##### 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 September 30, 2004 OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 Commission File Number 000-49755   QUINTON CARDIOLOGY SYSTEMS, INC.  Delaware
    
    94-3300396(State of Incorporation)
    
    (IRS Employer Identification No.)
 3303 Monte Villa Parkway
Bothell, Washington 98021
(Address of principal executive offices) (425) 402-2000
(Registrants telephone number) 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. YESx NOo Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). YESx NOo The number of shares outstanding of the registrants common stock as of
November 1, 2004 was 14,036,783. 1




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TABLE OF CONTENTS PART I  FINANCIAL INFORMATION
    
    
    3Item 1. Financial Statements
    
    
    3Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    29Item 4. Controls and Procedures
    
    
    29PART II  OTHER INFORMATION
    
    
    30Item 1. Legal Proceedings
    
    
    30Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    30Item 3. Defaults Upon Senior Securities
    
    
    30Item 4. Submission of Matters to a Vote of Security Holders
    
    
    30Item 5. Other Information
    
    
    30Item 6. Exhibits
    
    
    30SIGNATURE
    
    
    31EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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PART I  FINANCIAL INFORMATION 
 Item 1. Financial Statements QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts) December 31,
    
    September 30,2003
    
    2004ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    185
    
    
    $
    17,774Accounts receivable, net of allowance for doubtful accounts
    
    
    12,480
    
    
    
    13,848Inventories
    
    
    12,690
    
    
    
    10,802Prepaid expenses and other current assets
    
    
    1,419
    
    
    
    1,549Total current assets
    
    
    26,774
    
    
    
    43,973Machinery and equipment, net of accumulated depreciation and
amortization
    
    
    4,918
    
    
    
    4,320Intangible assets, net of accumulated amortization
    
    
    5,672
    
    
    
    5,700Investment in unconsolidated entity
    
    
    1,000
    
    
    
    1,000Goodwill
    
    
    9,953
    
    
    
    9,690Total assets
    
    $
    48,317
    
    
    $
    64,683LIABILITIES AND SHAREHOLDERS EQUITYCurrent Liabilities:Line of credit
    
    $
    354
    
    
    $
    Current portion of long term debt
    
    
    363
    
    
    
    91Accounts payable
    
    
    6,183
    
    
    
    5,993Accrued liabilities
    
    
    7,349
    
    
    
    4,406Warranty liability
    
    
    2,059
    
    
    
    2,009Deferred revenue
    
    
    4,499
    
    
    
    4,365Total current liabilities
    
    
    20,807
    
    
    
    16,864Deferred tax liability
    
    
    1,180
    
    
    
    1,194Total liabilities
    
    
    21,987
    
    
    
    18,058Minority interest in consolidated entity
    
    
    198
    
    
    
    163Shareholders Equity:Preferred stock (10,000,000 shares authorized), $0.001 par
value, no shares outstanding in 2003 or 2004
    
    
    
    
    
    
    Common stock (65,000,000 shares authorized), $0.001 par
value, 12,214,905 and 14,031,583 shares issued and
outstanding at December 31, 2003 and September 30,
2004, respectively
    
    
    45,617
    
    
    
    61,804Deferred stock-based compensation
    
    
    (106
    )
    
    
    (52
    )Accumulated deficit
    
    
    (19,379
    )
    
    
    (15,290
    )Total shareholders equity
    
    
    26,132
    
    
    
    46,462Total liabilities and shareholders equity
    
    $
    48,317
    
    
    $
    64,683
 The accompanying notes are an integral part of these unaudited condensed
consolidated financial statements. 3




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QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except share and per share amounts) Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2003
    
    2004
    
    2003
    
    2004Revenues:Systems
    
    $
    17,747
    
    
    $
    19,434
    
    
    $
    52,308
    
    
    $
    56,502Service
    
    
    3,287
    
    
    
    3,064
    
    
    
    9,715
    
    
    
    9,296Total revenues
    
    
    21,034
    
    
    
    22,498
    
    
    
    62,023
    
    
    
    65,798Cost of Revenues:Systems
    
    
    10,669
    
    
    
    10,800
    
    
    
    31,793
    
    
    
    31,666Service
    
    
    1,777
    
    
    
    1,798
    
    
    
    5,356
    
    
    
    5,556Total cost of revenues
    
    
    12,446
    
    
    
    12,598
    
    
    
    37,149
    
    
    
    37,222Gross profit
    
    
    8,588
    
    
    
    9,900
    
    
    
    24,874
    
    
    
    28,576Operating Expenses:Research and development
    
    
    1,969
    
    
    
    1,882
    
    
    
    6,045
    
    
    
    5,509Write off of purchased in-process research and
development projects
    
    
    
    
    
    
    
    
    
    
    1,290
    
    
    
    Sales and marketing
    
    
    4,519
    
    
    
    4,768
    
    
    
    13,336
    
    
    
    13,506General and administrative, excluding
stock-based compensation expense
    
    
    1,838
    
    
    
    1,974
    
    
    
    5,807
    
    
    
    6,011Stock-based compensation
    
    
    18
    
    
    
    18
    
    
    
    54
    
    
    
    54Total operating expenses
    
    
    8,344
    
    
    
    8,642
    
    
    
    26,532
    
    
    
    25,080Operating income (loss)
    
    
    244
    
    
    
    1,258
    
    
    
    (1,658
    )
    
    
    3,496Other Income (Expense):Interest income
    
    
    
    
    
    
    54
    
    
    
    10
    
    
    
    75Interest expense
    
    
    (63
    )
    
    
    (16
    )
    
    
    (221
    )
    
    
    (97
    )Interest income, putable warrants
    
    
    
    
    
    
    
    
    
    
    32
    
    
    
    Other income (expense), net
    
    
    2
    
    
    
    17
    
    
    
    (7
    )
    
    
    650Total other income (expense)
    
    
    (61
    )
    
    
    55
    
    
    
    (186
    )
    
    
    628Income (loss) before income taxes and minority
interest in consolidated entity
    
    
    183
    
    
    
    1,313
    
    
    
    (1,844
    )
    
    
    4,124Income tax provision
    
    
    (4
    )
    
    
    
    
    
    
    (13
    )
    
    
    (70
    )Income (loss) before minority interest in
consolidated entity
    
    
    179
    
    
    
    1,313
    
    
    
    (1,857
    )
    
    
    4,054Minority interest in loss of consolidated entity
    
    
    4
    
    
    
    5
    
    
    
    24
    
    
    
    35Net income (loss)
    
    $
    183
    
    
    $
    1,318
    
    
    $
    (1,833
    )
    
    $
    4,089Net income (loss) per share  basic
    
    $
    0.02
    
    
    $
    0.09
    
    
    $
    (0.15
    )
    
    $
    0.31Net income (loss) per share  diluted
    
    $
    0.01
    
    
    $
    0.09
    
    
    $
    (0.15
    )
    
    $
    0.29Weighted average shares outstanding  basic
    
    
    12,168,390
    
    
    
    13,940,839
    
    
    
    12,131,066
    
    
    
    13,001,058Weighted average shares outstanding  diluted
    
    
    13,052,236
    
    
    
    14,699,294
    
    
    
    12,131,066
    
    
    
    13,951,790
 The accompanying notes are an integral part of these unaudited condensed
consolidated financial statements. 4




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QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2003
    
    2004
    
    2003
    
    2004Operating Activities:Net income (loss)
    
    $
    183
    
    
    $
    1,318
    
    
    $
    (1,833
    )
    
    $
    4,089Adjustments to reconcile net income (loss) to net cash flows from
operating activitiesDepreciation and amortization
    
    
    420
    
    
    
    392
    
    
    
    1,393
    
    
    
    1,180Loss on disposal of equipment
    
    
    
    
    
    
    
    
    
    
    6
    
    
    
    4Gain on sale of hemodynamic monitoring business
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (633
    )Amortization of deferred stock-based compensation
    
    
    18
    
    
    
    18
    
    
    
    54
    
    
    
    54Interest income, putable warrants
    
    
    
    
    
    
    
    
    
    
    (32
    )
    
    
    Deferred taxes
    
    
    
    
    
    
    4
    
    
    
    
    
    
    
    14Write off of purchased in-process research and development
    
    
    
    
    
    
    
    
    
    
    1,290
    
    
    
    Minority interest in loss of consolidated entity
    
    
    (4
    )
    
    
    (5
    )
    
    
    (24
    )
    
    
    (35
    )Changes in operating assets and liabilities, net of
businesses acquired and divested:Accounts receivable
    
    
    (783
    )
    
    
    (310
    )
    
    
    81
    
    
    
    (1,368
    )Inventories
    
    
    158
    
    
    
    563
    
    
    
    2,315
    
    
    
    1,020Prepaid expenses and other current assets
    
    
    239
    
    
    
    50
    
    
    
    344
    
    
    
    (60
    )Accounts payable
    
    
    336
    
    
    
    25
    
    
    
    (2,317
    )
    
    
    (190
    )Accrued liabilities
    
    
    627
    
    
    
    372
    
    
    
    (508
    )
    
    
    (1,482
    )Warranty liability
    
    
    5
    
    
    
    (1
    )
    
    
    (4
    )
    
    
    (35
    )Deferred revenue
    
    
    183
    
    
    
    72
    
    
    
    (71
    )
    
    
    63Net cash flows from operating activities
    
    
    1,382
    
    
    
    2,498
    
    
    
    694
    
    
    
    2,621Investing Activities:Purchases of machinery and equipment
    
    
    (275
    )
    
    
    (228
    )
    
    
    (1,067
    )
    
    
    (343
    )Purchase of technology
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (125
    )Proceeds from sale of machinery and equipment
    
    
    
    
    
    
    
    
    
    
    108
    
    
    
    Purchase of Burdick, Inc., net of cash acquired
    
    
    (13
    )
    
    
    
    
    
    
    (19,385
    )
    
    
    Net cash flows used in investing activities
    
    
    (288
    )
    
    
    (228
    )
    
    
    (20,344
    )
    
    
    (468
    )Financing Activities:Borrowings (repayments) on bank line of credit, net
    
    
    (1,591
    )
    
    
    
    
    
    
    883
    
    
    
    (354
    )Payments of long term debt
    
    
    (90
    )
    
    
    (90
    )
    
    
    (272
    )
    
    
    (272
    )Proceeds from exercise of stock options and issuance of shares
under employee stock purchase plan
    
    
    135
    
    
    
    329
    
    
    
    404
    
    
    
    736Payment of note payable in connection with purchase of technology
    
    
    
    
    
    
    (125
    )
    
    
    
    
    
    
    (125
    )Redemption of putable warrants
    
    
    
    
    
    
    
    
    
    
    (296
    )
    
    
    Proceeds from issuance of stock, net of issuance costs
    
    
    
    
    
    
    (340
    )
    
    
    
    
    
    
    15,451Net cash flows from (used in) financing activities
    
    
    (1,546
    )
    
