##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
   FORM 10-Q x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended June 30, 2004 OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 Commission File Number 000-49755   QUINTON CARDIOLOGY SYSTEMS, INC.  Delaware
    
    94-3300396(State of Incorporation)
    
    (IRS Employer Identification No.)
 3303 Monte Villa Parkway
Bothell, Washington 98021
(Address of principal executive offices) (425) 402-2000
(Registrants telephone number) Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to
such filing requirements for the past 90 days. YES x  NOo Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). YESx  NOo The number of shares outstanding of the registrants common stock as of
July 26, 2004 was 13,919,940. 1




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TABLE OF CONTENTS PART I - FINANCIAL INFORMATION
    
    
    3Item 1. Financial Statements
    
    
    3Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    27Item 4. Controls and Procedures
    
    
    27PART
II - OTHER INFORMATION
    
    
    28Item 1. Legal Proceedings
    
    
    28Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    28Item 3. Defaults Upon Senior Securites
    
    
    28Item 4. Submission of Matters to a Vote of Security Holders
    
    
    28Item 5. Other Information
    
    
    28Item 6. Exhibits and Reports on Form 8-K
    
    
    28SIGNATURE
    
    
    29EXHIBIT 10.34EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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PART I - FINANCIAL INFORMATION 
 Item 1. Financial Statements QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands, except share amounts) December 31,
    
    June 30,2003
    
    2004ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    185
    
    
    $
    15,730Accounts receivable, net of allowance for doubtful accounts
    
    
    12,480
    
    
    
    13,538Inventories
    
    
    12,690
    
    
    
    11,365Prepaid expenses and other current assets
    
    
    1,419
    
    
    
    1,599Total current assets
    
    
    26,774
    
    
    
    42,232Machinery and equipment, net of accumulated depreciation
and amortization
    
    
    4,918
    
    
    
    4,403Intangible assets, net of accumulated amortization
    
    
    5,672
    
    
    
    5,781Investment in unconsolidated entity
    
    
    1,000
    
    
    
    1,000Goodwill
    
    
    9,953
    
    
    
    9,690Total assets
    
    $
    48,317
    
    
    $
    63,106LIABILITIES AND SHAREHOLDERS EQUITYCurrent Liabilities:Line of credit
    
    $
    354
    
    
    $
    Current portion of long term debt
    
    
    363
    
    
    
    181Accounts payable
    
    
    6,183
    
    
    
    6,308Accrued liabilities
    
    
    7,349
    
    
    
    4,159Warranty liability
    
    
    2,059
    
    
    
    2,010Deferred revenue
    
    
    4,499
    
    
    
    4,293Total current liabilities
    
    
    20,807
    
    
    
    16,951Deferred tax liability
    
    
    1,180
    
    
    
    1,190Total liabilities
    
    
    21,987
    
    
    
    18,141Minority interest in consolidated entity
    
    
    198
    
    
    
    168Shareholders Equity:Preferred stock (10,000,000 shares authorized), $0.001 par
value, no shares outstanding in 2003 or 2004
    
    
    
    
    
    
    Common stock (65,000,000 shares authorized), $0.001 par
value, 12,214,905 and 13,917,701 shares issued and
outstanding at December 31, 2003 and June 30, 2004,
respectively
    
    
    45,617
    
    
    
    61,475Deferred stock-based compensation
    
    
    (106
    )
    
    
    (70
    )Accumulated deficit
    
    
    (19,379
    )
    
    
    (16,608
    )Total shareholders equity
    
    
    26,132
    
    
    
    44,797Total liabilities and shareholders equity
    
    $
    48,317
    
    
    $
    63,106
 The accompanying notes are an integral part of these unaudited condensed consolidated financial statements. 3




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QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except share and per share amounts) Three months Ended
    
    Six months endedJune 30,
    
    June 30,2003
    
    2004
    
    2003
    
    2004Revenues:Systems
    
    $
    17,604
    
    
    $
    18,542
    
    
    $
    34,561
    
    
    $
    37,068Service
    
    
    3,102
    
    
    
    3,106
    
    
    
    6,428
    
    
    
    6,232Total revenues
    
    
    20,706
    
    
    
    21,648
    
    
    
    40,989
    
    
    
    43,300Cost of Revenues:Systems
    
    
    10,472
    
    
    
    10,591
    
    
    
    21,124
    
    
    
    20,866Service
    
    
    1,792
    
    
    
    1,833
    
    
    
    3,579
    
    
    
    3,758Total cost of revenues
    
    
    12,264
    
    
    
    12,424
    
    
    
    24,703
    
    
    
    24,624Gross profit
    
    
    8,442
    
    
    
    9,224
    
    
    
    16,286
    
    
    
    18,676Operating Expenses:Research and development
    
    
    1,989
    
    
    
    1,796
    
    
    
    4,076
    
    
    
    3,627Write off of purchased in-process research
and development projects
    
    
    
    
    
    
    
    
    
    
    1,290
    
    
    
    Sales and marketing
    
    
    4,491
    
    
    
    4,367
    
    
    
    8,817
    
    
    
    8,738General and administrative, excluding
stock-based compensation expense
    
    
    1,942
    
    
    
    1,949
    
    
    
    3,969
    
    
    
    4,037Stock-based compensation
    
    
    18
    
    
    
    18
    
    
    
    36
    
    
    
    36Total operating expenses
    
    
    8,440
    
    
    
    8,130
    
    
    
    18,188
    
    
    
    16,438Operating income (loss)
    
    
    2
    
    
    
    1,094
    
    
    
    (1,902
    )
    
    
    2,238Other Income (Expense):Interest income
    
    
    9
    
    
    
    16
    
    
    
    10
    
    
    
    21Interest expense
    
    
    (82
    )
    
    
    (35
    )
    
    
    (158
    )
    
    
    (81
    )Interest income (expense), putable warrants
    
    
    (63
    )
    
    
    
    
    
    
    32
    
    
    
    Other income (expense), net
    
    
    (13
    )
    
    
    633
    
    
    
    (9
    )
    
    
    633Total other income (expense)
    
    
    (149
    )
    
    
    614
    
    
    
    (125
    )
    
    
    573Income (loss) before income taxes and minority interest
in consolidated entity
    
    
    (147
    )
    
    
    1,708
    
    
    
    (2,027
    )
    
    
    2,811Income tax provision
    
    
    (9
    )
    
    
    (35
    )
    
    
    (9
    )
    
    
    (70
    )Income (loss) before minority interest in consolidated
entity
    
    
    (156
    )
    
    
    1,673
    
    
    
    (2,036
    )
    
    
    2,741Minority interest in loss (income) of consolidated
entity
    
    
    (1
    )
    
    
    10
    
    
    
    20
    
    
    
    30Net income (loss)
    
    $
    (157
    )
    
    $
    1,683
    
    
    $
    (2,016
    )
    
    $
    2,771Net income (loss) per share  basic
    
    $
    (0.01
    )
    
    $
    0.13
    
    
    $
    (0.17
    )
    
    $
    0.22Net income (loss) per share  diluted
    
    $
    (0.01
    )
    
    $
    0.12
    
    
    $
    (0.17
    )
    
    $
    0.20Weighted average shares outstanding  basic
    
    
    12,130,211
    
    
    
    12,806,759
    
    
    
    12,112,095
    
    
    
    12,526,004Weighted average shares outstanding  diluted
    
    
    12,130,211
    
    
    
    13,957,926
    
    
    
    12,112,095
    
    
    
    13,572,874
 The accompanying notes are an integral part of these unaudited condensed consolidated financial statements. 4




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QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW (in thousands) Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2003
    
    2004
    
    2003
    
    2004Operating Activities:Net income (loss)
    
    $
    (157
    )
    
    $
    1,683
    
    
    $
    (2,016
    )
    
    $
    2,771Adjustments to reconcile net income (loss) to net cash flows from
(used in) operating activitiesDepreciation and amortization
    
    
    476
    
    
    
    402
    
    
    
    973
    
    
    
    788Loss on disposal of equipment
    
    
    6
    
    
    
    4
    
    
    
    6
    
    
    
    4Gain on sale of hemodynamic monitoring business
    
    
    
    
    
    
    (633
    )
    
    
    
    
    
    
    (633
    )Amortization of deferred stock-based compensation
    
    
    18
    
    
    
