##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
   FORM 10-Q x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2004 OR 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
(State of Incorporation)
    
    94-3300396
(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. YES
x NO o Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). YES
x NO o The number of shares outstanding of the registrants common stock as of
April 15, 2004 was 12,285,659. 1




---



TABLE OF CONTENTS PART I  FINANCIAL INFORMATION
    
    
    3Item 1. Unaudited 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
    
    
    24Item 4. Controls and Procedures
    
    
    24PART II  OTHER INFORMATION
    
    
    25Item 1. Legal Proceedings
    
    
    25Item 2. Changes in Securities and Use of Proceeds
    
    
    25Item 3. Defaults Upon Senior Securites
    
    
    25Item 4. Submission of Matters to a Vote of Security Holders
    
    
    25Item 5. Other Information
    
    
    25Item 6. Exhibits and Reports on Form 8-K
    
    
    25SIGNATURE
    
    
    27EXHIBIT 10.28EXHIBIT 10.29EXHIBIT 10.30EXHIBIT 10.31EXHIBIT 10.32EXHIBIT 10.33EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




---



##### Table of Contents



PART I - FINANCIAL INFORMATION 
 Item 1. Unaudited Financial Statements QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS(in thousands, except share amounts) December 31,
    
    March 31,2003
    
    2004ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    185
    
    
    $
    163Accounts receivable, net of allowance for doubtful accounts
    
    
    12,480
    
    
    
    12,412Inventories
    
    
    12,690
    
    
    
    12,784Prepaid expenses and other current assets
    
    
    1,419
    
    
    
    1,409Total current assets
    
    
    26,774
    
    
    
    26,768Machinery and equipment, net of accumulated depreciation
and amortization
    
    
    4,918
    
    
    
    4,649Intangible assets, net of accumulated amortization
    
    
    5,672
    
    
    
    5,861Investment in unconsolidated entity
    
    
    1,000
    
    
    
    1,000Goodwill
    
    
    9,953
    
    
    
    9,953Total assets
    
    $
    48,317
    
    
    $
    48,231LIABILITIES AND SHAREHOLDERS EQUITYCurrent Liabilities:Line of credit
    
    $
    354
    
    
    $
    923Current portion of long term debt
    
    
    363
    
    
    
    272Accounts payable
    
    
    6,183
    
    
    
    5,818Accrued liabilities
    
    
    7,349
    
    
    
    5,965Warranty liability
    
    
    2,059
    
    
    
    2,035Deferred revenue
    
    
    4,499
    
    
    
    4,391Total current liabilities
    
    
    20,807
    
    
    
    19,404Deferred tax liability
    
    
    1,180
    
    
    
    1,185Total liabilities
    
    
    21,987
    
    
    
    20,589Minority interest in consolidated entity
    
    
    198
    
    
    
    178Shareholders 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 12,281,401 shares issued and
outstanding at December 31, 2003 and March 31, 2004,
respectively
    
    
    45,617
    
    
    
    45,843Deferred stock-based compensation
    
    
    (106
    )
    
    
    (88
    )Accumulated deficit
    
    
    (19,379
    )
    
    
    (18,291
    )Total shareholders equity
    
    
    26,132
    
    
    
    27,464Total liabilities and shareholders equity
    
    $
    48,317
    
    
    $
    48,231
 The accompanying notes are an integral part of these unaudited condensed
consolidated balance sheets. 3




---



##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except share and per share amounts) Three months EndedMarch 31,2003
    
    2004Revenues:Systems
    
    $
    16,957
    
    
    $
    18,526Service
    
    
    3,326
    
    
    
    3,126Total revenues
    
    
    20,283
    
    
    
    21,652Cost of Revenues:Systems
    
    
    10,652
    
    
    
    10,275Service
    
    
    1,787
    
    
    
    1,925Total cost of revenues
    
    
    12,439
    
    
    
    12,200Gross profit
    
    
    7,844
    
    
    
    9,452Operating Expenses:Research and development
    
    
    2,087
    
    
    