    
    (226
    )
    
    
    719
    
    
    
    15,436Net change in cash and cash equivalents
    
    
    (452
    )
    
    
    2,044
    
    
    
    (18,931
    )
    
    
    17,589Cash and cash equivalents, beginning of period
    
    
    903
    
    
    
    15,730
    
    
    
    19,382
    
    
    
    185Cash and cash equivalents, end of period
    
    $
    451
    
    
    $
    17,774
    
    
    $
    451
    
    
    $
    17,774Supplemental disclosure of cash flow information:Cash paid for interest
    
    $
    84
    
    
    $
    17
    
    
    $
    224
    
    
    $
    100Supplemental disclosure of noncash investing and financing
activities:Note issued in connection with purchase of technology
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    125
 The accompanying notes are an integral part of these unaudited condensed
consolidated financial statements. 5




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QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Description of Business Quinton Cardiology Systems, Inc. (QCS) is a Delaware corporation. QCS
and its subsidiary, Quinton Cardiology, Inc. (Quinton) and its majority
owned Shanghai-Burdick joint venture are referred to herein as the Company.
The Company develops, manufactures, markets and services a family of advanced
cardiology products used in the diagnosis, monitoring and management of
patients with heart disease. 2. Summary of Significant Accounting Policies Basis of Presentation The condensed financial statements present the Company on a consolidated
basis. All significant intercompany accounts and transactions have been
eliminated. The condensed consolidated balance sheet dated September 30,
2004, the condensed consolidated statements of operations for the three and
nine-month periods ended September 30, 2003 and 2004 and the condensed
consolidated statements of cash flows for the three and nine-month periods
ended September 30, 2003 and 2004 have been prepared by the Company and are
unaudited. The condensed consolidated balance sheet dated December 31, 2003
was derived from audited financial statements. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with accounting principles generally accepted in the United States
of America have been omitted pursuant to the rules and regulations of the
Securities and Exchange Commission. The notes to the audited consolidated
financial statements included in the Companys annual report on form 10-K for
the fiscal year ended December 31, 2003 provide a summary of significant
accounting policies and additional financial information that should be read
in conjunction with this report. In the opinion of management, all
adjustments, consisting only of normal recurring adjustments, necessary to
present fairly the financial position of the Company for the interim periods,
have been made. The results of operations for such interim periods are not
necessarily indicative of the results for the full year or any future period. Use of Estimates The preparation of financial statements and related disclosures in
conformity with accounting principles generally accepted in the United States
of America requires management to make estimates and assumptions that affect
the reported amounts of assets and liabilities, the disclosure of contingent
assets and liabilities at the date of the financial statements and revenues
and expenses during the periods reported. These estimates include but are not
limited to estimates affecting revenues and estimates assessing the
collectability of accounts receivable, the salability and recoverability of
inventory, the adequacy of warranty liabilities, the realizability of
investments, the realization of deferred tax assets and the useful lives of
tangible and intangible assets. The market for the Companys products is
characterized by intense competition, rapid technological development and
frequent new product introductions, all of which could affect the future
realizability of the Companys assets. The Company reviews estimates and
assumptions periodically, and the effects of revisions are reflected in the
consolidated financial statements in the period they are determined to be
necessary. Actual results could differ from these estimates. Recent Accounting Pronouncements In November 2002, the Emerging Issues Task Force (EITF) reached a
consensus on EITF 00-21, Revenue Arrangements with Multiple Deliverables
with respect to determining when and how to allocate revenue from sales with
multiple deliverables. The EITF 00-21 consensus provides a framework for
determining when and how to allocate revenue from sales with multiple
deliverables based on a determination of whether the multiple deliverables
qualify to be accounted for as separate units of accounting. The consensus is
effective prospectively for arrangements entered into in
fiscal periods beginning after June 15, 2003. The Company adopted this
consensus during the three-month period ended September 30, 2003. The
adoption of this consensus resulted in the Company deferring revenues
representing the value of 6




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installation obligations associated with the sales
of our systems. During the three-month period ended September 30, 2004, this
deferral increased approximately $3,000 to $226,000. In May 2003, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standard No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity.
The Statement establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of both liabilities and
equity. It requires that an issuer classify a financial instrument that is
within its scope as a liability (or an asset in some circumstances). The
Company adopted this statement at the beginning of the three-month period
ended September 30, 2003. While the adoption of this standard did not have a
material impact on the Companys consolidated financial statements as a
whole, Note 4 contains additional disclosures as required by the standard. In December 2003, the FASB revised FASB Interpretation No. 46 (FIN 46R),
Consolidation of Variable Interest Entities, an interpretation of ARB No.
51. This interpretation addresses how a business enterprise should evaluate
whether it has a controlling financial interest in an entity through means
other than voting rights and accordingly should consolidate the entity. FIN
46R requires that calendar year-end public companies apply the unmodified or
revised provisions of FIN 46 to entities previously considered special
purpose entities in the reporting period ended December 31, 2003. The
interpretation is applicable to all other entities not previously considered
special purpose entities in the quarter ended March 31, 2004. The adoption
of FIN 46R did not have a material effect on the Companys consolidated
financial statements as a whole. Further, the adoption in 2004 as it relates
to non-special purpose entities did not have an impact on the Companys
consolidated financial statements as a whole. Net Income (Loss) Per Share In accordance with Statement of Financial Accounting Standard No. 128,
Computation of Earnings Per Share, basic income (loss) per share is
computed by dividing net income (loss) by the weighted average number of
shares of common stock outstanding during the period. Diluted income per
share is computed by dividing net income by the weighted average number of
common and dilutive potential common shares outstanding during the period.
Dilutive potential common shares consist of shares issuable upon the exercise
of stock options, including outstanding shares subject to repurchase, and
warrants (using the treasury stock method). Potential common shares are
excluded from the calculation if their effect is antidilutive. The following table sets forth the computation of basic and diluted
weighted average common shares outstanding for the three and nine-month
periods ended September 30, 2003 and 2004: Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2003
    
    2004
    
    2003
    
    2004Shares (denominator basic and diluted):Weighted average common shares for basic
calculation
    
    
    12,168,390
    
    
    
    13,940,839
    
    
    
    12,131,066
    
    
    
    13,001,058Incremental shares from employee stock options
    
    
    883,846
    
    
    
    758,455
    
    
    
    
    
    
    
    950,732Weighted average shares for diluted calculation
    
    
    13,052,236
    
    
    
    14,699,294
    
    
    
    12,131,066
    
    
    
    13,951,790
 For the three and nine-month periods ended September 30, 2004, 868,223
and 297,741, respectively, stock options were excluded from the computation
of diluted income per share as their impact was antidilutive. For the
three-month period ended September 30, 2003, 385,276 stock options were
excluded from the computation of diluted income per share as their impact was
antidilutive. For the nine-month period ended September 30, 2003, 1,398,890
stock options were excluded from the computation of diluted loss per share as
their impact was antidilutive. If the Company had reported net income during
the nine-month period ended September 30, 2003, the calculation of earnings
per share would have included the dilutive effect of these potential common
shares using the treasury stock method. Accounting for Stock-Based Compensation The Company has elected to apply the disclosure-only provisions of SFAS
No. 123, Accounting for Stock-Based Compensation. In accordance with the
provisions of SFAS 123, the Company applies Accounting Principles Board
Opinion (APB) No. 25, Accounting for Stock Issued to Employees, and
related interpretations in accounting for its stock option plans. The Company
accounts for stock options issued to non-employees in accordance with the
provisions of 7




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SFAS 123 and Emerging Issues Task Force consensus on Issue No.
96-18, Accounting for Equity Instruments That are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling, Goods or Services
(EITF 96-18). Had compensation cost been determined based on the fair value of the
option awards at the grant dates during the three and nine-month periods
ended September 30, 2003 and 2004, consistent with the provisions of SFAS
123, the Companys reported net income (loss) would have been the pro forma
amounts indicated below (amounts in thousands except per share amounts): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2003
    
    2004
    
    2003
    
    2004Net income (loss)  as reported
    
    $
    183
    
    
    $
    1,318
    
    
    $
    (1,833
    )
    
    $
    4,089Add back: Total stock-based employee compensation
expense included in reported loss, net of related
tax effects
    
    
    18
    
    
    
    18
    
    
    
    54
    
    
    
    54Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects
    
    
    (348
    )
    
    
    (567
    )
    
    
    (918
    )
    
    
    (1,543
    )Net income (loss)  pro forma
    
    $
    (147
    )
    
    $
    769
    
    
    $
    (2,697
    )
    
    $
    2,600Net income (loss) per share  as reported  basic
    
    $
    0.02
    
    
    $
    0.09
    
    
    $
    (0.15
    )
    
    $
    0.31Net income (loss) per share  as reported  diluted
    
    $
    0.01
    
    
    $
    0.09
    
    
    $
    (0.15
    )
    
    $
    0.29Net income (loss) per share  pro forma  basic
    
    $
    (0.01
    )
    
    $
    0.06
    
    
    $
    (0.22
    )
    
    $
    0.20Net income (loss) per share  pro forma  diluted
    
    $
    (0.01
    )
    
    $
    0.05
    
    
    $
    (0.22
    )
    
    $
    0.19
 The fair value of each employee option grant is established on the date
of grant using the Black-Scholes option-pricing model with the following
assumptions used for grants during 2003 and 2004: zero dividend yield;
risk-free interest rate of 3.5% and 3.8%, respectively; volatility of 85% and
70%, respectively; and expected lives of seven years. The weighted-average
fair value of options granted in 2003 and 2004 was $4.89 and $6.40,
respectively. The weighted average fair value of each employee stock purchase right
under the Companys 2002 Employee Stock Purchase Plan was $1.93 in 2003 and
$2.54 in 2004. The following assumptions were used in the Black-Scholes
option-pricing model to perform the calculation in 2003 and 2004: zero
dividend yield; risk-free interest rate of 2.0%; volatility ranging from 70%
to 85%; and expected lives from grant date of 0.75 years and 0.5 years,
respectively. Goodwill Goodwill represents the excess of costs over the estimated fair values
of net assets acquired in connection with our acquisitions of the medical
treadmill manufacturing line in 2002 and Spacelabs Burdick, Inc. (Burdick)
in 2003, which, in accordance with SFAS No. 142, Goodwill and Other
Intangible Assets, is not being amortized. Also in accordance with SFAS No.
142, the Company tests goodwill for impairment at the reporting unit level on
an annual basis and between annual tests in certain circumstances. The
Company has determined that it has two reporting units, consisting of the
Quinton Cardiology reporting unit and the Shanghai-Burdick joint venture
reporting unit. SFAS No. 142 requires a two-step goodwill impairment test whereby the
first step, used to identify potential impairment, compares the fair value of
a reporting unit with its carrying amount including goodwill. If the fair
value of a reporting unit exceeds its carrying amount, goodwill of the
reporting unit is considered not impaired, and the second step of the
goodwill impairment test used to quantify impairment is unnecessary.
Management has estimated that the fair values of the Companys reporting
units to which goodwill has been allocated exceed their carrying amounts, and
as a result, the second step of the impairment test, which would compare the
implied fair value of the reporting unit goodwill with the carrying amount of
that goodwill, was unnecessary for the periods presented. Intangible Assets The Companys intangible assets are comprised primarily of a trade name,
developed technology and customer relationships, most of which were acquired
in our acquisition of Burdick. Management uses judgment to estimate the
fair value of each of these intangible assets. The judgment about fair
value is based on expectations of future cash flows and an appropriate
discount rate. Management also uses judgment to estimate the useful lives of
each intangible asset. The Company believes the Burdick trade name, with a
carrying value of $3,400,000, has an indefinite life, and accordingly does
not amortize the trade name. The Company evaluates this conclusion annually
and makes a judgment about whether 8




