    
    
    6,508Gross
      profit
    
    
    8,744
    
    
    9,096Operating
      expenses:Sales
      and marketing
    
    
    4,906
    
    
    6,003Research
      and development
    
    
    1,457
    
    
    1,669General
      and administrative
    
    
    5,198
    
    
    4,166Amortization
      of intangible assets
    
    
    403
    
    
    503Goodwill
      impairment charge
    
    
    47,269
    
    
    —Total
      operating expenses
    
    
    59,233
    
    
    12,341Loss
      from operations
    
    
    (50,489
    )
    
    (3,245
    )Interest
      and other expense, net
    
    
    (3,353
    )
    
    (1,587
    )Loss
      before income taxes
    
    
    (53,842
    )
    
    (4,832
    )Provision
      for income taxes
    
    
    —
    
    
    —Net
      loss
    
    $
    (53,842
    )
    $
    (4,832
    )Net
      loss per share (basic and diluted)
    
    $
    (0.63
    )
    $
    (0.06
    )Weighted
      average number of shares used in the computation of net loss per
      share
    
    
    86,018,766
    
    
    80,532,811
 
 The
accompanying notes are an integral part of these unaudited financial
statements.
 
  2
 **CARDIAC
SCIENCE, INC.**
  **CONSOLIDATED
CONDENSED STATEMENTS OF COMPREHENSIVE LOSS**
 **(Unaudited)**
 **(In
thousands)**
 
 **Three
      Months Ended****March
      31,**
      **2005**
    
    **March
      31,**
      **2004**Net
      loss
    
    $
    (53,842
    )
    $
    (4,832
    )Other
      comprehensive income (loss):Foreign
      currency translation adjustments
    
    
    —
    
    
    (8
    )Comprehensive
      loss
    
    $
    (53,842
    )
    $
    (4,840
    )
 
 The
accompanying notes are an integral part of these unaudited financial
statements.
 
  3
 **CARDIAC
SCIENCE, INC.**
  **CONSOLIDATED
CONDENSED STATEMENTS OF CASH FLOWS**
 **(Unaudited)**
 **(In
thousands)**
 
 **Three
      Months Ended****March
      31,**
      **2005**
    
    **March
      31,**
      **2004**Cash
      flows from operating activities:Net
      loss
    
    $
    (53,842
    )
    $
    (4,832
    )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
    
    
    556
    
    
    639Amortization
      of intangible assets
    
    
    507
    
    
    503Provision
      for doubtful accounts
    
    
    251
    
    
    239Inventory
      obsolescence
    
    
    91
    
    
    —Accrued
      interest and amortization of debt discount/issuance costs
    
    
    1,792
    
    
    1,612Value
      of consideration for filing delay
    
    
    1,449
    
    
    —Goodwill
      impairment charge
    
    
    47,269
    
    
    —Changes
      in operating assets and liabilities:Accounts
      receivable
    
    
    3,368
    
    
    2,995Inventories
    
    
    (2,591
    )
    
    (1,320
    )Placement
      of Powerheart CRMs at customer locations
    
    
    (20
    )
    
    —Prepaid
      expenses and other assets
    
    
    (1,061
    )
    
    (638
    )Accounts
      payable and accrued expenses
    
    
    (432
    )
    
    (1,229
    )Deferred
      revenue
    
    
    (605
    )
    
    177Net
      cash used in operating activities
    
    
    (3,268
    )
    
    (1,854
    )Cash
      flows from investing activities:Purchase
      of property and equipment
    
    
    (420
    )
    
    (447
    )Acquisition
      costs paid
    
    
    —
    
    
    (50
    )Purchase
      of intangible assets
    
    
    (8
    )
    
    (16
    )Net
      cash used in investing activities
    
    
    (428
    )
    
    (513
    )Cash
      flows from financing activities:Payments
      on long term obligations
    
    
    (8
    )
    
    (22
    )Proceeds
      from exercise of common stock options and warrants
    
    
    —
    
    
    195Cash
      consideration paid for filing delay
    
    
    (556
    )
    
    —Costs
      of equity issuances
    
    
    (29
    )
    
    (28
    )Net
      cash provided by (used in) financing activities
    
    
    (593
    )
    
    145Effect
      of exchange rates on cash and cash equivalents
    
    
    —
    
    
    (8
    )Net
      decrease in cash and cash equivalents
    
    
    (4,289
    )
    
    (2,230
    )Cash
      and cash equivalents at beginning of period
    
    
    13,913
    
    
    8,871Cash
      and cash equivalents at end of period
    
    $
    9,624
    
    $
    6,641
 
 The
accompanying notes are an integral part of these unaudited financial
statements.
 
    4
 **CARDIAC
SCIENCE, INC.**
  **CONSOLIDATED
CONDENSED NOTES TO FINANCIAL STATEMENTS**
 **(In
thousands, except share and per share data)**
 
 
 **1.**
    **Organization
      and Description of the Business**
 
 Cardiac
Science, Inc. (the “Company”) was incorporated in May 1991 and develops,
manufactures and markets portable automated public access defibrillators and a
fully-automatic in-hospital bedside defibrillator-monitor that continuously
monitors cardiac patients, instantly detects the onset of life-threatening
abnormal heart rhythms, and, when appropriate, delivers defibrillation shocks
within seconds and without human intervention to convert the heart back to its
normal rhythm. The Company’s core technology platform consists of its
proprietary arrhythmia detection and discrimination software
(“RHYTHMx ® ”), which
is combined with its proprietary STAR ® Biphasic
defibrillation hardware and electrode technology to create the only
fully-automatic in-hospital cardioverter defibrillator (the
“Powerheart ® CRM ® ” or
“CRM”) and a unique semi-automatic, or automated defibrillator, (the “Powerheart
AED” or “G3 AED”) for use in out-of-hospital settings. The Company’s
Powerheart ® Cardiac
Rhythm Module TM and
Powerheart ® brand
AEDs are marketed by its direct sales force and distribution network in the
United States and around the world.
 
 On July
1, 2000, the Company acquired Cadent Medical Corporation, a privately-held
company, for an aggregate of 4,500,000 shares of the Company’s common
stock.
 
 On
September 26, 2001, the Company acquired Survivalink Corporation
(“Survivalink”), a privately-held company, for $10,500 in cash, $25,800 in
senior secured promissory notes, and 18,150,000 shares of the Company’s common
stock.
 
 On
November 30, 2001, the Company acquired 94.7% of Artema Medical AB and
Subsidiaries (“Artema”) for 4,150,976 shares of common stock and approximately
$215 in cash. During 2003, the Company acquired the remaining minority interest
for $843 in cash. On September 1, 2003, the Company transferred ownership of the
shares in Cardiac Science International A/S, its Danish operations and a
subsidiary of Artema, from Artema to Cardiac Science, Inc. in exchange for
forgiveness of intercompany debt. Then on September 21, 2003, the Company sold
100% of its shares in Artema to an outside party for $600 in cash.
 
 On May
29, 2003, the Company acquired Lifetec Medical Limited, its U.K. distributor,
for $383 in cash.
 
 On
October 21, 2003, the Company acquired substantially all of the assets and
liabilities of Complient Corporation (“Complient”), a privately-held company,
for 10,250,000 shares of the Company’s common stock.
 
 On
February 28, 2005, the Company announced the signing of a definitive merger
agreement with Quinton Cardiology Systems, Inc (“Quinton”). The transaction was
approved by the boards of directors of both companies and is anticipated to
close during the third quarter of 2005, subject to regulatory review, the
approval of its respective shareholders and other customary closing conditions.
The merger agreement calls for each Company shareholder to receive 0.10 of a
share of common stock of the new holding company for each share of Company
common stock owned prior to the transaction and each Quinton shareholder to
receive approximately 0.77 of a share of common stock of the new holding company
for each share of Quinton common stock owned prior to the transaction. The
number of all Company and Quinton stock options and warrants outstanding at the
effective time of the transaction, as well as their respective exercise prices,
will be adjusted in accordance with the same exchange ratios. In connection with
the transaction, the Company’s senior note holders have agreed to convert the
entire balance of principal and accrued interest under their senior notes (the
“Senior Notes”), or approximately $61,000, as well as warrants to purchase
13,438,599 shares of
the Company’s common stock, into an
aggregate of $20,000 in cash and 2,843,915 shares, or approximately 13 percent
immediately following the transaction, of the new holding company’s common
stock.
 
 **2.**
    **Continued
      Existence**
 
 The
accompanying consolidated condensed financial statements have been prepared on
the basis that the Company will continue as a going concern and that the Company
will recover its assets and satisfy its liabilities in the normal course of
business. From inception, the Company has incurred substantial losses and
negative cash flows from operations. As of March 31, 2005, the Company had cash
on hand of $9,624, working capital of $23,814, long term debt of $54,134, and an
accumulated deficit of $178,199.
 
 5
 The
Company believes that its current cash balance, in combination with net cash
expected to be generated from operations and its unused line of credit of
$5,000, will fund ongoing operations for the next twelve months. The Company’s
expected net cash from operations is predicated on achieving certain revenue
levels and maintaining its cost of goods, operating expenses and DSO ratio.
 
 If the
Company does not realize the expected revenue and cost of goods, or if operating
expenses increase substantially, or if it cannot maintain its DSO ratio, it may
not be able to fund its operations for the next twelve months. In addition, the
Company’s line of credit and its Senior Notes require maintenance of certain
financial covenants, of which the Company was in violation during 2004. Even
though the Company has obtained waivers for all covenant violations and has
amended the covenants for 2005 and going forward, if in the future, it fails to
comply with these financial covenants as amended, the Company could be unable to
use its line of credit or be in default under the Senior Notes. If the Company
is in default, it may be subject to claims by the senior note holders seeking to
enforce its security interest in its assets. Such claims, if they arise, may
substantially restrict or even eliminate the Company’s ability to utilize its
assets in conducting its business, and may cause the Company to incur
substantial legal and administrative costs.
 
 In the
event that the Company requires additional funding during the next twelve
months, it will attempt to raise the required capital through either debt or
equity arrangements. The Company cannot provide any assurance that the required
capital would be available on acceptable terms, if at all, or that any financing
activity would not be dilutive to its current stockholders. If the Company is
not able to raise additional funds, it may be required to significantly curtail
its operations and this would have an adverse effect on its financial position,
results of operations and cash flows, and as such there may be substantial doubt
about the Company’s ability to continue as a going concern.
 
 **3.**
    **Summary
      of Significant Accounting Policies**
 
 In the
opinion of the Company’s management, the accompanying consolidated condensed
unaudited financial statements include all adjustments (which consist only of
normal recurring adjustments) necessary for a fair statement of its financial
position at March 31, 2005 and results of operations and cash flows for the
periods presented. Although the Company believes that the disclosures in these
financial statements are adequate to make the information presented not
misleading, certain information and disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted and should be read in conjunction with the
Company’s audited financial statements included in the Company’s 2004 Annual
Report on Form 10-K. Results of operations for the three months ended March 31,
2005 are not necessarily indicative of results for the full year.
 