    1,831Write off of purchased in-process research and
development projects
    
    
    1,290
    
    
    
    Sales and marketing
    
    
    4,326
    
    
    
    4,371General and administrative, excluding
stock-based compensation expense
    
    
    2,027
    
    
    
    2,088Stock-based compensation
    
    
    18
    
    
    
    18Total operating expenses
    
    
    9,748
    
    
    
    8,308Operating income (loss)
    
    
    (1,904
    )
    
    
    1,144Other Income (Expense):Interest income
    
    
    1
    
    
    
    5Interest expense
    
    
    (76
    )
    
    
    (46
    )Interest income, putable warrants
    
    
    95
    
    
    
    Other income, net
    
    
    4
    
    
    
    Total other income (expense)
    
    
    24
    
    
    
    (41
    )Income (loss) before income taxes and minority interest
in consolidated entity
    
    
    (1,880
    )
    
    
    1,103Income tax provision
    
    
    
    
    
    
    (35
    )Income (loss) before minority interest in consolidated entity
    
    
    (1,880
    )
    
    
    1,068Minority interest in loss of consolidated entity
    
    
    21
    
    
    
    20Net income (loss)
    
    $
    (1,859
    )
    
    $
    1,088Net income (loss) per share  basic
    
    $
    (0.15
    )
    
    $
    0.09Net income (loss) per share  diluted
    
    $
    (0.15
    )
    
    $
    0.08Weighted average shares outstanding  basic
    
    
    12,093,777
    
    
    
    12,244,515Weighted average shares outstanding  diluted
    
    
    12,093,777
    
    
    
    13,187,087
 The accompanying notes are an integral part of these unaudited condensed
consolidated statements. 4




---



##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW (in thousands) Three Months EndedMarch 31,2003
    
    2004Operating Activities:Net income (loss)
    
    $
    (1,859
    )
    
    $
    1,088Adjustments to reconcile net income (loss) to net cash used in operating
activitiesDepreciation and amortization
    
    
    497
    
    
    
    386Write off of purchased in-process research and development
    
    
    1,290
    
    
    
    Amortization of deferred stock-based compensation
    
    
    18
    
    
    
    18Interest income, putable warrants
    
    
    (95
    )
    
    
    Deferred taxes
    
    
    
    
    
    
    5Minority interest in loss of consolidated entity
    
    
    (21
    )
    
    
    (20
    )Changes in operating assets and liabilities, net of business acquired:Accounts receivable
    
    
    614
    
    
    
    68Inventories
    
    
    486
    
    
    

    (94
    )Prepaid expenses and other current assets
    
    
    (20
    )
    
    
    10Accounts payable
    
    
    (1,534
    )
    
    
    (365
    )Accrued liabilities
    
    
    (208
    )
    
    
    (1,529
    )Warranty liability
    
    
    47
    
    
    
    (24
    )Deferred revenue
    
    
    (193
    )
    
    
    (108
    )Net cash used in operating activities
    
    
    (978
    )
    
    
    (565
    )Investing Activities:Purchases of machinery and equipment
    
    
    (435
    )
    
    
    (36
    )Purchase of technology
    
    
    
    
    
    
    (125
    )Proceeds from sale of machinery and equipment
    
    
    35
    
    
    
    Purchase of Burdick, Inc., net of cash acquired
    
    
    (21,549
    )
    
    
    Net cash used in investing activities
    
    
    (21,949
    )
    
    
    (161
    )Financing Activities:Borrowings on bank line of credit, net
    
    
    4,329
    
    
    
    569Payments of long term debt
    
    
    (91
    )
    
    
    (91
    )Proceeds from exercise of stock options and issuance of shares under
employee stock purchase plan
    
    
    44
    
    
    
    226Net cash from financing activities
    
    
    4,282
    
    
    
    704Net change in cash and cash equivalents
    
    
    (18,645
    )
    
    
    (22
    )Cash and cash equivalents, beginning of period
    
    
    19,382
    
    
    