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there are factors that would limit the
ability to benefit from the trade name in the future. If there were such
factors, the Company would start amortizing the trade name. The Company also
tests the indefinite life trade name intangible asset for impairment on an
annual basis or more frequently if events or changes in circumstances
indicate that the asset might be impaired. With respect to developed
technology and customer relationship intangible assets, the Company also
evaluates the remaining useful lives annually to evaluate whether the
intangible assets are impaired. For the trade name, this evaluation is
performed annually or if events occur that suggest there may be an impairment
loss, and involves comparing the carrying amount to the Companys estimate of
fair value. For developed technology and customer relationship intangible
assets, this evaluation would be performed if events occur that suggest there
may be an impairment loss. If we conclude that any of our intangible assets
are impaired, we would record this as a loss on our statement of operations
and as a reduction to the intangible asset. The Company recorded
amortization expense for identifiable intangibles of $84,000 and $81,000 for
the three-month periods ended September 30, 2003 and 2004, respectively, and
$301,000 and $242,000 for the nine-month periods ended September 30, 2003 and
2004, respectively. Purchase Accounting SFAS No. 141, Business Combinations, requires that the purchase method
of accounting be used for all business combinations and establishes specific
criteria for the recognition of intangible assets separately from goodwill.
In connection with the Companys acquisitions of the medical treadmill
manufacturing line and Burdick, the Company allocated the respective purchase
prices plus transaction costs to estimated fair values of assets acquired and
liabilities assumed. These purchase price allocation estimates were made
based on our estimates of fair values. 3. Public Equity Offering In June 2004, the Company consummated a public offering of its common
stock as more fully described in its prospectus dated May 25, 2004 filed with
the Securities and Exchange Commission. In the offering, the Company sold
1,605,976 shares of common stock at a price of $10.50 per share. Proceeds
from the offering were approximately $15,451,000, net of underwriting
discounts and offering expenses. In addition, a selling shareholder, as
named in the prospectus, sold 1,394,024 shares of common stock in this
offering. The Company did not receive any proceeds from the sale of shares
by the selling shareholder. 4. Acquisition of Burdick, Inc. On January 2, 2003, the Company purchased 100% of the stock of Burdick.
The consolidated financial statements include Burdicks results since January
2, 2003. The original purchase price of $24.0 million was funded with
approximately $20.2 million in cash, a holdback of $1.3 million for working
capital adjustments plus a partial draw down on our revolving bank credit
facility. Transaction related costs were approximately $700,000. On April 21, 2003, an agreement was reached with the seller to adjust
the purchase price to $20.4 million, based principally on the amount of
Burdicks net working capital at the date of acquisition. In accordance
with this agreement, the Company kept the $1.3 million that was held back at
closing and received a $2.3 million refund from the seller subsequent to the
April 21, 2003 agreement. The refund was used to reduce borrowings against
the Companys line of credit. The purchase price, including incremental costs directly related to the
transaction, was allocated as follows (in thousands): Cash and cash equivalents
    
    $
    386Accounts receivable, net of allowance for doubtful accounts
    
    
    3,798Inventories
    
    
    6,771Prepaid expenses and other current assets
    
    
    184Machinery and equipment
    
    
    2,104In-process research and development
    
    
    1,290Intangible assets
    
    
    5,660Goodwill
    
    
    9,027Total assets acquired
    
    
    29,220Current liabilities
    
    
    (6,961
    )Deferred income taxes
    
    
    (1,156
    )Net assets acquired
    
    $
    21,103
 9




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Inventories included an adjustment to Burdicks historical cost to
increase finished goods to fair market value less expected disposal costs and
selling margin. This adjustment resulted in valuation of inventory of
$300,000 in excess of Burdicks historical cost. This increase in the
inventory valuation was charged to cost of revenues in the nine-month period
ended September 30, 2003, as the associated inventories were sold in the
normal course of business. In-process research and development relates to two product development
projects underway at the time of the acquisition. Neither project had
received required regulatory approvals at the acquisition date, and each
project had risks associated with achieving desired functionality and market
acceptance. The value assigned to in-process research and development was
determined using a discounted cash flow method applied to expected cash flows
over a 15-year period commencing in 2003. In discounting expected future
cash flows, the Company used an annual discount rate of 16%, which management
believed to be an appropriate risk adjusted rate given the nature of the
projects, the project risks remaining at the time of acquisition and the
uncertainty of the future cash flows. The first of the two projects, representing 87% of the total value of
acquired in-process research and development, related to a new resting ECG
monitor. This project was approximately 70% complete at the date of
acquisition and was completed and the related product (the Atria 3000) was
released, as expected, at the end of the first quarter of 2003. Margins on
this product are in line with the Companys historical margins. Costs to
complete this project were expensed in the nine-month period ended September
30, 2003. The second of the two projects, representing 13% of the total value of
acquired in-process research and development relates to a product for the
detection and preprocessing of low-level electrical signals generated by the
heart. This project was approximately 50% complete at the date of
acquisition. Management assigned a low priority to this project and decided
to postpone further development indefinitely. In the opinion of management,
the indefinite postponement of further development of this project has not
materially adversely affected the overall return on investment relating to
the Burdick acquisition. All of the acquired in-process research and development was written off
during the nine-month period ended September 30, 2003, resulting in a charge
to operating expenses of $1,290,000. Intangible assets consist of the Burdick trade name of $3,400,000,
developed technology of $860,000 and distributor relationships of $1,400,000,
which were valued based on discounted cash flow methods applied to the
estimated future cash flows attributable to the respective assets. The
trade name was determined, by management, to have an indefinite useful life.
Developed technology was assigned a seven year useful life, based on the
estimated remaining economic life of the related products. Distributor
relationships relate to long-standing contractual relationships with an
extensive network of independent distributors, which represented the
exclusive channel through which Burdick sold its products. The economic
life of the distributor relationships has been determined to be 10 years,
based on historical turnover experience and in consideration of the long
standing and stable nature of these relationships. Goodwill in the amount of $9,027,000 represents the excess of the net
purchase price over the fair value of the assets and liabilities acquired.
Goodwill recorded in the Burdick acquisition relates to the long-standing
nature of Burdicks business, its substantial market share, its complementary
fit with Quintons pre-existing business, and managements expectations
relating to future operating synergies and cost efficiencies that can be
realized as a result of operating the businesses on a combined basis. A deferred income tax liability was recorded related to the trade name,
which has no tax basis. Because of the indefinite life of the trade name,
this liability was not used to reduce the valuation allowance against
existing deferred income tax assets. Minority Interest As part of the acquisition of Burdick, the Company acquired 56%
ownership of Shanghai Burdick Medical Instrument Co., LTD.
(Shanghai-Burdick). The Shanghai-Burdick joint venture has a limited life
of thirty years, terminating in 2030. If the joint venture is terminated,
the Company would be required to liquidate the net assets of the joint
venture and distribute proceeds to the partners. Assuming the joint venture
was to have been terminated effective September 30, 2004, 10




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the Company
estimates that such net proceeds allocable to the minority interest would
approximate the carrying value of the minority interest recorded in the
accompanying unaudited consolidated balance sheet, which was $163,000 at
September 30, 2004. 5. Consolidation of Manufacturing Operations During the third quarter of 2003, the Company announced plans to
consolidate its Deerfield, Wisconsin and Bothell, Washington manufacturing
and production activities to its Deerfield location. As a result of the
related transition activities, the Company recognized certain charges to cost
of revenues relating to severance and other consolidation related activities
of approximately $1,418,000 during the third and fourth quarters of 2003.
The Company completed this consolidation by the end of 2003. Changes in the Companys accrued liabilities for the nine-month period
ended September 30, 2004 related to the consolidation of manufacturing
operations were as follows (amounts in thousands): Manufacturing consolidation liabilities as of December 31, 2003
    
    $
    324Costs paid during the period
    
    
    (324
    )Manufacturing consolidation liabilities as of September 30, 2004
    
    $
    
 6. Inventories Inventories were valued at the lower of cost, on an average cost basis,
or market and were comprised of the following (amounts in thousands): December 31,
    
    September 30,2003
    
    2004Raw materials
    
    $
    9,708
    
    
    $
    7,544Finished goods
    
    
    2,982
    
    
    
    3,258Total inventories
    
    $
    12,690
    
    
    $
    10,802
 7. Borrowings In connection with the 2003 acquisition of Burdick, the Company
established a line of credit on December 30, 2002. Borrowings under the line
of credit are currently limited to the lesser of $12,000,000 or an amount
based on eligible accounts receivable and eligible inventories. Substantially
all of the Companys assets are pledged as collateral for the line of credit.
This line of credit bears interest at the greater of (i) a variable rate
ranging from the banks prime rate plus a minimum of 0.5% to a maximum of
1.5% based on a funded debt to Earnings Before Interest, Taxes, Depreciation,
and Amortization (EBITDA) ratio, which amounted to 5.25% at September 30,
2004, or (ii) $9,000 per month. In addition, unused balances under this
facility bear monthly fees equal to 0.50% per annum on the difference between
the maximum credit limit and the average daily principal balance during the
month. The current line of credit expires on December 30, 2004. At
September 30, 2004, the Company had no borrowings under this line of credit
and had capacity to borrow $10,235,000 based on eligible accounts receivable
and eligible inventory. 8. Putable Warrants In connection with a loan in 1998, the Company issued warrants to
purchase 123,536 shares of Series A convertible preferred stock with an
exercise price of $0.01 per share that were immediately exercisable. Upon
completion of the Companys initial public offering in 2002, the conversion
rights associated with the Companys Series A convertible preferred stock
resulted in the warrants being exercisable for 63,092 shares of common stock
at an exercise price equal to $0.02 per share. At the holders option, the
Company was required to make a cash payment to the holder equal to the
fair value of the shares issuable upon exercise of the warrants. On
July 22, 2002, a holder of 21,632 putable warrants exercised a put option for
cash when the fair value of the shares was approximately $158,000. On May
21, 2003, the 11




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holder of the remaining 41,460 putable warrants exercised a put
option for cash when the fair value of the shares was approximately $296,000.
Changes in the fair value of this liability are recorded in the statements
of operations as interest income (expense), putable warrants. There were no
warrants outstanding as of September 30, 2004. 9. Warranty Liability Changes in the warranty liability for the nine months ended September
30, 2003 and 2004 were as follows (amounts in thousands): Warranty liability as of December 31, 2003
    
    $
    2,059Charged to cost of revenues
    
    
    986Warranty expenditures
    
    
    (1,036
    )Warranty liability as of September 30, 2004
    
    $
    2,009Warranty liability as of December 31, 2002
    
    $
    1,089Charged to cost of revenues
    
    
    1,017Warranty expenditures
    
    
    (1,021
    )Warranty liability acquired from Burdick, Inc.
    