    18
    
    
    
    36
    
    
    
    36Interest expense (income), putable warrants
    
    
    63
    
    
    
    
    
    
    
    (32
    )
    
    
    Deferred taxes
    
    
    
    
    
    
    5
    
    
    
    
    
    
    
    10Write off of purchased in-process research and development
    
    
    
    
    
    
    
    
    
    
    1,290
    
    
    
    Minority interest in income (loss) of consolidated entity
    
    
    1
    
    
    
    (10
    )
    
    
    (20
    )
    
    
    (30
    )Changes in operating assets and liabilities, net of
businesses acquired and divested:Accounts receivable
    
    
    250
    
    
    
    (1,126
    )
    
    
    864
    
    
    
    (1,058
    )Inventories
    
    
    1,671
    
    
    
    551
    
    
    
    2,157
    
    
    
    457Prepaid expenses and other current assets
    
    
    125
    
    
    
    (120
    )
    
    
    105
    
    
    
    (110
    )Accounts payable
    
    
    (1,119
    )
    
    
    150
    
    
    
    (2,653
    )
    
    
    (215
    )Accrued liabilities
    
    
    (927
    )
    
    
    (325
    )
    
    
    (1,135
    )
    
    
    (1,854
    )Warranty liability
    
    
    (56
    )
    
    
    (10
    )
    
    
    (9
    )
    
    
    (34
    )Deferred revenue
    
    
    (61
    )
    
    
    99
    
    
    
    (254
    )
    
    
    (9
    )Net cash flows from (used in) operating activities
    
    
    290
    
    
    
    688
    
    
    
    (688
    )
    
    
    123Investing Activities:Purchases of machinery and equipment
    
    
    (357
    )
    
    
    (79
    )
    
    
    (792
    )
    
    
    (115
    )Purchase of technology
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (125
    )Proceeds from sale of machinery and equipment
    
    
    73
    
    
    
    
    
    
    
    108
    
    
    
    Purchase of Burdick, Inc., net of cash acquired
    
    
    2,177
    
    
    
    
    
    
    
    (19,372
    )
    
    
    Net cash flows from (used in) investing activities
    
    
    1,893
    
    
    
    (79
    )
    
    
    (20,056
    )
    
    
    (240
    )Financing Activities:Borrowings (repayments) on bank line of credit, net
    
    
    (1,855
    )
    
    
    (923
    )
    
    
    2,474
    
    
    
    (354
    )Payments of long term debt
    
    
    (91
    )
    
    
    (91
    )
    
    
    (182
    )
    
    
    (182
    )Proceeds from exercise of stock options and issuance of shares
under employee stock purchase plan
    
    
    225
    
    
    
    181
    
    
    
    269
    
    
    
    407Redemption of putable warrants
    
    
    (296
    )
    
    
    
    
    
    
    (296
    )
    
    
    Proceeds from issuance of stock, net of issuance costs
    
    
    
    
    
    
    15,791
    
    
    
    
    
    
    
    15,791Net cash flows from (used in) financing activities
    
    
    (2,017
    )
    
    
    14,958
    
    
    
    2,265
    
    
    
    15,662Net change in cash and cash equivalents
    
    
    166
    
    
    
    15,567
    
    
    
    (18,479
    )
    
    
    15,545Cash and cash equivalents, beginning of period
    
    
    737
    
    
    
    163
    
    
    
    19,382
    
    
    
    185Cash and cash equivalents, end of period
    
    $
    903
    
    
    $
    15,730
    
    
    $
    903
    
    
    $
    15,730Supplemental disclosure of cash flow information:Cash paid for interest
    
    $
    83
    
    
    $
    36
    
    
    $
    140
    
    
    $
    83Supplemental disclosure of noncash investing and financing
activities:Note issued in connection with purchase of technology
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    125
 The accompanying notes are an integral part of these unaudited condensed consolidated financial statements. 5




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




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installation obligations associated with the sales of our systems.
During the three-month period ended June 30, 2004, this deferral decreased
approximately $18,000 to $223,000. In May 2003, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standard No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity.
The Statement establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of both liabilities and
equity. It requires that an issuer classify a financial instrument that is
within its scope as a liability (or an asset in some circumstances). The
Company adopted this statement at the beginning of the three-month period
ended September 30, 2003. While the adoption of this standard did not have a
material impact on the Companys consolidated financial statements as a
whole, Note 4 contains additional disclosures as required by the standard. In December 2003, the FASB revised FASB Interpretation No. 46 (FIN 46R),
Consolidation of Variable Interest Entities, an interpretation of ARB No.
51. This interpretation addresses how a business enterprise should evaluate
whether it has a controlling financial interest in an entity through means
other than voting rights and accordingly should consolidate the entity. FIN
46R requires that calendar year-end public companies apply the unmodified or
revised provisions of FIN 46 to entities previously considered special
purpose entities in the reporting period ended December 31, 2003. The
interpretation is applicable to all other entities not previously considered
special purpose entities in the quarter ended March 31, 2004. The adoption
of FIN 46R did not have a material effect on the Companys consolidated
financial statements as a whole. Further, the adoption in 2004 as it relates
to non-special purpose entities did not have an impact on the Companys
consolidated financial statements as a whole. Net Income (Loss) Per Share In accordance with Statement of Financial Accounting Standard No. 128,
Computation of Earnings Per Share, basic income (loss) per share is
computed by dividing net income (loss) by the weighted average number of
            shares of common stock outstanding during the period. Diluted income per
share is computed by dividing net income by the weighted average number of
common and dilutive potential common shares outstanding during the period.
Dilutive potential common shares consist of shares issuable upon the exercise
of stock options, including outstanding shares subject to repurchase, and
warrants (using the treasury stock method). Potential common shares are
excluded from the calculation if their effect is antidilutive. The following table sets forth the computation of basic and diluted
weighted average common shares outstanding for the three and six-month
periods ended June 30, 2003 and 2004: Three months ended
    
    Six months endedJune 30,
    
    June 30,2003
    
    2004
    
    2003
    
    2004Shares (denominator basic and diluted):Weighted average common shares for basic
calculation
    
    
    12,130,211
    
    
    
    12,806,759
    
    
    
    12,112,095
    
    
    
    12,526,004Incremental shares from employee stock options
    
    
    
    
    
    
    1,151,167
    
    
    
    
    
    
    
    1,046,870Weighted average shares for diluted calculation
    
    
    12,130,211
    
    
    
    13,957,926
    
    
    
    12,112,095
    
    
    
    13,572,874
 As of June 30, 2003, 1,732,499 stock options and warrants were excluded
from the computation of diluted loss per share as their impact was
antidilutive. If the Company had reported net income during the three and
six-month periods ended June 30, 2003, the calculation of earnings per share
would have included the dilutive effect of these potential common shares
using the treasury stock method. As of June 30, 2004, there were no
antidilutive securities outstanding which were excluded from the computation
of diluted income per share. Accounting for Stock-Based Compensation The Company has elected to apply the disclosure-only provisions of SFAS
No. 123, Accounting for Stock-Based Compensation. In accordance with the
provisions of SFAS 123, the Company applies Accounting Principles Board
Opinion (APB) No. 25, Accounting for Stock Issued to Employees, and
related interpretations in accounting for its stock option plans. The Company
accounts for stock options issued to non-employees in accordance with the
provisions of SFAS 123 and Emerging Issues Task Force consensus on Issue No.
96-18, Accounting for Equity Instruments That are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling, Goods or Services
(EITF 96-18). 7




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Had compensation cost been determined based on the fair value of the
option awards at the grant dates during the three and six-month periods ended
June 30, 2003 and 2004, consistent with the provisions of SFAS 123, the
Companys reported net income (loss) would have been the pro forma amounts
indicated below (amounts in thousands except per share amounts): Three months ended
    
    Six months endedJune 30,
    
    June 30,2003
    
    2004
    
    2003
    
    2004Net income (loss)  as reported
    
    $
    (157
    )
    
    $
    1,683
    
    
    $
    (2,016
    )
    
    $
    2,771Add back: Total stock-based employee compensation
expense
included in reported loss, net of related tax effects
    
    
    18
    
    
    
    18
    
    
    
    36
    
    
    
