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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



For the Quarterly Period Ended September 30, 2003



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the Transition Period From  to



Commission File Number 000-49871



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HEALTHETECH, INC.

(Exact name of registrant as specified in its charter)



|Delaware                                                       |  | 77-0478611                          
|-------------------------------------------------------------- |  | ------------------------------------
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. employer identification no.)
|                                                               | 
|523 Park Point Drive, 3rdFloor, Golden, Colorado               |  | 80401                               
|(Address of principal executive office)                        |  | (Zip code)                          



Registrants
telephone number, including area code: (303) 526-5085



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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 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 whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).    Yes ̈No  x



As of November 3, 2003, the
number of shares outstanding of the registrants common stock, par value $0.001 per share, 19,718,321.



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##### Table of Contents

INDEX



|           |  |                                                                                       |  | Page
|---------- |  | ------------------------------------------------------------------------------------- |  | ----
|PART I.    |  | FINANCIAL INFORMATION                                                                 |  | 1   
|           |  |                                                                                      
|Item 1.    |  | Unaudited Financial Statements                                                        |  | 1   
|           |  | Unaudited Balance Sheets                                                              |  | 1   
|           |  | Unaudited Statements of Operations                                                    |  | 2   
|           |  | Unaudited Statements of Cash Flows                                                    |  | 3   
|           |  | Notes to Unaudited Financial Statements                                               |  | 4   
|Item 2.    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 11  
|Item 3.    |  | Quantitative and Qualitative Disclosures About Market Risk                            |  | 20  
|Item 4.    |  | Controls and Procedures                                                               |  | 20  
|           |  |                                                                                      
|PART II.   |  | OTHER INFORMATION                                                                     |  | 21  
|           |  |                                                                                      
|Item 1.    |  | Legal Proceedings                                                                     |  | 21  
|Item 2.    |  | Changes in Securities and Use of Proceeds                                             |  | 21  
|Item 3.    |  | Defaults Upon Senior Securities                                                       |  | 22  
|Item 4.    |  | Submission of Matters to a Vote of Security Holders                                   |  | 22  
|Item 5.    |  | Other Information                                                                     |  | 22  
|Item 6.    |  | Exhibits and Reports on Form 8-K                                                      |  | 22  
|           | 
|SIGNATURES |  | 23                                                                                   



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##### Table of Contents

PART I. FINANCIAL INFORMATION



ITEM 1. Unaudited Financial Statements



HEALTHETECH, INC.

Balance Sheets

Unaudited



|                                                                                                                                                      |  | September 30,2003 |             |   | December 31,2002 |            
|----------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ----------- | - | ---------------- | -----------
|ASSETS                                                                                                                                                |  |                   |             |   |                  |            
|Current assets:                                                                                                                                       |  |                   |             |   |                  |            
|Cash and cash equivalents                                                                                                                             |  | $                 | 8,725,839   |   |                  | 16,878,263 
|Investments                                                                                                                                           |  |                   |            |   |                  | 5,242,726  
|Receivables, net of allowance of $80,000 and $29,000 in 2003 and 2002                                                                                 |  |                   | 875,316     |   |                  | 3,156,686  
|Inventory                                                                                                                                             |  |                   | 1,741,557   |   |                  | 2,359,809  
|Prepaid expenses                                                                                                                                      |  |                   | 924,830     |   |                  | 3,082,412  
|Other current assets                                                                                                                                  |  |                   | 102,533     |   |                  | 17,420     
|                                                                                                                                                      |  |                   |             |   |                  |            
|Total current assets                                                                                                                                  |  |                   | 12,370,075  |   |                  | 30,737,316 
|                                                                                                                                                      |  |                  
|Property and equipment, net                                                                                                                           |  |                   | 2,131,918   |   |                  | 2,997,244  
|Deposits                                                                                                                                              |  |                   | 265,313     |   |                  | 266,363    
|Restricted cash                                                                                                                                       |  |                   | 171,986     |   |                  | 1,372,497  
|Intangible assets, net of accumulated amortization of $2,747,000 and $741,000 in 2003 and 2002, respectively                                          |  |                   | 1,612,194   |   |                  | 3,406,326  
|                                                                                                                                                      |  |                   |             |   |                  |            
|TOTAL ASSETS                                                                                                                                          |  | $                 | 16,551,486  |   |                  | 38,779,746 
|                                                                                                                                                      |  |                   |             |   |                  |            
|LIABILITIES & STOCKHOLDERS EQUITY                                                                                                                    |  |                   |             |   |                  |            
|Current liabilities:                                                                                                                                  |  |                   |             |   |                  |            
|Accounts payable                                                                                                                                      |  | $                 | 709,410     |   |                  | 2,243,769  
|Accrued liabilities                                                                                                                                   |  |                   | 2,126,269   |   |                  | 2,956,560  
|Current portion of deferred revenue                                                                                                                   |  |                   | 12,338      |   |                  | 689,851    
|Note payable to related party                                                                                                                         |  |                   |            |   |                  | 10,000     
|                                                                                                                                                      |  |                   |             |   |                  |            
|Total current liabilities                                                                                                                             |  |                   | 2,848,017   |   |                  | 5,900,180  
|                                                                                                                                                      |  |                  
|Other liabilities:                                                                                                                                    |  |                   |             |   |                  |            
|Deferred revenue, less current portion                                                                                                                |  |                   | 36,737      |   |                  | 669,767    
|Other liabilities                                                                                                                                     |  |                   | 193,366     |   |                  | 332,306    
|                                                                                                                                                      |  |                   |             |   |                  |            
|Total other liabilities                                                                                                                               |  |                   | 230,103     |   |                  | 1,002,073  
|                                                                                                                                                      |  |                   |             |   |                  |            
|Total liabilities                                                                                                                                     |  |                   | 3,078,120   |   |                  | 6,902,253  
|                                                                                                                                                      |  |                  
|Stockholders equity:                                                                                                                                 |  |                   |             |   |                  |            
|Common stock, $0.001 par value, 100,000,000 shares authorized; 19,689,521 and 19,562,680 shares issued and outstanding in 2003 and
2002, respectively |  |                   | 19,690      |   |                  | 19,563     
|Deferred stock-based charges                                                                                                                          |  |                   | (1,395,416  | ) |                  | (2,509,183 
|Additional paid-in capital                                                                                                                            |  |                   | 99,232,136  |   |                  | 98,566,849 
|Accumulated deficit                                                                                                                                   |  |                   | (84,383,044 | ) |                  | (64,199,736
|                                                                                                                                                      |  |                   |             |   |                  |            
|Total stockholders equity                                                                                                                            |  |                   | 13,473,366  |   |                  | 31,877,493 
|                                                                                                                                                      |  |                   |             |   |                  |            
|Commitments and contingencies                                                                                                                         |  |                   |             |   |                  |            
|                                                                                                                                                      |  |                  
|TOTAL LIABILITIES & STOCKHOLDERS EQUITY                                                                                                              |  | $                 | 16,551,486  |   |                  | 38,779,746 
|                                                                                                                                                      |  |                   |             |   |                  |            



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



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##### Table of Contents

HEALTHETECH, INC.

Statements of Operations

Unaudited



|                                                                                                                                                                                                                                               |  | Three Months EndedSeptember 30, |            |   | Nine Months EndedSeptember 30, |           
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ---------- | - | ------------------------------ | ----------
|                                                                                                                                                                                                                                               |  | 2003                            |            |   | 2002                           |           
|Revenue:                                                                                                                                                                                                                                       |  |                                 |            |   |                                |           
|Product sales                                                                                                                                                                                                                                  |  | $                               | 634,272    |   |                                | 4,381,481 
|Software and other                                                                                                                                                                                                                             |  |                                 | 1,173,634  |   |                                | 883,180   
|                                                                                                                                                                                                                                               |  |                                 |            |   |                                |           
|Total revenue                                                                                                                                                                                                                                  |  |                                 | 1,807,906  |   |                                | 5,264,661 
|                                                                                                                                                                                                                                               |  |                                 |            |   |                                |           
|Cost of revenue:                                                                                                                                                                                                                               |  |                                 |            |   |                                |           
|Product sales                                                                                                                                                                                                                                  |  |                                 | 727,266    |   |                                | 1,958,000 
|Software and other                                                                                                                                                                                                                             |  |                                 | 298,231    |   |                                | 164,650   
|Stock-based charges                                                                                                                                                                                                                            |  |                                 | 5,108      |   |                                | 5,342     
|                                                                                                                                                                                                                                               |  |                                 |            |   |                                |           
|Total cost of revenue                                                                                                                                                                                                                          |  |                                 | 1,030,605  |   |                                | 2,127,992 
|                                                                                                                                                                                                                                               |  |                                 |            |   |                                |           
|Gross profit                                                                                                                                                                                                                                   |  |                                 | 777,301    |   |                                | 3,136,669 
|                                                                                                                                                                                                                                               |  |                                 |            |  
|Operating expenses:                                                                                                                                                                                                                            |  |                                 |            |   |                                |           
|Research & development, excluding $138,085, $61,018, $322,993 and $184,259 of stock-based charges for the three months ended
September 30, 2003 and 2002 and the nine months ended September 30, 2003 and 2002, respectively                   |  |                                 | 1,305,115  |   |                                | 1,720,564 
|Selling, general and administrative, excluding $375,232, $814,412, $1,300,574 and $2,340,915 of stock-based charges for the three
months ended September 30, 2003 and 2002 and the nine months ended September 30, 2003 and 2002, respectively |  |                                 | 2,067,733  |   |                                | 4,024,940 
|Restructuring charges and asset impairment                                                                                                                                                                                                     |  |                                 | 90,500     |   |                                |          
|Stock-based charges                                                                                                                                                                                                                            |  |                                 | 513,317    |   |                                | 875,430   
|                                                                                                                                                                                                                                               |  |                                 |            |   |                                |           
|Total operating expenses                                                                                                                                                                                                                       |  |                                 | 3,976,665  |   |                                | 6,620,934 
|                                                                                                                                                                                                                                               |  |                                 |            |   |                                |           
|Loss from operations                                                                                                                                                                                                                           |  |                                 | (3,199,364 | ) |                                | (3,484,265
|                                                                                                                                                                                                                                               |  |                                 |            |  
|Interest income                                                                                                                                                                                                                                |  |                                 | 31,312     |   |                                | 136,657   
|Interest expense                                                                                                                                                                                                                               |  |                                 | (1,210     | ) |                                | (2,500    
|                                                                                                                                                                                                                                               |  |                                 |            |   |                                |           
|Net loss                                                                                                                                                                                                                                       |  | $                               | (3,169,262 | ) |                                | (3,350,108
|                                                                                                                                                                                                                                               |  |                                 |            |   |                                |           
|Basic and diluted loss per common share:                                                                                                                                                                                                       |  | $                               | (0.16      | ) |                                | (0.19     
|                                                                                                                                                                                                                                               |  |                                 |            |   |                                |           
|Basic and diluted weighted average number of shares outstanding                                                                                                                                                                                |  |                                 | 19,642,573 |   |                                | 17,978,508



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



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HEALTHETECH, INC.

