##### Table of Contents

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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 March 31, 2004
| |  | ---------------------------------------------



OR



| ̈ |  | 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: 0-21371



APPLIED IMAGING CORP.

(Exact name of
registrant as specified in its charter)



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 77-0120490                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



2380 Walsh Avenue,
Building B,

Santa Clara, California 95051

(Address of principal executive offices including zip code)



(408) 562-0250

(Registrants telephone number, including area code)



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 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 May 12, 2004 there were 19,072,502 shares of the Registrants
Common Stock outstanding.



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APPLIED IMAGING CORP.



INDEX



|        |  |                                                                                                                                    |  |      
|------- |  | ---------------------------------------------------------------------------------------------------------------------------------- |  | -----
|        |  |                                                                                                                                    |  | Page 
|        |  | PART I.    FINANCIAL INFORMATION                                                                                                   |  |      
|        |  |                                                                                                                                   
|Item 1. |  | Financial Statements (Unaudited)                                                                                                   |  |      
|        |  |                                                                                                                                   
|        |  | Condensed Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003                                                   |  | 3    
|        |  |                                                                                                                                   
|        |  | Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the three months ended March 31, 2004 and 2003 |  | 4    
|        |  |                                                                                                                                   
|        |  | Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2004 and 2003                                 |  | 5    
|        |  |                                                                                                                                   
|        |  | Notes to Condensed Consolidated Financial Statements                                                                               |  | 6-10 
|        |  |                                                                                                                                   
|Item 2. |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                              |  | 11-15
|        |  |                                                                                                                                   
|Item 3. |  | Quantitative and Qualitative Disclosures about Market Risk Derivatives and Financial Instruments                                   |  | 16   
|        |  |                                                                                                                                   
|Item 4. |  | Disclosure Controls and Procedures                                                                                                 |  | 16   
|        |  |                                                                                                                                   
|        |  | PART II.    OTHER INFORMATION                                                                                                      |  |      
|        |  |                                                                                                                                   
|Item 6. |  | Exhibits and Reports on Form 8-K                                                                                                   |  | 17   
|        |  |                                                                                                                                   
|        |  | Signatures                                                                                                                         |  | 18   



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PART IFINANCIAL INFORMATION



Item 1.    Financial Statements



APPLIED IMAGING CORP. AND SUBSIDIARIES



Condensed Consolidated Balance Sheets

(In thousands)

(Unaudited)



|                                           |  |                |         |   |                   |   |         |  
|------------------------------------------ |  | -------------- | ------- | - | ----------------- | - | ------- | -
|                                           |  | March 31, 2004 |         |   | December 31, 2003 |  
|ASSETS                                     |  |                |         |   |                   |   |         |  
|Current assets:                            |  |                |         |   |                   |   |         |  
|Cash and cash equivalents                  |  | $              | 1,845   |   |                   | $ | 2,047   |  
|Restricted cash                            |  |                | 183     |   |                   |   | 178     |  
|Trade accounts receivable, net             |  |                | 5,204   |   |                   |   | 6,365   |  
|Inventories                                |  |                | 1,092   |   |                   |   | 1,094   |  
|Prepaid expenses and other current assets  |  |                | 795     |   |                   |   | 537     |  
|                                           |  |                |         |   |                   |   |         |  
|Total current assets                       |  |                | 9,119   |   |                   |   | 10,221  |  
|Property and equipment, net                |  |                | 818     |   |                   |   | 812     |  
|Goodwill                                   |  |                | 2,364   |   |                   |   | 2,364   |  
|Other assets                               |  |                | 52      |   |                   |   | 18      |  
|                                           |  |                |         |   |                   |   |         |  
|Total assets                               |  | $              | 12,353  |   |                   | $ | 13,415  |  
|                                           |  |                |         |   |                   |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY       |  |                |         |   |                   |   |         |  
|Current liabilities:                       |  |                |         |   |                   |   |         |  
|Accounts payable                           |  | $              | 1,496   |   |                   | $ | 1,491   |  
|Accrued expenses                           |  |                | 1,966   |   |                   |   | 1,888   |  
|Bank debt                                  |  |                | 1,111   |   |                   |   | 1,728   |  
|Deferred revenue, current                  |  |                | 3,621   |   |                   |   | 3,543   |  
|Other current liabilities                  |  |                | 100     |   |                   |   |        |  
|                                           |  |                |         |   |                   |   |         |  
|Total current liabilities                  |  |                | 8,294   |   |                   |   | 8,650   |  
|Deferred revenue, non-current              |  |                | 430     |   |                   |   | 467     |  
|                                           |  |                |         |   |                   |   |         |  
|Total liabilities                          |  |                | 8,724   |   |                   |   | 9,117   |  
|                                           |  |                |         |   |                   |   |         |  
|Stockholders equity:                      |  |                |         |   |                   |   |         |  
|Common stock                               |  |                | 16      |   |                   |   | 16      |  
|Additional paid-in capital                 |  |                | 49,209  |   |                   |   | 49,207  |  
|Accumulated other comprehensive loss       |  |                | (367    | ) |                   |   | (367    | )
|Accumulated deficit                        |  |                | (45,229 | ) |                   |   | (44,558 | )
|                                           |  |                |         |   |                   |   |         |  
|Total stockholders equity                 |  |                | 3,629   |   |                   |   | 4,298   |  
|                                           |  |                |         |   |                   |   |         |  
|Total liabilities and stockholders equity |  | $              | 12,353  |   |                   | $ | 13,415  |  
|                                           |  |                |         |   |                   |   |         |  