    185Cash and cash equivalents, end of period
    
    $
    737
    
    
    $
    163Supplemental disclosure of cash flow information:Cash paid for interest
    
    $
    57
    
    
    $
    47Supplemental 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 statements. 5




---



##### Table of Contents



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 subsidiaries, Quinton Cardiology, Inc. (Quinton) and Burdick, Inc. (Burdick)
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 March 31, 2004,
the condensed consolidated statements of operations for the three-month
periods ended March 31, 2003 and 2004 and the condensed consolidated
statements of cash flows for the three-month periods ended March 31, 2003 and
2004 have been prepared by the Company and are unaudited. 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 6




---



##### Table of Contents



September 30, 2003. The adoption of this consensus resulted in
the Company deferring revenues representing the value of installation
obligations associated with the sales of our systems. During the three-month
period ended March 31, 2004, this deferral increased approximately $125,000
to $241,000. 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 3 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 ending 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. Common stock that the
Company has the right to repurchase is not included in the calculation of
outstanding shares. 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-month periods ended
March 31, 2003 and 2004: Three months endedMarch 31,2003
    
    2004Shares (denominator):Weighted average common shares for basic calculation
    
    
    12,093,777
    
    
    
    12,244,515Incremental shares from employee stock options
    
    
    
    
    
    
    942,572Weighted average shares for diluted calculation
    
    
    12,093,777
    
    
    
    13,187,087
 For the three-month period ended March 31, 2003, 1,802,435 stock options
and warrants were excluded from the computation of diluted loss per share as
their impact was antidilutive. If the Company had reported net income during
the three-month period ended March 31, 2003, the calculation of earnings per
share would have included the dilutive effect of these potential common
            shares using the treasury stock method. For the three-month period ended
March 31, 2004, 25,000 stock options were excluded from the computation of
diluted income per share as their impact was antidilutive. 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 7




---



##### Table of Contents



stock option plans. The Company
accounts for stock options issued to non-employees in accordance with the
provisions of 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-month periods ended March
31, 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 endedMarch 31,2003
    
    2004Net income (loss)  as reported
    
    $
    (1,859
    )
    
    $
    1,088Add back: Total stock-based employee compensation expense
included in reported income (loss), net of related tax effects
    
    
    18
    
    
    
    18Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects
    
    
    (256
    )
    
    
    (422
    )Net income (loss)  pro forma
    
    $
    (2,097
    )
    
    $
    684Net income (loss) per share  as reported  basic
    
    $
    (0.15
    )
    
    $
    0.09Net income (loss) per share  as reported  diluted
    
    $
    (0.15
    )
    
    $
    0.08Net income (loss) per share  pro forma  basic
    
    $
    (0.17
    )
    
    $
    0.06Net income (loss) per share  pro forma  diluted
    
    $
    (0.17
    )
    
    $
    0.05
 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 3.7%, 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 $4.62 and $6.43,
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 Burdick, Inc. 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. Company 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 8




---



##### Table of Contents



cash flows and an appropriate
discount rate. Company management also uses judgment to estimate the useful
lives of each intangible asset. The Company believes the Burdick trade name
has an indefinite life, and accordingly does not amortize the trade name.
The Company evaluates this conclusion annually and makes a judgment about
whether 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 $114,000 and $81,000 for the three-month periods ended March
31, 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 Spacelabs Burdick, Inc., 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. 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




---



##### Table of Contents



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 three-month period
ended March 31, 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 expected to be in line with the Companys historical
margins. In the opinion of management, failure to achieve expected market
results and margins relating to this product could materially adversely
affect the overall return on investment relating to the Burdick acquisition.
Costs to complete this project were expensed in the three-month period ended
March 31, 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, although the underlying
technology may have application to other projects that the Company may pursue
in the future. In the opinion of management, the indefinite postponement of
further development of this project will not materially adversely affect the
overall return on investment relating to the Burdick acquisition. All of the acquired in process research and development was written off
during the three-month period ended March 31, 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 has not been 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 were to have been terminated effective
March 31, 2004, 10