Statements of Cash Flows

Unaudited



|                                                                            |  | Nine months endedSeptember 30, 2003 |             |   | Nine months endedSeptember 30, 2002 |            
|--------------------------------------------------------------------------- |  | ----------------------------------- | ----------- | - | ----------------------------------- | -----------
|Cash flows from operating activities:                                       |  |                                     |             |   |                                     |            
|Net loss                                                                    |  | $                                   | (20,183,308 | ) |                                     | (11,257,697
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                                     |             |   |                                     |            
|Depreciation and amortization                                               |  |                                     | 1,511,763   |   |                                     | 1,366,642  
|Intangible asset impairment                                                 |  |                                     | 1,675,100   |   |                                     |           
|Inventory reserves and write-offs                                           |  |                                     | 699,976     |   |                                     |           
|Loss on disposal of property and equipment                                  |  |                                     | 56,267      |   |                                     | 125,076    
|Stock-based charges                                                         |  |                                     | 1,633,382   |   |                                     | 2,538,731  
|Change in deposits and other                                                |  |                                     | 1,050       |   |                                     | 425,294    
|Provision for doubtful accounts                                             |  |                                     | 68,200      |   |                                     | 53,000     
|Change in assets and liabilities:                                           |  |                                     |             |   |                                     |            
|Receivables                                                                 |  |                                     | 2,213,170   |   |                                     | (616,777   
|Inventory                                                                   |  |                                     | (81,724     | ) |                                     | 132,792    
|Prepaid expenses and other current assets                                   |  |                                     | 2,072,469   |   |                                     | (529,021   
|Accounts payable                                                            |  |                                     | (1,534,359  | ) |                                     | (827,834   
|Accrued and other liabilities                                               |  |                                     | (969,231    | ) |                                     | 858,793    
|Deferred revenue                                                            |  |                                     | (1,310,543  | ) |                                     | 1,424,914  
|                                                                            |  |                                     |             |   |                                     |            
|Net cash used in operating activities                                       |  |                                     | (14,147,788 | ) |                                     | (6,306,087 
|                                                                            |  |                                     |             |   |                                     |            
|Cash flows from investing activities:                                       |  |                                     |             |   |                                     |            
|Purchase of property and equipment                                          |  |                                     | (370,811    | ) |                                     | (1,473,724 
|Proceeds from the sale of marketable securities                             |  |                                     | 5,242,726   |   |                                     | 1,550,992  
|Purchase of intangible assets                                               |  |                                     | (212,861    | ) |                                     | (2,277,059 
|Proceeds from the sale of assets                                            |  |                                     |            |   |                                     | 46,563     
|Net change in restricted cash                                               |  |                                     | 1,200,511   |   |                                     | 101,719    
|                                                                            |  |                                     |             |   |                                     |            
|Net cash provided by (used) in investing activities                         |  |                                     | 5,859,565   |   |                                     | (2,051,509 
|                                                                            |  |                                     |             |   |                                     |            
|Cash flows from financing activities:                                       |  |                                     |             |   |                                     |            
|Payments on note payable to related party                                   |  |                                     | (10,000     | ) |                                     | (45,000    
|Proceeds from preferred stock offering                                      |  |                                     |            |   |                                     | 2,900,000  
|Preferred stock issuance costs                                              |  |                                     |            |   |                                     | (8,067     
|Exercise of common stock warrant                                            |  |                                     |            |   |                                     | 274,985    
|Repurchase of preferred stock                                               |  |                                     |            |   |                                     | (870,664   
|Proceeds from common stock offering                                         |  |                                     |            |   |                                     | 30,000,000 
|Common stock issuance costs                                                 |  |                                     |            |   |                                     | (4,320,041 
|Proceeds from common stock issuances                                        |  |                                     | 145,799     |   |                                     | 186,962    
|                                                                            |  |                                     |             |   |                                     |            
|Net cash provided by financing activities                                   |  |                                     | 135,799     |   |                                     | 28,118,175 
|                                                                            |  |                                     |             |   |                                     |            
|Net increase (decrease) in cash and cash equivalents                        |  |                                     | (8,152,424  | ) |                                     | 19,760,579 
|Cash and cash equivalents, beginning of period                              |  |                                     | 16,878,263  |   |                                     | 12,898,164 
|                                                                            |  |                                     |             |   |                                     |            
|Cash and cash equivalents, end of period                                    |  | $                                   | 8,725,839   |   |                                     | 32,658,743 
|                                                                            |  |                                     |             |   |                                     |            



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



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HEALTHETECH, INC.

UNAUDITED NOTES TO FINANCIAL STATEMENTS



(1) Business and Basis of Financial Statement Presentation



HealtheTech, Inc. (the Company or HealtheTech) was incorporated in February
1998 under the laws of the State of Delaware. The Company operates in one segment and develops and markets health solutions designed to give consumers simple, informative ways to improve and maintain health and wellness.



The accompanying financial statements as of September 30, 2003 and for the
three months and nine months ended September 30, 2003 and 2002 are unaudited and have been prepared in accordance with generally accepted accounting principles on a basis consistent with the December 31, 2002 audited financial statements and include
normal recurring adjustments which are, in the opinion of management, necessary for a fair statement of the results of these periods. These statements should be read in conjunction with our financial statements and notes thereto included in our Form
10-K (Commission File No. 000-49871), filed on February 25, 2003. Operating results for the three and nine months ended September 30, 2003 are not necessarily indicative of the results that may be expected for the full year.



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



The Companys financial statements are based on several significant estimates, including the reserve for warranty obligations and product returns,
provision for excess and obsolete inventory, provision for doubtful accounts and the selection of estimated useful lives of long-lived assets, as well as the recoverability of the investment in long-lived assets.



(2) Significant Accounting Policies



(a) Cash and Cash Equivalents and Restricted Cash



All highly liquid investments purchased with original maturities of three
months or less are considered to be cash equivalents. Restricted cash represents amounts the Company has pledged to collateralize letters of credit related to leases for office equipment. See Note 4 for release of restricted cash on office building
lease.



(b) Investments



Investments at December 31, 2002 consisted of mutual funds concentrated in
medium term U.S. governmental securities. Investments are stated at fair value and are classified as available for sale. The Company has sold all its investments as of September 30, 2003.



(c) Inventory



Inventory is stated at the lower of cost or market, using the first-in, first-out method and consists of purchased items or finished goods that were
manufactured for the Company by contract manufacturers. The Company is contractually required to purchase from a manufacturer raw materials and work-in-process that such manufacturer has purchased or processed based on the Companys initial
forecasts, but which will not be utilized within 90 days due to subsequently revised forecasts. The Company normally leaves such inventory at the manufacturer, but can request it to be shipped to another location, and bears risk of loss due to
obsolescence and other general inventory risk other than pilferage or mishandling by the manufacturer.



(d) Intangible Assets



Intangible assets consist of purchased patents and legal fees to obtain patents and are recorded at cost. Amortization of intangible assets is calculated
using the straight-line method over the estimated useful lives, generally five to ten years. Amortization expense was $55,404 and $147,181 for the three months ending September 30, 2003 and 2002, respectively and $331,893 and $308,660 for the nine
months ending September 30, 2003 and 2002, respectively. The Company periodically evaluates the recoverability of intangible assets and takes into account events or circumstances that warrant revised estimates of useful lives or that indicate that
impairment exists. In conjunction with the Companys change in business focus, the Company identified a number of patents and applications directed at products it has decided not to pursue and others that may not result in meaningful cash flow
within the next several years. For the three months ended September 30, 2003, the Company recorded an impairment charge of approximately $90,000 related to patents that the Company determined would not be defensible at this time. This charge in
conjunction with using probability-adjusted cash flow projections and other methods to value the remaining intangible asset portfolio, resulted in the Company recording an impairment charge of approximately $1.7 million for the nine months ended
September 30, 2003. The impairment charge is included in restructuring and asset impairment on the accompanying statements of operations.



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(e) Accrued liabilities



Accrued liabilities consists of the following:



|                                     |  | September 30, 2003 |           | December 31, 2002
|------------------------------------ |  | ------------------ | --------- | -----------------
|                                     |  | (unaudited)       
|Sales and marketing services         |  | $                  | 40,000    |                  
|Customer deposit                     |  |                    | 929,007   |                  
|Contract manufacturer                |  |                    |          |                  
|Compensation                         |  |                    | 580,138   |                  
|Consulting and professional services |  |                    | 43,754    |                  
|Lease costs                          |  |                    | 208,034   |                  
|Product royalties                    |  |                    | 265,500   |                  
|Other                                |  |                    | 59,836    |                  
|                                     |  |                    |           |                  
|Total                                |  | $                  | 2,126,269 |                  
|                                     |  |                    |           |                  



(f) Deferred
Revenue



Deferred revenue consisted primarily of a
non-refundable license fee paid by our international distributor to maintain exclusivity in certain markets. These exclusive rights were extinguished effective September 30, 2003 when the underlying distribution contract was formally terminated by
the Company following the distributors notice that it would not be meeting the balance of its purchase commitments for 2003. Approximately $837,000 is recorded in software and other revenue in the accompanying statements of operations, related
to the recognition of the remaining deferred revenue for the license fee payment.



(g) Fair Value of Financial Instruments



The carrying amounts of certain of the Companys financial instruments, including, cash and cash equivalents, restricted cash, short-term investments, accounts receivable, accounts payable and accrued expenses,
approximate fair value due to their short-term nature.



(h) Research and Development Costs and Software Development Costs



Research and development costs are expensed as incurred and consist of salaries and other direct costs. SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed, (SFAS
No. 86) requires the capitalization of certain software development costs once technological feasibility is established. The Companys software is deemed to be technologically feasible at the point a working model of the software product is
developed. Through September 30, 2003, the period between achieving technological feasibility and general availability of such software has been short. Consequently, software development costs qualifying for capitalization have been insignificant.



(i) Revenue



The Company generates revenue from the sale of its products, software and
licensing arrangements. Revenue from the sale of products is recognized when evidence of an arrangement exists, ownership transfers to the customer or distributor, the price is fixed and collectibility is probable. The software component of the
Companys products is considered incidental under Statement of Position (SOP) 97-2, Software Revenue Recognition.



Software fees are comprised of sales of prepackaged software that can be sold independently or in conjunction with product sales. Software fees are
recognized according to the criteria of SOP 97-2, as amended. Revenue is recognized upon execution of a license agreement or signed written contract with fixed or determinable fees, shipment or electronic delivery of the product, and when collection
of the receivable is probable. Software sales are to retail consumers who install the software themselves and pay via credit card prior to shipment. During the six months ended June 30, 2003, the Company also sold software to mass-market resellers
and recognized revenue when the software was sold through to the end user. The Company made the decision to exit the mass market retail distribution channel in the second quarter of 2003.



Service revenue, including training and consulting services, is recognized as services are performed. Licensing fees are
recognized ratably over the contract term.



Cost of product
revenue consists primarily of purchases of products from contract manufacturers, warranty reserves and royalty payments, obsolescence reserves and costs of personnel directly related to managing the supply chain and related overhead. Cost of
software revenue primarily consists of purchases of product. Additionally, costs of shipping are included in software and other cost of revenue.



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The Company provides 30 day right of return on software sales and limited warranty on its software
products for 90 days from date of purchase. However as returns and warranty claims have been insignificant, no reserve has been established.



In general, the Company does not provide price protection or right of return on health monitoring devices. The Company does provide limited warranty on
its devices for periods of 12 to 15 months.



