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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549



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FORM 10-Q

(Mark One)



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

For the quarterly period ended June 30, 2002

OR



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

For the transition period from                          to

Commission File Number 000-49755

QUINTON CARDIOLOGY SYSTEMS, INC.

(Exact name of registrant as specified in its charter)


|                                    |  |                                             
|----------------------------------- |  | --------------------------------------------
|California
(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)

Indicated by check üwhether 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     þNo     [   ]

As of August 12, 2002, 11,947,568 shares of the issuers common stock were
outstanding.



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TABLE OF CONTENTS



|                               |                                                                                               |  |  |  |  |  |  | 
|------------------------------ | --------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I  FINANCIAL INFORMATION
|                               | Item 1. Unaudited Financial Statements                                                       
|                               | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                               | Item 3. Quantitative and Qualitative Disclosures About Market Risk                           
|PART II  OTHER INFORMATION   
|                               | Item 1. Legal Proceedings                                                                    
|                               | Item 2. Changes in Securities and Use of Proceeds                                            
|                               | Item 6. Exhibits and Reports on Form 8-K                                                     
|SIGNATURE                     
|EXHIBIT 99.1                  
|EXHIBIT 99.2                  



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##### Table of Contents



TABLE OF CONTENTS

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|PART I  FINANCIAL INFORMATION |                                                                                               |  | 3  |   
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|                               | Item 1. Unaudited Financial Statements                                                        |  |    | 3  | 
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|                               | Item 2. Managements Discussion and Analysis of
Financial Condition and Results of Operations |  |    | 10 | 
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|                               | Item 3. Quantitative and Qualitative Disclosures About Market Risk                            |  |    | 18 | 
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|PART II  OTHER INFORMATION    |                                                                                               |  | 19 |   
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|                               | Item 1. Legal Proceedings                                                                     |  |    | 19 | 
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|                               | Item 2. Changes in Securities and Use of Proceeds                                             |  |    | 19 | 
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|                               | Item 6. Exhibits and Reports on Form 8-K                                                      |  |    | 20 | 
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|SIGNATURE                      |                                                                                               |  | 21 |   



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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, |        | June 30,
|                                                         |                                                                                                                                                                       |                                      |                                            |         | 2001         |        | 2002    
|                                                         |                                                                                                                                                                       |                                      |                                            |         |              |        |         
|ASSETS                                                  
|Current Assets:                                          |                                                                                                                                                                       |                                      |                                            |         |              |        |          |        
|                                                         | Cash and cash equivalents                                                                                                                                             |                                      | $                                          | 218     |              |        | $        | 24,265  |  
|                                                         | Accounts receivable, net of allowance for doubtful accounts                                                                                                           |                                      |                                            | 6,123   |              |        |          | 6,171   |  
|                                                         | Inventories                                                                                                                                                           |                                      |                                            | 6,161   |              |        |          | 5,406   |  
|                                                         | Prepaid expenses and other current assets                                                                                                                             |                                      |                                            | 626     |              |        |          | 715     |  
|                                                         |                                                                                                                                                                       |                                      |                                            |         |              |        |          |        
|                                                         |                                                                                                                                                                       |                                      | Total current assets                       |         |              | 13,128 |          |         |   | 36,557 | 
|Machinery and equipment, net of accumulated depreciation |                                                                                                                                                                       |                                      | 3,165                                      |         |              |        | 3,032    |        
|Patents, net of accumulated amortization                 |                                                                                                                                                                       |                                      | 173                                        |         |              |        | 112      |        
|Investment in unconsolidated entity                      |                                                                                                                                                                       |                                      | 1,000                                      |         |              |        | 1,000    |        
|                                                         |                                                                                                                                                                       |                                      |                                            |         |              |        |          |        
|                                                         |                                                                                                                                                                       |                                      | Total assets                               |         | $            | 17,466 |          |         | $ | 40,701 | 
|                                                         |                                                                                                                                                                       |                                      |                                            |         |              |        |          |        
|LIABILITIES AND SHAREHOLDERS EQUITY                    
|Current Liabilities:                                     |                                                                                                                                                                       |                                      |                                            |         |              |        |          |        
|                                                         | Line of credit                                                                                                                                                        |                                      | $                                          | 4,471   |              |        | $        |        |  
|                                                         | Accounts payable                                                                                                                                                      |                                      |                                            | 4,029   |              |        |          | 4,940   |  
|                                                         | Accrued liabilities                                                                                                                                                   |                                      |                                            | 2,548   |              |        |          | 3,124   |  
|                                                         | Warranty liability                                                                                                                                                    |                                      |                                            | 1,269   |              |        |          | 1,097   |  
|                                                         | Deferred revenue                                                                                                                                                      |                                      |                                            | 3,556   |              |        |          | 3,839   |  
|                                                         | Putable warrants                                                                                                                                                      |                                      |                                            | 705     |              |        |          | 572     |  
|                                                         |                                                                                                                                                                       |                                      |                                            |         |              |        |          |        
|                                                         |                                                                                                                                                                       |                                      | Total current liabilities                  |         |              | 16,578 |          |         |   | 13,572 | 
|Sublease liability, net of current portion               |                                                                                                                                                                       |                                      | 831                                        |         |              |        | 415      |        
|                                                         |                                                                                                                                                                       |                                      |                                            |         |              |        |          |        
|                                                         |                                                                                                                                                                       |                                      | Total liabilities                          |         |              | 17,409 |          |         |   | 13,987 | 
|                                                         |                                                                                                                                                                       |                                      |                                            |         |              |        |          |        
|Shareholders Equity:                                    |                                                                                                                                                                       |                                      |                                            |         |              |        |          |        
|                                                         | Preferred stock (50,000,000 shares authorized):                                                                                                                       |                                      |                                            |         |              |        |          |         |  
|                                                         |                                                                                                                                                                       | Series A convertible preferred stock |                                            |         | 12,230       |        |          |         |  |       
|                                                         |                                                                                                                                                                       | Series B convertible preferred stock |                                            |         | 865          |        |          |         |  |       
|                                                         | Common stock (100,000,000 shares authorized), no par
value, 677,275 and 11,945,681 shares issued and
outstanding at December 31, 2001 and June 30, 2002,
respectively |                                      |                                            | 3,490   |              |        |          | 44,841  |  
|                                                         | Deferred stock-based compensation                                                                                                                                     |                                      |                                            | (287    | )            |        |          | (217    | )
|                                                         | Accumulated deficit                                                                                                                                                   |                                      |                                            | (16,241 | )            |        |          | (17,910 | )
|                                                         |                                                                                                                                                                       |                                      |                                            |         |              |        |          |        
|                                                         |                                                                                                                                                                       |                                      | Total shareholders equity                 |         |              | 57     |          |         |   | 26,714 | 
|                                                         |                                                                                                                                                                       |                                      |                                            |         |              |        |          |        
|                                                         |                                                                                                                                                                       |                                      | Total liabilities and shareholders equity |         | $            | 17,466 |          |         | $ | 40,701 | 
|                                                         |                                                                                                                                                                       |                                      |                                            |         |              |        |          |        

The accompanying notes are an integral part of these unaudited condensed
consolidated balance sheets.