---



##### Table of Contents



the Company estimates that such net proceeds would
approximate the carrying value of the minority interest recorded in the
accompanying consolidated balance sheet, which was $178,000 at March 31,
2004. 4. 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
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 three-month period
ended March 31, 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
    
    
    (251
    )Manufacturing consolidation liabilities as of March 31, 2004
    
    $
    73
 5. 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,
    
    March 31,2003
    
    2004Raw materials
    
    $
    9,708
    
    
    $
    9,080Finished goods
    
    
    2,982
    
    
    
    3,704Total inventories
    
    $
    12,690
    
    
    $
    12,784
 6. 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 4.75% at March 31, 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 March
31, 2004, the Company had borrowings under this line of credit of $923,000
and had capacity to borrow an additional $7,485,000 based on eligible
accounts receivable and eligible inventory. 7. 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 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, 11




---



##### Table of Contents



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 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 March 31, 2004. 8. Warranty Liability Changes in the warranty liability for the three months ended March 31,
2003 and 2004 were as follows (amounts in thousands): Warranty liability as of December 31, 2003
    
    $
    2,059Charged to cost of revenues
    
    
    453Warranty expenditures
    
    
    (477
    )Warranty liability as of March 31, 2004
    
    $
    2,035Warranty liability as of December 31, 2002
    
    $
    1,089Charged to cost of revenues
    
    
    281Warranty expenditures
    
    
    (234
    )Warranty liability acquired from Burdick, Inc.
    
    
    1,016Warranty liability as of March 31, 2003
    
    $
    2,152
 9. 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. 10. 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 on October
21, 2003 and a note receivable for $750,000, due October 21, 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 the Companys post-closing transition responsibilities, which
extend into the second quarter of 2004, the Company has deferred the
recognition of any gain on the transaction until its transition
responsibilities are fulfilled. After the Company transfers inventory and
other assets associated with this line, having an aggregate value of
approximately $600,000, to the buyer, and writes-off goodwill associated with
this line of approximately $263,000, the Company expects to recognize a gain
in the second quarter of 2004 of between $600,000 and $800,000 on the
transaction, excluding the effect of any contingent consideration. Contingent consideration received during the three-month period ended
March 31, 2004 of $30,000 has been deferred while the Company is filling its
post-closing transitional obligations. Any additional contingent
consideration received during the period in which the Company is filling its
post-closing transitional obligations will also be deferred until those
obligations are fulfilled. Contingent consideration received after this
period will be recognized as income in the period in which it is earned. 12




---



##### Table of Contents






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. Except for historical information,
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, including future results
of operations or financial position, made in this Quarterly Report on Form
10-Q, 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 below, those discussed elsewhere in this report and those discussed
in our Annual Report on Form 10-K filed 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. Results of Operations Three Months EndedMarch 31,2003
    
    2004(as a percentage of revenues)Revenues:Systems
    
    
    83.6
    %
    
    
    85.6
    %Service
    
    
    16.4
    
    
    
    14.4Total revenues
    
    
    100.0
    
    
    
    100.0Gross Profit:Systems (as a percentage of systems revenue)
    
    
    37.2
    
    
    
    44.5Service (as a percentage of service revenue)
    
    
    46.3
    
    
    
    38.4Gross profit
    
    
    38.7
    
    
    
    43.7Operating Expenses:Research and development
    
    
    10.3
    
    
    
    8.5Write off of purchased in-process research
and development
    
    
    6.4
    
    
    
    Sales and marketing
    
    
    21.3
    
    
    
    20.2General and administrative, excluding
stock-based compensation expense
    
    
    10.0
    
    
    
    9.6Stock-based compensation
    
    
    0.1
    
    
    
    0.1Total operating expenses
    
    
    48.1
    
    
    
    38.4
 13




---



##### Table of Contents



Three Months EndedMarch 31,2003
    
    2004(as a percentage of revenues)Operating income (loss)
    
    
    (9.4
    )
    
    
    5.3Total other income (expense)
    
    
    0.1
    
    
    
    (0.2
    )Income tax provision
    
    
    0.0
    
    
    