(j)
Stock-Based Charges



The Company accounts for its
stock option plan in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Generally, compensation expense is recorded for options issued to
employees and directors on the date of grant only if the current estimated fair value of the underlying common stock exceeds the exercise price of the option, the intrinsic value method. SFAS No. 123, Accounting for Stock-Based Compensation,
permits entities to recognize as expense, over the vesting period, the fair value of all stock-based awards on the date of the grant. Alternatively, SFAS No. 123 allows entities to continue to apply the provisions of APB Opinion No. 25 and provide
pro forma net income or loss disclosures as if the fair value based method defined in SFAS No. 123 had been applied. The Company has elected to continue to apply the provisions of APB Opinion No. 25 and provide the pro forma disclosures required by
SFAS No. 123.



At September 30, 2003, the Company has one
stock-based employee compensation plan under which it makes stock option grants. The following table illustrates the effect on net loss if the Company had applied the fair value based measurement and recognition provisions of SFAS No. 123 to
stock-based employee compensation. Stock-based employee compensation costs exclude charges recognized for the issuance of warrants.



|                                                                        |  | Three months ended September 30, |           |   | Nine months ended September 30, |          
|----------------------------------------------------------------------- |  | -------------------------------- | --------- | - | ------------------------------- | ---------
|                                                                        |  | 2003                             |           |   | 2002                            |          
|                                                                        |  | (unaudited)                      |           |   | (unaudited)                     |          
|Net loss, as reported                                                   |  | $                                | 3,169,262 |   |                                 | 3,350,108
|Stock-based employee compensation costs, included in net loss           |  |                                  | (307,189  | ) |                                 | (580,481 
|Stock-based employee compensation cost, if fair value based method used |  |                                  | 731,581   |   |                                 | 1,492,122
|                                                                        |  |                                  |           |   |                                 |          
|Pro forma net loss                                                      |  | $                                | 3,593,654 |   |                                 | 4,261,749
|                                                                        |  |                                  |           |   |                                 |          
|Net loss per share, basic and diluted, as reported                      |  | $                                | (0.16     | ) |                                 | (0.19    
|Net loss per share, basic and diluted, pro forma                        |  | $                                | (0.18     | ) |                                 | (0.24    



The Company accounts
for non-employee stock based awards in accordance with SFAS No. 123 and related interpretations. Stock options are valued using the Black-Scholes option-pricing model. Prior to the Companys initial public offering in July 2002, the fair value
of equity instruments was determined by the Companys Board of Directors. Subsequent to July 2002, the fair value is based on the closing price of the Companys stock on the Nasdaq National Market.



(k) Income Taxes



The Company uses the asset and liability method of accounting for income
taxes as prescribed by SFAS No. 109, Accounting for Income Taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the
financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected
to be recovered or settled. The resulting deferred tax assets and liabilities are adjusted to reflect changes in tax laws or rates in the period of enactment.



(l) Advertising Costs



Advertising costs are expensed when media placements occur. Advertising expense was $0 and $40,000 for the three months ended September 30, 2003 and 2002,
respectively and $3,332,100 and $79,569 for the nine months ended September 30, 2003 and 2002, respectively.



(m) Loss Per Share



Loss per share is presented in accordance with the provisions of SFAS No. 128, Earnings Per Share, (SFAS No. 128). Under SFAS No. 128, basic loss
per share (EPS) excludes dilution for potential common stock issuances and is computed by dividing net loss by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that would occur if
securities or other contracts to issue common stock were exercised or converted into common stock. Basic and diluted EPS are the same for all periods, as all potential common stock instruments, consisting of common stock options and warrants and
convertible preferred stock, are anti-dilutive due to the net losses for each period.



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##### Table of Contents

The following is a reconciliation of the numerators and denominators of the basic and diluted EPS
computations:



|                                                                                                     |  | Three months ended September30, |            |   | Nine months endedSeptember 30, |           
|---------------------------------------------------------------------------------------------------- |  | ------------------------------- | ---------- | - | ------------------------------ | ----------
|                                                                                                     |  | 2003                            |            |   | 2002                           |           
|                                                                                                     |  | (unaudited)                     |            |   | (unaudited)                    |           
|Numerator:                                                                                           |  |                                 |            |   |                                |           
|Net loss                                                                                             |  | $                               | (3,169,262 | ) |                                | (3,350,108
|Denominator:                                                                                         |  |                                 |            |   |                                |           
|Historical common shares outstanding for basic and diluted loss per share at beginning of the period |  |                                 | 19,615,292 |   |                                | 7,318,161 
|Weighted average number of common equivalent shares issued during the period                         |  |                                 | 27,281     |   |                                | 10,660,347
|                                                                                                     |  |                                 |            |   |                                |           
|Denominator for basic and diluted loss per shareweighted average shares                             |  |                                 | 19,642,573 |   |                                | 17,978,508
|                                                                                                     |  |                                 |            |   |                                |           
|Basic and diluted net loss per share                                                                 |  | $                               | (0.16      | ) |                                | (0.19     



Potential common stock
equivalents, consisting of options and warrants, at September 30, 2003 and 2002 were 9,037,604 and 5,907,015, respectively, and were excluded from the diluted loss per share calculation because their effect would be anti-dilutive.



(2) Restructuring Charge



During the second quarter of 2003, the Company decided to refocus its
business on the medical markets and commercial weight loss markets and the products that support those markets. As a result of this refocus, the Company evaluated its operating expense levels and determined to restructure the business, resulting in
a company-wide cost reduction program achieved through a downsizing of its employee workforce, a significant reduction in its use of contractors and outside service firms, and company-wide salary reductions. Restructuring charges include severance
arrangements, early termination fees and legal costs associated with this effort. The Company expects an annual expense savings of approximately $6 million. The one remaining liability at September 30, 2003 is reflected in accrued liabilities on the
accompanying balance sheet. The liability will be relieved through the Companys normal bi-monthly payrolls and will extinguish in April 2004.



|                                          |  | September 30, 2003 |         
|----------------------------------------- |  | ------------------ | --------
|                                          |  | (unaudited)        |         
|Restructuring charge recorded             |  | $                  | 529,426 
|Cash paid by September 30, 2003           |  |                    | (339,697
|                                          |  |                    |         
|Liability remaining at September 30, 2003 |  | $                  | 189,729 
|                                          |  |                    |         



(3) Property and Equipment



Property and equipment consist of the following:



|                                               |  | September 30, 2003 |            |   | December 31, 2002 |            |   | Estimated useful life
|---------------------------------------------- |  | ------------------ | ---------- | - | ----------------- | ---------- | - | ---------------------
|                                               |  | (unaudited)        |            |   |                  
|Furniture and fixtures                         |  | $                  | 427,200    |   |                   | 418,084    |   |                      
|Computer equipment                             |  |                    | 1,246,526  |   |                   | 1,399,609  |   |                      
|Development tools                              |  |                    | 858,545    |   |                   | 668,925    |   |                      
|Leasehold improvements                         |  |                    | 796,135    |   |                   | 796,135    |   |                      
|Purchased software                             |  |                    | 974,159    |   |                   | 922,576    |   |                      
|Capitalized website and software               |  |                    | 769,156    |   |                   | 769,156    |   |                      
|Capital projects in process                    |  |                    | 93,844     |   |                   | 134,075    |   |                      
|                                               |  |                    |            |   |                   |            |   |                      
|                                               |  |                    | 5,165,565  |   |                   | 5,108,560  |   |                      
|Less accumulated depreciation and amortization |  |                    | (3,033,647 | ) |                   | (2,111,316 | ) |                      
|                                               |  |                    |            |   |                   |            |   |                      
|Total property and equipment                   |  | $                  | 2,131,918  |   |                   | 2,997,244  |   |                      
|                                               |  |                    |            |   |                   |            |   |                      



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(4) Line of Credit



In May 2003, the Company entered into a $4.0 million receivable-based bank line of credit. Cash advances under the line are available pursuant to a
borrowing-base formula and subject to the maintenance of certain financial covenants and other terms and conditions. Advances bear interest at prime rate, 4% at September 30, 2003. Amounts outstanding under the line are due May 5, 2004. There were
no amounts outstanding under the line at September 30, 2003. The amount of available credit approximates $0.4 million at September 30, 2003.



The Company has a lease commitment secured by an irrevocable standby letter of credit for $1.2 million. The standby letter of credit was a cash
collateralized instrument until September 30, 2003. As part of the $4.0 million line of credit discussed above, the Company entered into a new letter of credit facility, which no longer requires cash collateralization. The conditions for the new
credit facility include a requirement that the aggregate face amount of the letter of credit can not exceed the lesser of a) the remaining amount available under the revolving line of credit discussed above and b) 33.3% of the unrestricted cash
balance held by the Company at the bank which issued the letter of credit. The line of credit requires the Company to keep a minimum of $3.9 million in cash at the bank. Should the Company need to access those funds causing the cash balance to drop
below the $3.9 million level, it will then have to cash collateralize the letter of credit until it reaches the minimum cash balance requirements and, prior to the maturity of the line of credit, secure in cash all obligations under the outstanding
letter of credit on terms acceptable to the bank.



(5) Warrants



In August 2003, the Company issued to a marketing firm,
pursuant to a consulting arrangement, a fully vested warrant to purchase an aggregate of 100,000 shares of common stock at an exercise price of $7.50 per share. The fair value of the warrant was $16,500, as determined using the Black-Scholes option
pricing model assuming no dividends, 114% volatility, risk free interest rate of 2.27% and expected life of three years and has been included in stock-based charges on the accompanying statement of operations.



(6) Stockholders Equity



(a) Employee Stock Purchase Plan



The Company has an employee stock purchase plan for all eligible employees.
Under the plan, shares of the Companys common stock may be purchased at six-month intervals at 85% of the lower of the fair value on the first or the last day of each six-month period. Employees may purchase shares having a value not exceeding
15% of their gross compensation during an offering period. For the six-month offering period ended August 15, 2003, employees purchased 36,429 shares of common stock at a price of $0.57 per share.