 *Inventories*
 
 Inventories
are valued at the lower of cost (estimated using the first-in, first-out method)
or market. The Company periodically evaluates the carrying value of inventories
and maintains an allowance for obsolescence to adjust the carrying value, as
necessary, to the lower of cost or market. The allowance is based on its
assessment of future product demand, historical experience, and technical
obsolescence, as well as other factors affecting the recoverability of the asset
through future sales. Inventories consist of the following as of:
 
 **March
      31,**
      **2005**
    
    **December
      31,**
      **2004**Raw
      materials
    
    $
    5,315
    
    $
    3,705Work
      in process
    
    
    199
    
    
    13Finished
      goods
    
    
    7,837
    
    
    7,146Reserve
      for obsolescence
    
    
    (1,171
    )
    
    (1,184
    )$
    12,180
    
    $
    9,680
 
 *Goodwill
and Intangibles*
 
 In
accordance with SFAS No. 142 “Goodwill and Other Intangible Assets,” goodwill
and other intangible assets with indefinite lives are no longer subject to
amortization but are tested for impairment annually or whenever events or
changes in circumstances indicate that the asset might be impaired. The Company
operates in one operating segment and has one reporting unit; therefore,
goodwill is tested for impairment at the consolidated level against the fair
value of the Company. Per SFAS No. 142, the fair value of a reporting unit
refers to the amount at which the unit as a whole could be bought or sold in a
current transaction between willing parties. Quoted market prices in active
markets are the best evidence of fair value and shall be used as the basis on
the last day of the year for the measurement, if available. The Company assesses
potential impairment on an annual basis on the last day of the year and compares
its market capitalization to its carrying amount, including goodwill. A
significant decrease in its stock price could indicate a material impairment of
goodwill which, after further analysis, could result in a material charge to
operations. If goodwill is considered impaired, the impairment loss to be
recognized is measured by the amount by which the carrying amount of the
goodwill exceeds the implied fair value of that goodwill. Inherent in the
Company’s fair value determinations are certain judgments and estimates,
including projections of future cash flows, the discount rate reflecting the
risk inherent in future cash flows, the interpretation of current economic
indicators and market valuations and strategic plans with regard to operations.
A change in these underlying assumptions would cause a change in the results of
the tests, which could cause the fair value of the reporting unit to be less
than its respective carrying amount. In addition, to the extent that there are
significant changes in market conditions or overall economic conditions or
strategic plans change, it is possible that future goodwill impairments could
result, which could have a material impact on the financial position and results
of operations.
 
 6
 During
the quarter ended March 31, 2005, the Company’s stock price declined
significantly resulting in its market capitalization falling below the carrying
value of equity. Therefore, the Company performed an impairment test and
obtained independent third-party valuations to assist with this analysis. The
fair value estimates used in the initial impairment test, which were computed
primarily based on the present value of future cash flows, indicated that the
carrying amount exceeded the fair value and led the Company to conclude that
goodwill was impaired. The implied fair value of goodwill was then determined
through the allocation of the fair value to the underlying assets and
liabilities. During the quarter ended March 31, 2005, a non-cash goodwill
impairment charge of $47,269 was recorded to adjust the carrying value of the
Company’s goodwill to its implied fair value.
 
 Other
intangible assets with finite lives continue to be subject to amortization, and
any impairment is determined in accordance with SFAS No. 144 “Accounting for the
Impairment or Disposal of Long-Lived Assets. Estimated intangible asset
amortization expense for the years ending December 31, 2005, 2006, 2007, 2008,
2009, and thereafter is $2,029, $1,981, $1,744, $1,696, $1,191, and $1,036,
respectively.
 
 Goodwill
and other intangible assets consist of the following as of:
 
 **March
      31, 2005**
    
    **December
      31, 2004******
    
    
    **Cost**
    
    
    **Accumulated**
      **Amortization**
    
    
    **Net**
    
    
    **Cost**
    
    
    **Accumulated**
      **Amortization**
    
    
    **Net**
  Goodwill
    
    $
    92,268
    
    $
    —
    
    $
    92,268
    
    $
    140,544
    
    $
    3⁄4
    
    $
    140,544Intangible
      assets subject to amortization:Patents
      and patent applications
    
    
    10,473
    
    
    (4,787
    )
    
    5,686
    
    
    10,465
    
    
    (4,505
    )
    
    5,960Customer
      base
    
    
    4,082
    
    
    (1,502
    )
    
    2,580
    
    
    4,082
    
    
    (1,381
    )
    
    2,701Covenants
      not to compete
    
    
    726
    
    
    (343
    )
    
    383
    
    
    726
    
    
    (282
    )
    
    444URL
      website address
    
    
    656
    
    
    (195
    )
    
    461
    
    
    656
    
    
    (162
    )
    
    494Trade
      name
    
    
    378
    
    
    (378
    )
    
    —
    
    
    378
    
    
    (378
    )
    
    3⁄4Purchased
      software
    
    
    128
    
    
    (60
    )
    
    68
    
    
    128
    
    
    (50
    )
    
    78$
    16,443
    
    $
    (7,265
    )
    $
    9,178
    
    $
    16,435
    
    $
    (6,758
    )
    $
    9,677
 
 The
decrease in goodwill during the quarter ended March 31, 2005 was as
follows:
 
 Goodwill
      at December 31, 2004
    
    $
    140,544Refund
      of Complient purchase price shares in escrow
    
    
    (902
    )Goodwill
      impairment charge
    
    
    (47,269
    )Other
    
    
    (105
    )Goodwill
      at March 31, 2005
    
    $
    92,268
 
 *Product
Warranty*
 
 The
Company’s products are generally under warranty against defects in material and
workmanship for a period of one to seven years. Warranty costs are estimated at
the time of sale based on historical experience. Estimated warranty expenses are
recorded as an accrued liability, with a corresponding provision to cost of
sales.
 
 7
 Changes
in the product warranty accrual for the quarters ended March 31 were as
follows:
 
 **2005**
    
    **2004**Warranty
      accrual, Beginning of period
    
    $
    617
    
    $
    836Change
      in liability for warranties issued during the period
    
    
    161
    
    
    61Warranty
      expenditures
    
    
    (356
    )
    
    (188
    )Warranty
      accrual, End of period
    
    $
    422
    
    $
    709
 
 In April
2004, the Company received a Warning Letter from the U.S. Food and Drug
Administration following a routine inspection of its manufacturing facility in
Minneapolis. The letter specified certain procedural and documentation items in
the Company’s quality system. The Company took corrective and preventive action
to bring its quality system into compliance. In addition, during May 2004, the
Company initiated a limited, voluntary recall of approximately 5,800 units of
its older model Powerheart AEDs in order to replace a potentially faulty
capacitor component. As of March 31, 2005, the majority of the recalled units
have been replaced or repaired.
 
 Also in
May 2004, the Company initiated a limited, voluntary recall of approximately
4,800 AED batteries due to an error made by the Company’s battery supplier
whereby an incorrect fuse was used in the manufacture of a certain lot of
batteries. The recall and replacement of batteries was completed in 2004.
 
 The
Company estimated the cost of these voluntary recall actions to range from
$1,000 to $1,200. In 2004, the Company received from its suppliers credits
against amounts due to these suppliers totaling $1,240, which were recorded to
accrued expenses to establish a warranty accrual for these recall matters.
Actual recall related costs incurred have been charged against this accrual,
which is now $0 as of March 31, 2005. At this time, the Company believes any
remaining costs related to the recall will be inconsequential.
 
 The
decrease in warranty reserve requirements in 2005 compared with 2004 results
primarily from AED battery design changes in 2003 and early 2004 which
dramatically extended the life of the battery and resulted in a significant
reduction in no cost battery replacements, and therefore, a reduction in the
overall warranty reserve necessary.
 
 *Stock-Based
Compensation*
 
 On
December 31, 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS
No. 148, *Accounting
for Stock-Based Compensation—Transition and Disclosure* , which
amends SFAS No. 123, *Accounting
for Stock-Based Compensation* . SFAS
No. 148 allows for three methods of transition for those companies that adopt
SFAS No. 123’s provisions for fair value recognition. SFAS No. 148’s transition
guidance and provisions for annual and interim disclosures are effective for
fiscal periods ending after December 15, 2002. The Company has not adopted fair
value accounting for employee stock options under SFAS No. 123 and SFAS No.
148.
 
 The
Company has adopted the disclosure-only provisions of SFAS No. 123, *Accounting
for Stock-Based Compensation* . SFAS
No. 123 defines a fair value based method of accounting for an employee stock
option. Fair value of the stock option is determined considering factors such as
the exercise price, the expected life of the option, the current price of the
underlying stock, expected dividends on the stock, and the risk-free interest
rate for the expected term of the option. Under the fair value based method,
compensation cost is measured at the grant date based on the fair value of the
award and is recognized over the service period. Pro forma disclosures are
required for entities that elect to continue to measure compensation cost under
the intrinsic method provided by Accounting Principles Board Opinion (“APB”) No.
25.
 
 Additionally,
in accordance with SFAS No. 123 and Emerging Issues Task Force (“EITF”) No.
96-18, *Accounting
for Equity Instruments That are Issued to Other Than Employees for Acquiring, or
in Conjunction with Selling Goods or Services* , the
Company measures stock*-*based non-employee compensation at fair value.
 
 Under
SFAS No. 123, stock-based compensation expense related to stock options granted
to consultants is recognized as the stock options are earned. The fair value of
the stock options granted is calculated at each reporting date using the
Black-Scholes option pricing model. As a result, the stock-based compensation
expense will fluctuate as the fair market value of the Company’s stock
fluctuates.
  8
  *Pro
forma Effect of Stock-Based Compensation*
 
 In
calculating pro forma information as required by SFAS No. 123, the fair value
was estimated at the date of grant using a Black-Scholes option pricing model
with the following assumptions for the options of the Company’s common stock
granted during the quarter ended March 31, 2005: risk free rate of 3.46%;
dividend yield of 0%; volatility of 72.9%; and expected life of the options of
four years. There were no options granted during the quarter ended March 31,
2004.
 
 Had
compensation costs been determined based upon the fair value at the grant date,
consistent with the methodology prescribed under SFAS No. 123, the Company’s
total stock-based compensation cost, pro forma net loss, and pro forma net loss
per share, basic and diluted, would have been as follows:
 
 **Three
      Months Ended****March
      31,**
      **2005**
    
    **March
      31,**
      **2004**Net
      loss, as reported
    
    $
    (53,842
    )
    $
    (4,832
    )Add:
      Compensation expense included in reported net loss
    
    
    —
    
    
    —Deduct:
      Compensation expense determined under fair value based
    method
    
    
    (816
    )
    
    (1,237
    )Pro
      forma net loss
    
    $
    (54,658
    )
    $
    (6,069
    )Net
      loss per share, as reported (basic and diluted)
    
    $
    (0.63
    )
    $
    (0.06
    )Pro
      forma net loss per share (basic and diluted)
    
    $
    (0.64
    )
    $
    (0.08
    )
 
 *Recent
Pronouncements*
 
 In
November 2004, the FASB issued SFAS No. 151 “Inventory Costs, an Amendment of
ARB No. 43, Chapter 4, ‘Inventory Pricing,’” to clarify the accounting for
abnormal amounts of idle facility expense, freight, handling costs and wasted
material. This statement requires those items be recognized as current-period
charges. The provisions of this statement shall be effective for inventory costs
incurred during fiscal periods beginning after June 15, 2005. The Company does
not expect adoption of this statement to have a material impact on its financial
statements.
 