    (0.2
    )Minority interest in loss of consolidated entity
    
    
    0.1
    
    
    
    0.1Net income (loss)
    
    
    (9.2
    )%
    
    
    5.0
    %
 Three-Month Period Ended March 31, 2004 Compared to the Three-Month Period
Ended March 31, 2003 Revenues Revenues increased by $1,369,000, or 6.7%, to $21,652,000 for the
three-month period ended March 31, 2004 from $20,283,000 for the comparable
period in 2003. Revenues for the three-month period ended March 31, 2003
included system sales of $371,000 related to our hemodynamic monitoring
product line. We divested this product line in the third quarter of 2003.
As a result, revenues for the three-month period ended March 31, 2004 did not
include any sales from the hemodynamic monitoring product line. Systems revenues increased by $1,569,000, or 9.3%, to $18,526,000 for
the three-month period ended March 31, 2004 from $16,957,000 for the
comparable period in 2003. This growth was attributable to continued
strength in our core product line, most notably electrocardiographs
and stress testing systems. Service revenues decreased by $200,000, or 6.0%, to $3,126,000 for the
three-month period ended March 31, 2004 from $3,326,000 for the comparable
period in 2003 due principally to a decrease in service parts revenues, which
can fluctuate from period to period. While service revenues may decline
slightly in the second quarter of 2004, when we discontinue providing service
on systems related to the divested hemodynamic monitoring systems line, we do
not expect service revenues to decrease materially in periods after the
second quarter of 2004. Gross Profit Gross profit increased by $1,608,000, or 20.5%, to $9,452,000 for the
three-month period ended March 31, 2004 from $7,844,000 for the comparable
period in 2003. Gross profit, as a percentage of revenues, increased to
43.7% for the three-month period ended March 31, 2004 from 38.7% for the
comparable period in 2003. The increase in gross profit, as a percentage of
revenues, was primarily due to the results of cost reductions that were
realized after we completed the consolidation of our manufacturing operations
from two facilities (Bothell, WA and Deerfield, WI) into one facility in
Deerfield, WI, which was completed by the end of the fourth quarter of 2003.
To a lesser extent, the increase in gross profit was also due to the results
of product cost reduction initiatives, including design cost reductions and
other reductions in the cost of purchased components of our products. In
addition, during the three-month period ended March 31, 2003, we recognized
an acquisition-related charge to cost of revenues of $300,000, reflecting an
upward adjustment to Burdicks inventory valuation from Burdicks historical
cost at the acquisition date. This charge to cost of revenues represented an
adverse impact to gross profit of approximately 1.5 percentage points. There
was no similar charge in the three-month period ended March 31, 2004. Gross profit from systems revenues increased by $1,946,000, or 30.9%, to
$8,251,000 for the three-month period ended March 31, 2004 from $6,305,000
for the comparable period in 2003. Gross profit from systems revenues, as a
percentage of systems revenues, increased to 44.5% for the three-month period
ended March 31, 2004 from 37.2% for the comparable
period in 2003. This increase in gross profit, as a percentage of
revenues, was primarily due to the cost reductions relating to our
manufacturing facility consolidation and the product cost reduction measures
referred to above. For the three-month period ended March 31, 2003, we
recognized an acquisition-related charge to cost of systems revenues of
$300,000, which is discussed above. This charge to cost of systems revenues
represented an adverse impact to 14