    
    1,016Warranty liability as of September 30, 2003
    
    $
    2,101
 10. Contingencies Legal Matters The Company is a defendant in various legal matters arising in the
normal course of business. In the opinion of management, the ultimate
resolution of these matters is not expected to have a material effect on the
Companys consolidated financial statements as a whole. 11. Sale of Hemodynamic Monitoring Product Line On October 21, 2003, the Company sold its hemodynamic monitoring product
line. As consideration, the Company received $1,000,000 in cash and a note
payable for $750,000, which was paid on October 20, 2004. The buyer may pay
additional contingent consideration of up to $1,500,000 based on future sales
of the buyers products to our previous hemodynamic products customers, of
which approximately $77,000 in contingent consideration has been received
through September 30, 2004. Based on the Companys post-closing transition responsibilities, which
extended into the second quarter of 2004, the Company deferred the
recognition of any gain on the transaction until its transition
responsibilities were fulfilled. The Company recognized a gain in the second
quarter of 2004 of $633,000 on the transaction, including the effect of the
contingent consideration received through June 30, 2004. Contingent
consideration received after June 30, 2004 was recognized as income in the
period in which it was earned. 12




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Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations You should read the following discussion and analysis in conjunction
with our unaudited condensed consolidated financial statements and related
notes included elsewhere in this report. The following discussion contains
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995. All statements other than statements of
historical fact made in this Quarterly Report on Form 10-Q, including future
results of operations or financial position, are forward-looking. We use
words such as anticipate, believe, expect, future, intend and similar
expressions to identify forward-looking statements. These forward-looking
statements reflect managements current expectations and involve risks and
uncertainties. Our actual results could differ materially from results that
may be anticipated by such forward-looking statements. The principal factors
that could cause or contribute to such differences include, but are not
limited to, those discussed in the section entitled Certain Factors That May
Affect Future Results or the Trading Price of our Common Stock below, those
discussed elsewhere in this report and those discussed in our Annual Report
on Form 10-K filed with the Securities and Exchange Commission on March 15,
2004. Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date of this report.
We undertake no obligation to revise any forward-looking statements to
reflect events or circumstances that may subsequently arise. Readers are
urged to review and consider carefully the various disclosures made in this
report and in our other filings made with the SEC that attempt to advise
interested parties of the risks and factors that may affect our business,
prospects and results of operations. Critical Accounting Estimates The discussion and analysis of our financial condition and results of
operations are based upon our unaudited condensed consolidated financial
statements which have been prepared in accordance with accounting principles
generally accepted in the United States of America for interim financial
statements. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent
assets and liabilities. On an ongoing basis, we evaluate our estimates,
including those affecting revenues, the allowance for doubtful accounts, the
salability and recoverability of inventory, warranty liabilities, the
carrying value of our investments, the useful lives of intangible assets and
income taxes. We base our estimates on historical experience and on various
other assumptions that we believe to be reasonable under the circumstances,
the results of which form our basis for making judgments about the carrying
values of assets and liabilities that are not readily apparent from other
sources. Actual results may differ from these estimates under different
assumptions or conditions. A more complete description of our critical
accounting estimates established prior to the end of the fiscal year ending
December 31, 2003 is contained in our Annual Report on Form 10-K for the
fiscal year ended December 31, 2003. 13




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Results of Operations Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2003
    
    2004
    
    2003
    
    2004(as a percentage of revenues)
    
    (as a percentage of revenues)Revenues:Systems
    
    
    84.4
    %
    
    
    86.4
    %
    
    
    84.3
    %
    
    
    85.9
    %Service
    
    
    15.6
    
    
    
    13.6
    
    
    
    15.7
    
    
    
    14.1Total revenues
    
    
    100.0
    
    
    
    100.0
    
    
    
    100.0
    
    
    
    100.0Gross Profit:Systems (as a percentage of systems revenues)
    
    
    39.9
    
    
    
    44.4
    
    
    
    39.2
    
    
    
    44.0Service (as a percentage of service revenues)
    
    
    45.9
    
    
    
    41.3
    
    
    
    44.9
    
    
    
    40.2Gross profit
    
    
    40.8
    
    
    
    44.0
    
    
    
    40.1
    
    
    
    43.4Operating Expenses:Research and development
    
    
    9.4
    
    
    
    8.3
    
    
    
    9.8
    
    
    
    8.4Write off of purchased in-process research and
development
    
    
    
    
    
    
    
    
    
    
    2.1
    
    
    
    Sales and marketing
    
    
    21.5
    
    
    
    21.2
    
    
    
    21.5
    
    
    
    20.5General and administrative, excluding
stock-based compensation expense
    
    
    8.7
    
    
    
    8.8
    
    
    
    9.4
    
    
    
    9.1Stock-based compensation
    
    
    0.0
    
    
    
    0.1
    
    
    
    0.0
    
    
    
    0.1Total operating expenses
    
    
    39.6
    
    
    
    38.4
    
    
    
    42.8
    
    
    
    38.1Operating income (loss)
    
    
    1.2
    
    
    
    5.6
    
    
    
    (2.7
    )
    
    
    5.3Total other income (expense)
    
    
    (0.3
    )
    
    
    0.2
    
    
    
    (0.3
    )
    
    
    1.0Income tax provision
    
    
    (0.0
    )
    
    
    0.0
    
    
    
    (0.0
    )
    
    
    (0.1
    )Minority interest in loss of consolidated entity
    
    
    0.0
    
    
    
    0.0
    
    
    
    0.0
    
    
    
    0.0Net income (loss)
    
    
    0.9
    %
    
    
    5.8
    %
    
    
    (3.0
    )%
    
    
    6.2
    %
 Three-Month Period Ended September 30, 2004 Compared to the Three-Month
Period Ended September 30, 2003 Revenues Revenues increased by $1,464,000, or 7.0%, to $22,498,000 for the
three-month period ended September 30, 2004 from $21,034,000 for the
comparable period in 2003. Revenues for the three-month period ended
September 30, 2003 included sales of $918,000 related to the hemodynamic
monitoring product line. We divested this product line in the third quarter
of 2003, but continued to provide service to the related customers through
April, 2004. Systems revenues increased by $1,687,000, or 9.5%, to $19,434,000 for
the three-month period ended September 30, 2004 from $17,747,000 for the
comparable period in 2003. Systems revenues for the three-month period ended
September 30, 2003 included $641,000 related to our divested hemodynamic
monitoring line. Systems revenues for the three-month period ended September
30, 2004 did not include any sales from the divested line. The growth in
systems revenues was attributable to continued strong sales in most of our
core product lines. Service revenues decreased by $223,000, or 6.8%, to $3,064,000 for the
three-month period ended September 30, 2004 from $3,287,000 for the
comparable period in 2003. Service revenues for the three-month period ended
September 30, 2003 included $277,000 related to our divested hemodynamic
monitoring product line. Service revenues for the
three-month period ended September 30, 2004 did not include any sales
from the divested line. The increase in service revenues apart from the
decline related to the hemodynamic monitoring line was due to increases in
services relating to our other product lines. 14




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Gross Profit Gross profit increased by $1,312,000, or 15.3%, to $9,900,000 for the
three-month period ended September 30, 2004, from $8,588,000 for the
comparable period in 2003. Gross margin increased to 44.0% for the
three-month period ended September 30, 2004 from 40.8% for the comparable
period in 2003. The increase in gross margin was primarily attributable to
the results of cost reductions that were realized after we completed the
consolidation of our manufacturing operations at the end of the fourth
quarter of 2003 and the results of product cost reduction initiatives,
including design cost reductions and other reductions in the cost of
purchased components of our products. A charge to cost of revenues of
$262,000 related to the consolidation of our manufacturing operations was
included in our cost of sales for the three-month period ended September 30,
2003, thereby reducing gross profit. This adversely impacted gross margin by
1.2 percentage points in that period. Gross profit from systems revenues increased by $1,556,000, or 22.0%, to
$8,634,000 for the three-month period ended September 30, 2004 from
$7,078,000 for the comparable period in 2003. Gross margin from systems
revenues increased to 44.4% for the three-month period ended September 30,
2004 from 39.9% for the comparable period in 2003. The increase in gross
margin was primarily attributable to the cost reductions relating to our
manufacturing facility consolidation and the other product cost reduction
measures referred to above. In addition, systems gross profit for the
three-month period ended September 30, 2003 included a $240,000 charge
related to the consolidation of our manufacturing operations, which is
discuss above. There was no similar charge in the current year. Gross profit from service revenues decreased by $244,000, or 16.2%, to
$1,266,000 for the three-month period ended September 30, 2004 from
$1,510,000 for the comparable period in 2003. Gross margin from service
revenues decreased to 41.3% for the three-month period ended September 30,
2004 from 45.9% for the comparable period in 2003. The decrease in gross
margin was principally attributable to the combination of a change in the
service parts sales mix, which fluctuated due to the sale of our hemodynamic
monitoring business, and, to a lesser extent, to increases in service
staffing levels to provide enhanced support to our customers. In addition,
service gross profit for the three-month period ended September 30, 2003
included a $22,000 charge related to the consolidation of our manufacturing
operations, which is discuss above. There was no similar charge in the
current year. Operating Expenses Research and development expenses decreased by $87,000, or 4.4%, to
$1,882,000 for the three-month period ended September 30, 2004 from
$1,969,000 for the comparable period in 2003. This decrease was primarily
the result of staffing reductions associated with the sale of our hemodynamic
monitoring product line. As a percentage of revenues, research and
development expenses decreased to 8.3% for the three-month period ended
September 30, 2004 from 9.4% for the comparable period in 2003. This
decrease was attributable to lower labor costs and higher revenues during the
three-month period ended September 30, 2004 over the comparable period in
2003. Sales and marketing expenses increased by $249,000, or 5.5%, to
$4,768,000 for the three-month period ended September 30, 2004 from
$4,519,000 for the comparable period in 2003. This increase was due
principally to variable selling expenses associated with higher sales
volumes. As a percentage of revenues, sales and marketing expenses decreased
to 21.2% for the three-month period ended September 30, 2004 from 21.5% for
the comparable period in 2003. This primarily reflects an increase in
revenues for the three-month period ended September 30, 2004 over the
comparable period in 2003. General and administrative expenses, excluding stock-based compensation
expense, increased by $136,000, or 7.4%, to $1,974,000 for the three-month
period ended September 30, 2004, from $1,838,000 for the comparable period in
2003. This increase was principally the result of increased audit fees and
consulting costs associated with documentation and testing of internal
controls in compliance with Section 404 of the Sarbanes-Oxley Act. As a
percentage of revenues, general and administrative expenses, excluding
stock-based compensation, increased to 8.8% for the three-month period ended
September 30, 2004 from 8.7% for the comparable period in 2003, due primarily
to the increase in costs referred to above, offset by an increase in revenues
for the three-month period ended September 30, 2004 over the comparable
period in 2003. Stock-based compensation expense for the three-month period ended
September 30, 2004 was $18,000, which was the same as the amount expensed for
the comparable period in 2003. Stock-based compensation expense for both
periods 15