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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 June 30, |        | Six Months Ended June 30,
|                                                                             |                                |                                                                        |                              |     |                             |        |                          
|                                                                             |                                |                                                                        |                              |     | 2001                        |        | 2002                      |    | 2001  |        | 2002   
|                                                                             |                                |                                                                        |                              |     |                             |        |                           |    |       |        |        
|Revenues:                                                                    |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|                                                                             |                                | Systems                                                                |                              | $   | 9,250                       |        |                           | $  | 9,063 |        |         | $   | 16,953 |        |           | $   | 17,229 |       
|                                                                             |                                | Service                                                                |                              |     | 2,233                       |        |                           |    | 2,196 |        |         |     | 4,608  |        |           |     | 4,419  |       
|                                                                             |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|                                                                             |                                |                                                                        | Total revenues               |     |                             | 11,483 |                           |    |       | 11,259 |         |     |        | 21,561 |           |     |        | 21,648 |  
|                                                                             |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|Cost of Revenues:                                                            |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|                                                                             |                                | Systems                                                                |                              |     | 5,960                       |        |                           |    | 5,697 |        |         |     | 10,901 |        |           |     | 10,742 |       
|                                                                             |                                | Service                                                                |                              |     | 1,323                       |        |                           |    | 1,185 |        |         |     | 2,634  |        |           |     | 2,376  |       
|                                                                             |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|                                                                             |                                |                                                                        | Total cost of revenues       |     |                             | 7,283  |                           |    |       | 6,882  |         |     |        | 13,535 |           |     |        | 13,118 |  
|                                                                             |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|                                                                             |                                |                                                                        | Gross profit                 |     |                             | 4,200  |                           |    |       | 4,377  |         |     |        | 8,026  |           |     |        | 8,530  |  
|                                                                             |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|Operating Expenses:                                                          |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|                                                                             |                                | Research and development                                               |                              |     | 1,512                       |        |                           |    | 1,334 |        |         |     | 3,006  |        |           |     | 2,687  |       
|                                                                             |                                | Sales and marketing                                                    |                              |     | 2,518                       |        |                           |    | 2,466 |        |         |     | 4,764  |        |           |     | 4,919  |       
|                                                                             |                                | General and administrative, excluding
stock-based compensation expense |                              |     | 1,213                       |        |                           |    | 1,106 |        |         |     | 2,497  |        |           |     | 2,589  |       
|                                                                             |                                | Stock-based compensation                                               |                              |     | 312                         |        |                           |    | 35    |        |         |     | 451    |        |           |     | 70     |       
|                                                                             |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|                                                                             |                                |                                                                        | Total operating expenses     |     |                             | 5,555  |                           |    |       | 4,941  |         |     |        | 10,718 |           |     |        | 10,265 |  
|                                                                             |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|                                                                             |                                |                                                                        | Operating loss               |     |                             | (1,355 | )                         |    |       | (564   | )       |     |        | (2,692 | )         |     |        | (1,735 | )
|                                                                             |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|Other Income (Expense):                                                      |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|                                                                             |                                | Interest income                                                        |                              |     |                            |        |                           |    | 46    |        |         |     |       |        |           |     | 46     |       
|                                                                             |                                | Interest expense                                                       |                              |     | (95                         | )      |                           |    | (29   | )      |         |     | (183   | )      |           |     | (102   | )     
|                                                                             |                                | Non-cash interest income (expense),
Putable warrants                   |                              |     | (62                         | )      |                           |    | 133   |        |         |     | (62    | )      |           |     | 133    |       
|                                                                             |                                | Other income, net                                                      |                              |     | 30                          |        |                           |    |      |        |         |     | 24     |        |           |     | 3      |       
|                                                                             |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|                                                                             |                                |                                                                        | Total other income (expense) |     |                             | (127   | )                         |    |       | 150    |         |     |        | (221   | )         |     |        | 80     |  
|                                                                             |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|Loss before income taxes                                                     |                                |                                                                        | (1,482                       | )   |                             |        | (414                      | )  |       |        | (2,913  | )   |        |        | (1,655    | )  
|                                                                             | Income tax benefit (provision) |                                                                        |                              | (14 | )                           |        |                           | (4 | )     |        |         | 197 |        |        |           | (14 | )     
|                                                                             |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|                                                                             |                                | Net loss                                                               |                              | $   | (1,496                      | )      |                           | $  | (418  | )      |         | $   | (2,716 | )      |           | $   | (1,669 | )     
|                                                                             |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|Basic and diluted net loss per share                                         |                                | $                                                                      | (2.41                        | )   |                             | $      | (0.06                     | )  |       | $      | (4.43   | )   |        | $      | (0.44     | )  
|                                                                             |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    
|Weighted average shares used to compute
basic and diluted net loss per share |                                |                                                                        | 620,430                      |     |                             |        | 6,812,713                 |    |       |        | 612,986 |     |        |        | 3,751,667 |    
|                                                                             |                                |                                                                        |                              |     |                             |        |                           |    |       |        |         |     |        |        |           |    