---



##### Table of Contents



gross profit from systems revenues of
approximately 1.8 percentage points during the three month period ended March
31, 2003. Gross profit from service revenues decreased by $338,000, or 22.0%, to
$1,201,000 for the three-month period ended March 31, 2004 from $1,539,000
for the comparable period in 2003. Gross profit from service revenues, as a
percentage of services revenues, decreased to 38.4% for the three-month
period ended March 31, 2004 from 46.3% for the comparable period in 2003.
This decrease in gross margin was attributable to a combination of lower
service parts sales, which can fluctuate from period to period, increases in
service staffing levels to provide enhanced support to our customers and the
temporary effects of inefficiencies and changes relating to the recent
conversion of our enterprise resource planning system. Although margins may
be negatively affected due to an expected slight decline in service revenues
in the second quarter of 2004 when we discontinue providing service on
systems relating to the divested hemodynamic monitoring product line, we
expect service margins to improve in periods after the second quarter of
2004. Operating Expenses Research and development expenses decreased by $256,000, or 12.3%, to
$1,831,000 for the three-month period ended March 31, 2004 from $2,087,000
for the comparable period in 2003. This decrease was primarily due to
staffing reductions associated with the sale of our hemodynamic monitoring
product line. As a percentage of revenues, research and development expenses
decreased to 8.5% for the three-month period ended March 31, 2004 from 10.3%
for the comparable period in 2003. This decrease was attributed to lower
labor costs and higher revenues during the three-month period ended March 31,
2004 over the comparable period in 2003. Sales and marketing expenses increased by $45,000, or 1.0%, to
$4,371,000 for the three-month period ended March 31, 2004 from $4,326,000
for the comparable period in 2003. This increase was principally the result
of increases in commission expense associated with higher revenues during the
three-month period ended March 31, 2004 over the comparable period in 2003.
As a percentage of revenues, sales and marketing expenses decreased to 20.2%
for the three-month period ended March 31, 2004 from 21.3% for the comparable
period in 2003. This primarily reflects an increase in revenues for the
three-month period ended March 31, 2004 over the comparable period in 2003. General and administrative expenses, excluding stock-based compensation
expense, increased by $61,000, or 3.0%, to $2,088,000 for the three-month
period ended March 31, 2004, from $2,027,000 for the comparable period in
2003. This increase was the net effect of a variety of factors, none of
which were individually material. As a percentage of revenues, general and
administrative expenses, excluding stock-based compensation, decreased to
9.6% for the three-month period ended March 31, 2004 from 10.0% for the
comparable period in 2003. This primarily reflects an increase in revenues
for the three-month period ended March 31, 2004 over the comparable period in
2003. Stock-based compensation expense for the three-month period ended March
31, 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
relates to the intrinsic value of stock options granted in 2001. We expect
to record stock-based compensation expense in the second quarter of 2004 at a
level similar to the amount recorded in the first quarter of 2004. Other Income and Expense Total other expense for the three-month period ended March 31, 2004 was
$41,000, as compared to total other income of $24,000 for the comparable
period in 2003, which was primarily due to a decrease in interest income
related to putable warrants recognized during the three-month period ended
March 31, 2003. These warrants were retired in May 2003. This decrease was
partially offset with a decrease in interest expense of approximately
$30,000, primarily due to a decrease in average borrowings on our bank line
of credit over the three-month period ended March 31, 2004, as compared to
average borrowings over the comparable period in 2003. Income Taxes Income tax provisions recorded in the three-month period ended March 31,
2004 were due to estimated federal alternative minimum tax and to state
income tax liabilities. During
the three-month period ended March 31, 2004, net operating loss
carryforwards were utilized to offset taxable income. As a result,
our federal income tax provision has been estimated using alternative
minimum tax rates rather than federal statutory rates. We continue to
provide a full valuation allowance against deferred tax assets. Based
on a number of factors, including our 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 near term. The full impact of any
adjustment to the valuation allowance will be recognized in the
period of adjustment. 15