The accompanying notes
are an integral part of these unaudited condensed

consolidated financial statements.



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APPLIED IMAGING CORP. AND SUBSIDIARIES



Condensed Consolidated Statements of Operations

and Comprehensive Income (Loss)

(in thousands, except per share data)

(Unaudited)



|                                    |  |                             |        |   |      |   |        |  
|----------------------------------- |  | --------------------------- | ------ | - | ---- | - | ------ | -
|                                    |  | Three months endedMarch 31, |       
|                                    |  | 2004                        |        |   | 2003 |  
|Revenues                            |  | $                           | 4,849  |   |      | $ | 5,415  |  
|Cost of revenues                    |  |                             | 1,840  |   |      |   | 2,164  |  
|                                    |  |                             |        |   |      |   |        |  
|Gross profit                        |  |                             | 3,009  |   |      |   | 3,251  |  
|                                    |  |                             |        |   |      |   |        |  
|Operating expenses:                 |  |                             |        |   |      |   |        |  
|Research and development            |  |                             | 891    |   |      |   | 847    |  
|Sales and marketing                 |  |                             | 1,707  |   |      |   | 1,855  |  
|General and administrative          |  |                             | 1,037  |   |      |   | 813    |  
|                                    |  |                             |        |   |      |   |        |  
|Total operating expenses            |  |                             | 3,635  |   |      |   | 3,515  |  
|                                    |  |                             |        |   |      |   |        |  
|Operating loss                      |  |                             | (626   | ) |      |   | (264   | )
|Other expense, net                  |  |                             | (45    | ) |      |   | (4     | )
|                                    |  |                             |        |   |      |   |        |  
|Net loss                            |  | $                           | (671   | ) |      | $ | (268   | )
|                                    |  |                             |        |   |      |   |        |  
|Net loss per share                  |  |                             |        |   |      |   |        |  
|basic and diluted                  |  | $                           | (0.04  | ) |      | $ | (0.02  | )
|                                    |  |                             |        |   |      |   |        |  
|Weighted average shares outstanding |  |                             |        |   |      |   |        |  
|basic and diluted                  |  |                             | 15,962 |   |      |   | 15,913 |  
|                                    |  |                             |        |   |      |   |        |  





The accompanying notes are an integral part of these unaudited condensed

consolidated
financial statements.



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APPLIED IMAGING CORP. AND SUBSIDIARIES



Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)



|                                                                                          |  |                             |        |   |      |   |        |  
|----------------------------------------------------------------------------------------- |  | --------------------------- | ------ | - | ---- | - | ------ | -
|                                                                                          |  | Three months endedMarch 31, |       
|                                                                                          |  | 2004                        |        |   | 2003 |  
|Cash flows from operating activities:                                                     |  |                             |        |   |      |   |        |  
|Net loss                                                                                  |  | $                           | (671   | ) |      | $ | (268   | )
|Adjustments to reconcile net loss to net cash provided by (used in) operating activities: |  |                             |        |   |      |   |        |  
|Depreciation and amortization                                                             |  |                             | 141    |   |      |   | 166    |  
|Provision for doubtful accounts                                                           |  |                             |       |   |      |   | (43    | )
|Changes in operating assets and liabilities:                                              |  |                             |        |   |      |   |        |  
|Trade accounts receivable                                                                 |  |                             | 1,161  |   |      |   | 906    |  
|Inventories                                                                               |  |                             | 2      |   |      |   | 253    |  
|Prepaid expenses and other current assets                                                 |  |                             | (258   | ) |      |   | (136   | )
|Accounts payable                                                                          |  |                             | 5      |   |      |   | (757   | )
|Accrued expenses                                                                          |  |                             | 78     |   |      |   | (68    | )
|Deferred revenue                                                                          |  |                             | 41     |   |      |   | (266   | )
|Other current liabilities                                                                 |  |                             | 100    |   |      |   |       |  
|                                                                                          |  |                             |        |   |      |   |        |  
|Net cash provided by (used in) operating activities:                                      |  |                             | 599    |   |      |   | (213   | )
|                                                                                          |  |                             |        |   |      |   |        |  
|Cash flows from investing activities:                                                     |  |                             |        |   |      |   |        |  
|Restricted cash                                                                           |  |                             | (5     | ) |      |   | (1     | )
|Purchases of property and equipment                                                       |  |                             | (147   | ) |      |   | (132   | )
|Other assets                                                                              |  |                             | (34    | ) |      |   |       |  
|                                                                                          |  |                             |        |   |      |   |        |  
|Net cash used in investing activities:                                                    |  |                             | (186   | ) |      |   | (133   | )
|                                                                                          |  |                             |        |   |      |   |        |  
|Cash flows from financing activities:                                                     |  |                             |        |   |      |   |        |  
|Net proceeds from issuance of common stock                                                |  |                             | 2      |   |      |   |       |  
|Bank and other loan proceeds                                                              |  |                             | 2,781  |   |      |   | 3,441  |  
|Bank and other loan payments                                                              |  |                             | (3,398 | ) |      |   | (4,132 | )
|                                                                                          |  |                             |        |   |      |   |        |  
|Net cash used in financing activities:                                                    |  |                             | (615   | ) |      |   | (691   | )
|                                                                                          |  |                             |        |   |      |   |        |  
|Net decrease in cash and cash equivalents                                                 |  |                             | (202   | ) |      |   | (1,037 | )
|Cash and cash equivalents at beginning of period                                          |  |                             | 2,047  |   |      |   | 2,897  |  
|                                                                                          |  |                             |        |   |      |   |        |  
|Cash and cash equivalents at end of period                                                |  | $                           | 1,845  |   |      | $ | 1,860  |  
|                                                                                          |  |                             |        |   |      |   |        |  