 In
December 2004, the FASB issued SFAS No. 123 (revised 2004) “Share-Based Payment”
or SFAS No. 123R. SFAS No. 123R revises SFAS No. 123 “Accounting
for Stock-Based Compensation” and supersedes APB No. 25 “Accounting for
Stock Issued to Employees” and related interpretations and SFAS No. 148
“Accounting for Stock-Based Compensation-Transition and Disclosure.”
SFAS No. 123R requires compensation cost relating to all share-based
payments to employees to be recognized in the financial statements based on
their fair values. In April 2005, the SEC delayed the effective date of SFAS No.
123R to annual, rather than interim, reporting periods beginning after
June 15, 2005. The pro forma disclosures previously permitted under SFAS
No. 123 will no longer be an alternative to financial statement
recognition. The Company is evaluating the requirements of SFAS No. 123R
and expects that the adoption will have a material impact on the Company’s
consolidated financial position or results of operation. The Company has not
determined the method of adoption and it has not determined whether the adoption
will result in amounts recognized in the income statement that are similar to
the current pro forma disclosures under SFAS No. 123.
 
 In
December 2004, the FASB issued SFAS No. 153 “Exchanges of Non-monetary Assets --
an amendment of Accounting Principles Board ("APB") Opinion No. 29 “Accounting
for Non-monetary Transactions.” The guidance in APB No. 29 is based on the
principle that exchanges of non-monetary assets should be measured based on the
fair value of the assets exchanged. The guidance in that Opinion, however,
included certain exceptions to that principle. SFAS No. 153 amends APB No. 29 to
eliminate the exception for non-monetary exchanges of similar productive assets
and replaces it with a general exception for exchanges of non-monetary assets
that do not have commercial substance. A non-monetary exchange has commercial
substance if the future cash flows of the entity are expected to change
significantly as a result of the exchange. The provisions of SFAS No. 153 are
applicable for non-monetary asset exchanges occurring in fiscal periods
beginning after June 15, 2005. The Company does not expect adoption of this
statement to have a material impact on its financial
statments.
 
 In
December 2004, the FASB also issued FSP No. 109-2 “Accounting and Disclosure
Guidance for the Foreign Earnings Repatriation Provision within the American
Jobs Creation Act of 2004” ("FSP No. 109-2"). FSP No. 109-2 provides enterprises
more time (beyond the financial-reporting period during which the American Jobs
Creation Act took effect) to evaluate the impact on the enterprise's plan for
reinvestment or repatriation of certain foreign earnings for purposes of
applying SFAS No. 109. The FSP, issued on December 21, 2004, went into effect
upon being issued. The Company is not yet in a position to decide on whether,
and to what extent, it might repatriate foreign earnings that have not yet been
remitted to the U.S. The Company expects to conclude its analysis of this
repatriation incentive during 2005.
 
 9
 **4.**
    **Segment
      reporting**
 
 The
Company follows the provisions of SFAS No. 131 “Disclosures about Segments of an
Enterprise and Related Information *.”* SFAS No.
131 established standards for reporting information about operating segments in
annual financial statements and requires selected information about operating
segments in interim financial reports issued to stockholders. It also
established standards for related disclosures about products and services,
geographic areas and major customers. An operating segment is defined as a
component of an enterprise that engages in business activities from which it may
earn revenues and incur expenses whose separate financial information is
available and is evaluated regularly by the Company’s chief operating decision
makers, or decision making group, to perform resource allocations and
performance assessments.
 
 The
Company’s chief operating decision makers are the Executive Management Team
which is comprised of the Chief Executive Officer (“CEO”) and senior executive
officers of the Company. Based on evaluation of the Company’s financial
information, management believes that the Company operates in one reportable
segment with its various product lines that service the external defibrillation
and cardiac monitoring industry. The product lines include AEDs and related
training, services, and accessories; Powerhearts, electrodes and related
accessories; and emergency defibrillators, monitors, CPR products and related
accessories.
 
 The
Company’s chief operating decision makers evaluate revenue performance of
product lines, both domestically and internationally, however, operating,
strategic and resource allocation decisions are not based on product line
performance, but rather on the Company’s overall performance in its operating
segment.
 
 The
following is a breakdown of net revenue by product line:
 
 **Three
      Months Ended****March
      31,**
      **2005**
    
    **March
      31,**
      **2004**AEDs
      and related accessories
    
    $
    12,872
    
    $
    12,052AED/CPR
      training and program management services
    
    
    1,738
    
    
    1,739AED
      related revenue
    
    
    14,610
    
    
    13,791Powerhearts,
      electrodes and related accessories
    
    
    300
    
    
    333Emergency
      defibrillators, monitors, CPR products and related
    accessories
    
    
    101
    
    
    1,480$
    15,011
    
    $
    15,604
 
 The
following is a breakdown of net sales by geographic location:
  **Three
      Months Ended****March
      31,**
      **2005**
    
    **March
      31,**
      **2004**United
      States
    
    $
    9,491
    
    $
    11,211Foreign
    
    
    5,520
    
    
    4,393$
    15,011
    
    $
    15,604
 
 During
the quarter ended March 31, 2005, sales to the U.K. were approximately 17% of
net revenue. At March 31, 2005, one customer represented approximately 15% of
net accounts receivable and approximately 10% of net revenue for the quarter.
During the quarter ended March 31, 2004, no customer or foreign country
represented more than 10% of net revenue or net accounts receivable at March 31,
2004.
  
  The
following is a breakdown of the Company’s long-lived assets by geographic
location as of:
  **March
      31,**
      **2005**
    
    **December
      31**
      **2004**United
      States
    
    $
    4,680
    
    $
    4,773Foreign
    
    
    136
    
    
    159$
    4,816
    
    $
    4,932
 
  10
  **5.**
    **Line
      of Credit**
  
 In
February 2004, the Company secured a $5,000 line of credit with Silicon Valley
Bank. The line of credit may be used to provide additional working capital, as
needed, to fund the Company’s continued growth. This 24-month facility is
collateralized by accounts receivable, inventory and cash and cash equivalents,
has an interest rate of the bank’s prime rate plus .75% (with a floor of 5%)
payable monthly, and requires the Company to maintain certain financial
covenants. In February 2005, the Company obtained a waiver from the bank for the
quarter and year ended December 31, 2004 for non-compliance with certain
financial covenants required by the line of credit agreement and which also
modified one of the financial covenants for 2005. In May 2005, the Company
obtained a waiver and amendment from the bank to exclude the first quarter
goodwill impairment charge from the EBITDA calculation for 2005. As of March 31,
2005, the Company was in compliance with all other covenants required by the
line of credit agreement, as amended. There was no outstanding balance on the
line at March 31, 2005 and 2004, however, there were letters of credit totaling
$157 at March 31, 2005 issued as collateral for performance bonds that reduce
the available balance on the line of credit.
 
 **6.**
    **Notes
      Payable**
 
 In May
2002, the Company entered into a Senior Note and Warrant Purchase Agreement (the
“Agreement”) with investors, pursuant to which the investors loaned the Company
$50,000.  In March 2004, the Company amended the Agreement in order to ease
certain financial covenants into 2005 to reflect the Company’s actual and
expected financial results. In exchange for these modifications, the Company
issued the senior note holders 500,000 additional warrants to purchase shares of
common stock at $3.95 per share.  The warrants were valued at $1,301 using
a Black-Scholes model.  The significant assumptions used in the model were:
stock price of $3.98; risk free rate of 3.2%; volatility of 65%; dividend yield
of 0%; and contractual term of seven years. The value of the warrants is being
amortized over the remaining term of the Senior Notes using the effective
interest method.
 
 Under the
antidilution provisions of the Agreement, which were triggered by the September
2003 and July 2004 private placements and the July 2003 warrant issuance to GE
Healthcare, an additional 205,451 warrants were issuable to the senior note
holders at exercise prices ranging from $2.97 to $3.88.  In addition, the
exercise prices of the original warrants issued were also reduced to: (i) $2.97
for the 10,000,000 warrants that had an original exercise price of $3.00, (ii)
$3.88 for the 3,000,000 warrants that had an original exercise price of $4.00,
and (iii) $3.86 for the 500,000 warrants that had an original exercise price of
$3.95.
 
 In
January 2005, the Company entered into an amendment and limited waiver (the
“Amendment”) to the Agreement with the senior note holders.  Pursuant to
the terms of the Amendment, the Company and the senior note holders agreed to:
(i) extend the maturity date of the $50,000 in aggregate principal amount of
Senior Notes issued under the Agreement by twelve months to May 29, 2008; (ii)
defer all cash interest payments until maturity; and (iii) modify certain
financial covenants regarding minimum EBITDA, minimum debt to capitalization and
maximum capital expenditures, and delete certain other financial covenants for
2005 through maturity.  Additionally, the senior note holders waived
certain covenant violations, including all financial covenant violations for the
quarter and year ended December 31, 2004.  In exchange for the foregoing
amendments and waiver contained in the Amendment, the Company and the senior
note holders agreed to reduce the aggregate number of warrants to purchase
shares of common stock issued in connection with the Agreement to 13,438,599 and
reduce the exercise price of those warrants to $2.00 per share, down from the
original weighted average price of approximately $3.21 per share. The fair value
of the change in the exercise price of the warrants was valued at $2,777 using a
Black-Scholes model. The significant assumptions used in the model were: stock
price of $1.70; risk free rate of 3.5%; volatility of 75%; dividend yield of 0%;
and contractual term of approximately 4.3 years. The value of this change to the
warrant exercise price is being amortized over the remaining term of the Senior
Notes using the effective interest method.
 
 In May
2005, the Company obtained an amendment from the senior note holders to exclude
the first quarter goodwill impairment charge from the financial covenant
calculations for 2005. At March
31, 2005, the Company was in compliance with all covenants required by the
Agreement, as amended.
 
 **7.**
    **Common
      Stock**
 
 In July
2004, the Company completed a private placement of common stock and warrants
raising $12,370 in gross proceeds. The holders of the Senior Notes were the lead
investors. In connection with the private placement, the Company issued
5,219,409 shares of its common stock at a price of $2.37 per share and five-year
warrants to purchase 2,087,763 additional shares of its common stock at an
exercise price of $2.84 per share. Proceeds of the offering are providing
additional working capital and are funding product development initiatives.
 