---



##### Table of Contents



Liquidity and Capital Resources Net cash used for operating activities was $565,000 for the three-month
period ended March 31, 2004 compared to $978,000 for the comparable period in
2003. Net cash used for operating activities of $565,000 for the three-month
period ended March 31, 2004 was primarily due to decreases in accounts
payable, accrued liabilities and deferred revenue, aggregating
$2,002,000,
which was partially offset by net income, excluding non-cash expenses, of
$1,437,000. Accrued liabilities at March 31, 2004 decreased from the balance
at December 31, 2003 principally due to the payment during the three-month
period ended March 31, 2004 of accrued year-end compensation relating to 2003
sales and operating results and accrued costs relating to the consolidation
of manufacturing operations. Net
cash used for investing activities of $161,000 for the three-month
period ended March 31, 2004 consisted of
$36,000 for capital expenditures and $125,000 for the purchase of technology for use in future products. Net cash used
for investing activities of $21,949,000 for the three-month period
ended March 31, 2003 was primarily due to our
investment in Burdick of approximately $21,549,000 and capital equipment expenditures of $435,000, which were
primarily for the purchase of our enterprise resource planning system offset by proceeds received from sales of capital
equipment of $35,000. We are obligated to pay an additional $125,000 relating to technology we purchased during the three months
ended March 31, 2004. This amount is due in the third quarter of 2004 and is included in accrued liabilities in our
consolidated balance sheet dated March 31, 2004. In addition, we have a per unit royalty obligation relating to any
future products sold using this purchased technology. There is no minimum royalty payment obligation and the
maximum of such payments would be $650,000. Any such royalty payments will be expensed to cost of revenues as
incurred. Net cash provided from financing activities of $704,000 for the
three-month period ended March 31, 2004 was primarily due to net borrowings
on our credit line of $569,000 and a debt payment of $91,000 related to the
note payable issued in the treadmill manufacturing business acquisition,
which was partially offset by proceeds from exercises of stock options and
proceeds from the issuance of common stock in accordance with our employee
stock purchase plan of $226,000. Net cash provided from financing activities
of $4,282,000 for the three-month period ended March 31, 2003 was primarily
the result of net borrowings on our credit line of $4,329,000 and proceeds
from exercise of stock options of $44,000, which were offset by payments of
long term debt of $91,000. We anticipate that, for 2004, our future expected operating cash flow and borrowings available to us under our
line of credit will be sufficient to meet operating expenses, working capital
requirements, capital expenditures and other obligations for at
least 12 months. Our ability to repay borrowings under
our line of credit and to satisfy other liabilities may depend on future operating performance. We may be affected
by economic, financial, competitive, legislative, regulatory, business and other factors beyond our control. In addition,
we periodically consider acquisitions that complement or expand our existing
business or that may enable us to expand into new markets. Future acquisitions may require additional debt, equity
financing or both. We may not be able to obtain any additional financing, or may not be able to obtain additional
financing on acceptable terms. 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 on October
21, 2003 and a note receivable of $750,000, due October 21, 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
extend into the second quarter of 2004, we will defer the recognition of any
gain on the transaction. We expect to recognize a gain in the second quarter
of 2004 of between $600,000 and $800,000 on the transaction, excluding the
effect of any contingent consideration. Contingent consideration received
during the three-month period ended March 31, 2004 of $30,000 has been
deferred while the Company is filling its post-closing transitional
obligations. Any additional contingent consideration received during the
period in which we are filling our post-closing transitional obligations will
also be deferred until these obligations are fulfilled. Contingent
consideration received after this period will be recognized as income in the
period in which it is received. The hemodynamic monitoring product line represented approximately $0.4
million of our revenues for the three-month period ended March 31,
2003 and approximately $3.0 million for the year ended December 31, 2003. We have,
however, made cost adjustments, principally in the form of staffing
reductions. Accordingly, management does not expect the loss of these
revenues to have a materially adverse impact on operating income in 2004 and
beyond. 16




---



##### Table of Contents



Certain Factors that May Affect Future Results 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. Additional risks and
uncertainties not presently known to us or that we currently deem immaterial
also may impair our business operations. 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
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;
    
    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;
    
    the impact of exchange rate fluctuations on our operating
results and the carrying value of our assets and liabilities; 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
harm 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 and, if necessary, to obtain
satisfactory debt or equity financing. Acquisitions involve numerous risks,
including the following:  
    
    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; 17




---



##### Table of Contents




    
    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;
    
    manage customer acceptance and payment;
    
    limit demands by our customers for retrofits; 18




---



##### Table of Contents




    
    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 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. Effective January 1, 2002, we adopted Statement of Financial Accounting
Standards (SFAS) No. 142, Goodwill and Other Intangible Assets. SFAS No. 142
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 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 19