The accompanying notes
are an integral part of these unaudited condensed

consolidated financial statements.



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APPLIED IMAGING CORP. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



NOTE 1Basis of Presentation



The accompanying condensed consolidated financial statements include the
accounts of Applied Imaging Corp. and subsidiaries (the Company, we, us, our) for the three months ended March 31, 2004 and 2003. These financial statements are unaudited and reflect all adjustments,
consisting only of normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation of our financial position, operating results and cash flows for those interim periods presented. The results of operations
for the three months ended March 31, 2004 are not necessarily indicative of results to be expected for the fiscal year ending December 31, 2004. These condensed consolidated financial statements should be read in conjunction with the consolidated
financial statements and notes thereto, for the year ended December 31, 2003, contained in our 2003 annual report on Form 10-K.



Liquidity:    We expect negative cash flow from operations through at least 2004, as we continue research and development of new applications
for our OncoPathTMsystems, conduct clinical trials required for the U.S. Food and Drug Administration
(FDA) clearance of new products, litigate against ChromaVision, expand our marketing, sales and customer support capabilities, and add additional infrastructure. We currently estimate that our capital resources will enable us to meet our
capital needs for at least the next twelve months.



However,
expenditures required to achieve growth and profitability in the long term may be greater than projected or the cash flow generated from operations may be less than projected. As a result, our long-term capital needs may require us to try to obtain
additional funds through equity or debt financing, collaborative or other arrangements with other companies, bank financing and other sources. We have expended and will continue to expend substantial amounts of money for research and development,
litigation, preclinical testing, conducting clinical trials for FDA clearance of new products, capital expenditures, working capital needs and manufacturing and marketing of our products. Our future research and development efforts, in particular,
are expected to include development of additional applications of our current cytogenetic products and additional applications for the OncoPath systems, which may require additional funds.



There can be no assurance that we will be able to obtain additional debt or equity financing if needed and on terms acceptable to us. If adequate and
acceptable funding is not available, we could be required to delay development or commercialization of certain products, to license to third parties the rights to commercialize certain products or technologies that we would otherwise seek to
commercialize internally, or to reduce the marketing, customer support, or other resources devoted to product development. Accordingly, our failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on
our ability to achieve our long-term business objectives.



We
established a loan agreement with Silicon Valley Bank (SVB) on September 28, 2001. This new facility replaced a three-year term loan and a revolving line of credit that had an outstanding balance of $1.2 million on September 28, 2001. The new loan
agreement provided the capability to borrow up to $2.0 million based on the level of certain of our North American accounts receivable and inventories. On August 15, 2002 and on October 4, 2002, the loan agreement was amended to extend the term of
the loan for an additional year, through September 27, 2003, to increase borrowing capability to $3.5 million (based on the level of



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certain of our North American accounts receivable) and to increase the requirement for us to maintain a minimum level of
tangible net worth. On September 3, 2003, the loan agreement was amended to extend the term of the loan for an additional year, through September 26, 2004, and to establish the minimum level of net tangible worth that we had to maintain through the
end of the loan agreement. We were not in compliance with the covenant requiring us to maintain $2.2 million in minimum tangible net worth at December 31, 2003 and we obtained a waiver for this covenant violation and potential non-compliance with
the minimum net tangible worth covenant in January and February 2004. On March 31, 2004, the loan agreement was amended to extend the term of the loan through March 31, 2005 and to establish the minimum level of net tangible worth that we had to
maintain through the end of the loan agreement. We were in compliance with the loan covenant at March 31, 2004.