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relates to the intrinsic value of stock options granted in 2001. We
expect to record stock-based compensation expense in the fourth quarter of
2004 at a level similar to the amount recorded in the third quarter of 2004. Other Income and Expense Total other income was $55,000 for the three-month period ended
September 30, 2004, compared to other expense of $61,000 for the comparable
period in 2003. This change was principally the result of interest income
earned on our substantially increased average cash balances for the
three-month period ended September 30, 2004 as compared to interest paid on
net borrowings during the comparable period in 2003. Other income during the
three-month period ended September 30, 2004 also includes $17,000 in
contingent consideration earned during the period relating to the sale of our
divested hemodynamic monitoring line. Income Taxes During the three-month period ended September 30, 2004, net operating
loss carryforwards were utilized to offset taxable income. We continue to
provide a full valuation allowance against deferred tax assets. Based on a
number of factors, including the Companys prior history of operating losses,
we have not determined that it is more likely than not that we will realize
the future benefits of a significant portion of our deferred tax assets.
Various factors, such as our operating results, may cause our conclusions to
change in the future. The full impact of any adjustment to the valuation
allowance will be recognized in the period of adjustment by adjusting
goodwill, equity, and income from continuing operations, as appropriate. If
and when the valuation allowance against deferred tax assets is eliminated,
we will be required to recognize income tax expense at statutory rates. Nine-Month Period Ended September 30, 2004 Compared to the Nine-Month Period
Ended September 30, 2003 Revenues Revenues increased by $3,775,000, or 6.1% to $65,798,000 for the
nine-month period ended September 30, 2004 from $62,023,000 for the
comparable period in 2003. Revenues for the nine-month period ended
September 30, 2003 included sales of $2,591,000 related to our hemodynamic
monitoring product line. We divested this product line in the third quarter
of 2003, but continued to provide service to the related customers through
April 2004. Systems revenues increased by $4,194,000, or 8.0% to $56,502,000 for the
nine-month period ended September 30, 2004 from $52,308,000 for the
comparable period in 2003. Systems revenues for the nine-month period ended
September 30, 2003 included $1,759,000 related to our divested hemodynamic
monitoring product line. Systems revenues for the nine-month period ended
September 30, 2004 did not include any sales from the hemodynamic monitoring
product line. The growth in our systems revenues during the nine months
ended September 30, 2004 was attributable to continued strong sales in most
of our product lines. Service revenues decreased by $419,000, or 4.3%, to $9,296,000 for the
nine-month period ended September 30, 2004 from $9,715,000 for the comparable
period in 2003. This decrease was related primarily to the decline in
service revenues relating to our divested hemodynamic monitoring line.
Service revenues for the nine-month period ended September 30, 2003 included
$832,000 related to this divested line, compared to $221,000 for the nine
month period ended September 30, 2004. Gross Profit Gross profit increased by $3,702,000, or 14.9%, to $28,576,000 for the
nine-month period ended September 30, 2004 from $24,874,000 for the
comparable period in 2003. Gross margin increased to 43.4% for the
nine-month period ended September 30, 2004 from 40.1% for the comparable
period in 2003. The increase in gross margin was primarily
attributable to the results of cost reductions that were realized from
the consolidation of our manufacturing operations, which was completed at the
end of the fourth quarter of 2003, partially offset by a decline in service
margin. To a lesser extent, the increase in gross profit was due to the
results of product cost reduction initiatives, including design cost 16




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reductions and other reductions in the cost of purchased components of our
products. In addition, gross profit for the nine-month period ended
September 30, 2003 included both a manufacturing consolidation charge of
$262,000 and an acquisition-related charge of $300,000, reflecting an upward
adjustment to Burdicks inventory valuation from Burdicks historical cost at
the acquisition date. There were no similar charges in the nine-month period
ended September 30, 2004. Gross profit from systems revenues increased by $4,321,000, or 21.1%, to
$24,836,000 for the nine-month period ended September 30, 2004 from
$20,515,000 for the comparable period in 2003. Gross margin from systems
revenues increased to 44.0% for the nine-month period ended September 30,
2004 from 39.2% for the comparable period in 2003. This increase in gross
margin resulted primarily from the cost reductions realized from our
manufacturing facility consolidation and the product cost reduction measures
referred to above. In addition, gross margin from systems revenues for the
nine-month period ended September 30, 2003 included a manufacturing
consolidation charge of $240,000 and an acquisition related charge of
$300,000, collectively representing an adverse impact to gross margin from
systems revenues of approximately 1.0 percentage point. There were no
similar charges during the nine-month period ended September 30, 2004. Gross profit from service revenues decreased by $619,000, or 14.2%, to
$3,740,000 for the nine-month period ended September 30, 2004 from $4,359,000
for the comparable period in 2003. Gross margin from service revenues
decreased to 40.2% for the nine-month period ended September 30, 2004 from
44.9% for the comparable period in 2003. This decrease in gross margin was
attributable to a combination of a reduction in service revenues associated
with the sale of our hemodynamic monitoring business, increases in service
staffing levels to provide enhanced support to our customers and the
temporary effects in the first quarter of 2004 of inefficiencies relating to
the conversion of our enterprise resource planning system. Operating Expenses Research and development expenses decreased by $536,000, or 8.9%, to
$5,509,000 for the nine-month period ended September 30, 2004 from $6,045,000
for the comparable period in 2003. This decrease was primarily the result
of staffing reductions associated with the sale of our hemodynamic monitoring
product line. As a percentage of revenues, research and development expenses
decreased to 8.4% for the nine-month period ended September 30, 2004 from
9.8% for the comparable period in 2003. This decrease was attributable to
lower labor costs and higher revenues during the nine-month period ended
September 30, 2004 over the comparable period in 2003. Sales and marketing expenses increased by $170,000, or 1.3%, to
$13,506,000 for the nine-month period ended September 30, 2004 from
$13,336,000 for the comparable period in 2003. This increase was primarily
attributable to increases in commission expense associated with higher
revenues, partially offset by staffing reductions associated with the sale of
our hemodynamic monitoring product line. As a percentage of revenues, sales
and marketing expenses decreased to 20.5% for the nine-month period ended
September 30, 2004 from 21.5% for the comparable period in 2003. This
primarily reflects an increase in revenues for the nine-month period ended
September 30, 2004 over the comparable period in 2003. General and administrative expenses, excluding stock-based compensation
expense, increased by $204,000, or 3.5%, to $6,011,000 for the nine-month
period ended September 30, 2004, from $5,807,000 for the comparable period in
2003. This increase was principally the result of increased audit fees and
consulting costs associated with documentation and testing of internal
controls in compliance with Section 404 of the Sarbanes-Oxley Act. As a
percentage of revenues, general and administrative expenses, excluding
stock-based compensation, decreased to 9.1% for the nine-month period ended
September 30, 2004 from 9.4% for the comparable period in 2003. This
primarily reflects an increase in revenues for the nine-month period ended
September 30, 2004 over the comparable period in 2003. Stock-based compensation expense for the nine-month period ended
September 30, 2004 was $54,000, which was the same as the amount expensed for
the comparable period in 2003. Stock-based compensation expense for both
periods relates to the intrinsic value of stock options granted in 2001. Other Income and Expense Total other income was $628,000 for the nine-month period ended
September 30, 2004, compared to other expense of $186,000 for the comparable
period in 2003. The primary component of other income in 2004 was the gain
recorded on the sale of our hemodynamic monitoring business of $650,000.
During the nine-month period ended September 30, 2004, 17




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interest income
largely offset interest expense, as interest paid on net borrowings during
the first part of the period was largely offset by interest income earned on
invested cash balances during the latter part of the period. During the same
period of 2003, we incurred higher interest expense as our average borrowings
were higher. Income Taxes Income tax provisions recorded in the nine-month period ended September
30, 2004 were due principally to minimum state and local taxes During the nine-month period ended September 30, 2004, net operating
loss carryforwards were utilized to offset taxable income. We continue to
provide a full valuation allowance against deferred tax assets. Based on a
number of factors, including the Companys prior history of operating losses,
we have not determined that it is more likely than not that we will realize
the future benefits of a significant portion of our deferred tax assets.
Various factors, such as our operating results, may cause our conclusions to
change in the future. The full impact of any adjustment to the valuation
allowance will be recognized in the period of adjustment by adjusting
goodwill, equity, and income from continuing operations, as appropriate. If
and when the valuation allowance against deferred tax assets is eliminated,
we will be required to recognize income tax expense at statutory rates. Liquidity and Capital Resources Net cash flows from operating activities were $2,498,000 for the
three-month period ended September 30, 2004, compared to $1,382,000 for the
comparable period in 2003. Net cash flows from operating activities of
$2,498,000 for the three-month period ended September 30, 2004 was due
primarily to net income, excluding non-cash income and non-cash expenses, of
$1,727,000, a decrease in inventories of $563,000 and an increase in accrued
liabilities of $372,000, which was partially offset by an increase in
accounts receivable of $310,000. Net cash flows from operating activities were $2,621,000 for the
nine-month period ended September 30, 2004, compared to $694,000 for the
comparable period in 2003. Net cash flows from operating activities of
$2,621,000 for the nine-month period ended September 30, 2004 was due
primarily to net income, excluding non-cash income and non-cash expenses, of
$4,673,000 and a decrease in inventories of $1,020,000, which was partially
offset by an increase in accounts receivable of $1,368,000 and a decrease in
accrued liabilities of $1,482,000. Cash and cash equivalents at September 30, 2004 increased from balances
at December 31, 2003 due primarily to the receipt of proceeds from the
completion of our public equity offering in June of 2004 and to cash
generated from operations during the period. Cash and cash equivalents, net
of debt, at September 30, 2004 was $17,683,000. This compares to total debt,
net of cash, of $532,000 at December 31, 2003. Accounts receivable at
September 30, 2004 increased from balances at December 31, 2003 due
principally to an increase in revenues near the end of the third quarter of
2004, as compared to the end of the fourth quarter of 2003. Inventories
decreased at September 30, 2004 from balances at December 31, 2003 due
principally to the transfer of inventory related to the Companys hemodynamic
monitoring line to the purchaser of the line and to managements
implementation of inventory reduction measures. Accrued liabilities at
September 30, 2004 decreased from balances at December 31, 2003 due
principally to payments during the nine-month period ended September 30, 2004
of accrued year-end compensation relating to 2003 sales and operating
results, accrued costs relating to the consolidation of manufacturing
operations and other accrued liabilities. Net cash flows used in investing activities of $468,000 for the
nine-month period ended September 30, 2004 consisted of $343,000 for capital
expenditures and $125,000 for the purchase of technology for use in future
products. In connection with a purchase of technology, we were obligated to
pay an additional $125,000, which was paid during the third quarter of 2004.
We also have a future royalty obligation related to the technology purchase
for each unit sold. Such royalties will be expensed to cost of revenues when
incurred. There are no minimum commitments under this obligation. Net cash
flows used in investing activities of $20,344,000 for the nine-month period
ended September 30,
2003 related primarily to our investment in Burdick of approximately
$19,385,000 net of cash acquired, payments of acquisition costs and a refund
from the reduction in the purchase price. In addition, during the
nine-months ended September 30, 2003, we made capital equipment expenditures
of $1,067,000, which were primarily for the purchase of our enterprise
resource planning system, offset by proceeds received from sales of capital
equipment of $108,000. 18