(b) Stock Options



The following table summarizes stock option activity and balances for the
periods ended September 30, 2003 and 2002:



|                                    |  | 2003Number ofoptions |   |  | 2003Weighted-averageexercise price |      | 2002Number ofoptions |           |   | 2002Weighted-averageexercise price
|----------------------------------- |  | -------------------- | - |  | ---------------------------------- | ---- | -------------------- | --------- | - | ----------------------------------
|Beginning balance, January 1        |  | 4,508,180            |   |  | $                                  | 4.44 |                      | 1,927,594 |   |                                   
|Granted                             |  | 1,765,681            |   |  |                                    | 2.33 |                      | 512,661   |   |                                   
|Exercised                           |  | (426                 | ) |  |                                    | 2.63 |                      | (12,949   | ) |                                   
|Forfeited                           |  | (141,319             | ) |  |                                    | 5.83 |                      | (76,796   | ) |                                   
|                                    |  |                      |   |  |                                    |      |                      |           |   |                                   
|Balance at March 31 (unaudited)     |  | 6,132,116            |   |  | $                                  | 3.80 |                      | 2,350,510 |   |                                   
|Granted                             |  | 2,015,000            |   |  |                                    | 0.66 |                      | 539,268   |   |                                   
|Exercised                           |  |                     |   |  |                                    |     |                      | (5,941    | ) |                                   
|Forfeited                           |  | (534,477             | ) |  |                                    | 4.89 |                      | (23,775   | ) |                                   
|                                    |  |                      |   |  |                                    |      |                      |           |   |                                   
|Balance at June 30 (unaudited)      |  | 7,612,639            |   |  | $                                  | 2.93 |                      | 2,860,062 |   |                                   
|Granted                             |  | 32,750               |   |  |                                    | 0.83 |                      | 1,381,517 |   |                                   
|Exercised                           |  | (37,800              | ) |  |                                    | 0.50 |                      | (60,722   | ) |                                   
|Forfeited                           |  | (311,054             | ) |  |                                    | 1.87 |                      | (76,451   | ) |                                   
|                                    |  |                      |   |  |                                    |      |                      |           |   |                                   
|Balance at September 30 (unaudited) |  | 7,296,535            |   |  | $                                  | 2.97 |                      | 4,104,406 |   |                                   
|                                    |  |                      |   |  |                                    |      |                      |           |   |                                   



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##### Table of Contents

The following table summarizes information about stock options outstanding at September 30, 2003:



|Range ofexerciseprices |  | Numberoutstanding |  | Weightedaverageremainingcontractuallife |  | Weightedaverageexerciseprice |      | Numberexercisableas ofSeptember 30,2003 |           | Weightedaverageexerciseprice
|---------------------- |  | ----------------- |  | --------------------------------------- |  | ---------------------------- | ---- | --------------------------------------- | --------- | ----------------------------
|$0.50                  |  | 1,800,800         |  | 4.70                                    |  | $                            | 0.50 |                                         | 377,600   |                             
|$0.63  $1.68          |  | 1,600,892         |  | 5.00                                    |  |                              | 1.42 |                                         | 1,015,778 |                             
|$1.88  $2.63          |  | 1,607,921         |  | 5.67                                    |  |                              | 2.41 |                                         | 1,153,352 |                             
|$2.89  $6.98          |  | 1,097,733         |  | 7.66                                    |  |                              | 5.22 |                                         | 547,295   |                             
|$7.50                  |  | 1,189,189         |  | 8.53                                    |  |                              | 7.50 |                                         | 563,469   |                             
|                       |  |                   |  |                                         |  |                              |      |                                         |           |                             
|                       |  | 7,296,535         |  | 6.05                                    |  | $                            | 2.97 |                                         | 3,657,494 |                             
|                       |  |                   |  |                                         |  |                              |      |                                         |           |                             



The following table
includes grants of options for common stock whose exercise price was less than the fair market value, for financial reporting purposes, of the underlying common stock at the date of grant, equal to the fair market value at the date of grant or
greater than the fair market value at the date of grant. The weighted average fair value was determined using the Black-Scholes option-pricing model.



|                                           |  | Three months endedSeptember 30, |        | Nine months endedSeptember 30,
|------------------------------------------ |  | ------------------------------- | ------ | ------------------------------
|                                           |  | 2003                            |        | 2002                          
|Exercise Price:                            |  |                                 |        |                               
|                                           |  |                                 |        |                               
|Less than fair value Number of options    |  |                                 |       |                               
|Weighted average exercise price            |  |                                 |       |                               
|Weighted average fair value                |  |                                 |       |                               
|Equal to fair value Number of options     |  |                                 | 32,750 |                               
|Weighted average exercise price            |  | $                               | 0.83   |                               
|Weighted average fair value                |  | $                               | 0.62   |                               
|Greater than fair value Number of options |  |                                 |       |                               
|Weighted average exercise price            |  |                                 |       |                               
|Weighted average fair value                |  |                                 |       |                               



The following table
includes weighted average assumptions using the Black-Scholes option pricing model for determining the per share weighted average fair value of stock options granted:



|                                      |  | Three months ended September 30, |           |   | Nine months ended September 30, |  
|------------------------------------- |  | -------------------------------- | --------- | - | ------------------------------- | -
|                                      |  | 2003                             |           |   | 2002                            |  
|Per share weighted average fair value |  | $                                | 0.62      |   |                                 | $
|Dividends                             |  |                                  |          |   |                                 |  
|Volatility                            |  |                                  | 111       | % |                                 |  
|Risk-free interest rate               |  |                                  | 2.16      | % |                                 |  
|Expected life                         |  |                                  | 4.0 years |   |                                 |  



(7) Significant Customers



Revenue earned from significant customers is as follows:



|           |  | Three months ended September 30, |   |  | Nine months ended September 30, |  
|---------- |  | -------------------------------- | - |  | ------------------------------- | -
|           |  | 2003                             |   |  | 2002                            |  
|           |  | (unaudited)                      |   |  | (unaudited)                     |  
|Customer A |  |                                 |   |  | 69                              | %
|Customer B |  |                                 |   |  | 7                               | %
|Customer C |  | 17                               | % |  | 6                               | %
|Customer D |  |                                 |   |  | 1                               | %
|Customer E |  | 56                               | % |  | 13                              | %



At September 30, 2003
and 2002, receivables from these customers represented 78% and 93% of total receivables, respectively.



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##### Table of Contents

(8) Related Party Transactions



The Company received professional services from a law firm in which a former director is a partner. Fees paid were
approximately $108,000 and $214,000 for the three months ended September 30, 2003 and 2002, respectively, and $328,000 and $587,000 for the nine months ended September 30, 2003 and 2002, respectively. Effective September 2003, this director resigned
his position on the Companys Board of Directors and the Company is no longer using the services of the law firm on new matters.



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##### Table of Contents

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



The following discussion of HealtheTech, Inc.s (referred to herein as the Company, we, us or our) financial condition and results of operations
should be read in conjunction with the financial statements and notes thereto included in Item 1 of Part 1 of this quarterly report and the audited consolidated financial statements and notes thereto and Managements Discussion and Analysis of
Financial Condition and Results of Operations for the year ended December 31, 2002 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission. The following Managements Discussion and Analysis of Financial
Condition and Results of Operations, as well as information contained elsewhere in this report, contain statements that constitute 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 (the Exchange Act). You can identify these statements by forward-looking words such as may, will, expect, intend,
anticipate, believe, estimate, plan, could, should, and continue, or similar words. Actual results could differ materially from those anticipated in these
forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those mentioned in the discussion below, the summary Risk Factors contained herein and those described in the
Risk Factors discussion of our Annual Report on Form 10-K for the year ended December 31, 2002. As a result, you should not place undue reliance on these forward-looking statements. We do not intend to update or revise these
forward-looking statements to reflect future events or developments.



Overview



We were incorporated in Delaware in
February 1998. We design, develop and market technologically advanced and proprietary handheld medical devices and software for the measurement of resting metabolic rate and monitoring of nutrition.



We have incurred losses since commencing operations and, as of September 30,
2003, we had an accumulated deficit of $84.4 million. Our net loss was $3.2 million and $3.4 million for the three months ended September 30, 2003 and 2002, respectively and $20.2 million and $11.3 million for the nine months ended September 30,
2003 and 2002, respectively. We have not achieved profitability on a quarterly or annual basis. We intend to continue to develop our proprietary products and services and increase our sales efforts.



Early in the quarter ended June 30, 2003, we refocused our business on the
medical markets and commercial weight loss markets and the products that support those markets. As a result of this refocus, we in turn evaluated our operating expense levels and restructured the business, resulting in headcount and salary
reductions. Following the quarter ended September 30, 2003, we further reduced the number of employees in our Golden, Colorado headquarters by an additional 25% and announced plans to close our Los Gatos, California research and development facility
by the end of January 2004. We expect to continue to incur losses at least through 2004. Despite the progress we made in reducing expenses, we will need to generate substantially higher revenue than that generated in the current quarter and past
quarters and/or further reduce expenses in order to achieve and sustain profitability.



We are in the process of seeking additional capital and have received initial commitments for the purchase of $9.2 million of newly issued common stock and warrants to purchase common stock in a private placement from
a group of accredited investors, including current investors (one of whom is a current member of our Board of Directors). The private placement is subject to stockholder approval and other closing conditions, including our securing commitments for
the purchase of common stock and warrants in connection with the private placement representing aggregate gross proceeds of at least $10 million. We anticipate a total financing raise of $10 million to $14 million and expect the closing of this
financing to occur by the end of January 2004. If the financing does not occur by such time, we will need to delay, scale back or eliminate some or all of our current programs, or further reduce the scope of our operations. The primary purpose of
completing the private placement is to provide funds to allow us to meet our capital and operating needs.



In addition, we are in the process of seeking stockholder approval to effectuate a reverse stock split of shares of our common stock. On August 1, 2003,
we received a letter from Nasdaq advising us that our common stock had not met Nasdaqs minimum bid price requirement for 30 consecutive trading days and that, if we were unable to demonstrate compliance with this requirement during the 180
calendar days ending January 28, 2004, our common stock would be delisted at that time. Accordingly, we are in the process of seeking stockholder approval to effectuate a reverse stock split of shares of our common stock at an exchange ratio ranging
from one-to-two to one-to-15. We expect that a reverse stock split of our common stock will increase the market price of the common stock so that we will be able to maintain compliance with the Nasdaq minimum bid price listing standard. It is
possible, however, that the per share price of the common stock after the reverse split will not result in a market price per share will that remain in excess of the $1.00 minimum bid price for a sustained period of time. Notwithstanding the
foregoing, we believe that the proposed reverse stock split, if implemented, would result in the market price of our common stock rising to the level necessary, at least in the short term, to satisfy the $1.00 minimum bid price requirement.



Since our inception, our principal activities have involved
developing our products, forming distributor and strategic partner relationships, and more recently, marketing our initial products. We received FDA 510(k) clearance in January 2002 to market MedGem for the measurement of oxygen uptake in clinical
and research applications. BodyGem, which we promote for non-medical weight management applications, was commercially launched in November 2001. Our BalanceLog software application, which can be used as a stand-alone weight and nutrition management
program or in conjunction with measurements from our devices, was also commercially launched in November 2001.



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We derive revenue from the sale of our health monitoring devices, single-use disposables, software
products and license fees. We anticipate that our revenue will be generated primarily through sales into our target markets, both directly and indirectly through distribution partners. Our sales strategy is to focus on two key markets; medical and
weight-loss. In the medical and clinical markets, we currently have agreements with HealthSouth Corporation and Mead Johnson & Company (a subsidiary of Bristol-Myers Squibb Company) for use or distribution of MedGem. In 2002, HealthSouth
Corporation was our largest customer and contributed approximately 56% of our revenue. HealthSouth Corporation is currently the subject of various governmental investigations into its business. Because of the uncertainty around the outcome of these
investigations and HealthSouths business prospects, we currently anticipate that we will receive no revenue from HealthSouth in 2003.