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



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QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

|                                                  |                                                                           |                                                      |                                            |                                          |     |                           |        |        |      |      |        |  
|------------------------------------------------- | ------------------------------------------------------------------------- | ---------------------------------------------------- | ------------------------------------------ | ---------------------------------------- | --- | ------------------------- | ------ | ------ | ---- | ---- | ------ | -
|                                                  |                                                                           |                                                      |                                            |                                          |     | Six Months Ended June 30,
|                                                  |                                                                           |                                                      |                                            |                                          |     |                          
|                                                  |                                                                           |                                                      |                                            |                                          |     | 2001                      |        | 2002  
|                                                  |                                                                           |                                                      |                                            |                                          |     |                           |        |       
|Operating Activities:                             |                                                                           |                                                      |                                            |                                          |     |                           |        |       
|                                                  | Net loss                                                                  |                                                      | $                                          | (2,716                                   | )   |                           | $      | (1,669 | )   
|                                                  | Adjustments to reconcile net loss to net cash from operating activities  |                                                      |                                            |                                          |     |                           |        |        |     
|                                                  |                                                                           | Depreciation and amortization                        |                                            |                                          | 578 |                           |        |        | 583  |     
|                                                  |                                                                           | Loss on sale of equipment                            |                                            |                                          | 42  |                           |        |        | 9    |     
|                                                  |                                                                           | Amortization of deferred stock compensation          |                                            |                                          | 451 |                           |        |        | 70   |     
|                                                  |                                                                           | Non-cash interest expense (income), putable warrants |                                            |                                          | 62  |                           |        |        | (133 | )   
|                                                  |                                                                           | Changes in operating assets and liabilities:         |                                            |                                          |     |                           |        |        |      |     
|                                                  |                                                                           |                                                      | Accounts receivable                        |                                          |     | 853                       |        |        |      | (48  | )     
|                                                  |                                                                           |                                                      | Inventories                                |                                          |     | 423                       |        |        |      | 755  |       
|                                                  |                                                                           |                                                      | Prepaid expenses and other assets          |                                          |     | (200                      | )      |        |      | (89  | )     
|                                                  |                                                                           |                                                      | Income taxes receivable                    |                                          |     | 1,209                     |        |        |      |     |       
|                                                  |                                                                           |                                                      | Accounts payable                           |                                          |     | 306                       |        |        |      | 137  |       
|                                                  |                                                                           |                                                      | Accrued liabilities and sublease liability |                                          |     | 225                       |        |        |      | 160  |       
|                                                  |                                                                           |                                                      | Warranty liability                         |                                          |     | (246                      | )      |        |      | (172 | )     
|                                                  |                                                                           |                                                      | Deferred revenue                           |                                          |     | (246                      | )      |        |      | 283  |       
|                                                  |                                                                           |                                                      |                                            |                                          |     |                           |        |       
|                                                  |                                                                           |                                                      |                                            | Net cash flows from operating activities |     |                           | 741    |        |      |      | (114   | )
|                                                  |                                                                           |                                                      |                                            |                                          |     |                           |        |       
|Investing Activities:                             |                                                                           |                                                      |                                            |                                          |     |                           |        |       
|                                                  | Purchases of machinery and equipment                                      |                                                      |                                            | (171                                     | )   |                           |        | (398   | )   
|                                                  |                                                                           |                                                      |                                            |                                          |     |                           |        |       
|                                                  |                                                                           |                                                      |                                            | Net cash flows from investing activities |     |                           | (171   | )      |      |      | (398   | )
|                                                  |                                                                           |                                                      |                                            |                                          |     |                           |        |       
|Financing Activities:                             |                                                                           |                                                      |                                            |                                          |     |                           |        |       
|                                                  | Repayments of borrowings on the bank line of credit, net                  |                                                      |                                            | (602                                     | )   |                           |        | (4,471 | )   
|                                                  | Proceeds from issuance of common stock, net of issuance costs of $3,209   |                                                      |                                            |                                         |     |                           |        | 28,991 |     
|                                                  | Proceeds from exercise of stock options                                   |                                                      |                                            | 5                                        |     |                           |        | 39     |     
|                                                  | Repurchase of shares in connection with termination                       |                                                      |                                            | (94                                      | )   |                           |        |       |     
|                                                  |                                                                           |                                                      |                                            |                                          |     |                           |        |       
|                                                  |                                                                           |                                                      |                                            | Net cash flows from financing activities |     |                           | (691   | )      |      |      | 24,559 |  
|                                                  |                                                                           |                                                      |                                            |                                          |     |                           |        |       
|Net change in cash and cash equivalents           |                                                                           |                                                      | (121                                       | )                                        |     |                           | 24,047 |       
|Cash and cash equivalents, beginning of period    |                                                                           |                                                      | 423                                        |                                          |     |                           | 218    |       
|                                                  |                                                                           |                                                      |                                            |                                          |     |                           |        |       
|Cash and cash equivalents, end of period          |                                                                           | $                                                    | 302                                        |                                          |     | $                         | 24,265 |       
|                                                  |                                                                           |                                                      |                                            |                                          |     |                           |        |       
|Supplemental disclosure of cash flow information: |                                                                           |                                                      |                                            |                                          |     |                           |        |       
|                                                  | Cash paid for interest                                                    |                                                      | $                                          | 217                                      |     |                           | $      | 131    |     
|                                                  |                                                                           |                                                      |                                            |                                          |     |                           |        |       

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



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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. (Quinton) is a California corporation.
Quinton and its subsidiaries are referred to herein as the Company. The
Company develops, manufactures, markets and services a family of diagnostic
cardiology systems used in the diagnosis, treatment and rehabilitation 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 balance sheet dated June 30, 2002, the condensed statements of
operations for the three and six months ended June 30, 2001 and 2002 and the
condensed statements of cash flows for the six months ended June 30, 2001 and
2002 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 registration statement dated
February 22, 2002, as amended, on Form S-1 under the Securities Act of 1933
(Registration No. 333-83272) for the fiscal year ended December 31, 2001
provide a summary of significant accounting policies and additional financial
information that should be read in conjunction with this report. These
condensed financial statements should be read in conjunction with the audited
financial statements dated December 31, 2001 and the notes thereto. 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. All share information in these financial statements
gives effect to a 1 for 2.2 reverse stock split, which was effected in April
2002.

Initial Public Offering

In May 2002, the Company consummated a public offering of its common stock
as more fully described in its registration statement dated May 6, 2002 filed
with the Securities and Exchange Commission. In the offering, the Company sold
4,000,000 shares of common stock at a price of $7.00 per share. In June 2002,
the underwriters of the offering exercised their over-allotment option to
purchase an additional 600,000 shares at $7.00 per share. Proceeds from the
offering, including the over-allotment shares, were approximately $28.2
million, net of underwriting discounts and offering expenses. As a result of
the consummation of the offering, all of the convertible preferred stock
outstanding prior to the closing was automatically converted into an aggregate
of 6,639,347 shares of common stock.