At March 31, 2004, we had used $1,111,000 of the facility with $1,005,000 available but not used. The interest rate on the facility was 6.0% at March 31,
2004, computed as the SVB prime rate plus 2.0 percent. The loan is collateralized by substantially all of the assets of the U.S. corporation and requires maintenance of a minimum level of tangible net worth. Other loan covenants include the need to
maintain insurance on our property, monthly reporting to SVB, the need to obtain SVB approval for any extraordinary action and a limitation on the U.S. corporations ability to transfer more than $600,000 to a subsidiary.



We collateralize various credit card and bank guarantees (used for customs
clearance purposes) with cash deposits at an international bank in the United Kingdom. This amounted to £100,000 ($183,000) at March 31, 2004.



NOTE 2Inventories (in thousands)



|                |  |               |       |                  |   |      
|--------------- |  | ------------- | ----- | ---------------- | - | -----
|Balance as of   |  | March 31,2004 |       | December 31,2003
|Raw materials   |  | $             | 942   |                  | $ | 994  
|Work in process |  |               | 61    |                  |   | 25   
|Finished goods  |  |               | 89    |                  |   | 75   
|                |  |               |       |                  |   |      
|Total           |  | $             | 1,092 |                  | $ | 1,094
|                |  |               |       |                  |   |      



NOTE 3Net income (loss)
per share



The computation
of basic and diluted net loss per share (EPS) for the three months ended March 31, 2004 and March 31, 2003 is determined by dividing net loss as reported as the numerator by the number of shares included in the denominator as shown in
the following table (in thousands):



|                                            |  |                              |  |       
|------------------------------------------- |  | ---------------------------- |  | ------
|                                            |  | Three months ended March 31,
|                                            |  | 2004                         |  | 2003  
|Weighted average shares outstandingbasic   |  | 15,962                       |  | 15,913
|Dilutive sharesstock options               |  |                             |  |      
|Dilutive shareswarrants                    |  |                             |  |      
|                                            |  |                              |  |       
|Weighted average shares outstandingdiluted |  | 15,962                       |  | 15,913
|                                            |  |                              |  |       



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Securities excluded from the computation of EPS because their effect on EPS was antidilutive, but could
dilute basic EPS in future periods are as follows (in thousands):



|         |  |           |  |      
|-------- |  | --------- |  | -----
|         |  | March 31,
|         |  | 2004      |  | 2003 
|Options  |  | 3,277     |  | 3,153
|Warrants |  | 800       |  | 1,222
|         |  |           |  |      
|Total    |  | 4,077     |  | 4,375
|         |  |           |  |      



NOTE 4Stock Based
Compensation



We account for stock-based employee
compensation arrangements in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. Under APB No. 25, compensation expense is based on the difference, if
any, between the fair value of our stock and the exercise price on the date of the grant.



We have adopted the pro forma disclosure provisions of Statement of Financial Accounting Standards (SFAS) No. 148 Accounting for Stock-Based CompensationTransition and DisclosureAn
amendment of FASB No. 123 for the 1998 Stock Plan and Employee Stock Purchase Plan. The fair value of the stock options granted to employees is calculated using the Black-Scholes option pricing model as of the date of grant. Had compensation
cost for our stock-based compensation plans been determined in a manner consistent with the fair value approach described in SFAS No. 123, our net loss and net loss per share as reported would have been changed to the pro forma amounts indicated
below (in thousands, except per share data):



|                                                                             |  |                             |       |   |      |   |       |  
|---------------------------------------------------------------------------- |  | --------------------------- | ----- | - | ---- | - | ----- | -
|                                                                             |  | Three months endedMarch 31, |      
|                                                                             |  | 2004                        |       |   | 2003 |  
|Net loss:                                                                    |  |                             |       |   |      |   |       |  
|As reported                                                                  |  | $                           | (671  | ) |      | $ | (268  | )
|Stock-based employee compensation expense determined under fair-value method |  |                             | (174  | ) |      |   | (201  | )
|                                                                             |  |                             |       |   |      |   |       |  
|Pro forma                                                                    |  | $                           | (845  | ) |      | $ | (469  | )
|                                                                             |  |                             |       |   |      |   |       |  
|Net loss per share:                                                          |  |                             |       |   |      |   |       |  
|As reportedbasic and diluted                                                |  | $                           | (0.04 | ) |      | $ | (0.02 | )
|                                                                             |  |                             |       |   |      |   |       |  
|Pro formabasic and diluted                                                  |  | $                           | (0.05 | ) |      | $ | (0.03 | )
|                                                                             |  |                             |       |   |      |   |       |  



The fair value of each
option is estimated on the date of grant using the fair value method with the following weighted-average assumptions:



|                         |  |                             |   |  |      |  
|------------------------ |  | --------------------------- | - |  | ---- | -
|                         |  | Three months endedMarch 31, |  
|                         |  | 2004                        |   |  | 2003 |  
|Risk-free interest rate  |  | 2.03                        | % |  | 2.07 | %
|Expected life (in years) |  | 3                           |   |  | 3    |  
|Dividend yield           |  |                            | % |  |     | %
|Expected volatility      |  | 74                          | % |  | 83   | %



All of the above
assumptions were used for the Employee Stock Purchase Plan except that the expected life is six months.