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Net cash flows used in financing activities of $226,000 for the
three-month period ended September 30, 2004 related primarily to payments of
$340,000 in previously accrued issuance costs associated with our public
equity offering, a debt payment of $90,000 related to the note payable issued
in the treadmill manufacturing business acquisition and a payment of $125,000
related to an obligation issued in connection with a purchase of technology,
partially offset by proceeds from exercises of stock options and the issuance
of shares under our employee stock purchase plan aggregating $329,000. Net
cash flows used in financing activities of $1,546,000 for the three-month
period ended September 30, 2003 was primarily the result of net repayments on
our credit line of $1,591,000 and a debt payment of $90,000 related to the
note payable issued in the treadmill manufacturing business acquisition,
partially offset by proceeds from exercises of stock options and the issuance
of shares under our employee stock purchase plan of $135,000. Net cash flows from financing activities of $15,436,000 for the
nine-month period ended September 30, 2004 relate primarily to proceeds from
our public equity offering of $15,451,000, net of payments of issuance costs,
and proceeds from exercises of stock options and the issuance of shares under
our employee stock purchase plan of $736,000, offset partially by net
repayments on our credit line of $354,000, debt payments of $272,000 related
to the note payable issued in the treadmill manufacturing business
acquisition and a payment of $125,000 related to an obligation issued in
connection with a purchase of technology. Net cash flows from financing
activities of $719,000 for the nine-month period ended September 30, 2003 was
primarily the result of net borrowings on our credit line of $883,000 and
proceeds from exercises of stock options and the issuance of shares under our
employee stock purchase plan of $404,000, which was partially offset by debt
payments of $272,000 related to the note payable issued in the treadmill
manufacturing business acquisition and a payment of $296,000 for the
redemption of putable warrants. We anticipate that our future operating cash flow, existing cash
balances and borrowings available to us under credit facilities will be
sufficient to meet our operating expenses, working capital requirements,
capital expenditures and other obligations for at least twelve months. We
anticipate that our credit facility will be renewed or replaced upon its
expiration on December 30, 2004. However, we believe that failure to renew
or replace this facility will not have a material adverse effect on our
liquidity. Sale of Hemodynamic Monitoring Product Line On October 21, 2003, we announced the sale of our hemodynamic monitoring
product line. As consideration, we received $1,000,000 in cash and a note
payable for $750,000, which was paid on October 20, 2004. The buyer may pay
additional contingent consideration of up to $1,500,000 based on future sales
of the buyers products to our previous hemodynamic products customers.
Based on our post-closing transitional responsibilities, which extended into
the second quarter of 2004, we previously deferred the recognition of any
gain on the transaction. During the second quarter of 2004, we completed all
remaining substantive obligations related to the sale of this line and,
accordingly, we recognized a gain of $633,000 on the transaction. In
addition, during the three months ended September 30, 2004 we recognized
$17,000 in additional contingent consideration which was earned during the
period. Public Equity Offering In June 2004, we consummated a public offering of our common stock as
more fully described in our prospectus dated May 25, 2004 filed with the
Securities and Exchange Commission. In the offering, we sold 1,605,976
shares of common stock at a price of $10.50 per share. Proceeds from the
offering were $15,451,000, net of underwriting discounts and offering
expenses. In addition, a selling shareholder, as named in the prospectus,
sold 1,394,024 shares of common stock in this offering. We did not receive
any proceeds from the sale of shares by the selling shareholder. 19




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Certain Factors that May Affect Future Results or the Trading Price of our
Common Stock In addition to the other information contained in this report, the
following risk factors could affect our actual results and could cause our
actual results to differ materially from those achieved in the past or
expressed in our forward-looking statements or could cause the trading price
of our common stock to decline. Additional risks and uncertainties not
presently known to us or that we currently deem immaterial also may impair
our business operations or negatively impact the trading price of our common
stock. The unpredictability of our quarterly revenues and operating results may
cause the trading price of our stock to decrease. Our quarterly revenues and operating results have varied in the past and
may continue to vary in the future due to a number of factors, many of which
are outside of our control. Factors contributing to these fluctuations may
include:  
    
    the impact of acquisitions, divestitures, strategic alliances, and
other significant corporate events;  
    
    changes in our ability to obtain products and product components that
are manufactured for us by third parties, such as Holter monitors, as
well as variations in prices of these products and product components;  
    
    delays in the development or commercial introduction of new versions of products and systems;  
    
    the ability to attain and maintain production volumes and quality levels for our products and product components;  
    
    effects of domestic and foreign economic conditions on our industry and/or customers;  
    
    the successful implementation of our system-oriented sales approach;  
    
    changes in the demand for our products and systems;  
    
    varying sales cycles that can take up to a year or more;  
    
    changes in the mix of products and systems we sell, which could
affect our revenue levels as well as our gross margins;  
    
    unpredictable budgeting cycles of our customers;  
    
    delays in obtaining regulatory clearance for new versions of our products and systems;  
    
    increased product and price competition;  
    
    the impact of regulatory changes on the availability of third-party
reimbursement to customers of our products and systems;  
    
    the loss of key personnel;  
    
    the loss of key distributors or distribution companies; and  
    
    seasonality in the sales of our products and systems. Due to the factors summarized above, we believe that period-to-period
comparisons of our operating results are not a good indication of our future
performance and should not be relied on to predict future operating results.
Also, it is possible that, in future periods, our operating results will not
meet the expectations of public market analysts or investors. In that event,
the price of our common stock may decrease. We may make future acquisitions, which involve numerous risks that could
impact our business and results of operations. As part of our growth strategy, we intend to selectively acquire other
businesses, product lines, assets, or technologies. Successful execution of
our acquisition strategy depends upon our ability to identify, negotiate,
complete and integrate suitable acquisitions. Acquisitions involve numerous
risks, including the following: 20




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
    
    difficulties in integrating the operations, technologies, and products of the acquired companies;  
    
    the risk of diverting managements attention from normal daily operations of the business;  
    
    potential difficulties in completing projects associated with in-process research and development;  
    
    risks of entering markets in which we have no or limited direct prior
experience and where competitors in such markets have stronger market
positions;  
    
    initial dependence on unfamiliar supply chains or relatively small supply partners;  
    
    insufficient revenues to offset increased expenses associated with acquisitions;  
    
    the risk that acquired lines of business may reduce or replace the sales of existing products; and  
    
    the potential loss of key employees of the acquired companies. Mergers and acquisitions of high-technology companies are inherently risky, and
no assurance can be given that our previous or future acquisitions will be
successful and will not materially adversely affect our business, operating
results, or financial condition. We must also manage any growth effectively.
Failure to manage growth effectively and successfully integrate acquisitions we
make could harm our business and operating results in a material way. We may need additional capital to continue our acquisition growth
strategy. Successful continued execution of our acquisition strategy also depends
upon our ability to obtain satisfactory debt or equity financing. We may
require additional debt or equity financing to make any further significant
acquisitions. Such financing may not be available on terms that are acceptable
to us or at all. If we are required to incur additional indebtedness to fund
acquisitions in the future, our cash flow may be negatively affected by
additional debt servicing requirements and the terms of such indebtedness may
impose covenants and restrictions that provide us less flexibility in how we
operate our business. Fluctuations in our stock price may make it difficult to
make acquisitions using our stock as consideration. Moreover, use of our stock
to fund acquisitions may have a significant dilutive effect on existing
shareholders. Failure to keep pace with changes in the marketplace may cause us to lose
market share and our revenues may decrease. The marketplace for diagnostic cardiology systems is characterized by
rapid change and technological innovation, requiring suppliers in the market to
regularly update product features and incorporate new technologies in order to
remain competitive. In developing and enhancing our products we have made, and
will continue to make, assumptions about which features, technology standards
and performance criteria will be attractive to, or demanded by, our customers.
If we implement features, standards and performance criteria that are different
from those required by our customers or if our competitors introduce products
and systems that better address these needs, our products may suffer declines
in market acceptance or may become obsolete. In that event, our market share
and revenues would likely decrease. Failure to develop and commercialize new versions of our products would
cause our operating results to suffer, both domestically and
internationally. To be successful, we must develop and commercialize new versions of our
products for both domestic and international markets. Our products are
technologically complex and must keep pace with rapid and significant
technological change, comply with rapidly evolving industry standards and
government regulations, and compete effectively with new product introductions
of our competitors. Accordingly, many of our products require significant
planning, design, development and testing at the technological, product and
manufacturing process levels. Our success in developing and commercializing
new versions of our products is affected by our ability to:  
    
    accurately assess customer needs;  
    
    develop products that are easy to use;  
    
    minimize the time required to obtain, as well as the costs of, required regulatory clearance or approval;  
    
    price competitively;  
    
    manufacture and deliver on time;
    
    accurately predict and control costs associated with manufacturing, installation, warranty and maintenance; 21