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Weighted Average Common Shares

The following table sets forth the computation of basic and diluted weighted
average common shares outstanding for the three and six-month periods ended
June 30, 2001 and 2002:

|                                        |                                                     |  |                             |         |                           |  |      |           |      |  |  |          |   |  |  |           |  
|--------------------------------------- | --------------------------------------------------- |  | --------------------------- | ------- | ------------------------- |  | ---- | --------- | ---- |  |  | -------- | - |  |  | --------- | -
|                                        |                                                     |  | Three months ended June 30, |         | Six months ended June 30,
|                                        |                                                     |  |                             |         |                          
|                                        |                                                     |  | 2001                        |         | 2002                      |  | 2001 |           | 2002
|                                        |                                                     |  |                             |         |                           |  |      |           |     
|Shares (denominator basic and diluted): |                                                     |  |                             |         |                           |  |      |           |      |  |  |          |   |  |  |          
|                                        | Weighted average common shares
outstanding          |  |                             | 676,022 |                           |  |      | 6,822,488 |      |  |  | 761,460  |   |  |  | 3,766,948 |  
|                                        | Less: weighted average shares subject
to repurchase |  |                             | (55,592 | )                         |  |      | (9,775    | )    |  |  | (148,474 | ) |  |  | (15,281   | )
|                                        |                                                     |  |                             |         |                           |  |      |           |      |  |  |          |   |  |  |          
|                                        | Denominator for basic and diluted
calculation       |  |                             | 620,430 |                           |  |      | 6,812,713 |      |  |  | 612,986  |   |  |  | 3,751,667 |  
|                                        |                                                     |  |                             |         |                           |  |      |           |      |  |  |          |   |  |  |          

As of June 30, 2001 and 2002, 7,959,886 and 1,566,414, respectively, shares of
common stock subject to repurchase, stock options, warrants, and common stock
issuable upon conversion of outstanding preferred stock were excluded from the
computation of diluted loss per share, as their impact was antidilutive.

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 those affecting revenues,
assessing the collectability of accounts receivable, the saleability and
recoverability of inventory, the adequacy of warranty liabilities, the
realizability of investments, the realization of deferred tax assets, the fair
value of putable warrants and useful lives of tangible and intangible assets,
among others. 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. Estimates and assumptions are reviewed 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 August 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement
Obligations, which provides the accounting requirements for retirement
obligations associated with tangible long-lived assets. SFAS 143 requires
entities to record the fair value of a liability for an asset retirement
obligation in the period in which it is incurred. SFAS 143 is effective for the
Companys 2003 fiscal year, and early adoption is permitted. The adoption of
SFAS 143 is not expected to have a material impact on the Companys
consolidated results of operations, financial position or cash flows.

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No.
4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.
Among other things, this statement rescinds FASB Statements No. 4, Reporting
Gains and Losses from Extinguishment of Debt which required all gains and
losses from the early extinguishment of debt to be aggregated and, if material,
classified as an extraordinary item, net of the related income tax effect. As
a result, the criteria in APB Opinion No. 30, Reporting the Results of
Operations  Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions,
will now be used to classify those gains and losses. The statement was
effective upon issuance in April 2002 for



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prospective transactions. The adoption of this statement is not expected to
have a material impact on the Companys financial position or results of
operations.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities. This statement addresses financial
accounting and reporting for costs associated with exit or disposal activities
and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit
an Activity (including Certain Costs Incurred in a Restructuring). This
statement requires that a liability for a cost associated with an exit or
disposal activity should be recognized at fair value when the liability is
incurred. SFAS 146 is effective for the Companys 2003 fiscal year, and early
adoption is permitted. The adoption of SFAS 146 is not expected to have a
material impact on the Companys consolidated results of operations, financial
position or cash flows.

3. Inventories

Inventories are stated at the lower of weighted-average cost or market and are
comprised of the following as of December 31, 2001 and June 30, 2002 (amounts
in thousands):

|                 |                   |   |              |       |          |   |       |       | 
|---------------- | ----------------- | - | ------------ | ----- | -------- | - | ----- | ----- | 
|                 |                   |   | December 31, |       | June 30,
|                 |                   |   | 2001         |       | 2002    
|                 |                   |   |              |       |         
|Raw materials    |                   | $ | 2,037        |       |          | $ | 2,221 |      
|Work in progress |                   |   | 574          |       |          |   | 646   |      
|Finished goods   |                   |   | 3,550        |       |          |   | 2,539 |      
|                 |                   |   |              |       |          |   |       |      
|                 | Total inventories |   | $            | 6,161 |          |   | $     | 5,406 | 
|                 |                   |   |              |       |          |   |       |      

4. Borrowings

Borrowings under the Companys bank line of credit were limited to the
lesser of $7,500,000 or an amount based on eligible accounts receivable and
eligible inventories. Substantially all of the Companys assets were collateral
for the line of credit. This line of credit carried an interest rate at the
banks prime rate plus 2.0% (which was 6.75% at December 31, 2001). On May 10,
2002, the balance of the credit line was repaid with proceeds from the initial
public offering. The line of credit expired on June 5, 2002 and was not
renewed.

5. 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 which were immediately exercisable. Upon completion of our
initial public offering, the conversion rights associated with our 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
(taking into account the 1 for 2.2 reverse stock split effected in April 2002).
At the holders option, the Company is required to make a cash payment to the
holder equal to the fair market value of the shares issuable upon conversion of
the warrants. As of June 30, 2002, the fair value of this liability was
approximately $572,000. Changes in the fair value of this liability are
recorded in the statements of operations as non-cash interest income (expense),
putable warrants.