    36Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects
    
    
    (332
    )
    
    
    (554
    )
    
    
    (570
    )
    
    
    (976
    )Net income (loss)  pro forma
    
    $
    (471
    )
    
    $
    1,147
    
    
    $
    (2,550
    )
    
    $
    1,831Net income (loss) per share  as reported  basic
    
    $
    (0.01
    )
    
    $
    0.13
    
    
    $
    (0.17
    )
    
    $
    0.22Net income (loss) per share  as reported  diluted
    
    $
    (0.01
    )
    
    $
    0.12
    
    
    $
    (0.17
    )
    
    $
    0.20Net income (loss) per share  pro forma  basic
    
    $
    (0.04
    )
    
    $
    0.09
    
    
    $
    (0.20
    )
    
    $
    0.15Net income (loss) per share  pro forma  diluted
    
    $
    (0.04
    )
    
    $
    0.08
    
    
    $
    (0.20
    )
    
    $
    0.13
 The fair value of each employee option grant is established on the date
of grant using the Black-Scholes option-pricing model with the following
assumptions used for grants during 2003 and 2004: zero dividend yield;
risk-free interest rate of 3.5% and 3.8%, respectively; volatility of 85% and
70%, respectively; and expected lives of seven years. The weighted-average
fair value of options granted in 2003 and 2004 was $4.64 and $6.45,
respectively. The weighted average fair value of each employee stock purchase right
under the Companys 2002 Employee Stock Purchase Plan was $1.93 in 2003 and
$2.54 in 2004. The following assumptions were used in the Black-Scholes
option-pricing model to perform the calculation in 2003 and 2004: zero
dividend yield; risk-free interest rate of 2.0%; volatility ranging from 70%
to 85%; and expected lives from grant date of 0.75 years and 0.5 years,
respectively. Goodwill Goodwill represents the excess of costs over the estimated fair values
of net assets acquired in connection with our acquisitions of the medical
treadmill manufacturing line in 2002 and Burdick, Inc. in 2003, which, in
accordance with SFAS No. 142, Goodwill and Other Intangible Assets, is not
being amortized. Also in accordance with SFAS No. 142, the Company tests
goodwill for impairment at the reporting unit level on an annual basis and
between annual tests in certain circumstances. The Company has determined
that it has two reporting units, consisting of the Quinton Cardiology
reporting unit and the Shanghai-Burdick joint venture reporting unit. SFAS No. 142 requires a two-step goodwill impairment test whereby the
first step, used to identify potential impairment, compares the fair value of
a reporting unit with its carrying amount including goodwill. If the fair
value of a reporting unit exceeds its carrying amount, goodwill of the
reporting unit is considered not impaired, and the second step of the
goodwill impairment test used to quantify impairment is unnecessary.
Management has estimated that the fair values of the Companys reporting
units to which goodwill has been allocated exceed their carrying amounts, and
as a result, the second step of the impairment test, which would compare the
implied fair value of the reporting unit goodwill with the carrying amount of
that goodwill, was unnecessary for the periods presented. Intangible Assets The Companys intangible assets are comprised primarily of a trade name,
developed technology and customer relationships, most of which were acquired
in our acquisition of Burdick. Company management uses judgment to estimate
the fair value of each of these intangible assets. The judgment about fair
value is based on expectations of future cash flows and an appropriate
discount rate. Company management also uses judgment to estimate the useful
lives of each intangible asset. The Company believes the Burdick trade name
has an indefinite life, and accordingly does not amortize the trade name.
The Company evaluates this conclusion annually and makes a judgment about
whether there are factors that would limit the ability to benefit from the
trade name in the future. If there were such factors, the Company would
start amortizing the trade name. The Company also tests the indefinite life
trade name intangible asset for impairment on an annual basis or more
frequently if events or changes in circumstances indicate that the asset
might be impaired. With 8




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respect to developed technology and customer relationship intangible
assets, the Company also evaluates the remaining useful lives annually to
evaluate whether the intangible assets are impaired. For the trade name,
this evaluation is performed annually or if events occur that suggest there
may be an impairment loss, and involves comparing the carrying amount to the
Companys estimate of fair value. For developed technology and customer
relationship intangible assets, this evaluation would be performed if events
occur that suggest there may be an impairment loss. If we conclude that any
of our intangible assets are impaired, we would record this as a loss on our
statement of operations and as a reduction to the intangible asset. The
Company recorded amortization expense for identifiable intangibles of
$103,000 and $81,000 for the three-month periods ended June 30, 2003 and
2004, respectively, and $217,000 and $162,000 for the six-month periods ended
June 30, 2003 and 2004, respectively. Purchase Accounting SFAS No. 141, Business Combinations, requires that the purchase method
of accounting be used for all business combinations and establishes specific
criteria for the recognition of intangible assets separately from goodwill.
In connection with the Companys acquisitions of the medical treadmill
manufacturing line and Spacelabs Burdick, Inc., the Company allocated the
respective purchase prices plus transaction costs to estimated fair values of
assets acquired and liabilities assumed. These purchase price allocation
estimates were made based on our estimates of fair values. 3. Public Equity Offering In June 2004, the Company consummated a public offering of its common
stock as more fully described in its prospectus dated May 25, 2004 filed with
the Securities and Exchange Commission. In the offering, the Company sold
1,605,976 shares of common stock at a price of $10.50 per share. Proceeds
from the offering were approximately $15,452,000, net of underwriting
discounts and offering expenses. In addition, a selling shareholder, as
named in the prospectus, sold 1,394,024 shares of common stock in this
offering. The Company did not receive any proceeds from the sale of shares
by the selling shareholder. 4. Acquisition of Burdick, Inc. On January 2, 2003, the Company purchased 100% of the stock of Burdick.
The consolidated financial statements include Burdicks results since January
2, 2003. The original purchase price of $24.0 million was funded with
approximately $20.2 million in cash, a holdback of $1.3 million for working
capital adjustments plus a partial draw down on our revolving bank credit
facility. Transaction related costs were approximately $700,000. On April 21, 2003, an agreement was reached with the seller to adjust
the purchase price to $20.4 million, based principally on the amount of
Burdicks net working capital at the date of acquisition. In accordance
with this agreement, the Company kept the $1.3 million that was held back at
closing and received a $2.3 million refund from the seller subsequent to the
April 21, 2003 agreement. The refund was used to reduce borrowings against
the Companys line of credit. The purchase price, including incremental costs directly related to the
transaction, was allocated as follows (in thousands): Cash and cash equivalents
    