 11
  In
January 2005, as consideration for delays in filing a contractually required
registration statement in connection with the July 2004 financing, the Company
agreed with the investors to: (i) make a cash payment of $556, (ii) issue an
additional aggregate of 476,637 shares of common stock, valued at $810 or $1.70
per share which was the closing market price the day before the agreement was
signed, and (iii) reduce the exercise price on the investors’ warrants to $2.50
per share. The fair
value of the change in the exercise price of the warrants was valued at $83
using a Black-Scholes model. The significant assumptions used in the model were:
stock price of $1.70; risk free rate of 3.75%; volatility of 75%; dividend yield
of 0%; and contractual term of approximately 6.5 years. The total value of
consideration given to these investors of $1,449 was recorded to other
non-operating expense in the quarter ended March 31, 2005.
 
 **8.**
    **Litigation
      and Other Contingencies**
 
 In
February 2003, the Company filed a patent
infringement action against Philips Medical Systems North America, Inc., Philips
Electronics North America Corporation and Koninklijke Philips Electronics N.V.
(“Philips”) in the United States District Court for the District of Minnesota.
The suit alleges that Philips’ automated external defibrillators sold under the
names “HeartStart OnSite Defibrillator”, “HeartStart”, “HeartStart FR2” and the
“HeartStart Home Defibrillator,” infringe at least ten of the
Company’s United
States patents. In the same action, Philips counterclaimed for infringement of
certain of its patents and the
Company has sought a
declaration from the Court that the
Company’s products
do not infringe such patents. Many of the Philips defibrillators’ are promoted
by Philips as including, among other things, pre-connected disposable
defibrillation electrodes and daily self-testing of electrodes and battery,
features that the suit alleges are key competitive advantages of the
Company’s Powerheart and Survivalink AEDs and are covered under the
Company’s patents.
At this stage, the
Company is unable
to predict the outcome of this litigation. The
Company has not
established an accrual for this matter because a loss is not determined to be
probable.
 
 On April
30, 2003, the
Company filed a
Complaint against Defibtech, LLC for patent infringement in the United States
District Court for the District of Minnesota. The Complaint alleged that
Defibtech’s Sentry and Reviver AEDs infringe the
Company’s patented
disposable electrode pre-connect technology as well as other patents. Defibtech
answered the Complaint and asserted counterclaims alleging that the
Company has engaged
in activities that constitute tortious interference with present and prospective
contractual relations, common law business disparagement and statutory business
disparagement. The
Company responded to the counterclaims with a complete and general denial of the
allegations. At this stage, the
Company is unable
to predict the outcome of this litigation. The
Company has not
established an accrual for this matter because a loss is not determined to be
probable.
 
 On March
19, 2004, William S. Parker filed suit against the
Company for
patent infringement in the United States District Court for the Eastern Division
of Michigan. The Parker patent generally covers the use of a synthesized voice
to instruct a person to perform certain tasks. The Complaint alleges that
certain of the
Company’s AEDs
infringe the patent. The patent is now expired. The
Company has filed an
Answer to the Complaint stating the patent is not infringed and is otherwise
invalid and unenforceable. The patent has been submitted before the United
States Patent and Trademark Office for reexamination. On October 25, 2004, the
District Court issued an order staying the litigation pending resolution of the
reexamination. At this stage of the litigation, the
Company is unable
to predict the outcome of this litigation. The
Company has not
established an accrual for this matter because a loss is not determined to be
probable.
 
 In March
2005, the following complaints were filed in the Chancery Court of Delaware
concerning the Company’s merger agreement with Quinton and the transaction
contemplated thereby:
  ·  *Deborah
Silver v. Cardiac Science, Inc., et al.* , Case
No. 1138-N;
  ·  *Lisa
A. Weber v. Cardiac Science, Inc.* , et al.
Case No. 1140-N;
  ·  *Suan
Investments, Inc. v. Raymond W. Cohen* , et al.,
Case No. 1148-N;
  ·  *David
Shaev, et al. v. Cardiac Science, Inc.* , et al.,
Case No. 1153-N;
  ·  *Irvin
M. Chase, et al., v. Cardiac Science, Inc.* , et al.,
Case No. 1159-N; and
  ·  *James
Stellato v. Cardiac Science, Inc.* , et al.,
Case No. 1162-N.
  12
 Also, in
March 2005, the following complaints were filed in the Orange County Superior
Court concerning such merger agreement and transaction:
  ·  *Albert
Rosenfeld v. Cardiac Science, Inc.* , et al.
Case No. 05CC00057; and
  ·  *Jerrold
Schaffer v. Cardiac Science, Inc.* , et al.,
Case No. 05CC00059.
  Further,
on April 1, 2005, a complaint was filed in the Chancery Court in Delaware, *Oppenheim
Pramerica Asset Management v. Cardiac Science, Inc. et al.* , Case
No. 1222-N, which complaint is not consolidated yet.
 
 Generally,
the complaints allege that the Company’s board of directors breached its
fiduciary obligations with respect to the proposed merger transaction with
Quinton because the plaintiffs contend that the Company’s board of directors did
not negotiate for sufficient compensation and that the directors engaged in
self-dealing in connection with the Company’s senior note holders. The
complaints seek, among other things, injunctive relief enjoining the
transaction, recessionary damages if the transaction is completed and an order
that the Company’s board of directors hold an auction to obtain the best value
for the Company. The Company has retained legal counsel and intends to defend
the cases vigorously. The Company has not established an accrual for these
matters because a loss is not determined to be probable.
 
 In the
ordinary course of business, various lawsuits and claims are filed against the
Company. While the outcome of these matters is currently not determinable,
management believes that the ultimate resolution of these matters will not have
a material adverse effect on the Company’s operations or financial position.
 
 13
  **Item
2.** **Management’s
Discussion and Analysis of Financial Condition and Results of
Operations**
  **(In
thousands, except share and per share data)**
  The
following discussion should be read in conjunction with the consolidated
financial statements and notes thereto appearing elsewhere in this report.
 
 ***A
Warning About Forward-Looking Information and the Safe Harbor Under the
Securities Litigation Reform Act of 1995***
 
 *This
Quarterly Report on Form 10-Q contains certain forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended, and we intend
that such forward looking statements be subject to the safe harbors created
thereby. In some cases, you can identify forward-looking statements by words
like “may,” “will,” “should,” “could,” “believes,” “intends,” “expects,”
“anticipates,” “plans,” “estimates,” “predicts,” “potential,” “continue” and
similar expressions. These forward-looking statements relate to, among other
things, (i) future expenditures and results, (ii) business strategies, and (iii)
the need for, and availability of, additional financing.*
 
 *The
forward-looking statements included herein are based on current expectations,
which involve a number of risks and uncertainties and assumptions regarding our
business and technology. These assumptions involve judgments with respect to,
among other things, future economic and competitive conditions, and future
business decisions, all of which are difficult or impossible to predict
accurately and many of which are beyond our control. Although we believe that
the assumptions underlying the forward-looking statements are reasonable, any of
the assumptions could prove inaccurate and, therefore, there can be no assurance
that the results contemplated in forward-looking statements will be realized and
actual results may differ materially. In light of the significant uncertainties
inherent in the forward-looking information included herein, the inclusion of
such information should not be regarded as a representation by us or any other
person that our objectives or plans will be achieved. We undertake no obligation
to publicly release the result of any revisions to these forward-looking
statements that may be made to reflect events or circumstances after the date
hereof, or to reflect the occurrence of unanticipated events. Readers should
carefully review the risk factors described in the documents that we file from
time to time with the Securities and Exchange Commission, including Quarterly
Reports on Form 10-Q, Annual Reports on Form 10-K and subsequent current reports
on Form 8-K.*
 
 **Results
of Operations**
 
 **Quarter
Ended March 31, 2005 Compared to the Quarter Ended March 31,
2004**
 
 *Revenue*
 
 The
following is a summary of net revenue by product line for the quarters ended
March 31:
 **2005**
    
    **2004**
    
    **Change**AEDs
      and related accessories
    
    $
    12,872
    
    
    85.7
    %
    $
    12,052
    
    
    77.2
    %
    $
    820
    
    
    6.8
    %AED/CPR
      training and program management services
    
    
    1,738
    
    
    11.6
    %
    
    1,739
    
    
    11.2
    %
    
    (1
    )
    
    (0.1
    )%AED
      related revenue
    
    
    14,610
    
    
    97.3
    %
    
    13,791
    
    
    88.4
    %
    
    819
    
    
    5.9
    %Powerheart
      in-hospital defibrillators and accessories
    
    
    300
    
    
    2.0
    %
    
    333
    
    
    2.1
    %
    
    (33
    )
    
    (10.0
    )%Patient
      monitors, training products and accessories
    
    
    101
    
    
    0.7
    %
    
    1,480
    
    
    9.5
    %
    
    (1,379
    )
    
    (93.2
    )%Total
      net revenue
    
    $
    15,011
    
    
    100.0
    %
    $
    15,604
    
    
    100.0
    %
    $
    (593
    )
    
    (3.8
    )%
 
 Net
revenue for the quarter ended March 31, 2005 decreased $593 or 3.8% compared to
the quarter ended March 31, 2004. Revenue from the sale of AEDs and related
services increased $819 or 5.9% quarter over quarter. This increase was a result
of higher international AED revenue particularly in the U.K where we completed
shipping the balance of the large U.K government order we were awarded in 2004,
partially offset by lower sales to distributors in the U.S. reflecting our shift
from smaller, local dealers to larger national distribution partners that we
recently signed. The overall decrease in net revenue was primarily the result of
exiting the CPR Prompt and patient monitoring product lines in 2004 which
accounted for $1,389 of revenue in the first quarter of 2004. Sales of
Powerheart CRMs were $129 for the quarter ended March 31, 2005 compared to $59
for the same quarter in 2004, which represented less than 1% of total net
revenue in both periods. Sales of our Powerheart proprietary disposable
defibrillation electrodes used with the first generation Powerheart and the
Powerheart CRM were $171 for the quarter ended March 31, 2005 compared to $274
for the same quarter in 2004.
 **
 14
 *Gross
Margin*
 
 Cost of
revenue for the quarter ended March 31, 2005 was $6,267 compared to $6,508 for
the same quarter in 2004. Gross margin as a percentage of revenue was 58.3% for
the quarter ended March 31, 2005, consistent with the gross margin in the same
quarter in 2004. Cost of service revenue was $848 for the quarter ended March
31, 2005 with a gross margin of 51.2% compared to $879 with a gross margin of
49.5% for the same quarter in 2004.
 
 During
the quarter ended December 31, 2003, we recorded an impairment charge of $2,917
for the write off of first generation Powerhearts and CRM in-hospital
defibrillators in inventory related to a strategic decision to discontinue the
“no cap” Powerheart in-hospital defibrillator placement model. There were no
sales of first generation Powerhearts or CRMs previously written off in the
quarters ended March 31, 2005 and 2004. The majority of this inventory written
off is still on hand. We will continue to try to sell some of these units
internationally, but it is still uncertain as to how many units we will be able
to sell and at what price. Eventually we will scrap the units or use them for
spare parts.
 