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6. Income Taxes

The benefit from (provision for) income taxes is as follows (amounts in
thousands):

|         |         |                           |   |                            |     |                          |   |      |    |      |   |     |     |  |   |     |     |  
|-------- | ------- | ------------------------- | - | -------------------------- | --- | ------------------------ | - | ---- | -- | ---- | - | --- | --- |  | - | --- | --- | -
|         |         |                           |   | For the three months ended |     | For the six months ended
|         |         |                           |   | June 30,                   |     | June 30,                
|         |         |                           |   |                            |     |                         
|         |         |                           |   | 2001                       |     | 2002                     |   | 2001 |    | 2002
|         |         |                           |   |                            |     |                          |   |      |    |     
|Current: |         |                           |   |                            |     |                          |   |      |    |      |   |     |     |  |   |    
|         | Federal |                           | $ |                           |     |                          | $ |     |    |      | $ | 211 |     |  | $ |    |    
|         | State   |                           |   | (14                        | )   |                          |   | (4   | )  |      |   | (14 | )   |  |   | (14 | )  
|         |         |                           |   |                            |     |                          |   |      |    |      |   |     |     |  |   |    
|         |         | Total benefit (provision) |   | $                          | (14 | )                        |   | $    | (4 | )    |   | $   | 197 |  |   | $   | (14 | )
|         |         |                           |   |                            |     |                          |   |      |    |      |   |     |     |  |   |    

During the six-month period ended June 30, 2001 the Company recognized a
tax benefit for additional amounts refunded from the payment of taxes on the
sale of the Companys fitness business in 1999 through the ability to carry
back tax losses generated subsequent to the sale. During 2000, the Company
recorded an estimated income tax receivable of $1,209,000 related to the refund
of tax payments made on the sale of the fitness business. During the six-month
period ended June 30, 2001, the Company received a tax refund of $1,420,000 and
recorded a corresponding tax benefit of $211,000.

A valuation allowance has been recorded for the net balance of the
deferred tax assets as a result of uncertainties regarding realization of the
net asset. The tax benefit recorded in the six-month period ended June 30,
2001 resulted from reduction of the valuation allowance as a result of the
refund.

7. Contingencies

Legal Matters

In July 1998, the Company signed an Original Equipment Manufacturer and
Distributor Agreement with Zymed, Incorporated (Zymed), a related party. This
agreement provided for the purchase of certain Holter monitoring systems, and
appointed the Company exclusive distributor of such products in the United
States and Canada for a period of five years. In the third quarter of 2000 the
Company received a notice of termination of this agreement from Zymed based on
the alleged inability of the parties to agree on pricing and volume
requirements as set forth in the agreement. This notice of termination provided
for a 180-day notice period that expired in February 2001.

The Company has disputed this notice of termination, and has filed suit in
the State of Washington principally citing a claim for breach of contract. The
Company is seeking monetary damages and other remedies available under the law.
The products supplied under this agreement represented a significant portion of
the Companys revenues, approximately 12.0% in 2000 and 3.0% in 2001. The
Company has made a significant effort to mitigate the impact of this
termination by entering into contracts with other suppliers. The Company has
incurred, and may continue to incur, significant legal expenses related to the
litigation of this dispute, which may or may not be recoverable. A trial date
for this matter has been set for September 18, 2002.

The Company is a defendant in various other legal matters arising in the
normal course of business. In the opinion of management, the ultimate
resolution of these other matters is not expected to have a material effect on
the Companys financial position, results of operations or cash flows.



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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. 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 below and those
discussed elsewhere in this report and those discussed in our registration
statement on Form S-1 (Registration No. 333-83272) filed on February 22, 2002,
as amended. 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 in order to
reflect events or circumstances that may subsequently arise. Readers are urged
to carefully review and consider 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 is based upon our unaudited condensed consolidated financial
statements which have been prepared in accordance with accounting principles
generally accepted in the United States 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, revenue and
expenses, and related disclosure of contingent assets and liabilities. On an
on-going basis, we evaluate our estimates including those affecting revenues,
the allowance for doubtful accounts, the salability and recoverability of
inventory, warranty reserves, the carrying value of our investments, the useful
lives of tangible and intangible assets, income taxes, putable warrants and
contingencies. 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.

Results of Operations

Three and Six Month Periods Ended June 30, 2002 Compared to the Three and Six
Month Periods Ended June 30, 2001

Revenues

Revenues for the three-month period ended June 30, 2002 decreased
approximately $224,000, or 2.0%, to $11,259,000 from $11,483,000 for the
comparable period in 2001. Systems revenue decreased by $187,000, or 2.0%, to
$9,063,000 for the three-month period ended June 30, 2002 from $9,250,000 for
the comparable period in 2001. The release of our new rehabilitation telemetry
product in May 2002 resulted in an increase in telemetry sales for the
three-month period ended June 30, 2002 of approximately $618,000 as compared to
the same period in 2001. This was partially offset by some softness in our
sales of cardiac catheterization management systems, resulting in a decrease in
cardiac catheterization management system sales of approximately $475,000
during the three-month period ended June 30, 2002 as compared to the same
period in 2001. Service revenues remained relatively steady, decreasing by
$37,000, or 1.7%, to $2,196,000 for the three-month period ended June 30, 2002
from $2,233,000 as compared to the same period in 2001.



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Revenues for the six-month period ended June 30, 2002 increased
approximately $87,000, or 0.4%, to $21,648,000 from $21,561,000 for the
comparable period in 2001. Systems revenue increased by approximately
$276,000, or 1.6%, to $17,229,000 for the six-month period ended June 30, 2002
from $16,953,000 for the comparable period in 2001. Stress system revenues
increased by $1,195,000 for the six-month period ended June 30, 2002 as
compared to the same period in 2001. This was primarily due to the
introduction of our new stress product in April 2001. In addition, we
introduced the Q-Tel RMS system in May 2002, which resulted in an increase in
our rehabilitation telemetry revenues of $470,000 for the six-month period
ended June 30, 2002 over the comparable period in 2001. The increases in
stress and rehabilitation telemetry revenues were largely offset by decreases in
cardiac catheterization management systems, Holter systems and service
revenues. Our cardiac catheterization management system sales decreased by
$516,000 for the six-month period ended June 30, 2002 as compared to the same
period in 2001. We believe this decrease is due to the anticipated release of
our next generation cardiac catheterization management product, which is
scheduled for release in late 2002. Our Holter systems sales decreased by
$621,000 for the six-month period ended June 30, 2002 as compared to the same
period in 2001. This decrease was caused by an interruption in Holter
component supplies when we transitioned to a new supplier in mid-2001. Service
revenues decreased by $189,000, or 4.1%, to $4,419,000 for the six-month period
ended June 30, 2002 from $4,608,000 for the comparable period in 2001. This
decrease was primarily the result of reduced volume of spare parts sales and
labor repair services driven, in part, by the replacement by some of our
customers of aging equipment with newer models.