    $
    386Accounts receivable, net of allowance for doubtful accounts
    
    
    3,798Inventories
    
    
    6,771Prepaid expenses and other current assets
    
    
    184Machinery and equipment
    
    
    2,104In-process research and development
    
    
    1,290Intangible assets
    
    
    5,660Goodwill
    
    
    9,027Total assets acquired
    
    
    29,220
 9




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Current liabilities
    
    
    (6,961
    )Deferred income taxes
    
    
    (1,156
    )Net assets acquired
    
    $
    21,103
 Inventories included an adjustment to Burdicks historical cost to
increase finished goods to fair market value less expected disposal costs and
selling margin. This adjustment resulted in valuation of inventory of
$300,000 in excess of Burdicks historical cost. This increase in the
inventory valuation was charged to cost of revenues in the six-month period
ended June 30, 2003, as the associated inventories were sold in the normal
course of business. In-process research and development relates to two product development
projects underway at the time of the acquisition. Neither project had
received required regulatory approvals at the acquisition date, and each
project had risks associated with achieving desired functionality and market
acceptance. The value assigned to in-process research and development was
determined using a discounted cash flow method applied to expected cash flows
over a 15-year period commencing in 2003. In discounting expected future
cash flows, the Company used an annual discount rate of 16%, which management
believed to be an appropriate risk adjusted rate given the nature of the
projects, the project risks remaining at the time of acquisition and the
uncertainty of the future cash flows. The first of the two projects, representing 87% of the total value of
acquired in-process research and development, related to a new resting ECG
monitor. This project was approximately 70% complete at the date of
acquisition and was completed and the related product (the Atria 3000) was
released, as expected, at the end of the first quarter of 2003. Margins on
this product are in line with the Companys historical margins. Costs to
complete this project were expensed in the six-month period ended June 30,
2003. The second of the two projects, representing 13% of the total value of
acquired in-process research and development relates to a product for the
detection and preprocessing of low-level electrical signals generated by the
heart. This project was approximately 50% complete at the date of
acquisition. Management assigned a low priority to this project and decided
to postpone further development indefinitely. In the opinion of management,
the indefinite postponement of further development of this project has not
materially adversely affected the overall return on investment relating to
the Burdick acquisition. All of the acquired in-process research and development was written off
during the six-month period ended June 30, 2003, resulting in a charge to
operating expenses of $1,290,000. Intangible assets consist of the Burdick trade name of $3,400,000,
developed technology of $860,000 and distributor relationships of $1,400,000,
which were valued based on discounted cash flow methods applied to the
estimated future cash flows attributable to the respective assets. The
trade name was determined, by management, to have an indefinite useful life.
Developed technology was assigned a seven year useful life, based on the
estimated remaining economic life of the related products. Distributor
relationships relate to long-standing contractual relationships with an
extensive network of independent distributors, which represented the
exclusive channel through which Burdick sold its products. The economic
life of the distributor relationships has been determined to be 10 years,
based on historical turnover experience and in consideration of the long
standing and stable nature of these relationships. Goodwill in the amount of $9,027,000 represents the excess of the net
purchase price over the fair value of the assets and liabilities acquired.
Goodwill recorded in the Burdick acquisition relates to the long-standing
nature of Burdicks business, its substantial market share, its complementary
fit with Quintons pre-existing business, and managements expectations
relating to future operating synergies and cost efficiencies that can be
realized as a result of operating the businesses on a combined basis. A deferred income tax liability was recorded related to the trade name,
which has no tax basis. Because of the indefinite life of the trade name,
this liability has not been used to reduce the valuation allowance against
existing deferred income tax assets. Minority Interest As part of the acquisition of Burdick, the Company acquired 56%
ownership of Shanghai Burdick Medical Instrument Co., LTD.
(Shanghai-Burdick). The Shanghai-Burdick joint venture has a limited life
of thirty years, terminating in 2030. If the joint venture is terminated,
the Company would be required to liquidate the net assets of the joint
venture and 10




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distribute proceeds to the partners. Assuming the joint venture was to
have been terminated effective June 30, 2004, the Company estimates that such
net proceeds would approximate the carrying value of the minority interest
recorded in the accompanying unaudited consolidated balance sheet, which was
$168,000 at June 30, 2004. 5. Consolidation of Manufacturing Operations During the third quarter of 2003, the Company announced plans to
consolidate its Deerfield, Wisconsin and Bothell, Washington manufacturing
and production activities to its Deerfield location. As a result of the
related transition activities, the Company recognized certain charges
relating to severance and other consolidation related activities of
approximately $1,418,000 during the third and fourth quarters of 2003. The
Company completed this consolidation by the end of 2003. Changes in the Companys accrued liabilities for the six-month period
ended June 30, 2004 related to the consolidation of manufacturing operations
were as follows (amounts in thousands): Manufacturing consolidation liabilities as of December 31, 2003
    
    $
    324Costs paid during the period
    
    
    (290
    )Manufacturing consolidation liabilities as of June 30, 2004
    
    $
    34
 6. Inventories Inventories were valued at the lower of cost, on an average cost basis,
or market and were comprised of the following (amounts in thousands): December 31,
    
    June 30,2003
    
    2004Raw materials
    
    $
    9,708
    
    
    $
    7,457Finished goods
    
    
    2,982
    
    
    
    3,908Total inventories
    
    $
    12,690
    
    
    $
    11,365
 7. Borrowings In connection with the 2003 acquisition of Burdick, the Company
established a line of credit on December 30, 2002. Borrowings under the line
of credit are currently limited to the lesser of $12,000,000 or an amount
based on eligible accounts receivable and eligible inventories. Substantially
all of the Companys assets are pledged as collateral for the line of credit.
This line of credit bears interest at the greater of (i) a variable rate
ranging from the banks prime rate plus a minimum of 0.5% to a maximum of
1.5% based on a funded debt to Earnings Before Interest, Taxes, Depreciation,
and Amortization (EBITDA) ratio, which amounted to 4.75% at June 30, 2004,
or (ii) $9,000 per month. In addition, unused balances under this facility
bear monthly fees equal to 0.50% per annum on the difference between the
maximum credit limit and the average daily principal balance during the
month. The current line of credit expires on December 30, 2004. At June 30,
2004, the Company had no borrowings under this line of credit and had
capacity to borrow $11,053,000 based on eligible accounts receivable and
eligible inventory. 8. Putable Warrants In connection with a loan in 1998, the Company issued warrants to
purchase 123,536 shares of Series A convertible preferred stock with an
exercise price of $0.01 per share that were immediately exercisable. Upon
completion of the initial public offering in 2002, the conversion rights
associated with the Companys Series A convertible preferred stock resulted
in the warrants being exercisable for 63,092 shares of common stock at an
exercise price equal to $0.02 per share. At the holders option, the Company
was required to make a cash payment to the holder equal to the fair value of
the shares issuable upon exercise of the warrants. On July 22, 2002, a
holder of 21,632 putable warrants exercised a put option for cash when the
fair value of the shares was approximately $158,000. On May 21, 2003, the
holder of the 11




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remaining 41,460 putable warrants exercised a put option for cash when
the fair value of the shares was approximately $296,000. Changes in the
fair value of this liability are recorded in the statements of operations as
interest income (expense), putable warrants. There were no warrants
outstanding as of June 30, 2004. 9. Warranty Liability Changes in the warranty liability for the six months ended June 30, 2003
and 2004 were as follows (amounts in thousands): Warranty liability as of December 31, 2003
    
    $
    2,059Charged to cost of revenues

    
    
    779Warranty expenditures
    
    
    (828
    )Warranty liability as of June 30, 2004
    
    $
    2,010Warranty liability as of December 31, 2002
    
    $
    1,089Charged to cost of revenues
    
    
    562Warranty expenditures
    
    
    (571
    )Warranty liability acquired from Burdick, Inc.
    
    
    1,016Warranty liability as of June 30, 2003
    
    $
    2,096
 10. Contingencies Legal Matters The Company is a defendant in various legal matters arising in the
normal course of business. In the opinion of management, the ultimate
resolution of these matters is not expected to have a material effect on the
Companys consolidated financial statements as a whole. 11. Sale of Hemodynamic Monitoring Product Line On October 21, 2003, the Company sold its hemodynamic monitoring product
line. As consideration, the Company received $1,000,000 in cash on October
21, 2003 and a note receivable for $750,000, due October 21, 2004. The buyer
may pay additional contingent consideration of up to $1,500,000 based on
future sales of the buyers products to our previous hemodynamic products
customers. Approximately $55,000 in contingent consideration has been
received through June 30, 2004. Based on the Companys post-closing transition responsibilities, which
extended into the second quarter of 2004, the Company deferred the
recognition of any gain on the transaction until its transition
responsibilities were fulfilled. The Company recognized a gain in the second
quarter of 2004 of $633,000 on the transaction, including the effect of the
contingent consideration received through June 30, 2004. Contingent
consideration received after June 30, 2004 will be recognized as income in
the period in which it is earned. 12




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




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Results of Operations Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2003
    
    2004
    
    2003
    
    2004(as a percentage of revenues)
    
    (as a percentage of revenues)Revenues:Systems
    
    
    85.0
    %
    
    
    85.7
    %
    
    
    84.3
    %
    
    
    85.6
    %Service
    
    
    15.0
    
    
    
    14.3
    
    
    
    15.7
    
    
    
    14.4Total revenues
    
    
    100.0
    
    
    
    100.0
    
    
    
    100.0
    
    
    
    100.0Gross Profit:Systems (as a percentage of systems revenue)
    
    
    40.5
    
    
    
    42.9
    
    
    
    38.9
    
    
    
    43.7Service (as a percentage of service revenue)
    
    
    42.2
    
    
    
    41.0
    
    
    
    44.3
    
    
    
    39.7Gross profit
    
    
    40.8
    
    
    
    42.6
    
    
    
    39.7
    
    
    
    43.1Operating Expenses:Research and development
    
    
    9.6
    
    
    
    8.3
    
    
    
    9.9
    
    
    