 *Operating
Expenses*
 
 The
following is a summary of operating expenses as a percentage of net revenue for
the quarters ended March 31:
 
 **2005**
    
    **2004**
    
    **Change**Sales
      and marketing
    
    $
    4,906
    
    
    32.7
    %
    $
    6,003
    
    
    38.5
    %
    $
    (1,097
    )
    
    (18.3
    )%Research
      and development
    
    
    1,457
    
    
    9.7
    %
    
    1,669
    
    
    10.7
    %
    
    (212
    )
    
    (12.7
    )%General
      and administrative
    
    
    5,198
    
    
    34.6
    %
    
    4,166
    
    
    26.7
    %
    
    1,032
    
    
    24.8
    %Amortization
      of intangible assets
    
    
    403
    
    
    2.7
    %
    
    503
    
    
    3.2
    %
    
    (100
    )
    
    (19.9
    )%Goodwill
      impairment charge
    
    
    47,269
    
    
    314.9
    %
    
    —
    
    
    0.0
    %
    
    47,269
    
    
    n/aTotal
      operating expenses
    
    $
    59,233
    
    
    394.6
    %
    $
    12,341
    
    
    79.1
    %
    $
    46,892
    
    
    380.0
    %
 
 Sales and
marketing expenses decreased $1,097 or 18.3% for the quarter ended March 31,
2005 compared to the same quarter in 2004. Sales and marketing expenses as a
percentage of revenue were 32.7% for the quarter ended March 31, 2005 down from
38.5% for the same period in 2004. The decrease is primarily attributable to:
(i) a reduction in U.S. selling costs, primarily in the indirect sales channel
reflecting our shift from smaller, local dealers to larger national distribution
partners that we recently signed ($424), (ii) reduced sales expenses related to
our AED training services ($244), (iii) lower direct marketing activities in the
U.S. ($176), and (iv) lower international selling costs ($138).
 
 Research
and development expenses decreased by $212 or 12.7% for the quarter ended March
31, 2005 compared to the same quarter in 2004. In the quarter ended March 31,
2005, research and development expenses were 9.7% of net revenue, down from
10.7% of net revenue in the same quarter in 2004. The decrease is primarily due
to the reduction of the Complient engineering group ($101) and lower project
costs related to the development of the G3Pro and G3Auto AED units that were
introduced in 2004 ($190), offset slightly by higher payroll costs for the
product development group which is currently focused on completing the
traditional in-hospital defibrillator product for GE Healthcare which is
expected to be released in late June ($57).
 
 General
and administrative expenses increased $1,032 or 24.8% during the quarter ended
March 31, 2005 compared with the same quarter in 2004. As a percentage of
revenue, general and administrative expenses increased to 34.6% in the quarter
ended March 31, 2005 from 26.7% in the same quarter in 2004. The increase was
primarily due to: (i) new expenses related to the proposed merger transaction
with Quinton ($630), (ii) higher legal costs primarily related to the Philips
litigation ($333), (iii) settlement of certain litigation ($111), (iv) increased
corporate governance and compliance costs ($253), and (v) increased regulatory
and quality assurance activities ($194). This increase is partially offset by a
reduction in costs related to the Complient business, primarily headcount and
facilities ($385) and a reduction of headcount and related expenses from
consolidating our international operations in the second half of 2004 ($211).
 
 Amortization
of intangible assets included in operating expenses was $403 for the quarter
ended March 31, 2005, a decrease of $100 or 19.9% from the $503 for the same
quarter in 2004.
 
 During
the quarter ended March 31, 2005, our stock price declined significantly
resulting in our market capitalization falling below the carrying amount of
equity. Therefore, in accordance with SFAS 142, we performed an impairment test
and obtained independent third-party valuations to assist with this analysis.
The fair value estimates used in the initial impairment test, which were
computed primarily based on the present value of future cash flows, indicated
that the carrying amount exceeded the fair value and led us to conclude that
goodwill was impaired. The implied fair value of goodwill was then determined
through the allocation of the fair value to the underlying assets and
liabilities. During the quarter ended March 31, 2005, a non-cash goodwill
impairment charge of $47,269 was recorded to adjust the carrying value of our
goodwill to the implied fair value.
 
 15
 
 *Interest
and Other Expense, Net*
 
 Net
interest and other expense increased by $1,766 to $3,353 for the quarter ended
March 31, 2005 compared to $1,587 for the same quarter in 2004. This increase
was primarily due to a charge of $1,449 relating to the issuance of shares and a
cash payment as consideration for delays in filing a contractually required
registration statement in connection with the prior offering and an increase of
$186 of interest expense based on a higher average outstanding Senior Note
balance and the amortization of related warrant expenses which included the
additional warrants issued in March 2004 and the warrant exercise price
modification in January 2005. Interest expense was $1,803 for the quarter ended
March 31, 2005 compared to $1,617 for the same quarter last year.
 
 **Liquidity
and Capital Resources**
 
 **March
      31,**
      **2005**
    
    **December
      31,**
      **2004**Working
      capital
    
    $
    23,814
    
    $
    27,046Current
      ratio (current assets to current liabilities)
    
    
    2.5
      : 1.0
    
    
    2.6
      : 1.0Cash
      and cash equivalents
    
    $
    9,624
    
    $
    13,913Accounts
      receivable, net
    
    $
    13,623
    
    $
    17,978Inventories
    
    $
    12,180
    
    $
    9,680Short-term
      and long-term borrowings
    
    $
    54,146
    
    $
    52,664
 
 The
decrease in our current ratio, working capital and cash and cash equivalents is
primarily due to cash used from operations during the quarter.
 
 At March
31, 2005, our days sales outstanding on accounts receivable (“DSO”) was
approximately 83 days compared to approximately 79 days at December 31, 2004,
calculated based on a quarterly period using the ending net accounts receivable
balance. We anticipate that our DSO will continue to average less than 90 days
during 2005.
 
 In
February 2004, we secured a $5,000 line of credit with Silicon Valley Bank. The
line of credit may be used to provide additional working capital, as needed, to
fund our continued growth. This 24-month facility is collateralized by accounts
receivable, inventory and cash and cash equivalents, has an interest rate of the
bank’s prime rate plus .75% (with a floor of 5%) payable monthly, and requires
us to maintain certain financial covenants. In February 2005, we obtained a
waiver from the bank for the quarter and year ended December 31, 2004 for
non-compliance with certain financial covenants required by the line of credit
agreement and which also modified one of the financial covenants for 2005. In
May 2005, we obtained an amendment from the bank to exclude the first quarter
goodwill impairment charge from the EBITDA calculation for 2005. As of March 31,
2005, we were in compliance with all covenants required by the line of credit
agreement, as amended. There was no outstanding balance on the line at March 31,
2005 or through the date of this filing, however, there were letters of credit
totaling $157 at March 31, 2005 issued as collateral for performance bonds that
reduce the available balance on the line of credit.
 
 From
inception, our sources of funding for operations and mergers and acquisition
activity were derived from placements of debt and equity securities. In 2001, we
raised approximately $37,000 in a series of private equity placements and
through the receipt of proceeds from the exercise of outstanding options and
warrants. In May 2002, we issued notes payable in the aggregate principal amount
of $50,000. With the proceeds from these notes, we repaid the $26,468 plus
accrued interest in senior promissory notes relating to the Survivalink
acquisition. In September 2003, we raised $8,375 in a private equity placement
of 2,233,334 shares of our common stock at $3.75 per share to a small group of
institutional and accredited investors. In connection with this offering, we
also issued 223,333 five-year warrants with an exercise price of $5.00 per
share. In July 2004, we raised gross proceeds of approximately $12,370 in a
private equity placement of 5,219,409 shares of our common stock at $2.37 per
share. In connection with this offering, we issued five-year warrants to
purchase 2,087,763 shares of common stock at an exercise price of $2.84 per
share. In January 2005, as consideration for delays in filing the contractually
required registration statement for the July 2004 private placement, we agreed
with the investors to make a cash payment of $556, to issue an additional
aggregate of 476,637 shares of common stock at the market value on the date of
the agreement, and to reduce the exercise price on all the investors’ warrants
issued in such private placement to $2.50 per share. We incurred a charge of
$1,449 in the quarter ended March 31, 2005 as a result of this agreement.
 
 16
 In May
2002, we entered into a Senior Note and Warrant Purchase Agreement (the
“Agreement”) with investors, pursuant to which the investors loaned the Company
$50,000. Under the original terms of the Agreement, the Senior Notes issued
thereunder were due and payable in cash on May 30, 2007, unless accelerated
pursuant to the terms of the Agreement, and accrue interest at 6.9% per annum.
During the first three years of the term of the Senior Notes, accrued and unpaid
interest on the Senior Notes would, at the option of the Company, a) be due and
payable in cash, or b) accrue and be paid in kind, in each case quarterly in
arrears, and then due on the termination date of the Senior Notes. After the end
of the third year of the term of the Senior Notes, any additional accrued and
unpaid interest on the Senior Notes would be due and payable in cash quarterly
in arrears, and on the termination date of the Senior Notes. The Senior Notes
have certain monthly and quarterly financial and non-financial covenants. The
Senior Notes are collateralized by our assets and the assets of our
subsidiaries, to the extent permitted by law. Proceeds from the Senior Notes
were used to repay $26,468 of senior promissory notes plus accrued interest
issued in connection with the acquisition of Survivalink and the remaining
proceeds were used for working capital purposes.
 
 In
connection with the Senior Notes, the investors were issued warrants (the
“Warrants”) for the purchase of an aggregate of 10,000,000 shares of our common
stock at an exercise price of $3.00 per share, and an aggregate of 3,000,000
shares of common stock at an exercise price of $4.00 per share. The Warrants are
immediately exercisable, expire by their terms on May 30, 2009 and are subject
to certain limited antidilution adjustments. After two years, we have the right
to force the exercise of the Warrants pursuant to the terms of the Agreement.
The proceeds from the Senior Notes were allocated between the Senior Notes and
the Warrants based on their relative fair values which resulted in a discount
being recorded on the Senior Notes pursuant to APB No. 14 “Accounting for
Convertible Debt and Debt Issued with Stock Purchase Warrants.” We considered a
number of factors, including an independent valuation, when determining the fair
value of the Warrants. The significant assumptions used in the Black-Scholes
model were: stock price of $2.90, adjusted downward for a dilution factor to
$2.68; risk free rate of 4.98%; volatility of 0.90; dividend yield of 0%; and
contractual term of 7 years. Such allocation resulted in a discount being
recorded on the Senior Notes in the amount of $11,815, which is being amortized
over the term of the Senior Notes using the effective interest method. In
addition, we paid approximately $2,760 in debt issuance costs which are being
amortized over the term of the Senior Notes using the effective interest method.
 
 In March
2004, we amended the Agreement in order to ease certain financial covenants into
2005 to reflect our actual and expected financial results. In exchange for these
modifications, we issued the senior note holders 500,000 additional warrants to
purchase shares of common stock at $3.95 per share. The warrants were valued at
$1,301 using a Black-Scholes model. The significant assumptions used in the
model were: stock price of $3.98; risk free rate of 3.2%; volatility of 0.65;
dividend yield of 0%; and contractual term of seven years. The value of the
warrants is being amortized over the remaining term of the Senior Notes using
the effective interest method.
 