Gross Profit

Gross profit for the three-month period ended June 30, 2002 increased
approximately $177,000, or 4.2%, to $4,377,000 from $4,200,000 for the
comparable period in 2001. Overall gross margin percentage for the three-month
period ended June 30, 2002 increased to 38.9% from 36.6% for the comparable
period in 2001. Gross profit from systems increased approximately $76,000, or
2.2%, to $3,366,000 for the three-month period ended June 30, 2002 from
$3,290,000 for the comparable period in 2001. Gross profit from service
increased approximately $101,000, or 11.1%, to $1,011,000 for the three-month
period ended June 30, 2002 from $910,000 for the comparable period in 2001.
Our improvement in gross margin has been driven primarily by our continued
emphasis on cost reductions.

Gross profit for the six-month period ended June 30, 2002 increased
approximately $504,000, or 6.3%, to $8,530,000 from $8,026,000 for the
comparable period in 2001. Overall gross margin percentage for the six-month
period ended June 30, 2002 increased to 39.4% from 37.2% for the comparable
period in 2001. Gross profit from systems increased approximately $435,000, or
7.2%, to $6,487,000 for the six-month period ended June 30, 2002 from
$6,052,000 for the comparable period in 2001. Gross profit from service
increased approximately $69,000, or 3.5%, to $2,043,000 for the six-month
period ended June 30, 2002 from $1,974,000 for the comparable period in 2001.
Our improvement in gross margin has been driven primarily by our continued
emphasis on cost reductions.

Operating Expenses

Research and development expenses for the three-month period ended June
30, 2002 decreased approximately $178,000, or 11.8%, to $1,334,000 from
$1,512,000 for the comparable period in 2001. As a percentage of revenues,
research and development expenses decreased to 11.8% for the three-month period
ended June 30, 2002 from 13.2% for the comparable period in 2001.

Research and development expenses for the six-month period ended June 30,
2002 decreased approximately $319,000, or 10.6%, to $2,687,000 from $3,006,000
for the comparable period in 2001. As a percentage of revenues, research and
development expenses decreased to 12.4% for the six-month period ended June 30,
2002 from 13.9% for the comparable period in 2001. The decrease, in terms of
both dollars



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and as a percentage of revenue, resulted primarily from a decrease in the
use of outside engineering services, partially offset by an increase in
internal research and development staffing.

Sales and marketing expenses for the three-month period ended June 30,
2002 decreased approximately $52,000, or 2.1%, to $2,466,000 from $2,518,000
for the comparable period in 2001. As a percentage of revenues, sales and
marketing expenses remained flat at 21.9% for the three-month period ended June
30, 2002 as compared to the same period in 2001.

Sales and marketing expenses for the six-month period ended June 30, 2002
increased approximately $155,000, or 3.3%, to $4,919,000 from $4,764,000 for
the comparable period in 2001. As a percentage of revenues, sales and
marketing expenses increased to 22.7% for the six-month period ended June 30,
2002 from 22.1% for the comparable period in 2001. The increase, in terms of
both dollars and as a percentage of revenues, resulted primarily from an
increase in staffing which occurred for only one month during the six-month
period ended June 30, 2001, as compared to a full six months for the six-month
period ended June 30, 2002. The increases in staffing are related to the
recent introduction of new products into the market.

General and administrative expenses, excluding stock-based compensation,
for the three-month period ended June 30, 2002 decreased $107,000, or 8.8%, to
$1,106,000 from $1,213,000 for the comparable period in 2001. As a percentage
of revenues, general and administrative expenses, excluding stock-based
compensation, for the three-month period ended June 30, 2002 decreased to 9.8%
from 10.6% for the comparable period in 2001. The decrease in terms of both
dollars and as a percentage of revenues was caused primarily by collecting a
one-time business and occupation tax refund of $220,000 in April 2002,
partially offset by an increase in legal expenses associated with litigation
against a former supplier.

General and administrative expenses, excluding stock-based compensation,
for the six-month period ended June 30, 2002 increased $92,000, or 3.7%, to
$2,589,000 from $2,497,000 for the comparable period in 2001. As a percentage
of revenues, general and administrative expenses, excluding stock-based
compensation, for the six-month period ended June 30, 2002 increased to 12.0%
from 11.6% for the comparable period in 2001. The increase in general and
administrative expenses, excluding stock-based compensation, in terms of both
dollars and as a percentage of revenues was caused primarily by an increase in
legal expenses associated with litigation against a former supplier of
approximately $324,000, partially offset by the one-time collection of a
business and occupation tax refund of $220,000.

Stock-based compensation expense for the three-month period ended June 30,
2002 decreased approximately $277,000 to $35,000 from $312,000 for the
comparable period in 2001. Stock-based compensation expense for the six-month
period ended June 30, 2002 decreased approximately $381,000 to $70,000 from
$451,000 for the comparable period in 2001. The charges in 2001 relate
primarily to one-time variable compensation expenses recorded on issued stock
options. We expect to record stock-based compensation expense in the remaining
quarters of 2002 at levels similar to the amount recorded in the first and
second quarter of 2002.

Operating Loss

Operating loss for the three-month period ended June 30, 2002 decreased by
approximately $791,000, or 58.4%, to $564,000 from $1,355,000 for the
comparable period in 2001. The decrease in operating loss was attributable
primarily to an increase in gross profit of $177,000 and by a decrease in
operating expenses of $614,000, both due to factors noted above.

Operating loss for the six-month period ended June 30, 2002 decreased by
approximately $957,000, or 35.5%, to $1,735,000 from $2,692,000 for the
comparable period in 2001. The decrease in operating loss was attributable
primarily to an increase in gross profit of $504,000 and by a decrease in
operating expenses of $453,000, both due to factors noted above.



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Other Income and Expense

Total other income for the three-month period ended June 30, 2002
increased $277,000 to reflect income of $150,000 as compared to expense of
$127,000 for the comparable period in 2001. This increase was partially due to
reduced interest expense of approximately $66,000 on outstanding borrowings
under our bank line of credit that was paid off in May 2002 and interest income
of approximately $46,000 on our short-term investments. The increase in other
income is also partially the result of recording non-cash interest income on
putable warrants of $133,000 during the three-month period ended June 30, 2002
as compared to recording non-cash interest expense on putable warrants of
$62,000 for the same period in 2001.