    8.4Write off of purchased in-process research
and development
    
    
    
    
    
    
    
    
    
    
    3.2
    
    
    
    Sales and marketing
    
    
    21.7
    
    
    
    20.1
    
    
    
    21.5
    
    
    
    20.2General and administrative, excluding
stock-based compensation expense
    
    
    9.4
    
    
    
    9.0
    
    
    
    9.7
    
    
    
    9.3Stock-based compensation
    
    
    0.1
    
    
    
    0.1
    
    
    
    0.1
    
    
    
    0.1Total operating expenses
    
    
    40.8
    
    
    
    37.5
    
    
    
    44.4
    
    
    
    38.0Operating income (loss)
    
    
    0.0
    
    
    
    5.1
    
    
    
    (4.7
    )
    
    
    5.1Total other income (expense)
    
    
    (0.7
    )
    
    
    2.8
    
    
    
    (0.3
    )
    
    
    1.4Income tax provision
    
    
    (0.1
    )
    
    
    (0.2
    )
    
    
    
    
    
    
    (0.2
    )Minority interest in loss of
consolidated entity
    
    
    
    
    
    
    0.1
    
    
    
    0.1
    
    
    
    0.1Net income (loss)
    
    
    (0.8
    )%
    
    
    7.8
    %
    
    
    (4.9
    )%
    
    
    6.4
    %
 Three-Month Period Ended June 30, 2004 Compared to the Three-Month Period
Ended June 30, 2003 Revenues Revenues increased by $942,000, or 4.5%, to $21,648,000 for the
three-month period ended June 30, 2004 from $20,706,000 for the comparable
period in 2003. Revenues for the three-month period ended June 30, 2003
included sales of $1,025,000 related to the hemodynamic monitoring product
line. We divested this product line in the third quarter of 2003, but
continued to provide service to the related customers through April, 2004.
Service revenue related to this product line was $67,000 for the three-month
period ended June 30, 2004. Systems revenues increased by $938,000, or 5.3%, to $18,542,000 for the
three-month period ended June 30, 2004 from $17,604,000 for the comparable
period in 2003. Systems revenues for the three-month period ended June 30,
2003 included system revenues of $747,000 related to our divested hemodynamic
monitoring line. Systems revenues for the three-month period ended June 30,
2004 did not include any sales from the divested line. The growth in systems
revenue during the quarter was attributable to continued strong sales in most
of our core product lines, with the exception of some temporary softness in
Holter systems sales. Service revenues increased by $4,000, or 0.1%, to $3,106,000 for the
three-month period ended June 30, 2004 from $3,102,000 for the comparable
period in 2003. Service revenues for the three-month period ended June 30,
2003 included service revenues of $278,000 related to our divested
hemodynamic monitoring product line. Service revenues for the three-month
period ended June 30, 2004 included $67,000 relating to this divested line.
The net increase in service 14




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revenues despite the decline in revenues related to the hemodynamic
monitoring line was due to increases in services relating to our other
product lines. Gross Profit Gross profit increased by $782,000, or 9.3%, to $9,224,000 for the
three-month period ended June 30, 2004 from $8,442,000 for the comparable
period in 2003. Gross margin increased to 42.6% for the three-month period
ended June 30, 2004 from 40.8% for the comparable period in 2003. The
increase in gross margin was primarily due to the results of cost reductions
that were realized after we completed the consolidation of our manufacturing
operations at the end of the fourth quarter of 2003. To a lesser extent,
the increase in gross profit was due to the results of product cost reduction
initiatives, including design cost reductions and other reductions in the
cost of purchased components of our products. Gross profit from systems revenues increased by $819,000, or 11.5%, to
$7,951,000 for the three-month period ended June 30, 2004 from $7,132,000 for
the comparable period in 2003. Gross margin from systems revenues increased
to 42.9% for the three-month period ended June 30, 2004 from 40.5% for the
comparable period in 2003. This increase in gross margin was primarily due
to the cost reductions relating to our manufacturing facility consolidation
and the product cost reduction measures referred to above. Gross profit from service revenues decreased by $37,000, or 2.8%, to
$1,273,000 for the three-month period ended June 30, 2004 from $1,310,000 for
the comparable period in 2003. Gross margin from service revenues decreased
to 41.0% for the three-month period ended June 30, 2004 from 42.2% for the
comparable period in 2003. This decrease in gross margin was principally
attributable a change in the service parts sales mix,
as a result of the sale of our hemodynamic monitoring business, and,
to a lesser extent, to increases in service staffing levels to provide
enhanced support to our customers. Operating Expenses Research and development expenses decreased by $193,000, or 9.7%, to
$1,796,000 for the three-month period ended June 30, 2004 from $1,989,000 for
the comparable period in 2003. This decrease was due primarily to staffing
reductions associated with the sale of our hemodynamic monitoring product
line. As a percentage of revenues, research and development expenses
decreased to 8.3% for the three-month period ended June 30, 2004 from 9.6%
for the comparable period in 2003. This decrease was attributed to lower
labor costs and higher revenues during the three-month period ended June 30,
2004 over the comparable period in 2003. Sales and marketing expenses decreased by $124,000, or 2.8%, to
$4,367,000 for the three-month period ended June 30, 2004 from $4,491,000 for
the comparable period in 2003. This decrease was due principally to staffing
reductions associated with the sale of our hemodynamic monitoring product
line. As a percentage of revenues, sales and marketing expenses decreased to
20.1% for the three-month period ended June 30, 2004 from 21.7% for the
comparable period in 2003. This primarily reflects an increase in revenues
for the three-month period ended June 30, 2004 over the comparable period in
2003. General and administrative expenses, excluding stock-based compensation
expense, increased by $7,000, or 0.4%, to $1,949,000 for the three-month
period ended June 30, 2004, from $1,942,000 for the comparable period in
2003. As a percentage of revenues, general and administrative expenses,
excluding stock-based compensation, decreased to 9.0% for the three-month
period ended June 30, 2004 from 9.4% for the comparable period in 2003, due
primarily to the increase in revenues for the three-month period ended June
30, 2004 over the comparable period in 2003. Stock-based compensation expense for the three-month period ended June
30, 2004 was $18,000, which was the same as the amount expensed for the
comparable period in 2003. Stock-based compensation expense for both periods
relates to the intrinsic value of stock options granted in 2001. We expect
to record stock-based compensation expense in the third quarter of 2004 at a
level similar to the amount recorded in the second quarter of 2004. Other Income and Expense Total other income was $614,000 for the three-month period ended June
30, 2004, compared to other expense of $149,000 for the comparable period in
2003. This change was due primarily to the gain recorded on the sale of our
hemodynamic monitoring business of $633,000. In addition, our interest
expense for the three-month period ended June 15