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We account for equity instruments issued to non-employees in accordance with the provisions of SFAS No.
123 Accounting for Stock-based Compensation and Emerging Issues Task Force (EITF) Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction With Selling
Goods and Services.



NOTE 5Product Warranty



We generally warrant our products against defects for a
period of one year and record a liability for such product warranty obligations at the time of sale based upon historical experience. We do not provide separately priced extended warranty coverage. However, we sell separately priced service
contracts to provide additional service coverage on our systems when the warranty period expires. The related revenue on the service contracts is recognized on a straight-line basis over the life of the service contract, which is generally one year.
Costs associated with services performed under the service contract obligation are expensed as incurred.



Changes in product warranty obligations for the three months ended March 31, 2004 and March 31, 2003 are as follows (in thousands):



|                                            |  |      |     |   |      |   |     |  
|------------------------------------------- |  | ---- | --- | - | ---- | - | --- | -
|                                            |  | 2004 |     |   | 2003 |  
|Balance as of beginning of quarter          |  | $    | 102 |   |      | $ | 127 |  
|Add accruals for warranties issued          |  |      | 56  |   |      |   | 29  |  
|Less costs incurred under warranties issued |  |      | (20 | ) |      |   | (7  | )
|                                            |  |      |     |   |      |   |     |  
|Balance as of end of quarter                |  | $    | 138 |   |      | $ | 149 |  
|                                            |  |      |     |   |      |   |     |  



NOTE 6Other Income
(Expense)



The details of other income (expense) are
shown below (in thousands):



|                             |  |                              |     |   |      |   |     |  
|---------------------------- |  | ---------------------------- | --- | - | ---- | - | --- | -
|                             |  | Three months ended March 31, |    
|                             |  | 2004                         |     |   | 2003 |  
|Interest income              |  | $                            | 4   |   |      | $ | 6   |  
|Interest expense             |  |                              | (22 | ) |      |   | (32 | )
|Foreign exchange gain (loss) |  |                              | (26 | ) |      |   | 18  |  
|Income taxes                 |  |                              | (4  | ) |      |   | (3  | )
|Miscellaneous                |  |                              | 3   |   |      |   | 7   |  
|                             |  |                              |     |   |      |   |     |  
|Total                        |  | $                            | (45 | ) |      | $ | (4  | )
|                             |  |                              |     |   |      |   |     |  



NOTE 7Recent Accounting
Pronouncements



In December 2003, the Financial
Accounting Standards Board (FASB) issued a revised FASB Interpretation No. 46 (FIN 46R), Consolidation of Variable Interest Entities, an interpretation of ARB No. 51. The FASB published the revision to clarify and
amend some of the original provisions of FIN 46, which was issued in January 2003, and to exempt certain entities from its requirements. A variable interest entity (VIE) refers to an entity subject to consolidation according to the
provisions of this Interpretation. FIN 46R applies to entities whose equity



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investment at risk is insufficient to finance that entitys activities without receiving additional subordinated
financial support provided by any parties, including equity holders, or where the equity investors (if any) do not have a controlling financial interest. FIN 46R provides that if an entity is the primary beneficiary of a VIE, the assets,
liabilities, and results of operations of the VIE should be consolidated in the entitys financial statements. In addition, FIN 46R requires that both the primary beneficiary and all other enterprises with a significant variable interest in a
VIE provide additional disclosures. The provisions of FIN 46R were effective for the Companys fiscal 2004 first quarter. The adoption of FIN 46R did not have a material impact on our financial position or results of operations.



NOTE 8Commitments and Contingencies



On February 24, 2004 we received notice of a lawsuit alleging patent
infringement filed against us by ChromaVision Medical Systems, Inc. The lawsuit, as subsequently amended, claims that our Ariol system infringes on four ChromaVision patents. ChromaVision is seeking unspecified damages, as well as an injunction barring us from, among other
things, making, using, or selling any device in the United States that incorporates ChromaVisions patented technology.



On April 15, 2004, we filed a motion in the United States District Court for the Southern District of California to transfer the litigation to the United
States District Court for the Northern District of California, based in the San Francisco Bay Area. A hearing has been scheduled by the court on this motion for May 24, 2004.