Our strategic partnership agreement with Mead Johnson & Company provides that Mead Johnson is obligated to fulfill certain take-or-pay commitments in
exchange for exclusivity in certain medical markets. Since the second quarter of 2003, Mead Johnson has not fulfilled its commitment in its entirety due to a longer than expected sales and implementation cycle for our products. We have recently
restructured the strategic partnership agreement to eliminate exclusive distribution rights and take-or-pay commitments and open up certain previously excluded markets. We also expanded Mead Johnsons product offerings to include out-patient,
in-hospital and weight management starter kits, that combine our devices, disposables and software, and are focused in the medical and medically supervised weight management market segments. Strategically, we are moving away from sales and
distribution contracts that couple minimum purchase commitments with grants of exclusivity to our strategic partners and distributors. We believe that these arrangements are problematic for both us and our partners and distributors and that
replacing them with relationships not involving exclusivity and where product is ordered to satisfy near-term demand will improve competitiveness among our distributors and cause our reported revenue to better reflect actual usage or resale of our
products.



In the non-medical markets, we currently have
relationships with Natures Sunshine Products, Inc. for distribution of BodyGem through its independent distributors who provide measurement services to consumers; Bally Total Fitness for purchase of BodyGem devices to provide measurement
services in its fitness clubs; and a subsidiary of Microlife Corporation for distribution of BodyGem to retail pharmacies in Europe to provide in-store metabolic rate measurement services and the weight management and fitness/exercise markets in
Taiwan. We also have pilot programs underway in a number of commercial fitness and weight loss settings. In addition, we have entered into agreements with several regional distributors for the sale of MedGem and BodyGem into certain medical and
non-medical markets.



Our international distributor agreement
with Microlife Corporation required it to fulfill certain take-or-pay commitments in exchange for exclusivity in certain international markets through at least December 2004. Although Microlife continues to be a distributor of our products, these
exclusive rights were extinguished effective September 30, 2003 pursuant to the termination of the distribution agreement after Microlife notified us that it would not meet the balance of its purchase commitments for 2003. In addition to its
take-or-pay obligations, Microlife made a nonrefundable license fee payment of $2,000,000 in March 2002 in exchange for exclusivity that was ultimately extended though 2004. Prior to termination of the agreement, we recognized revenue ratably over
the period of exclusivity. As a consequence of terminating the underlying agreement effective September 30, 2003, the exclusive rights were extinguished and the end of the exclusivity period was shortened from December 2004 to September 2003. As a
result, we recognized the remaining $837,000 in deferred revenue related to the exclusive license fee payment in September 2003.



We recognize revenue from the sale of our products when ownership transfers to our customer or distributor. Other than software, we offer products with
warranty periods of 12 to 15 months from the date of purchase. With certain limited exceptions, we provide limited warranties on our software products for 90 days from the date of purchase.



In the future, we plan to convert to a measurement business model
in which customers receive MedGem and BodyGem devices from us, either directly or through commissioned sales agents, that are preloaded with the ability to perform a specific number of metabolic measurements and can be reloaded with
additional measurements. Customers will also receive a corresponding number of disposable mouthpieces at no additional charge. The principal advantage of this model to our customers is that it lowers the initial acquisition cost of deploying the
device in the customers business. As a result, we expect the model to accelerate the adoption, deployment and utilization rate of our technology, increasing our installed base of devices and, ultimately, positively impacting revenue and
profitability. In the first year of deployment of this model, however, our revenue is likely to be lower than it would be under the traditional sales model, because the expected selling price of a set number of measurements is expected to be lower
than the traditional selling price of a measurement device and quantity of disposable mouthpieces. Although this model has not yet been deployed, we currently expect that this system of selling measurements, rather than devices and disposables, will
be the dominant form of business in 2004 and beyond.



We pay
royalties to third parties to license various sensor and related technologies that are used in our health monitoring devices. These royalty expenses are included in our cost of revenue. In general, we pay the greater of minimum royalty amounts or a
percentage of product revenue to these third parties in order to maintain exclusivity in specified fields of use through the terms of the agreements covering the licensed technologies. We believe that such arrangements are no longer necessary due to
our established



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##### Table of Contents

product and patent protection around our core technology and have sought to restructure our relationships with several component suppliers. As of September
30, 2003, we had entered into a mutual termination of this sort of arrangement with one of our key component suppliers and converted to a purchase order based supply relationship with such supplier. We have also come to an agreement in principle
with another of our key suppliers to suspend a similar arrangement and plan to continue to purchase components on a purchase order basis from this supplier.



We currently outsource the manufacturing, testing and packaging of our health monitoring devices, disposable products and software. We pay our contract
manufacturers a negotiated price, inclusive of labor, material, overhead and profit, for the products that they manufacture. Generally, we pay for products as they are completed and move into finished goods inventory. In some circumstances, if we
reschedule purchase orders placed with our manufacturers, we may be liable for restocking fees or may be required to purchase surplus inventory at the manufacturer. Cost of revenue consists primarily of purchases of products from our contract
manufacturing partners, royalties, obsolescence reserves, tooling depreciation and costs of our manufacturing liaison group. We anticipate that we will recognize higher margins on our disposables and software products as compared to our health
monitoring devices under our current model. We anticipate that our gross margins will improve over time as product volume increases to cover fixed manufacturing costs and potentially enable us to negotiate lower contract manufacturing rates. We also
believe that the implementation in 2004 of the preloaded measurement model will positively impact gross margins.



Research and development expenses principally consist of compensation and other personnel costs, contractor fees, fees paid to outside service providers,
project material, and clinical expenses. Research and development costs are expensed as incurred.



Selling, general and administrative expenses consist of compensation and other personnel fees, professional fees, travel, tradeshows, marketing,
insurance, and, to a lesser extent, account management and customer training. Our sales and marketing strategy is to market directly to certain large customers and establish distribution relationships to reach others, generate awareness of our
products and penetrate and expand in the medical and commercial weight-loss markets. We initiated an awareness campaign emphasizing the importance of metabolism in weight management, which concluded in the first quarter of 2003. With the conclusion
of this campaign combined with the cost reduction efforts we undertook in the second quarter of 2003, we substantially reduced our selling, general and administrative expenditures. We plan additional reductions in operating expenses through such
measures as the closure of our Los Gatos, California research and development facility by the end of January 2004 and subletting office space, but can not predict when these savings might ultimately be achieved.



Results of Operations



Three Months and Nine months Ended September 30, 2003 and 2002



Revenue. Revenue decreased $3.5 million to $1.8 million in the quarter ended September 30, 2003 from $5.3 million in the comparable
quarter in 2002. Product revenue decreased $3.8 million to $0.6 million for the three months ended September 30, 2003 from $4.4 million in the comparable period in 2002. The primary reason for the significant decrease in product revenue is the
absence in 2003 of revenue from a significant 2002 customer, HealthSouth Corporation. In the third quarter of 2002, HealthSouth made a contractually required product purchase of $3.2 million from us, which represented approximately 74% of our
product revenue for that period. Since completing a total of $7.5 million in purchases from us in 2002, HealthSouth has failed, and is expected to continue to fail, to perform on certain of its contracted obligations, including the obligation to
make $20 million in purchases in 2003, and as a consequence have forfeited exclusivity previously granted to it in certain markets. Strategically, we are moving away from agreements that couple minimum purchase agreements with exclusivity, as we
believe this will promote more competitiveness among our distributors in the market and also cause our reported revenue to better reflect the deployment and usage of our products. Starting in the second quarter of 2003, we expanded our product mix
to include starter kits, which include the BodyGem or MedGem device, single-use disposables and BalanceLog or Analyzer software. We sold approximately 200 BodyGem and MedGem devices and approximately 78,000 single-use disposables in the third
quarter of 2003 compared to approximately 1,500 devices and over 300,000 single-use disposables in the third quarter of 2002. Software and other revenue increased $0.3 million to $1.2 million in the third quarter of 2003 from $0.9 million in the
comparable quarter of 2002. We recognized approximately $0.8 million of deferred license fees due to the extinguishment of an exclusivity arrangement with our international distributor, as described in Overview, above. This increase in
license revenue was offset by the absence of software purchases from HealthSouth, who in the second quarter of 2002 purchased approximately $0.4 million of software. Sales of software in the third quarter of 2003 were primarily generated from our
website and through distributors.



Revenue decreased $6.3
million to $4.6 million for the nine months ended September 30, 2003 from $10.9 million in the comparable period in 2002. Product revenue decreased $6.9 million for the nine months ended September 30, 2003 to $2.2 million from $9.1 million in the
comparable period in 2002. We sold approximately 680 Gems and approximately 258,000 single-use disposables in the nine months ended September 30, 2003 compared to approximately 4,400 Gems and over 500,000 single-use disposables in the comparable
period of 2002. In the nine months ended September 30, 2003, we shipped two large re-stocking orders of single-use disposables to a key customer and have sold kits comprised of the MedGem, single-use disposables and software to our medical
distributor. We also shipped re-stocking orders to our international distributor in the second quarter of 2003. Sales for the nine months ended September 30, 2002 were primarily to our domestic and international distributors for initial stocking
orders of BodyGems, MedGems and single-use disposables, in addition to a large sale made to HealthSouth, as discussed above, and sales to a key customer in the home measurement market. Software and other revenue increased $0.6 million to $2.4
million for the nine months



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ended September 30, 2003 from $1.8 million in the comparable period of 2002. The primary reason for the increase relates to the $0.8 million recognition of
deferred license fees as discussed above. This increase is partially offset by the elimination of our personal digital assistant product we had offered in early 2002. Other variances are nominal.



In late 2002 and early 2003, we received purchase orders from SAMs Club
and Wal-Mart and shipped a total of $3.8 million of BalanceLog software based on our retail selling prices. Through June 30, 2003, we recognized revenue of only $228,000 based on the sell-through of our software to customers from these retail
stores. Because of the low sell-through rates, we decided to exit the mass-market retail channel and therefore SAMs and Wal-Mart have returned the majority of the unsold product to us during the second quarter of 2003. Based on our current
sales forecasting, we do not anticipate selling this quantity of software in the next twelve months. Accordingly, we reserved approximately $254,000 as excess inventory in the quarter ended June 30, 2003. This charge is included in software and
other cost of revenue in the nine months ended September 30, 2003.



Revenue from customers outside the United States accounted for 56% and 13% of total revenue for the three months ended September 30, 2003 and 2002, respectively and 38% and 14% for the nine months ended September 30, 2003 and 2002,
respectively.



Cost of Revenue. Total cost of revenue increased to 57%
of sales in the third quarter of 2003 from 40% of sales in the third quarter of 2002. Total cost of revenue for the nine months ended September 30, 2003 increased to 72% of sales from 52% of sales in the prior year period. The increase in cost of
revenue as a percent of sales primarily reflects obsolescence reserves related to remaining BalanceLog 2.0 software, old style single use mouthpieces and flowtubes and some sensor components that did not meet our quality specifications. The
write-off of the old style mouthpieces, flowtubes and sensor components were the primary cause for the negative product margins for the three and nine months ended September 30, 2003.



Research and Development. Research and development expenses decreased $0.4 million to $1.3 million in the quarter ended September 30,
2003 from $1.7 million in the comparable quarter in 2002. The variance is primarily due to a 31% decrease in headcount resulting from the cost reduction measures undertaken in the second quarter of 2003. In addition, we have reduced our use of
outside service firms and contractors resulting in a savings of 61% in the third quarter of 2003 compared to the third quarter of 2002. We have focused our research and development efforts on a few key projects, which are now being handled with
internal resources, and clinical validation studies conducted by outside providers. We believe that a continued commitment to research and development is essential in order to provide enhancements to and validation of existing products.