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30, 2004 decreased by approximately $47,000 due primarily to a decline
in average borrowings on our bank line of credit over the comparable period
in 2003, while our interest expense during the three-month period ended June
30, 2003 included interest expense of $63,000 associated with outstanding
balances related to our putable warrants. These warrants were retired in May
2003. There were no such warrants outstanding during the comparable period
in 2004. Income Taxes Income tax provisions recorded in the three-month period ended June 30,
2004 were due to estimated federal alternative minimum tax and state income
tax liabilities. During the three-month period ended June 30, 2004, net operating loss
carryforwards were utilized to offset taxable income. As a result, our
current federal income tax provision has been estimated using alternative
minimum tax rates rather than federal statutory rates. We continue to provide
a full valuation allowance against deferred tax assets. Based on a number of
factors, including the Companys prior history of operating losses, we have
not determined that it is more likely than not that we will realize the
future benefits of a significant portion of our deferred tax assets. Various
factors, such as our operating results, may cause our conclusions to change
in the future. The full impact of any adjustment to the valuation allowance
will be recognized in the period of adjustment by adjusting goodwill, equity,
and income from continuing operations, as appropriate. If and when the
valuation allowance against deferred tax assets is eliminated, we will be
required to recognize income tax expense at statutory rates. Six-Month Period Ended June 30, 2004 Compared to the Six-Month Period Ended
June 30, 2003 Revenues Revenues increased by $2,311,000, or 5.6%, to $43,300,000 for the
six-month period ended June 30, 2004 from $40,989,000 for the comparable
period in 2003. Revenues for the six-month period ended June 30, 2003
included sales of $1,673,000 related to our hemodynamic monitoring product
line. We divested this product line in the third quarter of 2003, but
continued to provide service to the related customers through April 2004.
Service revenue relating to this line was $221,000 for the six-month period
ended June 30, 2004. Systems revenues increased by $2,507,000, or 7.3%, to $37,068,000 for
the six-month period ended June 30, 2004 from $34,561,000 for the comparable
period in 2003. Systems revenues for the six-month period ended June 30,
2003 included system revenues of $1,118,000 related to our divested
hemodynamic monitoring product line. Systems revenues for the six-month
period ended June 30, 2004 did not include any sales from the hemodynamic
monitoring product line. The growth in our systems revenues during the six
months ended June 30, 2004 was attributable to continued strong sales in most
of our product lines. Service revenues decreased by $196,000, or 3.0%, to $6,232,000 for the
six-month period ended June 30, 2004 from $6,428,000 for the comparable
period in 2003. This decrease was related primarily to the decline in
service revenues relating to our divested hemodynamic monitoring line.
Service revenues for the six-month period ended June 30, 2003 included
service revenues of $555,000 related to this divested line, compared to
$221,000 for the six month period ended June 30, 2004. Gross Profit Gross profit increased by $2,390,000, or 14.7%, to $18,676,000 for the
six-month period ended June 30, 2004 from $16,286,000 for the comparable
period in 2003. Gross margin increased to 43.1% for the six-month period
ended June 30, 2004 from 39.7% for the comparable period in 2003. The
increase in gross margin was due primarily to the results of cost reductions
that were realized after we completed the consolidation of our manufacturing
operations at the end of the fourth quarter of 2003. To a lesser extent,
the increase in gross profit was due to the results of product cost reduction
initiatives, including design cost reductions and other reductions in the
cost of purchased components of our products. In addition, during the
six-month period ended June 30, 2003, we recognized an acquisition-related
charge to cost of revenues of $300,000, reflecting an upward adjustment to
Burdicks inventory valuation from Burdicks historical cost at the
acquisition date. This charge to cost of revenues represented an adverse
impact to gross profit of approximately 0.7 percentage points. There was no
similar charge in the six-month period ended June 30, 2004. 16




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Gross profit from systems revenues increased by $2,765,000, or 20.6%, to
$16,202,000 for the six-month period ended June 30, 2004 from $13,437,000 for
the comparable period in 2003. Gross margin from systems revenues increased
to 43.7% for the six-month period ended June 30, 2004 from 38.9% for the
comparable period in 2003. This increase in gross margin was due primarily
to the cost reductions realized from our manufacturing facility consolidation
and the product cost reduction measures referred to above. The
acquisition-related charge to cost of systems revenues of $300,000 recognized
during the six-month period ended June 30, 2004 represented an adverse impact
to gross profit from systems revenues of approximately 0.9 percentage points
during the six-month period ended June 30, 2003. Gross profit from service revenues decreased by $375,000, or 13.2%, to
$2,474,000 for the six-month period ended June 30, 2004 from $2,849,000 for
the comparable period in 2003. Gross margin from service revenues decreased
to 39.7% for the six-month period ended June 30, 2004 from 44.3% for the
comparable period in 2003. This decrease in gross margin was attributable to
a combination of a change in the service parts sales mix, which fluctuated
due to the sale of our hemodynamic monitoring business, increases in service
staffing levels to provide enhanced support to our customers and the
temporary effects in the first quarter of 2004 of inefficiencies and changes
relating to the recent conversion of our enterprise resource planning system. Operating Expenses Research and development expenses decreased by $449,000, or 11.0%, to
$3,627,000 for the six-month period ended June 30, 2004 from $4,076,000 for
the comparable period in 2003. This decrease was due primarily to staffing
reductions associated with the sale of our hemodynamic monitoring product
line. As a percentage of revenues, research and development expenses
decreased to 8.4% for the six-month period ended June 30, 2004 from 9.9% for
the comparable period in 2003. This decrease was attributed to lower labor
costs and higher revenues during the six-month period ended June 30, 2004
over the comparable period in 2003. Sales and marketing expenses decreased by $79,000, or 0.9%, to
$8,738,000 for the six-month period ended June 30, 2004 from $8,817,000 for
the comparable period in 2003. This decrease was due primarily to staffing
reductions associated with the sale of our hemodynamic monitoring product
line, partially offset by increases in staffing and in commission expense
associated with higher revenues during the six-month period ended June 30,
2004 over the comparable period in 2003. As a percentage of revenues, sales
and marketing expenses decreased to 20.2% for the six-month period ended June
30, 2004 from 21.5% for the comparable period in 2003. This primarily
reflects an increase in revenues for the six-month period ended June 30, 2004
over the comparable period in 2003. General and administrative expenses, excluding stock-based compensation
expense, increased by $68,000, or 1.7%, to $4,037,000 for the six-month
period ended June 30, 2004, from $3,969,000 for the comparable period in
2003. This increase was the net effect of a variety of factors, none of
which were individually material. As a percentage of revenues, general and
administrative expenses, excluding stock-based compensation, decreased to
9.3% for the six-month period ended June 30, 2004 from 9.7% for the
comparable period in 2003. This primarily reflects an increase in revenues
for the six-month period ended June 30, 2004 over the comparable period in
2003. Stock-based compensation expense for the six-month period ended June 30,
2004 was $36,000, which was the same as the amount expensed for the
comparable period in 2003. Stock-based compensation expense for both periods
relates to the intrinsic value of stock options granted in 2001. Other Income and Expense Total other income was $573,000 for the six-month period ended June 30,
2004, compared to other expense of $125,000 for the comparable period in
2003. This change was due primarily to the gain recorded on the sale of our
hemodynamic monitoring business of $633,000. In addition, our interest
expense for the six-month period ended June 30, 2004 decreased by
approximately $77,000 due primarily to a decline in average borrowings on our
bank line of credit over the comparable period in 2003, which was offset with
interest income during the six-month period ended June 30, 2003 of $32,000
associated with outstanding balances related to our putable warrants. These
warrants were retired in May 2003. There were no such warrants outstanding
during the comparable period in 2004. 17




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Income Taxes Income tax provisions recorded in the six-month period ended June 30,
2004 were due to estimated federal alternative minimum tax and state income
tax liabilities. During the six-month period ended June 30, 2004, net operating loss
carryforwards were utilized to offset taxable income. As a result, our
current federal income tax provision has been estimated using alternative
minimum tax rates rather than federal statutory rates. We continue to provide
a full valuation allowance against deferred tax assets. Based on a number of
factors, including the Companys prior history of operating losses, we have
not determined that it is more likely than not that we will realize the
future benefits of a significant portion of our deferred tax assets. Various
factors, such as our operating results, may cause our conclusions to change
in the future. The full impact of any adjustment to the valuation allowance
will be recognized in the period of adjustment by adjusting goodwill, equity,
and income from continuing operations, as appropriate. If and when the
valuation allowance against deferred tax assets is eliminated, we will be
required to recognize income tax expense at statutory rates. Liquidity and Capital Resources Net
cash flows from operating activities were $688,000 for the
three-month period ended June 30, 2004, compared to $290,000 for the
comparable period in 2003. Net cash flows from operating activities of
$688,000 for the three-month period ended June 30, 2004 were due primarily to
net income, excluding non-cash income and non-cash expenses, of $1,469,000
and a decrease in inventories of $551,000, which was partially offset by an
increase in accounts receivable of $1,126,000 and a decrease in accrued
liabilities of $325,000. Net
cash flows from operating activities were $123,000 for the six-month
period ended June 30, 2004, compared to net cash flows used in operating
activities of $688,000 for the comparable period in 2003. Net cash flows
from operating activities of $123,000 for the six-month period ended June 30,
2004 were due primarily to net income, excluding non-cash income and non-cash
expenses, of $2,946,000 and a decrease in inventories of $457,000, which was
partially offset by an increase in accounts receivable of $1,058,000 and a
decrease in accrued liabilities of $1,854,000. Cash and cash equivalents at June 30, 2004 increased from balances at
December 31, 2003 due primarily to completion of our public equity offering
in June of 2004 and receipt of the net proceeds. Cash and cash equivalents,
net of debt, at June 30, 2004 was $15,549,000. This compares to total debt,
net of cash, of $532,000 at December 31, 2003. Accounts
receivable at June 30, 2004 increased from balances at
December 31, 2003 due principally to an increase in revenues
near the end of the period. Inventories decreased at June 30,
2004 from balances at December 31, 2003 due principally to the transfer of
inventory related to the Companys hemodynamic monitoring line to the
purchaser of the line and to managements implementation of inventory
reduction measures. Accrued liabilities at June 30, 2004 decreased from
balances at December 31, 2003 due principally to the payment during the
six-month period ended June 30, 2004 of accrued year-end compensation
relating to 2003 sales and operating results, accrued costs relating to the
consolidation of manufacturing operations and other accrued liabilities. Net cash flows used for investing activities of $79,000 for the
three-month period ended June 30, 2004 consisted of $79,000 for capital
expenditures. Net cash flows from investing activities of $1,893,000 for the
three-month period ended June 30, 2003 were due primarily to a refund on the
Burdick acquisition price of $2,297,000, which was partially offset with
purchases of capital equipment related to our enterprise resource planning,
or ERP, system conversion. Net cash flows used for investing activities of $240,000 for the
six-month period ended June 30, 2004 consisted of $115,000 for capital
expenditures and $125,000 for the purchase of technology for use in future
products. We are obligated to pay an additional $125,000 related to the
purchase of technology, which is due in the third quarter of 2004 and is
included in accrued liabilities on our balance sheet at June 30, 2004. In
connection with the purchase of technology, we have a royalty obligation per
system sold, which will be expensed to cost of revenues, and bears no minimum
commitments. Net cash flows used for investing activities of $20,056,000 for
the six-month period ended June 30, 2003 were due primarily to our investment
in Burdick of approximately $19,372,000 net of cash acquired, payments of
acquisition costs and a refund from the reduction in the purchase price. In
addition, we made capital equipment expenditures of $792,000, which were
primarily for the purchase of our enterprise resource planning system, offset
by proceeds received from sales of capital equipment of $108,000. 18