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
    
    manage customer acceptance and payment;  
    
    limit demands by our customers for retrofits;  
    
    access new interface standards needed for product connectivity;  
    
    anticipate and meet demands of our international customers for products featuring local language capabilities; and  
    
    anticipate and compete effectively with our competitors efforts. The rate of market acceptance of our current or future products and
systems may impact our operating results. In addition, we may experience
design, manufacturing, marketing or other difficulties that could delay or
prevent our development, introduction or marketing of new versions of our
products. Such difficulties and delays could adversely affect our gross profit
expectations and/or cause our development expenses to increase and harm our
operating results. If market conditions cause us to reduce the selling price of our products
and systems, or our market share is negatively affected by the activities
of our competitors, our margins and operating results will decrease. The selling price of our products and systems and the extent of our market
share are subject to market conditions. Market conditions that could impact
these aspects of our operations include:  
    
    lengthening of buying or selling cycles;  
    
    the introduction of competing products;  
    
    price reductions by our competitors;  
    
    development of more effective products by our competitors;  
    
    hospital budgetary constraints; and  
    
    changes in the reimbursement policies of government and third-party payers. If such conditions force us to sell our products and systems at lower
prices, or if we are unable to effectively develop and market competitive
products, our market share, margins and operating results will likely decrease. Our future financial results could be adversely impacted by asset
impairments or other charges. Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and
Other Intangible Assets requires that we cease amortization of goodwill and
other intangible assets determined to have indefinite lives, and established a
method of testing these assets for impairment on an annual or on an interim
basis if certain events occur or circumstances change that would reduce the
fair value of a reporting unit below its carrying value or if the fair value of
intangible assets with indefinite lives falls below their carrying value. We
also evaluate intangible assets determined to have finite lives for
recoverability whenever events or changes in circumstances indicate that their
carrying amounts may not be recoverable. These events or circumstances could
include a significant change in the business climate, legal factors, operating
performance indicators, competition, sale or disposition of a significant
portion of the business, or other factors such as a decline in our market value
below our book value for an extended period of time. In the case of intangible
assets with indefinite lives, we evaluate whether events or circumstances
continue to support an indefinite useful life. We evaluate the estimated lives
of all intangible assets on an annual basis, including those with indefinite
lives, to determine if events and circumstances continue to support an
indefinite useful life or the remaining useful life, as applicable, or if a
revision in the remaining period of amortization is required. The amount of
any such annual or interim impairment charge could be significant, and could
have a material adverse effect on our reported financial results for the period
in which the charge is taken. We own preferred equity securities of a privately held company, ScImage,
Inc., which we account for using the cost method. The fair value of our
investment is not readily determinable from published market data, so we use
our judgment to estimate the fair value. There can be no assurance that the
estimated fair value of this investment will not decline to an amount below its
carrying amount, in which case we would be required to record a loss on this
investment. If we fail to maintain our relationships with distribution organizations,
our sales and operating results may suffer. We sell our products to the domestic primary care market and to
substantially all international markets principally 22




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through third party
distribution organizations. While we have well established relationships with
these distribution organizations, the underlying agreements are generally for
periods of one year or less. One of these domestic distribution organizations,
Physicians Sales and Service, Inc., accounted for 14% of our revenues in 2003.
If these agreements are cancelled or if we are unable to renew them as they
expire, our sales and operating results may suffer materially. Our international distribution relationships may be terminated on little
or no notice because we do not generally have long-term contracts with these
distributors. Consequently, our success in expanding international sales may
be limited if our international distributors lack, or are unable to develop,
relationships with important target customers in international markets. If our relationships change with any significant distribution
organization, or if any of our distribution organizations devote more effort to
selling competing products and systems, our sales and operating results may
suffer and our growth may be limited. Our lack of customer purchase contracts and our limited order backlog
make it difficult to predict sales and plan manufacturing requirements,
which can lead to lower revenues, higher expenses and reduced margins. Our customers typically order products on a purchase order basis, and we
do not generally have long-term purchase contracts. In limited circumstances,
customer orders may be cancelled, changed or delayed on short notice. Lack of
significant order backlog makes it difficult for us to forecast future sales
with certainty. Long and varying sales cycles with our customers make it
difficult to accurately forecast component and product requirements. These
factors expose us to a number of risks:  
    
    if we overestimate our requirements we may be obligated to purchase
more components or third-party products than is required;  
    
    if we underestimate our requirements, our third-party manufacturers
and suppliers may have an inadequate product or product component
inventory, which could interrupt manufacturing of our products and
result in delays in shipments and revenues;  
    
    we may also experience shortages of product components from time to
time, which also could delay the manufacturing of our products; and  
    
    over or under production can lead to higher expense, lower than
anticipated revenues, and reduced margins. If suppliers discontinue production of purchased components of our
products and we are unable to secure alternative sources for these
components on a timely basis, our ability to ship products to our
customers may be adversely affected, our revenues may decline and our
costs may increase as a result. For a variety of reasons, including but not limited to relatively low
volumes, our suppliers may discontinue production of component parts for our
products. Alternative sources of these components may result in higher costs.
In addition, if we are unable to secure alternative sources for these
components, significant delays in product shipments may result while we
re-engineer our products to utilize available components. This could result in
reduced revenues, higher costs or both. Undetected product errors or defects could result in increased warranty
costs, loss of revenues, product recalls, delayed market acceptance, and
claims against us. Any errors or defects in our products discovered after commercial release could result in:  
    
    failure to achieve market acceptance;  
    
    loss of customers, revenues, and market share;  
    
    diversion of development resources;  
    
    increased service and warranty costs;
    
    legal actions by our customers; and  
    
    increased insurance costs. 23




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Inadequate levels of reimbursement from governmental or other third-party
payers for procedures using our products and systems may cause our
revenues to decrease. Significant changes in the healthcare systems in the U.S. or elsewhere
could have a significant impact on the demand for our products and services as
well as the way we conduct business. Federal, state, and local governments
have adopted a number of healthcare policies intended to curb rising healthcare
costs. In the U.S., healthcare providers that purchase our products and
systems generally rely on governmental and other third-party payers, such as
federal Medicare, state Medicaid, and private health insurance plans, to pay
for all or a portion of the cost of heart-monitoring procedures and consumable
products utilized in those procedures. The availability of such reimbursement
affects our customers decisions to purchase capital equipment. Denial of
coverage or reductions in levels of reimbursement for procedures performed
using our products and systems by governmental or other third-party payers
would cause our revenues to decrease. We are unable to predict whether
federal, state or local healthcare reform legislation or regulation affecting
our business may be proposed or enacted in the future, or what effect any such
legislation or regulation would have on our business. If we fail to obtain or maintain applicable regulatory clearances or
approvals for our products, or if clearances or approvals are delayed, we
will be unable to commercially distribute and market our products in the
U.S. and other jurisdictions. Our products are medical devices that are subject to significant
regulation in the U.S. and in foreign countries where we do business. The
processes for obtaining regulatory approval can be lengthy and expensive, and
the results are unpredictable. If we are unable to obtain clearances or
approvals needed to market existing or new products, or obtain such clearances
or approvals in a timely fashion, it could adversely affect our revenues and
profitability. Recent and future federal and state regulations in the U.S. relating to
patient privacy could impose burdens on us. Federal and state laws regulate the confidentiality of certain patient
health information, including patient records, and the use and disclosure of
that protected health information. We are subject to these regulations when
we access, collect, and analyze patient data. Our compliance obligations with
these regulations would include agreeing, typically by contract, to use that
protected health information only for certain purposes, to safeguard that
information from misuse and to help those providers comply with their duties to
provide patients with access to their health information. Failure to comply
with these regulations could restrict our ability to sell products to customers
and could result in penalties, which could negatively impact our financial
results. In addition, our products must have features that permit health care
providers to comply with these regulations. We continually evaluate the
applicability of these regulations to our existing and new products and
services and our compliance obligations. To the extent these regulations
change in the future, we may need to devote additional resources in the future
in order to comply with these regulations. We depend on the expertise of key personnel to manage our businesses
effectively in a changing market, and if we lose one or more members of
our senior management team or if our management team does not work
together effectively, our business could be harmed. The success of our business depends in part on key managerial, sales and
technical personnel, as well as our ability to continue to attract and retain
additional highly qualified personnel. We compete for such key personnel with
other companies, academic institutions, government entities, and other
organizations. We do not have agreements whereby our employees agree not to
compete with us, nor do we maintain key person life insurance on any of our
executive officers. Our ability to maintain and expand our business may be
impaired if we are unable to retain our current key personnel, hire or retain
other qualified personnel in the future, or if our key personnel decided to
join a competitor or otherwise compete with us. Several of our existing management personnel have held their current
positions for less than two years, including our Vice President, Acute Care,
Vice President, Marketing and Vice President, Operations. Our future success
depends to a significant extent on the ability of our executive officers and
other members of our management team to operate effectively, both individually
and as a group. Our business may be harmed if we do not successfully allocate
responsibilities among our management team or if some of our management do not
succeed in their roles. 24




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Competition may decrease our market share and cause our revenues to
decrease. The diagnostic cardiology systems market is highly competitive and we
expect competition to intensify in the future. Some of our competitors are
larger companies, such as General Electric Company and Koninklijke Philips
Electronics N.V., and may have:  
    
    greater financial and other resources;  
    
    greater variety of products;  
    
    greater pricing flexibility;  
    
    more extensive technical capabilities;  
    
    patent portfolios that may present an obstacle to our conduct of business;  
    
    stronger name recognition; and  
    
    larger distribution networks. As a result, we may be unable to offer products similar to, or more
desirable than, those offered by our competitors, market our products as
effectively as our competitors, price our products competitively or otherwise
respond successfully to competitive pressures. In addition, our competitors
may be able to offer discounts on competing products as part of a bundle of
non-competing products, systems, and services that they sell to our customers,
and we may not be able to profitably match those discounts. Our competitors
may develop technologies and products that are more effective than those we
currently offer or that render our products obsolete or noncompetitive. In
addition, the timing of the introduction of competing products into the market
could affect the market acceptance and market share of our products. If we are
unable to develop competitive products, gain regulatory approval or clearance
and supply sufficient quantities of such products to the market as quickly and
effectively as our competitors, market acceptance of our products may be
limited, and our revenues and operating results may suffer. If we do not maintain or grow revenues from our support services or
consumables, our operating and financial results may be negatively
impacted. A significant portion of our revenues is generated from post-sale support
services we provide for our products and from the sale of ancillary cardiology
products and consumables related to our products and systems, such as patented
electrodes, pads, cables, leads, and thermal chart paper. As hospitals expand
their in-house capabilities to service diagnostic equipment and systems, they
may be able to service our products without additional support from us. In
addition, our customers may express an increasing preference for ancillary
cardiology products and consumables that are manufactured or provided by other
vendors. Any of these events could result in a decline in our revenues and a
resulting adverse effect on our financial and operating results. Failure to adequately protect our intellectual property rights will cause
our business to suffer. Our success depends in part on obtaining, maintaining, and enforcing our
copyrights, patents and other proprietary rights, and our ability to avoid
infringing the proprietary rights of others. We take precautionary steps to
protect our technological advantages and intellectual property and rely in part
on patent, trade secret, copyright, know-how, and trademark laws, license
agreements and contractual provisions to establish our intellectual property
rights and protect our products. The precautionary steps we have taken may not
adequately protect our intellectual property rights. Our patents may not provide commercially meaningful protection, as
competitors may be able to design around our patents. We may not be able to
protect our rights in unpatented technology, trade secrets, and confidential
information effectively. We require our new employees, consultants, and
corporate partners to execute a confidentiality agreement at the commencement
of their employment or consulting relationship with us. However, these
agreements may not provide effective protection of our information or, in the
event of unauthorized use or disclosure, they may not provide adequate
remedies. If third parties claim that our products infringe their intellectual
property rights, we may be forced to expend significant financial
resources and management time and our operating results would suffer. Third parties may claim that our products and systems infringe on
third-party patents and other intellectual property rights. Identifying
third-party patent rights can be particularly difficult because, in the U.S.,
patent applications are
maintained 25