Research and development expense increased $0.7 million to $5.4 million
for the nine months ended September 30, 2003 from $4.7 million in the comparable period of the prior year. The primary reason for the increase includes contracting hardware and software developers and outside service firms early in 2003 to assist in
enhancing our current products and designing and developing next generation products. We have curtailed efforts in developing any new products unrelated to our existing product line at this time. Many of the outside service firms and contractors
have now been eliminated as a result of our second quarter 2003 cost reduction efforts.



Selling, General and Administrative. Selling, general and administrative expenses decreased $1.9 million to $2.1 million in the quarter ended September 30, 2003 from $4.0 million in the comparable quarter of the prior year. The
primary reason for the decrease is significantly reduced marketing spending. Marketing costs declined 90% in the third quarter of 2003 compared to the third quarter of 2002. In the third quarter of 2002, we were preparing for the launch of our
BalanceLog software into the retail channel by hiring marketing firms to conduct consumer and medical studies, packaging firms for product redesign, and a marketing agency for promotion services, which activities were not conducted by us in the
third quarter of 2003. Other reasons for the decrease in selling, general and administrative expenses include a 14% reduction in headcount and company-wide salary reductions, as a result of our second quarter 2003 cost reduction efforts, along with
related travel expense reductions. In addition, we are now using internal resources for most formerly contracted functions, such as web hosting, customer service, and investor and public relations.



Selling, general and administrative expense increased $2.9 million to $12.4
million for the nine months ended September 30, 2003 from $9.5 million in the comparable period of the prior year. This was primarily due to the first quarter 2003 metabolism awareness campaign and BalanceLog software radio and print advertising
which totaled $3.3 million. In the first quarter of 2003, we also incurred approximately $0.7 million of merchandising costs launching into the mass-market retail channel. As of June 30, 2003, we exited the mass-market retail channel. We have
reduced our marketing efforts to focus on two markets; the medical market and the commercial weight loss market. Our tradeshow and other marketing activity will be limited to those markets. We do not expect to incur significant advertising
expenditures in the near term.



Stock-based Charges. Stock-based charges
decreased $0.4 million for the third quarter of 2003 to $0.5 million from $0.9 million in the comparable quarter of the prior year. We recorded deferred stock-based charges of $4.9 million with respect to stock options that we granted through
September 30, 2003. We recognized $2.1 million of the deferred stock-based charges through September 30, 2003, reduced deferred stock-based charges by $1.4 million for unvested options that have been forfeited and will ratably recognize the
remaining $1.4 million of deferred stock-based charges over the remaining vesting period of the options, which is generally four years from the date of grant. We expect to record expense for deferred compensation as follows: $0.3 million for the
remainder of 2003, $0.7 million during 2004 and $0.4 million during 2005. The amount of deferred compensation expense to be recorded in future periods may again decrease if unvested options for which deferred compensation has been recorded
subsequently lapse or are cancelled.



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Restructuring Charges and Asset Impairment. During the second quarter of 2003, we implemented a company-wide cost
reduction program, which reduced our quarterly operating expenses by approximately 25%. This was achieved through a downsizing of our employee workforce, a significant reduction in our use of contractors and outside service firms, and company-wide
salary reductions. We incurred approximately $0.5 million of severance charges and termination fees associated with this effort.



Asset Impairment.We revised our business plan during the second quarter of 2003 to focus on a few core markets and the products that support these markets. The
change in our business plan caused us to re-evaluate the fair value of our intellectual property portfolio, which we do on a periodic basis. This evaluation identified a number of patents and applications directed at products we have decided not to
pursue, and others that may not result in meaningful cash flow within the next several years. For the three months ended September 30, 2003, we recorded an impairment charge of approximately $90,000 related to patents that we determined would not be
defensible at this time. This charge in conjunction with using probability-adjusted cash flow projections and other methods to value the remaining intangible asset portfolio, resulted in an impairment charge of approximately $1.7 million for the
nine months ended September 30, 2003. We continue to have a strong patent portfolio addressing methods of indirect calorimetry, integrated calorie management and other technologies that are related to or extensions of our current products.



Liquidity and Capital Resources



Unrestricted cash, cash equivalents and short-term investments totaled $8.7
million at September 30, 2003. Cash used in operating activities was $14.1 million in the nine months ended September 30, 2003 compared to $6.3 million in the comparable period of 2002. The increase in usage reflects expenditures for supporting an
advertising and awareness campaign to support the launch of our BalanceLog software in the mass-market retail channel earlier in the year, severance payments to employees whose jobs were eliminated as part of our company-wide cost reduction program
in the second quarter of 2003, and an $0.8 million payment to our contract manufacturer for excess raw materials reserved in previous years. The increase was offset primarily by a reduction in our accounts receivable and prepaid expenses and a $0.9
million customer deposit that will be refunded in the fourth quarter of 2003.



Cash provided by investing activities was $5.9 million in the nine months ended September 30, 2003, an increase of $7.9 million from the comparable period of the prior year, primarily due to the redemption of
marketable equity securities and the release of a cash collateral restriction on a letter of credit securing an office building lease. These provisions are offset by minimal purchases of capital and intangible assets.



Cash flows from financing activities were $0.1 million in the nine months
ended September 30, 2003, a decrease of $28.0 million from the comparable period of the prior year. Net cash from financing activities for the nine months ended September 30, 2003 primarily reflects proceeds from the sale of equity securities from
our employee stock purchase plan and exercise of stock options. Net cash from financing activities for the nine months ended September 30, 2002 primarily reflects proceeds from the sale of equity securities from our initial public offering and
exercise of stock options.



We have no long-term debt.
Stockholders equity at September 30, 2003 was $13.5 million. We expect to continue to modestly invest in sales and marketing programs and research and development. We do not expect significant additions to property and equipment in the near
term. In May 2003, we entered into a $4.0 million receivable-based line of credit with a large bank. Advances under the line of credit are available to us pursuant to a borrowing-base formula and subject to the maintenance of certain financial
covenants and other terms and conditions. Amounts outstanding under the line of credit are due one year from the execution of the agreement. As of September 30, 2003, there are no amounts outstanding under the line of credit. The amount of available
credit under the line approximates $0.4 million at September 30, 2003.



We do not believe our current cash, investments and cash generated from operations is sufficient to fund our operations and working capital needs through 2004 without obtaining additional financing or significantly contracting the scope of
our current operations. We have initiated a process to obtain additional capital, and we received initial commitments for the purchase of $9.2 million of newly issued common stock and warrants in a private placement from a group of accredited
investors, subject to shareholder approval and other closing conditions, including our securing commitments for the purchase of common stock and warrants in connection with the private placement representing aggregate gross proceeds of at least $10
million. We anticipate a total financing raise of $10 million to $14 million and expect the closing of this financing to occur by the end of January 2004. We believe that this additional capital would meet our operating and capital needs through
2004. We cannot assure you that our stockholders will approve the transaction, or that our current estimates and assumptions of timing will remain unchanged. If, as of January 2004, a sufficient financing or corporate partnering transaction is not
reasonably assured, we will be required to significantly scale back our operations and reduce all discretionary spending. In addition, if we do not consummate the financing transaction, we would be forced to immediately consider other financing or
strategic alternatives and consider selling some or all of our assets. We believe that the execution of such actions would adversely impact our ability to generate increased revenue.



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To the extent we raise additional capital by issuing equity securities, our stockholders would at that
time experience substantial dilution.



The following table sets
forth information concerning our material contractual obligations as of September 30, 2003:



|Material Contractual Obligations |  | Total |           | Due in next3 months |   | Due 2004and 2005 |  | Due 2006and 2007 |           | Due after2007
|-------------------------------- |  | ----- | --------- | ------------------- | - | ---------------- |  | ---------------- | --------- | -------------
|Operating Lease Obligations      |  | $     | 3,103,000 |                     | $ | 251,000          |  | $                | 1,698,000 |              



Critical Accounting Policies and
Estimates



We have disclosed in Note 2 to our financial
statements those accounting policies that we consider to be significant in determining our results of operations and our financial position.



The preparation of financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and
expenses. We evaluate our estimates, including those related to bad debts, inventories and warranty obligations, on an ongoing basis. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under
the circumstances. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. The actual results may
differ from these estimates under different assumptions or conditions.



The significant accounting policies which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:



Revenue recognition



We derive our revenue primarily from the sale of our health monitoring devices, the recurring sale of our single-use disposables and our companion
software. Our software revenue is recognized in accordance with Statement of Position 97-2, as amended by Statement of Position 98-9. We license our software products on a perpetual basis. We recognize revenue from the sale of our health monitoring
devices and single-use disposables upon ownership transfer to the customer and when it is determined that a continuing service obligation no longer exists. We recognize revenue from the sale of our software when persuasive evidence of an arrangement
exists, the product is delivered, the price is fixed or determinable and collectibility is probable. For sales of our software over the Internet, we use a credit card authorization as evidence of an arrangement. Sales through our distributors are
evidenced by a master agreement governing the relationship together with binding purchase orders on a transaction-by-transaction basis. Delivery generally occurs when the product is delivered to a common carrier. Service revenue, including training,
is recognized as services are performed. We offer customers a limited right to return software products within 30 days if they do not accept the terms and conditions of our software license agreement. We provide limited warranties on our health
monitoring devices for a period of 12 to 15 months from the date of purchase and on our software products for 90 days from date of purchase, with certain limited exceptions.



Receivables are recorded net of allowance for doubtful accounts. We regularly review the adequacy of our accounts receivable
allowance after considering the accounts receivable aging, the ages of each invoice, each customers expected ability to pay and our collection history with each customer. We review any invoice greater than 90 days past due to determine if an
allowance is appropriate based on the risk category using the factors discussed above. The allowance for doubtful accounts represents our best estimate, but changes in circumstances relating to accounts receivable may result in additional allowances
or recoveries in the near future.



Valuation allowances, specifically sales
returns and warranty reserve



Management makes estimates
of potential future product returns and product warranties related to current period product revenue, based on historical returns, current economic trends and changes in customer demand and acceptance of our products when evaluating the adequacy of
the sales returns and other allowances. Significant management judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period. Significant differences may result in the
amount and timing of our revenue for any period if management made different judgments or used different estimates.



Asset impairment



We revised our strategic business plan during the second quarter of 2003. The change in our business plan necessitated an evaluation of our intellectual property portfolio for realizability. This evaluation identified
a number of patents and patent applications directed at products we have decided not to pursue, and others that may not result in meaningful cash flow within the next several years. For the three months ended September 30, 2003, we recorded an
impairment charge of approximately $90,000 related to patents that we determined would not be defensible at this time. This charge in conjunction with using probability-adjusted cash flow projections and other methods to value the remaining
intangible asset portfolio, resulted in an impairment charge of approximately $1.7 million for the nine months ended September 30, 2003.



Related party transactions



We periodically enter into transactions with individuals or entities that are considered to be related parties. Our policy is to enter into these
transactions on terms consistent with those that have been, or would be, granted to unrelated parties.



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Risk Factors



In addition to the other information contained in this report, we caution stockholders and potential investors that the following summary risk factors and those
additional factors described in the Risk Factors discussion of our Annual Report on Form 10-K for the year ended December 31, 2002, in some cases have affected, and in the future could affect, our actual results of operations and could
cause our actual operating results to differ materially from those expressed in any forward-looking statements made by or on our behalf. The following information is not intended to limit in any way the characterization of other statements or
information under other captions or in the Risk Factors section of our Annual Report on Form 10-K for such purpose.