Total other income for the six-month period ended June 30, 2002 increased
$301,000 to reflect income of $80,000 as compared to expense of $221,000 for
the comparable period in 2001. This increase was partially due to reduced
interest expense of approximately $81,000 on outstanding borrowings under our
bank line of credit that was paid off in May 2002 and interest income of
approximately $46,000 on our short-term investments. The increase in other
income is also partially the result of recording non-cash interest income on
putable warrants of $133,000 during the six-month period ended June 30, 2002 as
compared to recording non-cash interest expense on putable warrants of $62,000
for the same period in 2001.

Income Tax Benefit

For the six-month period ended June 30, 2001, we recorded an income tax
benefit of $197,000, which was primarily the result of additional refund
amounts of $211,000 from the payment of taxes on the sale of our fitness
business in 1999 as a result of our ability to carry back tax losses generated
subsequent to the sale. For the six-month period ended June 30, 2002, we had
no such income tax benefit.

Liquidity and Capital Resources

We have required cash to fund our operations and for working capital
purposes. Historically, our primary sources of financing have been borrowings
from a commercial bank and proceeds from the sale of convertible preferred
stock. In May and June of 2002, we received proceeds from our recent initial
public offering.

We maintained a $7,500,000 credit facility originally entered into in June
1998 with Silicon Valley Bank subject to certain accounts receivable and
inventory provisions. This facility expired June 5, 2002, and all borrowings
under this facility were repaid in May 2002 with the proceeds of our initial
public offering. We did not renew this facility.

For the three-month period ended June 30, 2002, we used cash of $93,000 in
operating activities. This cash flow resulted primarily from a $224,000
operating loss excluding non-cash income and expenses and a decrease in
accounts payable and accrued liabilities of $96,000, partially offset by a
decrease in inventories of $351,000. This was an improvement over the
three-month period ended June 30, 2001, in which we used cash from operating
activities of $975,000.

For the six-month period ended June 30, 2002, we used cash of $114,000 in
operating activities. This cash flow resulted primarily from a $1,140,000 loss
excluding non-cash income and expenses, which was offset by a reduction in
working capital of $1,026,000. The reduction in working capital was primarily
due to decreases in inventory of approximately $755,000 and increases in
payables and accrued liabilities of approximately $297,000. For the comparable
six-month period ended June 30, 2001, we generated cash of $741,000, which was
primarily due to an income tax refund of approximately $1,420,000. Excluding
the impact of the tax refund, we used cash in operating activities of $679,000
for the six-month period ended June 30, 2001, as compared to $114,000 for the
same six-month period ended June 30, 2002.



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Net cash used in investing activities was $66,000 and $325,000 for capital
expenditures for the three-month periods ended June 30, 2001 and 2002,
respectively, and $171,000 and $398,000 for capital expenditures for the
six-month periods ended June 30, 2001 and 2002, respectively. Our capital
expenditures increased during the three and six-month periods ended June 30,
2002 primarily as a result of the purchase and conversion of an enterprise
resource planning system and the purchase of a new telephone system. We
anticipate our capital expenditures will increase by approximately $450,000
during the remainder of 2002 primarily to continue funding the purchase of our
enterprise resource planning system.

Net cash from financing activities for the three-month period ended June
30, 2002 of $24,253,000 was due primarily to proceeds of approximately
$28,991,000, net of offering expenses, received from our initial public
offering. The offering proceeds were offset by payments made for net
repayments of our bank borrowings on our line of credit of approximately
$4,777,000. Net cash from financing activities of $990,000 for the comparable
three-month period ended June 30, 2001 was due primarily to borrowings on our
bank line of credit of $985,000.

Net cash from financing activities for the six-month period ended June 30,
2002 of $24,559,000 was due primarily to proceeds of approximately $28,991,000,
net of offering expenses, received from our initial public offering. The
offering proceeds were offset by payments made for net repayments of our bank
borrowings on our line of credit of approximately $4,471,000. Net cash used
for financing activities of $691,000 for the comparable six-month period ended
June 30, 2001 was due primarily to net repayments on our bank borrowings of
$602,000.

We anticipate that proceeds from our initial public offering, together
with our operating cash flow, will be sufficient to meet operating expenses,
working capital requirements, capital expenditures and other obligations for at
least 12 months. We periodically evaluate potential acquisitions of technology
or businesses 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.

Initial Public Offering

In May 2002, we consummated an initial public offering of our common
stock. In the offering, we sold 4,000,000 shares of our common stock at a
price of $7.00 per share. In addition, in June 2002, the underwriters of the
offering exercised their over-allotment option to purchase an additional
600,000 shares at $7.00 per share. Proceeds from the offering, including the
over-allotment shares, were approximately $28.2 million, net of underwriting
discounts and offering expenses. The principal purposes of the offering were
to obtain additional working capital and to establish a public market for our
common stock. In May 2002, we used approximately $4,500,000 of the offering
proceeds to repay the outstanding balance under our line of credit. Although
we currently have no specific plans for the application of a significant
portion of the remaining net proceeds, we expect to use the remaining net
proceeds from this offering:



| |  |  | To acquire complementary businesses, product lines, assets or technologies;
| | - |  | ---------------------------------------------------------------------------
|
| |  |  | To fund product research and development;                                  
|
| |  |  | To expand international sales efforts; and                                 
|
| |  |  | For working capital and other general corporate purposes.                  

We will have significant discretion in the use of the net proceeds of the
offering, including with respect to net proceeds used to acquire complementary
businesses, product lines, assets or technologies.



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Certain Factors that May Affect Future Results

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:



| |  |  | changes in our ability to obtain products and product
components that are manufactured for us by third parties, such as
treadmills and Holter monitors, as well as variations in prices of
these products and product components;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | increased expenses we may incur in connection with ongoing
litigation with a former supplier of our Holter monitor systems;                                                                                                      
|
| |  |  | delays in the development or commercial introduction of new
versions of products and systems;                                                                                                                                    
|
| |  |  | our ability to attain and maintain production volumes and
quality levels for our products and product components;                                                                                                                
|
| |  |  | the impact of acquisitions, divestitures and other significant corporate events;                                                                                                                                                 
|
| |  |  | effects of domestic and foreign economic conditions on our industry and/or customers;                                                                                                                                            
|
| |  |  | adoption 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 sales personnel or distributors; 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.

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, market acceptance of our offerings
may suffer or may become obsolete. In that event, our market share and
revenues would likely decrease.