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in secrecy for up to eighteen months after their filing dates.
Moreover, patent applications can be maintained in secrecy until they issue, if
they were filed before November 29, 2000, are not subject to publication in any
country, or have otherwise properly requested maintaining secrecy to issuance.
Some companies in the medical device industry have used intellectual property
infringement litigation to gain a competitive advantage. In the event a
competitor were to challenge our patents or licenses, or assert that our
products infringe its patent or other intellectual property rights, we could
incur substantial litigation costs, be forced to make expensive changes to our
product designs, license rights in order to continue manufacturing and selling
our products, or pay substantial damages. Third-party infringement claims,
regardless of their outcome, would not only drain our financial resources but
also divert the time and effort of our management and could result in our
customers or potential customers deferring or limiting their purchase or use of
the affected products until resolution of the litigation. If we fail to successfully enter into strategic alliances to generate
growth, our operating results may be negatively affected. A component of our growth strategy is to enter into strategic alliances in
order to complement and expand our current product and service offerings and
distribution. There can be no assurances that a strategic alliance will perform
as expected or generate significant revenues or profits. If we do not identify
potential strategic alliances or enter into strategic alliances that fail to
generate additional revenue, our operating and financial results may be
negatively impacted. Our reliance on a principal manufacturing facility may impair our ability to
respond to natural disasters or other unforeseen catastrophic events. Our principal manufacturing facility is located in a single building
in Deerfield, Wisconsin. Despite precautions taken by us, a natural
disaster or other unanticipated catastrophic events at this building
could significantly impair our ability to manufacture our products and
operate our business. Our facility and certain manufacturing equipment
would be difficult to replace and could require substantial replacement
lead-time. Such catastrophic events may also destroy any inventory of
product or components. While we carry insurance for natural disasters and
business interruption, the occurrence of such an event could result in
losses that exceed the amount of our insurance coverage, which would
impair our financial results. Compliance with changing regulation of corporate governance, public disclosure
and accounting matters may result in additional expenses. Changing laws, regulations and standards relating to corporate governance
and public disclosure, including the Sarbanes-Oxley Act of 2002 and new rules
subsequently implemented by the SEC and The NASDAQ Stock Market, as well as new
accounting pronouncements, are creating uncertainty and additional complexities
for companies. To maintain high standards of corporate governance, public
disclosure and financial reporting, we continue to invest resources to comply
with evolving standards. This investment may result in increased general and
administrative expenses and a diversion of management time and attention from
revenue generating and cost management activities. We are dependent upon licensed and purchased technology for some of our
products, and we may not be able to renew these licenses or purchase agreements
in the future. We license and purchase technology from third parties for features in some
of our products. We anticipate that we will need to license and purchase
additional technology to remain competitive. We may not be able to renew our
existing licenses and purchase agreements or to license and purchase other
technologies on commercially reasonable terms or at all. If we are unable to
renew our existing licenses and purchase agreements or we are unable to license
or purchase new technologies, we may not be able to offer competitive products. Delaware law and provisions in our charter could make the acquisition of our
company by another company more difficult. Certain provisions of our certificate of incorporation and bylaws may make
it more difficult for a third party to acquire, or discourage a third party
from attempting to acquire us. This could limit the price that certain
investors might be willing to pay in the future for shares of our common stock.
Our certificate of incorporation and bylaws allow us to issue preferred stock
without any vote or further action by the stockholders, eliminate the right of
stockholders to act by written consent without a meeting, provide that special
meetings of stockholders may be called only by our board of directors, the
chairman of our board, or our president, specify advance notice procedures
for director nominations by stockholders and submission of other proposals for
consideration at stockholder meetings, and eliminate cumulative voting in the
election of 26




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directors. Moreover, our board of directors is divided into three
classes, with directors in each class elected to staggered three year terms,
and directors may only be removed by the stockholders for cause. Some
provisions of Delaware law could also delay or make more difficult a third
partys efforts to effect a merger with or tender offer for us, including
Section 203 of the Delaware General Corporation Law, which prohibits a Delaware
corporation from engaging in any business combination with any interested
stockholder for a period of three years unless certain conditions are met.
Similar provisions under Washington law may also apply. The possible issuance
of preferred stock, our classified board, procedures required for director
nominations and stockholder proposals and Delaware law could have the effect of
delaying, deferring or preventing a change in control of our company, including
without limitation, discouraging a proxy contest or making more difficult the
acquisition of a substantial block of our common stock. Future changes in the accounting treatment for employee stock options may
cause adverse unexpected fluctuations and affect our reported results of
operations. We currently elect to apply the disclosure-only provisions of SFAS
No. 123, Accounting for Stock-Based Compensation. In accordance with
the provisions of SFAS 123, we apply Accounting Principles Board Opinion
No. 25, Accounting for Stock Issued to Employees, and related
interpretations in accounting for our stock option plans. Under this
election, we account for stock options granted to employees using the
intrinsic value method of accounting. Under this method, employee
stock-based compensation expense is based on the difference, if any,
between the fair value of our stock and the exercise price of the award
on the grant date. On March 31, 2004, the Financial Accounting Standards
Board, or FASB, the principle United States accounting standards setting
organization, issued a draft accounting pronouncement, referred to as the
exposure draft, which, if implemented, will require us to record an
expense for all outstanding unvested stock options and grants of new
stock options effective for fiscal periods beginning after June 15, 2005.
The exposure draft would also require us to record an expense for our
employee stock purchase plan. There is considerable uncertainty as to how
the final pronouncement will deal with those issues and certain portions
of the exposure draft may change. If we are required to change our
accounting policy in accordance with this exposure draft, our reported
earnings, beginning in the third quarter of 2005, would most likely be
significantly negatively impacted. If we eliminate the valuation allowance against our deferred tax assets, we
will be required to recognize income tax expense at statutory rates in future
periods, which will materially adversely impact our net income. We account for income taxes pursuant to the provisions of SFAS No.109,
Accounting for Income Taxes. We have recorded a valuation allowance for the
net balance of our deferred tax assets as a result of uncertainties regarding
realization of these assets, including our historical lack of profitability,
until recently, and the uncertainty as to the sustainability of our recently
achieved profitability. The deferred income tax assets primarily relate to
net operating losses, NOL, we have incurred in prior years and tax credits,
both of which are available to reduce income taxes in future periods. As we
continue to periodically assess our future operating plans and prospects, we
may become convinced that we will remain profitable into the foreseeable future
and that the recognition of the benefit of our deferred tax asses has become
more likely than not, in which case, we would remove some or all of the
remaining valuation allowance and recognize on our deferred tax assets. After
the valuation allowance has been removed, we would be required to recognize and
record federal income tax expense at statutory rates in subsequent periods,
which would have an adverse impact on net income. Until our NOL and tax credit
carryforwards are exhausted, we will not be required to make cash payments for
income taxes other than for federal alternative minimum taxes and some state
minimum taxes. The market price of our stock may be highly volatile. During the nine months ended September 30, 2004, our common stock traded
between a range of $7.06 and $14.00 per share. The market price of our common
stock could continue to fluctuate substantially due to a variety of factors,
including:  
    
    quarterly fluctuations in results of our operations;
    
    our ability to successfully commercialize our products;  
    
    changes in coverage or earnings estimates by analysts; 27




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
    
    impact of acquisitions, divestitures, strategic alliances, and other significant corporate events;  
    
    changes in the mix of products and systems we sell, which could affect our gross margins;  
    
    the loss of key distributors or distribution companies; and  
    
    seasonality in the sales of our products and systems. The market price for our common stock may also be affected by our ability
to meet analysts expectations. Any failure to meet such expectations, even
slightly, could have an adverse effect on the market price and volume
fluctuations. This volatility has had a significant effect on the market prices
of securities issued by many companies for reasons unrelated to the operating
performance of these companies. In the past, following periods of volatility in
the market price of a companys securities, securities class action litigation
has often been instituted against the company. If similar litigation were
instituted against us, it could result in substantial costs and a diversion of
our managements attention and resources, which could have an adverse effect on
our business, results of operations and financial condition. See Item 5:
Market for Companys Common Stock and Related Shareholder Matters in our Form
10-K for the year ended December 31, 2003 for more information regarding
fluctuations in the price of our common stock. 28




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Item 3. Quantitative and Qualitative Disclosures About Market Risk We develop products in the U.S. and sell them worldwide. As a result,
our financial results could be affected by factors such as changes in foreign
currency exchange rates or weak economic conditions in foreign markets. Since
our products are currently priced in U.S. dollars and are translated to local
currency amounts, a strengthening of the dollar could make our products less
competitive in foreign markets. Interest income is sensitive to changes in
the general level of U.S. interest rates, particularly since our investments
are in short-term investments bearing variable rates. 
 Item 4. Controls and Procedures We maintain disclosure controls and procedures designed to ensure that
information required to be disclosed in our filings under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported within
the time periods specified in the Securities and Exchange Commissions rules
and forms. Our chief executive officer and chief financial officer have
evaluated our disclosure controls and procedures as of the end of the period
covered by this quarterly report of Form 10-Q and have determined that such
disclosure controls and procedures are effective. There has been no change in our internal control over financial
reporting during the three-month period ended September 30, 2004 in
connection with this evaluation that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting. 29




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PART II  OTHER INFORMATION 
 Item 1. Legal Proceedings We are not currently a party to any material legal proceedings. 
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds None. 
 Item 3. Defaults Upon Senior Securities None. 
 Item 4. Submission of Matters to a Vote of Security Holders None. 
 Item 5. Other Information None. 
 Item 6. Exhibits (a) Exhibits Exhibit 31.1
    
    Certification of Chief Executive Officer pursuant to
Section 302(a) of the Sarbanes-Oxley Act of 2002.Exhibit 31.2
    
    Certification of Chief Financial Officer pursuant to
Section 302(a) of the Sarbanes-Oxley Act of 2002.Exhibit 32.1
    
    Certification 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.Exhibit 32.2
    
    Certification 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.
 30




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SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. QUINTON CARDIOLOGY SYSTEMS, INC.By:
    /s/ Michael K. MatysikMichael K. MatysikSenior Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer) Date: November 9, 2004 31