Our existing capital resources are not sufficient to support our current operating plan, and we will need to obtain additional capital in order to continue operations
through 2004.



We do not believe our current cash,
investments and cash generated from operations is sufficient to fund our operations and working capital needs through 2004 without obtaining additional financing or significantly contracting the scope of our current operations. We cannot assure you
that our stockholders will approve the proposed financing transaction, or that our current estimates and assumptions of timing will remain unchanged. If, as of January 2004, a sufficient financing or corporate partnering transaction is not
reasonably assured, we will be required to significantly scale back our operations and reduce all discretionary spending. We believe that the execution of such actions would adversely impact our ability to generate increased revenue. Thus, if we do
not consummate the financing transaction, we would be forced to immediately consider other financing or strategic alternatives that we expect would be substantially less attractive than the contemplated financing. An alternative financing is
unlikely to be available on acceptable terms, or at all, and we cannot predict whether a corporate partnering transaction would be available on acceptable terms, or at all. In addition to other possibilities, we may be forced to consider selling
some or all of our assets. However, there can be no assurance that we would be able to sell any of our assets, or that if we were able to sell some or all of our assets, that we would be able to do so on favorable terms. To the extent we raise
additional capital by issuing equity securities, our stockholders would experience substantial dilution.



We may be unable to maintain our listing on the Nasdaq National Market, which could cause our stock price to fall and decrease the liquidity of our common stock.



Our common stock is currently quoted on the Nasdaq National Market. In order
for our common stock to continue to be quoted on the Nasdaq National Market, we must satisfy certain listing maintenance standards established by Nasdaq. Among other things, if the closing bid price of our common stock is under $1.00 per share for
30 consecutive trading days and does not thereafter reach $1.00 per share or higher for a minimum of ten consecutive trading days during the 180 calendar days following notification by Nasdaq, Nasdaq may delist our common stock from trading on the
Nasdaq National Market. On August 1, 2003, we received a letter from Nasdaq advising us that our common stock had not met Nasdaqs minimum bid price requirement for 30 consecutive trading days and that, if we were unable to demonstrate
compliance with this requirement during the 180 calendar days ending January 28, 2004, our common stock would be delisted at that time. The Nasdaq National Market also requires maintenance of minimum stockholders equity of $10 million. Without
raising additional equity capital, it is possible that our stockholders equity could fall below the $10 million minimum.



If our common stock were to be delisted, and the common stock does not qualify for trading on the Nasdaq SmallCap Market, our common stock would trade on
the over-the-counter bulletin board or in the pink sheets maintained by the National Quotation Bureau, Inc. Such alternative markets are generally considered to be less efficient than, and not as broad as, the Nasdaq National Market, and
would seriously impair the liquidity of our common stock and limit our potential to raise future capital through the sale of our common stock, which would materially harm our business. In addition, delisting from the Nasdaq National Market could
result in a loss of confidence by our customers, suppliers and employees, the loss of analyst coverage and institutional investor interest, and fewer business development opportunities.



While we are planning to effect a reverse stock split in an effort to regain compliance, we cannot assure you that we will
be able to secure the necessary stockholder approval of the proposed stock split, or, if effected, that the stock split will be sufficient to maintain our stock price on a sustainable basis.



Our brief operating history makes it difficult to evaluate our prospects.



We were incorporated in February 1998. Through November 2001, we were
primarily engaged in the research and development of our initial products. We commenced shipment of our health monitoring devices in 2001 and executed our first significant distribution agreement in August 2001. As a result of our limited operating
history, we have a limited amount of financial data that you can use to evaluate our business. Moreover, the revenue and profitability potential of our markets are unproven. You must consider our prospects in light of the risks, expenses and
challenges we might encounter because we are at an early stage of development in new and developing markets. We may not successfully address these risks, and our business strategy may not prove successful.



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We recorded only $21.6 million in revenue since our inception, we have a large accumulated deficit, we expect future
losses and we may not achieve or maintain profitability.



Since our inception through September 30, 2003, we recorded only $21.6 million in revenue. As a result, we will need to significantly increase the revenue we receive from sales of our products, while controlling our expenses, in order to
achieve profitability. We have incurred substantial losses each year since our inception in funding the research and development of our products and technologies, the Food and Drug Administration (FDA) marketing clearance process for MedGem, the
growth of our organizational resources and other activities. As of September 30, 2003, we had an accumulated deficit of $84.4 million. We may not generate a sufficient level of revenue to offset our planned expenditures, and we may be unable to
adjust spending in a timely manner to respond to any failure to increase our revenue. Even if we do achieve profitability, we may not be able to sustain or increase profitability.



We expect our future financial results to fluctuate significantly, and failure to increase our revenue or achieve profitability may
disappoint securities analysts or investors and result in a decline in our stock price.



We believe that period-to-period comparisons of our historical results of operations are not meaningful and are not a good predictor of our future performance. In 2002, for example, several of our customers and
distributors purchased products from us in order to meet contracted minimum purchase requirements, and actually deployed or resold only portions of the products purchased. We expect our future quarterly and annual operating results to fluctuate
significantly as we attempt to expand our product offerings and increase sales into different markets. Our revenue, gross margins and operating results are difficult to forecast and may vary significantly from period to period due to a number of
factors, many of which are not in our control. These factors include:



| | market acceptance of our MedGem, BodyGem and software products;
|- | ---------------------------------------------------------------



| | the ability of our distributors and strategic partners to penetrate our target markets;
|- | ---------------------------------------------------------------------------------------



| | the amount and mix of health monitoring devices, disposable products and software sold by us or our strategic partners and distributors;
|- | ----------------------------------------------------------------------------------------------------------------------------------------



| | our ability to develop new products and introduce enhancements to our existing products on a timely basis and to obtain any required regulatory clearances or approvals for those
products;
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | the success of new product introductions, distribution channels, sales and marketing efforts and pricing changes by our competitors;
|- | ------------------------------------------------------------------------------------------------------------------------------------



| | the success of our advertising and customer awareness program which concluded in the first quarter of 2003;
|- | -----------------------------------------------------------------------------------------------------------



| | unanticipated delays in production by our third-party contract manufacturers caused by insufficient capacity or delays in the availability of components;
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------



| | changes in the amount or timing of product orders;
|- | --------------------------------------------------



| | the utilization rate of our monitoring devices sold, which directly impacts the sales of disposables; and
|- | ---------------------------------------------------------------------------------------------------------



| | our ability to expand our operations, and the amount and timing of expenditures to expand our operations, including costs related to acquisitions of technologies and businesses.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We forecast the volume and timing of orders for
our products for operational and production planning and in some cases we become liable for procurement costs based on these forecasts. These forecasts, however, are based on many factors and subjective judgments, and they may be inaccurate. In
particular, because of our limited operating history, we do not have meaningful historical information to predict demand for our products, and trends that may emerge, in the various markets into which we sell and plan to sell our products. Moreover,
because most of our expenses, such as employee compensation and lease payment obligations, are relatively fixed in the short term, we may be unable to adjust spending quickly enough to offset any unexpected shortfall in revenue growth or any
decrease in revenue levels in any particular period. As a result of the foregoing, our operating results may fall below the expectations of securities analysts or investors in future quarters or years, causing our stock price to decline.



Our strategic partners may experience financial difficulties or undergo organizational
changes, which may harm our ability to distribute our products, and could result in a substantial decline in our revenue and overall operating results.



We expect that a majority of our sales will be made to a limited number of customers, including our strategic partners and distributors. One or more of
our strategic partners may experience financial difficulties or undergo organizational changes that could affect their ability or need to purchase our products. Organizational restructurings and financial concerns may cause our strategic partners to
substantially reduce the volume of their purchases of our products, or to no longer continue as our distributors. As a result, our ability to effectively distribute our products may be harmed, and we may experience a significant decline in our
revenue and overall operating results.



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We have very limited product offerings from which we expect to derive substantially all of our future revenue. If
demand for our limited number of products fails to develop as we expect or otherwise declines, we could fail to generate sufficient revenue to achieve profitability.



We derive substantially all of our revenue from the sale of MedGem, BodyGem, disposables and software. In January 2002, we
obtained FDA clearance to market MedGem and accordingly did not derive any of our revenue from the sale of MedGem prior to that time. We expect that revenue from the sale of MedGem, BodyGem, disposables and our BalanceLog and BalanceLog Pro software
will account for substantially all of our revenue for the foreseeable future. The limited development and sales of our product line makes our future prospects difficult to predict. If the anticipated demand for our products fails to develop, our
ability to generate revenue and achieve profitability would be significantly harmed. In particular, the failure to sell sufficient quantities of MedGem and BodyGem would not only directly affect revenue but would also significantly harm our ability
to generate recurring revenue from the sale of our disposables and may limit sales of software products.



We currently rely on a limited number of distributors for the sale of MedGem and BodyGem into our target markets and, to a lesser extent, other target markets. If these distributors are not successful selling our
products, or if we are unable to establish additional distributor arrangements as planned, we will not be able to achieve our sales goals and our business will be harmed.



We expect to rely primarily upon distributors and their sales forces to sell MedGem into the medical market and to
increasingly rely upon distributors and their sales forces to sell BodyGem into the retail pharmacy, weight management, fitness and other target markets. We currently have a limited number of distributors of our products into global markets. Our
reliance on distributors subjects us to many risks, including risks related to their inventory levels and support for our products. If any of our distributors attempt to reduce their inventory levels or if they do not maintain sufficient levels to
meet customer demand, our sales could be negatively affected. As is generally the case with our current distribution agreements, we anticipate that our future distribution agreements will allow our distributors to reduce or discontinue purchases of
our products with short notice. Further, distributors may not recommend, or continue to recommend, our products. We will rely heavily upon our distributors for the sales and marketing activities that we believe are critical to the successful sale of
our products. However, our distributors may not market or sell our products effectively or continue to develop and devote the resources necessary to provide us with effective sales, marketing and technical support. In addition, we intend to attract
additional distributors of MedGem and BodyGem in order to increase penetration in the medical and other markets. It may be difficult to increase our distributor base due to current exclusivity arrangements and prospective requests for exclusivity
from distributors and other customers. If we are unable to maintain successful relationships with our distributors or obtain additional distributors, we will have to devote substantially more resources to the distribution, sales, marketing,
implementation and support of our products than we would otherwise and our efforts may not be as effective. The loss of any one or more of our distributors, a reduction in purchases of our products by or through our distributors, the decline of our
distributors business or the inability to increase our third-party distributor base may limit our revenue growth and harm our operating results.



In particular, HealthSouth, which contributed 56% of our revenue in 2002, is currently the subject of various governmental investigations into its
business. Because of the uncertainty of the outcome of these investigations and HealthSouths business prospects, we currently anticipate that we will receive no revenue from HealthSouth in 2003. If we are unable to offset the anticipated loss
or decrease of this revenue stream, our operating results and financial condition will be materially and adversely affected.