 Under the
antidilution provisions of the Agreement, which were triggered by the September
2003 and July 2004 private placements and the July 2003 warrant issuance to GE
Healthcare, an additional 205,451 warrants were issuable to the senior note
holders at exercise prices ranging from $2.97 to $3.88. In addition, the
exercise prices of the original warrants issued were also reduced to: (i) $2.97
for the warrants to purchase 10,000,000 shares that had an original exercise
price of $3.00, (ii) $3.88 for the warrants to purchase 3,000,000 shares that
had an original exercise price of $4.00, and (iii) $3.86 for the warrants to
purchase 500,000 shares that had an original exercise price of
$3.95.
 
 In
January 2005, we entered into an amendment and limited waiver (the “Amendment”)
to the Agreement with the senior note holders. Pursuant to the terms of the
Amendment, we and the senior note holders agreed to: (i) extend the maturity
date of the $50,000 in aggregate principal amount of Senior Notes issued under
the Agreement by twelve months to May 29, 2008; (ii) defer all cash interest
payments until maturity; and (iii) modify certain financial covenants regarding
minimum EBITDA, minimum debt to capitalization and maximum capital expenditures,
and delete certain other financial covenants for 2005 through maturity.
Additionally, the senior note holders waived certain covenant violations,
including all financial covenant violations for the quarter and year ended
December 31, 2004. In exchange for the foregoing amendments and waiver contained
in the Amendment, we and the senior note holders agreed to reduce the number of
warrants to purchase shares of common stock issued in connection with the
Agreement to 13,438,599 and reduce the exercise price of those warrants to $2.00
per share, down from the original weighted average price of approximately $3.21
per share. The fair
value of the change in the exercise price of the warrants was valued at $2,777
using a Black-Scholes model. The significant assumptions used in the model were:
stock price of $1.70; risk free rate of 3.5%; volatility of 75%; dividend yield
of 0%; and contractual term of approximately 4.3 years. The value of this change
to the warrant exercise price is being amortized over the remaining term of the
Senior Notes using the effective interest method.
 
 17
 In May
2005, we obtained an amendment from the senior note holders to exclude the first
quarter goodwill impairment charge from the financial covenant calculations for
2005. At March 31, 2005, we were in compliance with all covenants required by
the Agreement, as amended.
 
 The
accompanying consolidated financial statements have been prepared on the basis
that we will continue as a going concern and that we will recover our assets and
satisfy our liabilities in the normal course of business. From inception, we
have incurred substantial losses and negative cash flows from operations. As of
March 31, 2005, the Company had cash on hand of $9,624, working capital of
$23,814, long term debt of $54,134, and an accumulated deficit of
$178,199.
 
 We
believe that our current cash balance, in combination with net cash expected to
be generated from operations and our unused line of credit of $5,000, will fund
ongoing operations for the next twelve months. Our expected net cash from
operations is predicated on achieving certain revenue levels and maintaining our
cost of goods, operating expenses, and DSO ratio.
 
 If we do
not realize the expected revenue and cost of goods, or if operating expenses
increase substantially, or if we cannot maintain our DSO ratio, we may not be
able to fund our operations for the next twelve months. In addition, our line of
credit and our Senior Notes require maintenance of certain financial covenants,
of which we were in violation during 2004. Even though we have obtained waivers
for all covenant violations in 2004 and have amended the covenants for 2005 and
going forward, if in the future, we fail to comply with these financial
covenants as amended, we could be unable to use our line of credit or be in
default under the Senior Notes. If we are in default, we may be subject to
claims by the senior note holders seeking to enforce their security interest in
our assets. Such claims, if they arise, may substantially restrict or even
eliminate our ability to utilize our assets in conducting our business, and may
cause us to incur substantial legal and administrative costs.
 
 In the
event that we require additional funding during the next twelve months, we will
attempt to raise the required capital through either debt or equity
arrangements. We cannot provide any assurance that the required capital would be
available on acceptable terms, if at all, or that any financing activity would
not be dilutive to our current stockholders. If we are not able to raise
additional funds, we may be required to significantly curtail our operations and
this would have an adverse effect on our financial position, results of
operations and cash flows and as such, there may be substantial doubt about our
ability to continue as a going concern.
 
 *Cash
Flows*
 
 The
following table presents the abbreviated cash flows for the quarters ended March
31:
  **2005**
    
    **2004**Net
      cash used in operating activities
    
    $
    (3,268
    )
    $
    (1,854
    )Net
      cash used in investing activities
    
    
    (428
    )
    
    (513
    )Net
      cash provided by (used in) financing activities
    
    
    (593
    )
    
    145Effect
      of exchange rates on cash and cash equivalents
    
    
    —
    
    
    (8
    )Net
      decrease in cash and cash equivalents
    
    
    (4,289
    )
    
    (2,230
    )Cash
      and cash equivalents, beginning of year
    
    
    13,913
    
    
    8,871Cash
      and cash equivalents, end of year
    
    $
    9,624
    
    $
    6,641
 
 Cash used
in operating activities for the quarter ended March 31, 2005 increased by $1,414
compared to the same quarter in 2004. The increase is primarily due to the
increase in the change in inventories of $1,271.
 
 Cash used
in investing activities for the quarter ended March 31, 2005 decrease by $85
compared to the same quarter in 2004. This decrease was primarily attributable
to no acquisition costs paid in the quarter ended March 31, 2005 compared to $50
paid in the same quarter in 2004.
 
 Cash used
in financing activities for the quarter ended March 31, 2005 increased by $738
compared to the cash provided by financing activities for the quarter ended
March 31, 2004. This increase was primarily due to the cash consideration paid
for the filing delay of $556 during the quarter ended March 31, 2005 and a
decrease in proceeds from the exercise of stock options of $195 compared to the
same period in 2004.
  18
  **Off-Balance
Sheet Arrangements**
 
 At March
31, 2005, our Danish subsidiary has outstanding bank performance guarantees
totaling 2,229 Danish Kroner (approximately $386 in U.S. dollars) that were
issued in 1999 through 2002 in connection with sales contracts to foreign
governments. These bank performance guarantees expire in 2005 and 2006, but are
not officially released until the customer notifies the bank that renewal is not
required. In addition, we have issued performance bonds for $157 collateralized
by letters of credit issued by Silicon Valley Bank under our line of credit in
connection with sales contracts. The performance bonds expire through November
2007. We have no further performance obligations under these contracts other
than providing normal warranty service on the products sold under the contracts.
 
 In
addition, we have non-cancelable operating leases entered into in the ordinary
course of business. For liquidity purposes, we choose to lease our facilities,
automobiles, and certain equipment instead of purchasing them.
 
 **Contractual
Obligations and Other Commercial Commitments**
 
 We had no
material commitments for capital expenditures as of March 31, 2005.
 
 The
following table presents our expected cash requirements for contractual
obligations outstanding as of March 31, 2005:
  **Total**
    
    **Less
      than**
      **1
      Year**
    
    **1-3
      Years**
    
    **4-5
      Years**
    
    **After**
      **5
      Years**Senior
      Notes, including interest expense
    
    $
    75,553
    
    $
    —
    
    $
    —
    
    $
    75,553
    
    
    —Long-term
      obligations
    
    
    33
    
    
    12
    
    
    21
    
    
    —
    
    
    —Operating
      lease obligations
    
    
    5,178
    
    
    1,568
    
    
    3,120
    
    
    490
    
    
    —$
    80,764
    
    $
    1,580
    
    $
    3,141
    
    $
    76,043
    
    $
    —
 
 **Income
Taxes**
 
 As of
December 31, 2004, we have research and experimentation credit carry forwards
for federal and state purposes of approximately $3,000 and $1,000, respectively.
These credits begin to expire in 2006 for federal purposes and carry forward
indefinitely for California state purposes. We have capital loss carry forwards
of approximately $1,000 for both federal and state purposes which begin to
expire in 2006 for federal purposes and carry forward indefinitely for state
purposes. We also have approximately $139,000 and $69,000, respectively, of
federal and state net operating loss carry forwards which will begin to expire
in 2006 and 2005, respectively.
 
 Internal
Revenue Code Sections 382 and 383, and similar state provisions place certain
limitations on the annual amount of loss and credit carryforwards that can be
utilized if certain changes to a company’s ownership occur. The acquisition of
Survivalink in 2001 resulted in a change in ownership pursuant to Section 382 of
the Internal Revenue Code. The annual limitation is as follows: $8,300 for 2005,
$6,500 for 2006 and $1,800 thereafter. The amount of net operating loss subject
to this limitation, for federal and state purposes, is approximately $53,000 and
$24,000, respectively. Research and experimentation credits and capital loss
carryovers are also subject to the limitation under Internal Revenue Code
Sections 382 and 383 and similar state provisions. The utilization of net
operating loss carryovers and other tax attributes may be subject to further
substantial limitations if certain ownership changes occur in future periods.
 
 We
recorded deferred tax assets of approximately $16,000 upon the acquisition of
Survivalink in 2001. The deferred tax assets are composed primarily of loss and
tax credit carryforwards and other temporary differences. The deferred tax
assets recorded were reduced by a valuation allowance of $16,000. Due to the
expiration of some of the net operating loss carryovers the balance is $13,000
as of December 31, 2004. If we determine that we will realize the tax benefit
related to these Survivalink deferred assets in the future, the related decrease
in the valuation allowance will reduce goodwill instead of the provision for
taxes.
 
 We also
recorded deferred tax assets of approximately $8,000 upon the acquisition of
Cadent in 2000. The deferred tax asset was composed primarily of loss
carryforwards and other temporary differences. The deferred tax assets recorded
were also reduced by a valuation allowance of $8,000. Due to the expiration of
some of the net operating loss carryovers, the balance is $7,000 as of December
31, 2004. If we determine that we will realize the tax benefit related to these
Cadent deferred assets in the future, the related decrease in the valuation
allowance will reduce goodwill instead of the provision for taxes.
 
 19
 Additionally,
approximately $1,600 of the net operating loss carryforward represents
deductions claimed as the result of stock options. If we determine that we will
realize the benefit of this net operating loss carryforward in the future, the
related decrease in the valuation allowance will be credited to additional
paid-in capital instead of the provision for taxes.
 
 At
December 31, 2004, we had foreign net operating loss carryforwards. The losses
carry over indefinitely, unless certain defined changes in business operations
occur during the carryover period. We have established a full valuation
allowance against these deferred tax assets since it cannot be established that
these foreign subsidiaries’ net operating loss carryforwards will be fully
utilized.
 
 
 **Critical
Accounting Policies**
 
 Our
discussion and analysis of our financial condition and results of operations are
based upon our 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 the reported amount of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amount of revenue and expenses for each
period.
 
 The
following represents a summary of our critical accounting policies, defined as
those policies that we believe are: (a) the most important to the portrayal of
our financial condition and results of operations, and (b) that require our most
difficult, subjective or complex judgments, often as a result of the need to
make estimates about the effects of matters that are inherently
uncertain.
 