On April 20, 2004, we responded to ChromaVisions complaint by denying ChromaVisions infringement allegations and
by asserting the invalidity of ChromaVisions alleged patents, trademarks and copyrights. In addition, we are countersuing ChromaVision for infringing our valid US Patent 6,633,662. We are seeking an injunction against ChromaVisions
continued manufacture, sale and use of the Automated Cellular Imaging System (ACIS®) in the United States and enhanced economic damages for ChromaVisions willful infringement. We have also asserted claims against ChromaVision for intentionally interfering with our relationships with our
customers, unfair competition and false advertising under the Lanham Act, as well as misappropriation of trade secrets.



Because of the inherent complexity and unpredictable nature of patent litigation we are not able to make any predictions regarding the outcome of this
litigation. As a result, we have not made any provisions for either a favorable or unfavorable outcome to this litigation.



NOTE 9Subsequent Events



On April 13, 2004, we completed the private placement of 3.1 million shares of common stock and warrants to purchase 620,000 additional shares of common
stock for an aggregate purchase price of $4.25 million. Each warrant is exercisable for one share of common stock at an exercise price of $1.70 per share, from six months following the closing date of April 13, 2004 until October 13, 2009.



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



The following discussion should be read in conjunction with the attached unaudited condensed consolidated financial statements and notes, and with
our audited financial statements and notes for the fiscal year ended December 31, 2003.



This quarterly report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Our actual results could differ materially from those predicted in the
forward-looking statements as a result of risks and uncertainties including, but not limited to, those discussed in this quarterly report and those discussed under Item 1Business, Additional Factors That Might Affect Future
Results, commencing on page 12 in our Annual Report on Form 10-K for the fiscal year ended December 31, 2003. You should not rely on these forward-looking statements, which reflect our position as of the date of this report. We are under no
obligation to revise or update any forward-looking statements.



Results
of Operations



Revenues.    Our revenues are
derived primarily from the sale of systems, service contracts, software maintenance and grant revenues. Revenues for the three months ended March 31, 2004 were $4.8 million compared to $5.4 million for the corresponding period in 2003. The decrease
in revenues in the quarter was due primarily to lower international sales caused by weakness in several of our international markets.



Sales of systems were $3.6 million in the three months ended March 31, 2004, compared to $4.1 million for the corresponding period in 2003. The decrease
in system revenues in the current quarter was due primarily to lower international sales caused by weakness in several of our international markets.



Service contract, software maintenance and grant revenues were $1,256,000 in the three months ended March 31, 2004, essentially the same level as in the
corresponding period in 2003 ($1,300,000).



Cost of
revenues.    Cost of revenues includes direct material and labor costs, manufacturing overhead, installation costs, warranty-related expenses and service and application support expenses. Costs of revenues for the three
months ended March 31, 2004 were $1.8 million, compared to $2.2 million for the corresponding period in 2003. Cost of revenues, as a percentage of total revenues, for the three months ended March 31, 2004 were 38% compared to 40% for the
corresponding prior year period. The decrease is primarily due to the sale of a number of our Ariol systems during the first quarter of 2003 at a lower gross margin percent for market development purposes. There were no such sales during the first quarter of 2004.



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Research and development expenses.    Research and development expenses for the three months
ended March 31, 2004 were $891,000, compared to $847,000 in the comparative prior year period. This increase in the first quarter is due primarily to $46,000 in costs associated with additional research staff in the U.S.



Sales and marketing expenses.    Sales and marketing expenses for
the three months ended March 31, 2004 were $1.7 million, compared to $1.9 million in the comparative prior year period. The decline was due primarily to lower commissions paid to our distributors outside North America.



General and administrative expenses.    General and administrative
expenses for the first quarter of 2004 were $1.0 million, compared to $813,000 in the comparative prior year quarter. The increase in general and administrative expenses in the first quarter was primarily attributable to outside professional
accountant services of $105,000 and $80,000 for additional personnel costs in the U.S.



Other expenseThe other expense of $45,000 in the first quarter of 2004 was due primarily to interest expense of $22,000 and foreign exchange losses of $26,000. Other expense of $4,000 in the first three months
of 2003 was primarily comprised of $32,000 in interest expense payable on our bank borrowings and $18,000 of foreign currency gains. The foreign currency losses incurred in the first three months of 2004 were due to the impact of the weakening of
the U.S. dollar versus foreign currencies on the translation of various balance sheet items from foreign currencies into the U.S. dollar. The foreign currency gains incurred in the first three months of 2003 were due to the impact of the
strengthening of the U.S. dollar versus the foreign currencies on the translation of various balance sheet items from foreign currencies into the U.S. dollar.



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Liquidity and Capital Resources



At March 31, 2004, we had cash, cash equivalents and restricted cash of $2.0 million and working capital of $825,000,
compared to $2.2 million and $1.6, million, respectively, at December 31, 2003. Restricted cash, which collateralizes various credit card and bank guarantees in the United Kingdom, amounted to $183,000 at March 31, 2004 and $178,000 at December 31,
2003.