Our strategic partnership agreement with Mead Johnson & Company provides that Mead Johnson is obligated to fulfill certain take-or-pay commitments in
exchange for exclusivity in certain medical markets. As of June 30, 2003, Mead Johnson had not fulfilled its commitment in its entirety due to a longer than expected sales and implementation cycle for our products. As a result, both parties are
currently working to restructure the strategic partnership agreement and have expanded Mead Johnsons product offerings to include weight management starter kits, which combine our devices, disposables and software, and are focused in the
medically supervised weight management market segment.



Our
international distributor agreement with Microlife Corporation required it to fulfill certain take-or-pay commitments in exchange for exclusivity in certain international markets through at least December 2004. Although Microlife continues to be a
distributor of our products, these exclusive rights were extinguished effective September 30, 2003 pursuant to the termination of the distribution agreement after Microlife notified us that it would not meet the balance of its purchase commitments
for 2003.



Because a small number of customers are likely to account for a
substantial portion of our revenue, the loss of any of these customers or the cancellation or deferment of a customers order could cause our revenue to decline substantially and may result in a decline in our share price.



We expect that the majority of our revenue will depend on sales of our
products to a limited number of customers, which include our strategic partners and our distributors. We intend to establish strategic relationships with large, prominent companies that possess significant sales, marketing and distribution
capabilities in each of our targeted medical and non-medical channels. We have not had significant working experience with these new customers and it is difficult to predict purchasing patterns. Many of our contracts with our customers do not
contain minimum purchase requirements and any customer may reduce or discontinue purchases of our products at any time. The loss of one or more of our customers, a reduction in purchases of our products by our customers or the decline of our
customers business may cause our revenue to decline substantially or fall short of our expectations. In addition, because we expect our accounts receivable to be concentrated on a small group of customers, the failure of any of them to pay on
a timely basis would reduce our cash flow and negatively affect our operating results.



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In the past we granted certain of our customers exclusive rights to particular markets. These
exclusive agreements may limit our ability to add additional customers. If one of these current or future customers fails to adequately promote and sell our products, our sales and penetration into their markets will be adversely affected. Moreover,
if any customer that has an exclusive right in a particular market proves to be ineffective, we may not be able to replace that customer for a significant period of time, if at all.



Our workforce reductions may have an adverse impact on our ability to recruit and retain key personnel which could delay our ability to
execute our business plan.



In the second quarter of 2003,
we refocused our business on the medical markets and commercial weight loss markets. As a result of such refocus, we implemented a company-wide cost reduction program, achieved through a reduction in force, company-wide salary reductions and
significant reduction in the use of contractors and outside service firms. In November 2003, we announced further expense reductions, including an additional reduction in force. As a result of a perceived risk of future workforce and expense
reductions, we may not be able to attract and retain personnel on acceptable terms, which could adversely affect our business.



We intend to convert to a measurement business model in 2004 from which we expect to derive substantially all of our future MedGem and BodyGem device revenue. If
acceptance of our new business model fails to develop as we expect or otherwise declines, we could fail to generate sufficient revenues to achieve profitability.



Beginning in 2004, we plan to convert to a measurement business model in which customers will receive our MedGem
and BodyGem devices, either through us or our distributors, that are preloaded with the ability to perform a specific number of metabolic measurements and can be reloaded with additional measurements. Customers will receive a
corresponding number of disposable mouthpieces at no additional charge and will periodically return the device to be reloaded with additional measurements. We have not had significant working experience with this measurement model and it is
difficult to predict customers purchasing patterns. As a result, there can be no assurance that we will be able to successfully introduce the measurement model, that the model and the corresponding preloaded MedGem and BodyGem devices will be
accepted by customers, or that we will recoup or realize a return on our capital investment and increase revenues. If the anticipated demand for these revised products fails to develop, our ability to generate revenues and achieve profitability
would be significantly harmed.



From time to time we may
experience difficulties or delays in the development, production or marketing of the preloaded devices. In addition, the preloaded devices could contain unknown errors or defects, which could result in rejection of our products, product recalls,
damage to our reputation, lost revenues, and increased service costs and warranty claims. Any of these results could materially harm our business.



Item 3. Quantitative and Qualitative Disclosures About Market Risk



Our interest income is sensitive to changes in the general level of interest rates in the United States, particularly since the majority of our
investments are short-term in nature. Due to the nature of our short-term investments, we have concluded that we do not have material market risk exposure.



Our investment policy requires us to invest funds in excess of current operating requirements. At September 30, 2003, our cash and cash equivalents
consisted primarily of money market and mutual funds with average maturities of less than 90 days. The recorded carrying amounts of cash and cash equivalents approximate fair value due to their short maturities.



Item 4. Controls and Procedures



Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and
procedures within 90 days of filing of this quarterly report, and, based on their evaluation, our principal executive officer and principal financial officer have concluded that these controls and procedures are effective. There were no significant
changes in our internal controls or other factors that could significantly affect these controls subsequent to the date of their evaluation.



Disclosure controls and procedures are our controls and other procedures that are designed to ensure that information required to be disclosed by us in
the reports that we file or submit under the Securities Exchange Act of 1934, as amended (the Exchange Act), is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange
Commissions rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange
Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.



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PART II. OTHER INFORMATION



Item 1. Legal Proceedings



In
the ordinary course of business, we may from time to time become involved in certain legal proceedings. As of the date of this quarterly report, we are not a party to any pending material legal proceedings.



Item 2. Changes in Securities and Use of Proceeds



Changes in Securities. On August 28, 2003, we issued a warrant to MARC USA/Pittsburgh, Inc. to purchase an aggregate of 100,000 shares of our common stock at an exercise price of $7.50 per share pursuant to a consulting arrangement.
We relied upon Rule 506 under the Securities Act of 1933, as amended (the Securities Act) and Section 4(2) of the Securities Act, as an exemption from the registration requirements of the Securities Act for the issuance of these
securities.



Use of Proceeds. On July 12, 2002, the initial public
offering of our common stock, $0.001 par value, commenced trading on the Nasdaq National Stock Market. The managing underwriters were UBS Warburg LLC, Credit Suisse First Boston Corporation, William Blair & Company, L.L.C. and Stifel, Nicolaus
& Company, Inc. The shares of common stock sold in the offering were registered under the Securities Act on a registration statement on Form S-1 (File No. 333-86076) that was declared effective by the SEC on July 12, 2002. All of the 4,000,000
shares of common stock registered under the registration statement were sold at a price to the public of $7.50 per share. All of the shares of common stock sold in the offering were sold by us. The offering did not terminate until after the sale of
all of the securities registered on the registration statement, which closing occurred on July 17, 2002. The aggregate gross proceeds were approximately $25.7 million after deducting $2.1 million in underwriting discounts and commissions and an
estimated $2.2 million in other expenses incurred in connection with the offering.



Upon closing of the initial public offering, we paid $1.75 million out of the proceeds of the offering to Dr. James R. Mault, our former Chief Executive Officer, as partial consideration for the sale and assignment of
patent rights by Dr. Mault to us.



We spent $3.5 million of the
proceeds from the offering to implement and support a marketing campaign that was launched in the fourth quarter of 2002 and concluded in the first quarter of 2003 and an additional $1.0 million for radio and print advertising for our BalanceLog
software product.



No other proceeds of the offering were paid,
directly or indirectly, to any other of our officers or directors or any of their associates, or to any persons owning 10% or more of our outstanding common stock or to any of our affiliates. We invested the remaining proceeds in short-term,
investment-grade, interest bearing instruments, pending their use to fund working capital and capital expenditures.



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##### Table of Contents

Item 3. Defaults Upon Senior Securities



None.



Item 4. Submission of Matters to a Vote of Security Holders



None.



Item 5. Other Information



Following the quarter ended September 30, 2003, our Board of Directors promoted Alexander Sandy MacPherson to the office of President and Chief Operating Officer and appointed Mr. MacPherson to serve as a member of our Board of
Directors. In addition, our Board of Directors appointed James W. Dennis to serve as Chairman of the Board.



Item 6. Exhibits and Reports on Form 8-K



| | (a) | Exhibits
| | --- | --------



|ExhibitNo. |   |  |                                                                                                                                                                               
|---------- | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|           |  
|4.17       |   |  | Warrant to Purchase Shares of Common Stock issued by the registrant to MARC USA/Pittsburgh, Inc.                                                                              
|           |  
|10.52      |   |  | Employment Offer Letter, dated February 22, 2003, between the registrant and Alexander MacPherson.                                                                            
|           |  
|10.53      |   |  | Employment Agreement, dated March 7, 2003, between the registrant and James W. Dennis.                                                                                        
|           |  
|10.54      |   |  | Employment Agreement, dated March 7, 2003, between the registrant and Stephen E. Webb.                                                                                        
|           |  
|10.55      |   |  | Termination Agreement and Mutual General Release, dated August 31, 2003, between the registrant and Sensors for Medicine and Science, Inc.                                    
|           |  
|10.56      | * |  | Amendment to Strategic Partnership Agreement, dated October 28, 2003, between the registrant and Mead Johnson & Company.                                                      
|           |  
|31.1       |   |  | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                           
|           |  
|31.2       |   |  | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                           
|           |  
|32.1       |   |  | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.

---

|* | Confidential treatment has been requested with respect to certain portions of this exhibit. Omitted portions have been filed separately with the SEC.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------



(b) Reports on Form 8-K:



During the third quarter ended September 30, 2003, the Company filed a
report on Form 8-K on July 30, 2003, regarding the issuance of a second quarter 2003 earnings press release dated July 30, 2003.



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##### Table of Contents

SIGNATURES



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



|Dated: November 6, 2003 |  |     |  | HEALTHETECH, INC. (Registrant)                                                                                  
|----------------------- |  | --- |  | ----------------------------------------------------------------------------------------------------------------
|                        |  |    
|                        |  | By: |  | /s/ James W. Dennis                                                                                             
|                        |  |     |  | James W. Dennis Chairman and Chief Executive Officer                                                            
|                        |  |    
|                        |  | By: |  | /s/ Stephen E. Webb                                                                                             
|                        |  |     |  | Stephen E. Webb Chief Financial Officer (Duly Authorized Officer and Principal Financial and Accounting
Officer)



23



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##### Table of Contents

EXHIBIT INDEX



|ExhibitNo. |   |  |                                                                                                                                                                               
|---------- | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|           |  
|4.17       |   |  | Warrant to Purchase Shares of Common Stock issued by the registrant to MARC USA/Pittsburgh, Inc.                                                                              
|           |  
|10.52      |   |  | Employment Offer Letter, dated February 22, 2003, between the registrant and Alexander MacPherson.                                                                            
|           |  
|10.53      |   |  | Employment Agreement, dated March 7, 2003, between the registrant and James W. Dennis.                                                                                        
|           |  
|10.54      |   |  | Employment Agreement, dated March 7, 2003, between the registrant and Stephen E. Webb.                                                                                        
|           |  
|10.55      |   |  | Termination Agreement and Mutual General Release, dated August 31, 2003, between the registrant and Sensors for Medicine and Science, Inc.                                    
|           |  
|10.56      | * |  | Amendment to Strategic Partnership Agreement, dated October 28, 2003, between the registrant and Mead Johnson & Company.                                                      
|           |  
|31.1       |   |  | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                           
|           |  
|31.2       |   |  | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                           
|           |  
|32.1       |   |  | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.

---

|* | Confidential treatment has been requested with respect to certain portions of this exhibit. Omitted portions have been filed separately with the SEC.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------