 ***Valuation
of Accounts Receivable***
 
 We
maintain an allowance for uncollectible accounts receivable to estimate the risk
of extending credit to customers. The allowance is estimated based on customer
compliance with credit terms, the financial condition of the customer, and
collection history, where applicable. Additional allowances could be required if
the financial condition of our customers were to be impaired beyond our
estimates.
 
 ***Valuation
of Inventory***
 
 Inventory
is valued at the lower of cost (estimated using the first-in, first-out method)
or market. We periodically evaluate the carrying value of inventories and
maintain an allowance for obsolescence to adjust the carrying value, as
necessary, to the lower of cost or market. The allowance is based on our
assessment of future product demand, historical experience and technical
obsolescence, as well as other factors affecting the recoverability of the asset
through future sales. Unfavorable changes in estimates of obsolete inventory
would result in an increase in the allowance and a decrease in gross
profit.
 
 ***Goodwill
and Other Intangibles***
 
 In
accordance with SFAS No. 142 “Goodwill and Other Intangible Assets,” goodwill
and other intangible assets with indefinite lives are no longer
subject to amortization but are tested for impairment annually or whenever
events or changes in circumstances indicate that the asset might be impaired. We
operate in one operating segment and have one reporting unit; therefore, we test
goodwill for impairment at the consolidated level against the fair value of the
Company. Per SFAS No. 142, the fair value of a reporting unit refers to the
amount at which the unit as a whole could be bought or sold in a current
transaction between willing parties. Quoted market prices in active markets are
the best evidence of fair value and shall be used as the basis on the last day
of the year for the measurement, if available. We assess potential impairment on
an annual basis on the last day of the year and compare our market
capitalization to the book value of the Company including goodwill. A
significant decrease in our stock price could indicate a material impairment of
goodwill which, after further analysis, could result in a material charge to
operations. If goodwill is considered impaired, the impairment loss to be
recognized is measured by the amount by which the carrying amount of the
goodwill exceeds the implied fair value of that goodwill. Inherent in our fair
value determinations are certain judgments and estimates, including projections
of future cash flows, the discount rate reflecting the risk inherent in future
cash flows, the interpretation of current economic indicators and market
valuations and strategic plans with regard to operations. A change in these
underlying assumptions would cause a change in the results of the tests, which
could cause the fair value of the reporting unit to be less than its respective
carrying amount. In addition, to the extent that there are significant changes
in market conditions or overall economic conditions or strategic plans change,
it is possible that future goodwill impairments could result, which could have a
material impact on the financial position and results of
operations.
 
 20
 See Note
3 of the Consolidated Condensed Notes to Financial Statements for results of
recent impairment tests.
 
 Other
intangible assets with finite lives continue to be subject to amortization, and
any impairment is determined in accordance with SFAS No. 144 “Accounting for the
Impairment or Disposal of Long-Lived Assets.
 
 ***Valuation
of Long-Lived Assets***
 
 In
accordance with SFAS No. 144, long-lived assets and intangible assets with
determinate lives are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. We evaluate potential impairment by comparing the carrying amount
of the asset with the estimated undiscounted future cash flows associated with
the use of the asset and its eventual disposition. Should the review indicate
that the asset is not recoverable, our carrying value of the asset would be
reduced to its estimated fair value, which is generally measured by future
discounted cash flows. In our estimate, no provision for impairment is currently
required on any of our long-lived assets.
 
 ***Valuation
of Warrants***
 
 We
periodically issue warrants in connection with debt issuances and in exchange
for goods and services. We follow the guidance of APB No. 14 “Accounting for
Convertible Debt and Debt Issued with Stock Purchase Warrants” for warrants we
issue in connection with debt. We follow the guidance in EITF No. 96-18
“Accounting for Equity Instruments That are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services” and EITF No. 01-9
“Accounting for Consideration Given by a Vendor to a Customer (Including a
Reseller of the Vendor’s Products)” for warrants we issue in exchange for or in
connection with goods and services. Management considers a number of factors,
including independent valuations, when determining the fair value of warrants
issued. We estimate the fair value of warrants issued using the Black-Scholes
model. Of the various assumptions considered by the Black-Scholes model, the
volatility and the risk free rate used require us to make certain assumptions
and estimations. We estimate volatility using a statistical method based on the
historical stock price for the historical period equal to the expected life of
the warrant being valued. The risk free interest rate is determined using the
treasury note rate for the number of years corresponding to the expected life of
the warrant being valued. Potentially, the value of warrants could be materially
different if different assumptions were used and under different markets
conditions.
 
 ***Revenue
Recognition***
 
 We record
revenue in accordance with Securities and Exchange Commission (“SEC”) Staff
Accounting Bulletin No. 104, Revenue Recognition in Financial Statements (“SAB
No. 104”). SAB No. 104 requires that product sales be recognized when there is
persuasive evidence of an arrangement which states a fixed and determinable
price and terms, delivery of the product has occurred in accordance with the
terms of the sale, and collectibility of the sale is reasonably assured. We
record product sales when we have received a valid customer purchase order for
product at a stated price, the customer’s credit is approved, and we have
shipped the product to the customer whereby title and risk have passed to the
customer.
 
 We are
not contractually obligated to repurchase any inventory from distributors or end
user customers. Some of our customers are distributors that sell goods to third
party end users. For certain identified distributors where collection may be
contingent on the distributor’s resale, revenue recognition is deferred and
recognized on a “sell through” basis. The determination of whether sales to
distributors are contingent on resale is subjective because we must assess the
financial wherewithal of the distributor to pay us regardless of resale. For
sales to distributors, we consider several factors, including past payment
history, where available, trade references, bank account balances, Dun &
Bradstreet reports and any other financial information provided by the
distributor, in assessing whether the distributor has the financial wherewithal
to pay regardless of, or prior to, resale of the product and that collection of
the receivable is not contingent on resale.
 
 We offer
limited volume price discounts and rebates to certain customers. Volume price
discounts are on a per order basis based on the size of the order and are netted
against the revenue recorded at the time of shipment. We have no arrangements
that provide for volume discounts at a later date, such as based on meeting
certain quarterly or annual purchase levels. Rebates are paid quarterly or
annually based on sales performance and are accrued for at the end of a
reporting period. To date, all rebate arrangements have been immaterial.
 
 21
 We follow
the guidance of EITF No. 00-21 *“Accounting
for Revenue Arrangements with Multiple Deliverables.”* In
accordance, we consider our program management packages and training and other
services as separate units of accounting when sold with an AED based on the fact
that the items have value to the customer on a stand alone basis and could be
acquired from another vendor. Training and AED program management service
revenue is deferred and recognized at the time the training occurs. AED program
management services pursuant to agreements that existed with Complient customers
pursuant to annual or multi-year terms are deferred and amortized straight-line
over the related contract period.
 
 Upfront
license fees are deferred and recognized to revenue using the straight-line
method over the term of the related license agreement. Royalty revenue is due
and payable quarterly (generally 60 days after period end) pursuant to the
related license agreements. An estimate of royalty revenue is recorded quarterly
in the period it is earned based on the prior quarter’s historical results
adjusted for any new information or trends known to management at the time of
estimation.
 
 ***Product
Warranty***
 
 Products
sold are generally covered by a warranty against defects in material and
workmanship for a period of one to seven years. We accrue a warranty reserve to
estimate the risk of incurring costs to provide warranty services. The accrual
is based on our historical experience and our expectation of future conditions.
An increase in warranty claims or in the costs associated with servicing those
claims would result in an increase in the accrual and a decrease in gross
profit.
 
 ***Litigation
and Others Contingencies***
 
 We
regularly evaluate our exposure to threatened or pending litigation and other
business contingencies. Because of the uncertainties related to the amount of
loss from litigation and other business contingencies, the recording of losses
relating to such exposures requires significant judgment about the potential
range of outcomes. We are not presently affected by any litigation or other
contingencies that have had, or are currently anticipated to have, a material
impact on our results of operations or financial position. As additional
information about current or future litigation or other contingencies becomes
available, we will assess whether such information warrants the recording of
additional expense relating to these contingencies. To be recorded as expense, a
loss contingency must generally be both probable and measurable. If a loss
contingency is material but is not both probable and estimable, we will disclose
it in notes to the financial statements.
 
 ***New
Accounting Standards***
 
 In
November 2004, the FASB issued SFAS No. 151 “Inventory Costs, an Amendment of
ARB No. 43, Chapter 4, ‘Inventory Pricing,’” to clarify the accounting for
abnormal amounts of idle facility expense, freight, handling costs and wasted
material. This statement requires those items be recognized as current-period
charges. The provisions of this statement shall be effective for inventory costs
incurred during fiscal periods beginning after June 15, 2005. We do not expect
adoption of this statement to have a material impact on our financial
statements.
 
 In
December 2004, the FASB issued SFAS No. 123 (revised 2004) “Share-Based Payment”
or SFAS No. 123R. SFAS No. 123R revises SFAS No. 123 “Accounting
for Stock-Based Compensation.” and supersedes APB No. 25 “Accounting for
Stock Issued to Employees” and related interpretations and SFAS No. 148
“Accounting for Stock-Based Compensation-Transition and Disclosure.”
SFAS No. 123R requires compensation cost relating to all share-based
payments to employees to be recognized in the financial statements based on
their fair values. In April 2005, the SEC delayed the effective date of SFAS No.
123R to annual, rather than interim, reporting periods beginning after
June 15, 2005. The pro forma disclosures previously permitted under
SFAS No. 123 will no longer be an alternative to financial statement
recognition. We are evaluating the requirements of SFAS No. 123R and expect
that the adoption of SFAS No. 123R will have a material impact on our
consolidated financial position or results of operation. We have not determined
the method of adoption or determined whether the adoption will result in amounts
recognized in the income statement that are similar to the current pro forma
disclosures under SFAS No. 123.
 
 In
December 2004, the FASB issued SFAS No. 153 “Exchanges of Non-monetary Assets --
an amendment of APB Opinion No. 29 “Accounting for Non-monetary Transactions.”
The guidance in APB No. 29 is based on the principle that exchanges of
non-monetary assets should be measured based on the fair value of the assets
exchanged. The guidance in that Opinion, however, included certain exceptions to
that principle. SFAS No. 153 amends APB No. 29 to eliminate the exception for
non-monetary exchanges of similar productive assets and replaces it with a
general exception for exchanges of non-monetary assets that do not have
commercial substance. A non-monetary exchange has commercial substance if the
future cash flows of the entity are expected to change significantly as a result
of the exchange. The provisions of SFAS No. 153 are applicable for non-monetary
asset exchanges occurring in fiscal periods beginning after June 15, 2005. We do
not expect adoption of this statement to have a material impact on our financial
statements.
 