Cash provided by operations for the three months ended
March 31, 2004 was $599,000, compared to cash used in operations of $213,000 for the first three months of 2003. Changes in the components of cash used in operations included: an increase in net loss amounting to $403,000 (a net loss of $671,000 in
the first three months of 2004 versus a net loss of $268,000 in the first three months of 2003), and decreased requirements for trade accounts receivables of $255,000 (a decrease of $1.2 million in the first quarter of 2004 reflecting improved
collections versus a decrease of $906,000 in the first three months of 2004) and for inventories of $251,000 (a decrease of $2,000 in 2004 and a decrease of $253,000 in 2003 reflecting a reduction in the components that had been built up for new
products.) Accounts payable increased $762,000 (an increase of $5,000 in the first three months of 2004 and a decrease of $757,000 in 2003). The decrease in the first quarter of 2003 was due primarily to a reduction in accounts payable to vendors
supplying system components, reflecting lower inventory at the end of the quarter.



Trade accounts receivable as a percent of first quarter revenues were 107% at March 31, 2004, compared to 116% at March 31, 2003 and 124% at December 31, 2003, reflecting improved collections in the quarter. This
strong relationship between quarter-end receivables and that quarters sales is primarily due to the fact that most of our sales occur late in the quarter as is typical of a capital equipment business. Although our payment terms are net 30
days, certain customers, specifically government, university, Asian and European customers, tend to take longer to pay their receivable balances.



Cash used in investing activities was $186,000 in the first three months of 2004, compared to $133,000 in the first three months of 2003. We invested
$147,000 for purchases of capital equipment in the first three months of 2004, compared to $132,000 in the first three months of 2003.



Cash used in financing activities was $615,000 in the first three months of 2004, compared to $691,000 in the first three months of 2003. In both
quarters, this was primarily due to repayments on our bank line with Silicon Valley Bank (SVB).



We established a loan agreement with SVB on September 28, 2001. This new facility replaced a three-year term loan and a revolving line of credit that had
an outstanding balance of $1.2 million on September 28, 2001. The new loan agreement provided the capability to borrow up to $2.0 million based on the level of certain of our North American accounts receivable and inventories. On August 15, 2002 and
on October 4, 2002, the loan agreement was amended to extend the term of the loan for an additional year, through September 27, 2003, to increase borrowing capability to $3.5 million (based on the level of certain of our North American accounts
receivable) and to increase the requirement for us to maintain a minimum level of tangible net worth. On September 3, 2003, the loan agreement was amended to extend the term of the loan for an additional year, through September 26, 2004, and to
establish the minimum level of net tangible worth that we had to maintain through the end of the loan agreement. We were not in compliance with the covenant requiring us to maintain $2.2 million in minimum tangible net worth at December 31, 2003 and
we obtained a waiver for this covenant violation and potential non-compliance with the minimum net tangible worth covenant in January and February, 2004. On March 31, 2004, the loan agreement was amended to extend the term of the loan through March



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31, 2005 and to establish the minimum level of net tangible worth that we had to maintain through the end of the loan agreement.

We were in compliance with the loan covenant at March 31, 2004.



At March 31, 2004, we had used $1,111,000 of the facility with $1,005,000 available but not used. The interest rate on the facility was 6.0% at March 31,
2004, computed as the SVB prime rate plus 2 percent. The loan is collateralized by substantially all of the assets of the U.S. corporation and requires maintenance of a minimum level of tangible net worth. Other loan covenants include the need to
maintain insurance on our property, monthly reporting to SVB, the need to obtain SVB approval for any extraordinary action and a limitation on the U.S. corporations ability to transfer more than $600,000 to a subsidiary.



We have received from SVB various waivers of our non-compliance with the loan
covenant requiring us to maintain a minimum level of tangible net worth. There is no assurance that SVB will continue to provide such waivers in the future. In the event that we are unable to remain in compliance with this covenant, we would have to
repay any outstanding balance on the SVB loan, which could limit our ability to fund our working capital and growth objectives.



We collateralize various credit card and bank guarantees (used for customs clearance purposes) with cash deposits at an international bank in the United
Kingdom. This amounted to £100,000 ($183,000) at March 31, 2004.



We expect negative cash flow from operations through at least 2004, as we continue research and development of new applications for our OncoPathTMsystems, conduct clinical trials required for the U.S. Food and Drug Administration (FDA) clearance of new products, litigate against ChromaVision, expand our marketing, sales and customer
support capabilities, and add additional infrastructure. We currently estimate that our capital resources will enable us to meet our capital needs for at least the next twelve months.



However, expenditures required to achieve growth and profitability in the long term may be greater than projected or the
cash flow generated from operations may be less than projected. As a result, our long-term capital needs may require us to try to obtain additional funds through equity or debt financing, collaborative or other arrangements with other companies,
bank financing and other sources. We have expended and will continue to expend substantial amounts of money for research and development, preclinical testing, conducting clinical trials for FDA clearance of new products, capital expenditures,
working capital needs and manufacturing and marketing of our products. Our future research and development efforts, in particular, are expected to include development of additional applications of our current cytogenetic products and additional
applications for the OncoPath systems, which may
require additional funds.