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Net cash flows provided from financing activities of $14,958,000 for the
three-month period ended June 30, 2004 were due primarily to proceeds from our
public equity offering of $15,791,000, net of payments of offering expenses,
and proceeds from exercises of stock options and issuance of shares under our
employee stock purchase plan of $181,000, offset partially by net repayments
on our credit line of $923,000 and a debt payment of $91,000 related to the
note payable issued in the treadmill manufacturing business acquisition. Net
cash flows used for financing activities of $2,017,000 for the three-month
period ended June 30, 2003 were primarily the result of net repayments on our
credit line of $1,855,000, a debt payment of $91,000 related to the note
payable issued in the treadmill manufacturing business acquisition and a
payment of $296,000 for the redemption of putable warrants, partially offset
with proceeds from exercises of stock options and issuance of shares under
our employee stock purchase plan of $225,000. Net cash flows provided from financing activities of $15,662,000 for the
six-month period ended June 30, 2004 were due primarily to proceeds from our
public equity offering of $15,791,000, net of payments of offering expenses,
and proceeds from exercises of stock options and issuance of shares under our
employee stock purchase plan of $407,000, offset partially with net
repayments on our credit line of $354,000 and debt payments of $182,000
related to the note payable issued in the treadmill manufacturing business
acquisition. Net cash flows provided from financing activities of $2,265,000
for the six-month period ended June 30, 2003 were primarily the result of net
borrowings on our credit line of $2,474,000 and proceeds from exercises of
stock options and issuance of shares under our employee stock purchase plan
of $269,000, which was partially offset by debt payments of $182,000 related
to the note payable issued in the treadmill manufacturing business
acquisition and a payment of $296,000 for the redemption of putable warrants. We anticipate that our future operating cash flow, existing cash
balances and borrowings available to us under credit facilities will be
sufficient to meet our operating expenses, working capital requirements,
capital expenditures and other obligations for at least twelve months. We
anticipate that our credit facility will be renewed or replaced upon its
expiration on December 30, 2004. However, we believe that failure to renew
or replace this facility will not have a material adverse effect on our
liquidity. Sale of Hemodynamic Monitoring Product Line On October 21, 2003, we announced the sale of our hemodynamic monitoring
product line. As consideration, we received $1,000,000 in cash on October
21, 2003 and a note receivable of $750,000, due October 21, 2004. The buyer
may pay additional contingent consideration of up to $1,500,000 based on
future sales of the buyers products to our previous hemodynamic products
customers. Based on our post-closing transitional responsibilities, which
extended into the second quarter of 2004, we previously deferred the
recognition of any gain on the transaction. During the second quarter of
2004, we completed all remaining substantive obligations related to the sale
of this line and, accordingly, we recognized a gain of $633,000 on the
transaction. This gain includes contingent consideration which has been
earned through June 30, 2004 of $55,000. Contingent consideration received
after this period will be recognized as income in the period in which it is
received. Public Equity Offering In June 2004, we consummated a public offering of our common stock as
more fully described in our prospectus dated May 25, 2004 filed with the
Securities and Exchange Commission. In the offering, we sold 1,605,976
shares of common stock at a price of $10.50 per share. Proceeds from the
offering were $15,452,000 , net of underwriting discounts and offering
expenses. In addition, a selling shareholder, as named in the prospectus,
sold 1,394,024 shares of common stock in this offering. We did not receive
any proceeds from the sale of shares by the selling shareholder. 19




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




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




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
    
    access new interface standards needed for product connectivity;
    
    anticipate and meet demands of our international customers for products featuring local language capabilities; and
    
    anticipate and compete effectively with our competitors efforts. The rate of market acceptance of our current or future products and
systems may impact our operating results. In addition, we may experience
design, manufacturing, marketing or other difficulties that could delay or
prevent our development, introduction or marketing of new versions of our
products. Such difficulties and delays could cause our development expenses to
increase and harm our operating results. If market conditions cause us to reduce the selling price of our products
and systems, or our market share is negatively affected by the activities
of our competitors, our margins and operating results will decrease. The selling price of our products and systems and the extent of our market
share are subject to market conditions. Market conditions that could impact
these aspects of our operations include:  
    
    lengthening of buying or selling cycles;
    
    the introduction of competing products;
    
    price reductions by our competitors;
    
    development of more effective products by our competitors;
    
    hospital budgetary constraints; and
    
    changes in the reimbursement policies of government and third-party payers. If such conditions force us to sell our products and systems at lower
prices, or if we are unable to effectively develop and market competitive
products, our market share, margins and operating results will likely decrease. Our future financial results could be adversely impacted by asset
impairments or other charges. Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and
Other Intangible Assets requires that we cease amortization of goodwill and
other intangible assets determined to have indefinite lives, and established a
method of testing these assets for impairment on an annual or on an interim
basis if certain events occur or circumstances change that would reduce the
fair value of a reporting unit below its carrying value or if the fair value of
intangible assets with indefinite lives falls below their carrying value. We
also evaluate intangible assets determined to have finite lives for
recoverability whenever events or changes in circumstances indicate that their
carrying amounts may not be recoverable. These events or circumstances could
include a significant change in the business climate, legal factors, operating
performance indicators, competition, sale or disposition of a significant
portion of the business, or other factors such as a decline in our market value
below our book value for an extended period of time. In the case of intangible
assets with indefinite lives, we evaluate whether events or circumstances
continue to support an indefinite useful life. We evaluate the estimated lives
of all intangible assets on an annual basis, including those with indefinite
lives, to determine if events and circumstances continue to support an
indefinite useful life or the remaining useful life, as applicable, or if a
revision in the remaining period of amortization is required. The amount of
any such annual or interim impairment charge could be significant, and could
have a material adverse effect on our reported financial results for the period
in which the charge is taken. We own preferred equity securities of a privately held company, ScImage,
Inc., which we account for using the cost method. The fair value of our
investment is not readily determinable from published market data, so we use
our judgment to estimate the fair value. There can be no assurance that the
estimated fair value of this investment will not decline to an amount below its
carrying amount, in which case we would be required to record a loss on this
investment. If we fail to maintain our relationships with distribution organizations,
our sales and operating results may suffer. We sell our products to the domestic primary care market and to
substantially all international markets principally through third party
distribution organizations. While we have well established relationships with
these distribution organizations, the underlying agreements are generally for
periods of one year or less. One of these domestic distribution organizations,
Physicians Sales and Service, Inc., accounted for 14% of our revenues in 2003.
If these agreements are 22