 22
 In
December 2004, the FASB issued FSP No. 109-2 “Accounting and Disclosure Guidance
for the Foreign Earnings Repatriation Provision within the American Jobs
Creation Act of 2004.” FSP No. 109-2 provides enterprises more time (beyond the
financial-reporting period during which the American Jobs Creation Act took
effect) to evaluate the impact on the enterprise's plan for reinvestment or
repatriation of certain foreign earnings for purposes of applying SFAS No. 109.
The FSP, issued on December 21, 2004, went into effect upon being issued. We are
not yet in a position to decide on whether, and to what extent, it might
repatriate foreign earnings that have not yet been remitted to the U.S. We
expect to conclude our analysis of this repatriation incentive during
2005.
  23
  **Item
3.** **Quantitative
and Qualitative Disclosures about Market Risk**
 
 *Interest
Rate and Market Risk* .
  We do not
use derivative financial instruments in our investment portfolio. We are averse
to principal loss and try to ensure the safety and preservation of our invested
funds by limiting default risk, market risk, and reinvestment risk. We attempt
to mitigate default risk by investing in only the safest and highest credit
quality securities. At March 31, 2005, we invested our available cash in money
market securities of high credit quality financial institutions.
 
 Interest
expense on our existing long-term debt commitments is based on a fixed interest
rate and therefore it is unaffected by fluctuations in interest rates. However,
our line of credit with our bank bears interest at our bank’s prime rate plus
..75% and if we ever draw down upon the line of credit, the outstanding balance
could be affected by fluctuations in interest rates.
 
 *Foreign
Currency Exchange Rate Risk.*
  The
majority of our international sales are made in U.S. dollars, however, some
sales to the U.K. are in pounds and to other parts of Europe in Euros, and thus
may be adversely affected by fluctuations in currency exchange rates.
Additionally, fluctuations in currency exchange rates may adversely affect
foreign demand for our products by increasing the price of our products in the
currency of the countries in which the products are sold. The majority of
inventory purchases, both components and finished goods, in our foreign
operations are made in U.S. dollars. The functional currency of our foreign
operations in Denmark and the U.K. is the U.S. dollar and therefore, the
financial statements of these operations are maintained in U.S. dollars. Any
assets and liabilities in foreign currencies, such as bank accounts and certain
payables and receivables, are re-measured in U.S. dollars at period-end exchange
rates in effect. Any transactions in foreign currencies, such as wages paid in
local currencies, are re-measured in U.S. dollars using an average monthly
exchange rate. Any resulting gains and losses are included in operations and
were not material in any period.
 
 The
functional currency of our Swedish holding company is the local currency. Thus,
assets and liabilities are translated to U.S. dollars at period end exchange
rates in effect. Translation adjustments are included in accumulated other
comprehensive income in stockholders’ equity. Gains and losses on foreign
currency transactions are included in operations and were not material in any
period.
 
 Our
Danish subsidiary has outstanding performance bonds totaling approximately
2,229,000 Danish Kroner (approximately $386,000 U.S. dollars) at March 31, 2005.
Fluctuations in currency could increase the U.S. dollar value exposure under
these guarantees.
 
 
 **Item
4.** **Controls
and Procedures**
  Our
management, including the Chief Executive Officer, Chief Financial Officer and
Vice President Finance, conducted an evaluation as of the end of the period
covered by this quarterly report of the effectiveness of our disclosure controls
and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) under the
Securities Exchange Act of 1934 as amended). Based on that evaluation, our
management concluded that the disclosure controls and procedures were effective
in ensuring that all material information required to be disclosed in the
reports we file and submit under the Securities and Exchange Act of 1934, as
amended, have been made known to them on a timely basis and that such
information has been properly recorded, processed, summarized and reported, as
required.
 
 There
have been no significant changes in our internal control over financial
reporting during the most recent fiscal quarter ended March 31, 2005 that
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting.
 
 Our
management does not expect that our disclosure controls and procedures or our
internal controls over financial reporting will prevent all errors and all
fraud. A control system, no matter how well conceived and operated, can provide
only reasonable, not absolute, assurance that the objectives of the control
system are met. Further, the design of a control system must reflect the fact
that there are resource constraints, and the benefits of controls must be
considered relative to their costs. Because of the inherent limitations in all
control systems, no evaluation of controls can provide absolute assurance that
all control issues and instances of fraud, if any, within our company have been
detected.
  24
  **PART
II. OTHER INFORMATION**
 
 **Item
      1.**
    **Legal
      Proceedings**
 
 In
February 2003, we filed a patent infringement action against Philips Medical
Systems North America, Inc., Philips Electronics North America Corporation and
Koninklijke Philips Electronics N.V. (“Philips”) in the United States District
Court for the District of Minnesota. The suit alleges that Philips’ automated
external defibrillators sold under the names “HeartStart OnSite Defibrillator”,
“HeartStart”, “HeartStart FR2” and the “HeartStart Home Defibrillator,” infringe
at least ten of our United States patents. In the same action, Philips
counterclaimed for infringement of certain of its patents and we had sought a
declaration from the Court that our products do not infringe such patents. Many
of the Philips defibrillators’ are promoted by Philips as including, among other
things, pre-connected disposable defibrillation electrodes and daily
self-testing of electrodes and battery, features that the suit alleges are key
competitive advantages of our Powerheart and Survivalink AEDs and are covered
under our patents. At this stage, we are unable to predict the outcome of this
litigation. We have not established an accrual for this matter because a loss is
not determined to be probable.
 
 On April
30, 2003, we filed a Complaint against Defibtech, LLC for patent infringement in
the United States District Court for the District of Minnesota. The Complaint
alleged that Defibtech’s Sentry and Reviver AEDs infringe our patented
disposable electrode pre-connect technology as well as other patents. Defibtech
answered the Complaint and asserted counterclaims alleging that we have engaged
in activities that constitute tortious interference with present and prospective
contractual relations, common law business disparagement and statutory business
disparagement. We responded to the counterclaims with a complete and general
denial of the allegations. At this stage, we are unable to predict the outcome
of this litigation. We have not established an accrual for this matter because a
loss is not determined to be probable.
 
 On March
19, 2004, William S. Parker filed suit against us for patent infringement in the
United States District Court for the Eastern Division of Michigan. The Parker
patent generally covers the use of a synthesized voice to instruct a person to
perform certain tasks. The Complaint alleges that certain of our AEDs infringe
the patent. The patent is now expired. We have filed an Answer to the Complaint
stating the patent is not infringed and is otherwise invalid and unenforceable.
The patent has been submitted before the United States Patent and Trademark
Office for reexamination. On October 25, 2004, the District Court issued an
order staying the litigation pending resolution of the reexamination. At this
stage of the litigation, we are unable to predict the outcome of this
litigation. We have not established an accrual for this matter because a loss is
not determined to be probable.
 
 In March
2005, the following complaints were filed in the Chancery Court of Delaware
concerning our merger agreement with Quinton and the transaction contemplated
thereby:
  ·  *Deborah
Silver v. Cardiac Science, Inc., et al.* , Case
No. 1138-N;
  ·  *Lisa
A. Weber v. Cardiac Science, Inc.* , et al.
Case No. 1140-N;
  ·  *Suan
Investments, Inc. v. Raymond W. Cohen* , et al.,
Case No. 1148-N;
  ·  *David
Shaev, et al. v. Cardiac Science, Inc.* , et al.,
Case No. 1153-N;
  ·  *Irvin
M. Chase, et al., v. Cardiac Science, Inc.* , et al.,
Case No. 1159-N; and
  ·  *James
Stellato v. Cardiac Science, Inc.* , et al.,
Case No. 1162-N.
  Also, in
March 2005, the following complaints were filed in the Orange County Superior
Court concerning such merger agreement and transaction:
  ·  *Albert
Rosenfeld v. Cardiac Science, Inc.* , et al.
Case No. 05CC00057; and
  ·  *Jerrold
Schaffer v. Cardiac Science, Inc.* , et al.,
Case No. 05CC00059.
  Further,
on April 1, 2005, a complaint was filed in the Chancery Court in Delaware, *Oppenheim
Pramerica Asset Management v. Cardiac Science, Inc. et al.* , Case
No. 1222-N, which complaint is not consolidated yet.
  Generally,
the complaints allege that our board of directors breached its fiduciary
obligations with respect to the proposed merger transaction with Quinton because
the plaintiffs contend that our board of directors did not negotiate for
sufficient compensation and that the directors engaged in self-dealing in
connection with our senior note holders. The complaints seek, among other
things, injunctive relief enjoining the transaction, recessionary damages if the
transaction is completed and an order that our board of directors hold an
auction to obtain the best value for the Company. We have retained legal counsel
and intend to defend the cases vigorously. We have not established an accrual
for these matters because a loss is not determined to be probable.
 
 25
 In the
ordinary course of business, various lawsuits and claims are filed against us
including product liability suits. While the outcome of these matters is
currently not determinable, management believes that the ultimate resolution of
these matters will not have a material adverse effect on our operations or
financial position.
  **Item
2.**  **Unregistered
Sales of Equity Securities and Use of Proceeds**
 
 In
January 2005, as consideration for delays in filing a contractually required
registration statement in connection with our July 2004 financing, we issued an
additional aggregate of 476,637 shares of common stock to four accredited
investors (see Note 7 of the Consolidated Condensed Notes to Financial
Statements).
 
 The
issuances of the foregoing were made in reliance upon the exemption from the
registration provisions of the Securities Act of 1933, as amended, set forth in
Section 4(2) thereof as transactions by an issuer not involving any public
offering. The issuance agreement contains representations to support our
reasonable belief that the investor is familiar with or has access to
information concerning the operations and financial condition of the Company,
and the investor is acquiring the securities for investment and not with a view
to the distribution thereof. At the time of their issuance, the shares of common
stock were deemed to be restricted securities for purposes of the Securities Act
of 1933, as amended, and the shares bear legends to that effect. A registration
statement registering the resale of such securities was declared effective by
the Securities and Exchange Commission on February 7, 2005 (Registration No.
333-122397).
 
 We did
not repurchase any of our securities during the quarter ended March 31,
2005.
  **Item
3.**  **Defaults
Upon Senior Securities**
 
 None
 
 **Item
4.**  **Submission
of Matters to a Vote of Security Holders**
 
 None
 
 **Item
5.**  **Other
Information**
 
 None
 
 **Item
6.**  **Exhibits**
 
 a)
    Exhibits:Exhibit 31.1 Chief Executive Officer’s
      Certification as required by Section 302 of the Sarbanes-Oxley Act of
      2002Exhibit 31.2 Chief Financial Officer’s
      Certification as required by Section 302 of the Sarbanes-Oxley Act of
      2002Exhibit 32.1 Chief Executive Officer’s
      Certification as required by Section 906 of the Sarbanes-Oxley Act of
      2002Exhibit 32.2 Chief Financial Officer’s
      Certification as required by Section 906 of the Sarbanes-Oxley Act of
      2002
  26
  Signatures
 
 Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this 10-Q report to be signed on its behalf by the undersigned
thereunto duly authorized.
  CARDIAC SCIENCE,
      INC.(Registrant)Date:
      May 10, 2005
    /s/
      RODERICKDEGREEFRoderick
      de Greef
      Executive
      Vice President and Chief Financial Officer
      (Duly
      Authorized Officer and Principal Financial
Officer)
 
 27