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Failure to develop and commercialize new versions of our products would cause
our operating results to suffer.

To be successful, we must develop and commercialize new versions of our
products. 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; and                                                          
|
| |  |  | anticipate and compete effectively with our competitors efforts.                                          

The rate of market acceptance of our current or future products and
systems using our recently introduced Microsoft Windows-based software platform
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:



| |  |  | delays in product launches;                                                
| | - |  | ---------------------------------------------------------------------------
|
| |  |  | 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 payors.

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.

If we fail to successfully integrate acquired businesses, product lines, assets
or technologies, our operating results may suffer.

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,



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negotiate, complete and integrate suitable acquisitions and, if necessary,
to obtain satisfactory debt or equity financing. If we acquire complementary
businesses or assets but fail to successfully integrate them, our financial
condition or results of operations may suffer.

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.

We do not generally have long-term purchase contracts with our customers,
who order products on a purchase order basis. 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 we do not develop or maintain successful relationships with international
distributors, our growth may be limited, sales of our products and systems may
decrease and our operating results may suffer.

We have historically generated approximately 10% of our revenues from
international sales and our growth strategy contemplates expanded efforts to
increase international sales. All of our international sales in recent periods
were attributable to third-party distributors, and our success in expanding
international sales in the future will depend on our ability to develop and
manage a network of international distributors and the performance of our
distributors. Because we generally do not have long-term contracts with our
distributors, our distribution relationships may be terminated on little or no
notice. If we lose any significant international distributors, or if any of
our distributors devote more effort to selling competing products and systems,
our international sales and operating results may suffer and our growth may be
limited. Consequently, our success in expanding international sales may be
limited if our distributors lack, or are unable to develop, relationships with
important target customers in international markets.

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.                   



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Inadequate levels of reimbursement from governmental or other third-party
payors 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 payors, 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 payors
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.

Our operating results may be subject to seasonal fluctuations during the first
and third fiscal quarters of each year, which can lead to unpredictable
variations in our quarterly results and cause the stock price of our common
stock to decrease.

Companies in the medical device industry have historically experienced
sales decreases in the first calendar quarter due to patterns in the capital
budgeting and purchasing cycles of medical device customers. We may experience
similar seasonality. We may also experience declining revenues in the third
fiscal quarter due to summer holiday and vacation schedules. These seasonal
factors may lead to unpredictable variations in our quarterly operating results
and cause the stock price of our common stock to decrease.




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 revenues 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.



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PART II  OTHER INFORMATION




Item 1. Legal Proceedings

As previously reported, In July 1998, we signed an Original Equipment
Manufacturer and Distributor Agreement with Zymed, Incorporated, a subsidiary
of Koninklijke Philips Electronics N.V. and an affiliate of Philips Electronics
North America Corporation. This agreement provides for the purchase of certain
Holter monitoring systems, and appointed us the exclusive distributor of such
products in the United States and Canada for a period of five years. In the
third quarter of 2000, we received a notice of termination of this agreement
from Zymed based on the alleged inability of the parties to agree on pricing
and volume requirements as set forth in the agreement. This notice of
termination provided for a 180-day notice period that expired in February 2001.

We disputed this notice of termination and in November 2000 initiated a
lawsuit in the federal district court for the Western District of Washington
against Zymed. We also named Agilent Technologies, Inc. and The Hewlett-Packard
Company as defendants. We are seeking damages against the defendants for harm
to our business resulting from Zymeds termination of our Holter monitoring
systems distribution agreement in November 2000. We are seeking monetary
damages and other remedies available under the law. We incurred significant
costs in prosecuting this lawsuit in 2001 and in the three months ended March
31, 2002. Expenses we incur in connection with this lawsuit may increase in the
future, particularly if it goes to trial or if the trial is delayed or
continued or any judgment rendered in the trial is appealed. On April 8, 2002,
the court entered an order denying defendants motion to dismiss our breach of
contract claim. A trial date has been set for September 18, 2002.

Other than the lawsuit described above, we are not currently a party to
any material legal proceedings.




Item 2. Changes in Securities and Use of Proceeds

(d)  Use of Proceeds from Sale of Registered Securities

Our registration statement on Form S-1 under the Securities Act of 1933
(File No. 333-83272), relating to our initial public offering of common stock,
without par value, was declared effective by the Securities and Exchange
Commission on May 6, 2002. The offering was co-managed by Adams, Harkness &
Hill, Inc., WR Hambrecht+Co and Delafield Hambrecht, Inc. Pursuant to the
registration statement, we registered and sold an aggregate of 4,600,000 shares
of common stock, including the underwriters exercise of their over-allotment
option to purchase 600,000 shares, at $7.00 per share, for an aggregate
offering price of $32.2 million. In connection with the offering we incurred
total expenses of approximately $4.0 million, including underwriting discounts
and commissions of approximately $2.3 million. WR Hambrecht+Co, which is a
member of W.R.Hambrecht/QIC, LLC, our largest shareholder, and of which our
director, William R. Hambrecht, is a significant shareholder, director and
officer, received approximately $348,000 as compensation for its underwriting
services. Delafield Hambrecht, Inc., of which our director, John D. Delafield,
is a significant shareholder, director and officer, received approximately
$288,000 as compensation for its underwriting services. The remaining expenses
were all direct or indirect payments to others and not payments to our
directors, officers (or their associates), affiliates or 10% shareholders.
None of the proceeds was used as payments to our director, officers (or their
associates), affiliates or 10% shareholders. In May 2002, we used
approximately $4.5 million of the net proceeds from the offering to repay
outstanding balances under our bank line of credit. We have invested the
remaining proceeds from the offering in a variety of investment grade, fixed
income securities, including corporate bonds, commercial paper and money market
instruments.



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Item 6. Exhibits and Reports on Form 8-K



| | (a) |  | Exhibits                                                                                                                                
| | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------
|
| |     |  | Exhibit 99.1     Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
|
| |     |  | Exhibit 99.2     Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
|
| | (b) |  | Reports on Form 8-K for the quarter ended June 30, 2002                                                                                 
|
| |     |  | A Form 8-K was filed on May 16, 2002, under Item 4, changing
our certifying accountants to KPMG LLP.                                    



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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. Matysik
| |                                                                                                                  
| | Michael K. Matysik
Senior Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)

Date: August 14, 2002



21