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




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




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
    
    more extensive technical capabilities;
    
    patent portfolios that may present an obstacle to our conduct of business;
    
    stronger name recognition; and
    
    larger distribution networks. As a result, we may be unable to offer products similar to, or more
desirable than, those offered by our competitors, market our products as
effectively as our competitors, price our products competitively or otherwise
respond successfully to competitive pressures. In addition, our competitors
may be able to offer discounts on competing products as part of a bundle of
non-competing products, systems, and services that they sell to our customers,
and we may not be able to profitably match those discounts. Our competitors
may develop technologies and products that are more effective than those we
currently offer or that render our products obsolete or noncompetitive. In
addition, the timing of the introduction of competing products into the market
could affect the market acceptance and market share of our products. If we are
unable to develop competitive products, gain regulatory approval or clearance
and supply sufficient quantities of such products to the market as quickly and
effectively as our competitors, market acceptance of our products may be
limited, and our revenues and operating results may suffer. If we do not maintain or grow revenues from our support services or
consumables, our operating and financial results may be negatively
impacted. A significant portion of our revenues is generated from post-sale support
services we provide for our products and from the sale of ancillary cardiology
products and consumables related to our products and systems, such as patented
electrodes, pads, cables, leads, and thermal chart paper. As hospitals expand
their in-house capabilities to service diagnostic equipment and systems, they
may be able to service our products without additional support from us. In
addition, our customers may express an increasing preference for ancillary
cardiology products and consumables that are manufactured or provided by other
vendors. Any of these events could result in a decline in our revenues and a
resulting adverse effect on our financial and operating results. Failure to adequately protect our intellectual property rights will cause
our business to suffer. Our success depends in part on obtaining, maintaining, and enforcing our
copyrights, patents and other proprietary rights, and our ability to avoid
infringing the proprietary rights of others. We take precautionary steps to
protect our technological advantages and intellectual property and rely in part
on patent, trade secret, copyright, know-how, and trademark laws, license
agreements and contractual provisions to establish our intellectual property
rights and protect our products. The precautionary steps we have taken may not
adequately protect our intellectual property rights. Our patents may not provide commercially meaningful protection, as
competitors may be able to design around our patents. We may not be able to
protect our rights in unpatented technology, trade secrets, and confidential
information effectively. We require our new employees, consultants, and
corporate partners to execute a confidentiality agreement at the commencement
of their employment or consulting relationship with us. However, these
agreements may not provide effective protection of our information or, in the
event of unauthorized use or disclosure, they may not provide adequate
remedies. If third parties claim that our products infringe their intellectual
property rights, we may be forced to expend significant financial
resources and management time and our operating results would suffer. Third parties may claim that our products and systems infringe on
third-party patents and other intellectual property rights. Identifying
third-party patent rights can be particularly difficult because, in the U.S.,
patent applications are maintained in secrecy for up to eighteen months after
their filing dates. Moreover, patent applications can be maintained in secrecy
until they issue, if they were filed before November 29, 2000, are not subject
to publication in any country, or have otherwise properly requested maintaining
secrecy to issuance. Some companies in the medical device industry have used
intellectual property infringement litigation to gain a competitive advantage.
In the event a competitor were to challenge our patents or licenses, or assert
that our products infringe its patent or other intellectual property rights, we
could incur substantial litigation costs, be forced to make expensive changes
to our product designs, license rights in order to continue manufacturing and
selling our products, or pay substantial damages. Third-party infringement
claims, regardless of their outcome, would not only drain our financial
resources but also divert the time and effort of our management and could
result in our customers or potential customers deferring or limiting their
purchase or use of the affected products until resolution of the litigation. 25




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If we fail to successfully enter into strategic alliances to generate
growth, our operating results may be negatively affected. A component of our growth strategy is to enter into strategic alliances in
order to complement and expand our current product and service offerings and
distribution. There can be no assurances that a strategic alliance will perform
as expected or generate significant revenues or profits. If we do not identify
potential strategic alliances or enter into strategic alliances that fail to
generate additional revenue, our operating and financial results may be
negatively impacted. Our liquidity and financial condition could be adversely impacted if we
are unable to satisfy our obligations under our revolving credit facility
or any future debt arrangements. In December 2002, in order to provide additional funding for the
acquisition of Burdick, we established a $12.0 million revolving credit
facility with Silicon Valley Bank, with available borrowings subject to certain
accounts receivable and inventory provisions. This facility has a term of two
years. We had no outstanding borrowings under the facility at June 30, 2004.
The credit facility contains standard negative covenants and restrictions on
actions by us, including but not limited to, activity related to our common
stock repurchases, liens, investments, capital expenditures, indebtedness,
restricted payments including cash payments of dividends, and fundamental
changes in, or disposition of our assets. Certain of these actions may be
taken by us with the consent of the lender. The credit agreement requires that
we meet certain financial covenants, namely a minimum tangible net worth
measure. We may in the future enter into additional debt arrangements that
contain similar or additional covenants. If we are unable to maintain the
financial performance necessary to comply with the financial covenants in the
credit agreement or in other debt arrangements we enter into, we may be deemed
in breach our obligations and these covenants, which could result in an
acceleration of our debt. In addition, these financial covenants may limit our
ability to incur additional debt. Any of these events could adversely affect
the value of our common stock, and our access to capital could be negatively
impacted. 26




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Item 3. Quantitative and Qualitative Disclosures About Market Risk We develop products in the U.S. and sell them worldwide. As a result,
our financial results could be affected by factors such as changes in foreign
currency exchange rates or weak economic conditions in foreign markets. Since
our products are currently priced in U.S. dollars and are translated to local
currency amounts, a strengthening of the dollar could make our products less
competitive in foreign markets. Interest income is sensitive to changes in
the general level of U.S. interest rates, particularly since our investments
are in short-term investments bearing variable rates. 
 Item 4. Controls and Procedures We maintain disclosure controls and procedures designed to ensure that
information required to be disclosed in our filings under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported within
the time periods specified in the Securities and Exchange Commissions rules
and forms. Our chief executive officer and chief financial officer have
evaluated our disclosure controls and procedures as of the end of the period
covered by this quarterly report of Form 10-Q and have determined that such
disclosure controls and procedures are effective. There has been no change in our internal control over financial
reporting during the three-month period ended June 30, 2004 in connection
with this evaluation that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting. 27




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PART II  OTHER INFORMATION 
 Item 1. Legal Proceedings We are not currently a party to any material legal proceedings. 
 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of
Equity Securities None. 
 Item 3. Defaults Upon Senior Securities None. 
 Item 4. Submission of Matters to a Vote of Security Holders At our Annual Meeting of Stockholders held on May 14, 2004, the
following action was taken:  1.
    
    Election of Directors For
    
    WithheldW. Robert Berg
    
    
    9,827,120
    
    
    
    17,074Jue-Hsien Chern
    
    
    9,827,091
    
    
    
    17,103
 
 Item 5. Other Information None. 
 Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit 10.34*
    
    Employment Agreement between Quinton Cardiology Systems,
Inc. and Allan Criss dated as of March 1, 2004Exhibit 31.1
    
    Certification of Chief Executive Officer pursuant to
Section 302(a) of the Sarbanes-Oxley Act of 2002.Exhibit 31.2
    
    Certification of Chief Financial Officer pursuant to
Section 302(a) of the Sarbanes-Oxley Act of 2002.Exhibit 32.1
    
    Certification of Chief Executive Officer Pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.Exhibit 32.2
    
    Certification of Chief Financial Officer Pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
  *
    
    Indicates management contract or compensatory plan or arrangement. (b) Reports on Form 8-K On April 27, 2004, pursuant to Item 12 of Form 8-K, we furnished a press
release announcing results for the fiscal quarter ended March 31, 2004. 28




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SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. QUINTON CARDIOLOGY SYSTEMS, INC.By:
    /s/ Michael K. MatysikMichael K. MatysikSenior Vice President and Chief Financial
Officer
(Principal Financial and Accounting Officer) Date: July 30, 2004 29