There can be no assurance that we
will be able to obtain additional debt or equity financing if needed and on terms acceptable to us. If adequate and acceptable funding is not available, we could be required to delay development or commercialization of certain products, to license
to third parties the rights to commercialize certain products or technologies that we would otherwise seek to commercialize internally, or to reduce the marketing, customer support, or other resources devoted to product development. Accordingly, our
failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on our ability to achieve our long-term business objectives.



We transferred our listing from the Nasdaq National Market to the Nasdaq SmallCap Market, which has less stringent listing
requirements, as of February 4, 2003. As a result, we may find it more difficult to raise additional capital should the need arise in the future.



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We prepare our financial statements in conformity with accounting principles generally accepted in the
United States of America. These principles are subject to interpretation by the Securities and Exchange Commission (the SEC) and various bodies formed to interpret and create appropriate accounting policies. A change in these policies
can have a significant effect on our reported results and may even retroactively affect previously reported transactions. In particular, changes to FASB guidelines relating to accounting for stock-based compensation will likely increase our
compensation expense, could make our net income less predictable in any given reporting period and could change the way we compensate our employees or cause other changes in the way we conduct our business.



Recent Accounting Pronouncements



In December 2003, the FASB issued a revised FASB Interpretation No. 46
(FIN 46R), Consolidation of Variable Interest Entities, an interpretation of ARB No. 51. The FASB published the revision to clarify and amend some of the original provisions of FIN 46, which was issued in January 2003, and to
exempt certain entities from its requirements. A variable interest entity (VIE) refers to an entity subject to consolidation according to the provisions of this Interpretation. FIN 46R applies to entities whose equity investment at risk
is insufficient to finance that entitys activities without receiving additional subordinated financial support provided by any parties, including equity holders, or where the equity investors (if any) do not have a controlling financial
interest. FIN 46R provides that if an entity is the primary beneficiary of a VIE, the assets, liabilities, and results of operations of the VIE should be consolidated in the entitys financial statements. In addition, FIN 46R requires that both
the primary beneficiary and all other enterprises with a significant variable interest in a VIE provide additional disclosures. The provisions of FIN 46R are effective for the Companys fiscal 2004 first quarter. The adoption of FIN 46R did not
have a material impact on our financial position or results of operations.



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Item 3.    Quantitative and Qualitative Disclosures about Market Risk Derivatives and Financial Instruments.



For the three months ended March 31, 2004, there were no material changes from the disclosures made in our Form 10-K for the year ended December 31, 2003.
We maintain our funds as cash or cash equivalents, primarily in money market investments with a maturity of less than 90 days. We invested these funds at an average interest rate of 0.85% during the first quarter of 2004. These investments are not
subject to interest rate risk.



Item 4.    Disclosure Controls and Procedures.



(a) Evaluation of disclosure controls and procedures.Based on their evaluation as of the end of the period covered by this Quarterly Report on
Form 10-Q, our chief executive officer and chief financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the Exchange Act) are
effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission
rules and forms.



(b) Changes in internal control over
financial reporting. There were no changes in our internal control over financial reporting or in other factors during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control
over financial reporting.



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PART IOTHER INFORMATION



Item 6.    Exhibits and Reports on Form 8-K.



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



|            |  |                                                                                                                                                
|----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                    
|31.1        |  | Chief Executive Officers Certification Pursuant to 15 U.S.C. Section 7241                                                                     
|            | 
|31.2        |  | Chief Financial Officers Certification Pursuant to 15 U.S.C. Section 7241                                                                     
|            | 
|32.1        |  | Certificate of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
|            | 
|32.2        |  | Certificate of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002



| | (b) |  | Reports on Form 8-K
| | --- |  | -------------------



On March 19, 2004, we filed a Current Report on Form 8-K which contained as an exhibit a copy of our press release announcing earnings for the fourth
quarter of fiscal 2003.



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APPLIED IMAGING CORP.



SIGNATURES



Pursuant to the requirements of the
Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on our behalf by the undersigned thereunto duly authorized.



|                   |  |  |  |                                    |  |                        |  |                                                        
|------------------ |  |  |  | ---------------------------------- |  | ---------------------- |  | -------------------------------------------------------
|                   |  |  |  | APPLIED IMAGING CORP. (Registrant)
|                   |  |  | 
|Date: May 17, 2004 |  |  |  | By:                                |  | /s/    CARL
HULL      
|                   |  |  |  |                                    |  |                        |  | Carl Hull Chief Executive Officer                      
|                   |  |  | 
|Date: May 17, 2004 |  |  |  | By:                                |  | /s/    BARRY
HOTCHKIES
|                   |  |  |  |                                    |  |                        |  | Barry Hotchkies Vice President, Chief Financial Officer



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