---



##### Table of Contents



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;
    
    costs associated with product recalls;
    
    increased service and warranty costs;
    
    legal actions by our customers; and
    
    increased insurance costs. 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 20




---



##### Table of Contents



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 some or all of 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. 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. A small number of companies, all
of which are larger than us, dominate the market. Some of our larger
competitors, such as General Electric Company and Koninklijke Philips
Electronics N.V., may have:  
    
    greater financial and other resources;
    
    greater variety of products; 21




---



##### Table of Contents




    
    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 with
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 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 22




---



##### Table of Contents



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 liquidity and financial condition could be adversely impacted if we
are unable to satisfy our obligations under our revolving credit facility
or any future debt arrangements. In December 2002, in order to provide additional funding for the
acquisition of Burdick, we established a $12.0 million revolving credit
facility with Silicon Valley Bank, with available borrowings subject to certain
accounts receivable and inventory provisions. This facility has a term of two
years. Outstanding borrowings under the facility were $0.9 million at March
31, 2004. The credit facility contains standard negative covenants and
restrictions on actions by us, including but not limited to, activity related
to our common stock repurchases, liens, investments, capital expenditures,
indebtedness, restricted payments including cash payments of dividends, and
fundamental changes in, or disposition of our assets. Certain of these actions
may be taken by us with the consent of the lender. The credit agreement
requires that we meet certain financial covenants, namely a minimum tangible
net worth measure. We may in the future enter into additional debt
arrangements that contain similar or additional covenants. If we are unable to
maintain the financial performance necessary to comply with the financial
covenants in the credit agreement or in other debt arrangements we enter into,
we may be deemed in breach our obligations and these covenants, which could
result in an acceleration of our debt. In addition, these financial covenants
may limit our ability to incur additional debt. Any of these events could
adversely affect the value of our common stock, and our access to capital could
be negatively impacted. We cannot assure you that we will generate sufficient
cash flow or be able to obtain sufficient funding or take other actions to
satisfy our debt service requirements. 23




---



##### Table of Contents



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 calculated at 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 in connection with this evaluation that has materially affected, or
is reasonably likely to materially affect, our internal control over
financial reporting. 24




---



##### Table of Contents



PART II - OTHER INFORMATION 
 Item 1. Legal Proceedings We are not currently a party to any material legal proceedings. 
 Item 2. Changes in 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 and Reports on Form 8-K (a)
    
    ExhibitsExhibit 10.28*
    
    Employment Agreement between Quinton Cardiology Systems,
Inc. and Ruediger Naumann-Etienne dated as of February 6, 2004.Exhibit 10.29*
    
    Employment Agreement between Quinton Cardiology Systems,
Inc. and John R. Hinson dated as of February 6, 2004.Exhibit 10.30*
    
    Employment Agreement between Quinton Cardiology Systems,
Inc. and Michael K. Matysik dated as of February 6, 2004.Exhibit 10.31*
    
    Employment Agreement between Quinton Cardiology Systems,
Inc. and Darryl Lustig dated as of February 6, 2004.Exhibit 10.32*
    
    Letter Agreement between Quinton Cardiology Systems, Inc.
and John R. Serino dated February 17, 2004.Exhibit 10.33*
    
    Quinton Cardiology Systems, Inc. Stock Option Grant Notice
and Stock Option Agreement between Quinton Cardiology Systems, Inc.
and Allan Criss, dated as of March 10, 2004.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.
 25




---



##### Table of Contents



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.
  *
    
    Indicates management contract or compensatory plan or
arrangement. (b) Reports on Form 8-K On February 12, 2004, pursuant to Item 12 of Form 8-K, we furnished a
press release announcing results for the fiscal quarter ended December 31,
2003 and the 2003 fiscal year. 26




---



##### Table of Contents



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. Matysik
Senior Vice President and Chief Financial
Officer
(Principal Financial and Accounting Officer)
 Date: April 27, 2004 27