##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
  
 FORM 10-Q þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2005 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 þ    NO o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). YES þ    NO o The number of shares outstanding of the registrants common stock as of May 3, 2005 was
14,083,730.




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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
    
    
    12Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    26Item 4.
    
    Controls and Procedures
    
    
    26PART II - OTHER INFORMATION
    
    
    27Item 1.
    
    Legal Proceedings
    
    
    27Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    27Item 3.
    
    Defaults Upon Senior Securites
    
    
    27Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    27Item 5.
    
    Other Information
    
    
    27Item 6.
    
    Exhibits
    
    
    27SIGNATURE
    
    
    28EXHIBIT 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 December 31,
    
    
    March 31,2004
    
    
    2005(in thousands, exceptshare and per share amounts)ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    21,902
    
    
    $
    22,821Marketable equity securities
    
    
    646
    
    
    
    607Accounts receivable, net of allowance for doubtful accounts
    
    
    13,649
    
    
    
    12,222Inventories
    
    
    11,047

    
    
    
    11,739Deferred income taxes
    
    
    5,542
    
    
    
    5,221Prepaid expenses and other current assets
    
    
    790
    
    
    
    777Total current assets
    
    
    53,576
    
    
    
    53,387Machinery and equipment, net of accumulated depreciation
    
    
    4,314
    
    
    
    4,177Deferred income taxes
    
    
    3,594
    
    
    
    3,494Intangible assets, net of accumulated amortization
    
    
    5,619
    
    
    
    5,539Investment in unconsolidated entity
    
    
    1,000
    
    
    
    1,000Goodwill
    
    
    9,072
    
    
    
    9,072Deferred acquisition related costs
    
    
    
    
    
    
    885Total assets
    
    $
    77,175
    
    
    $
    77,554LIABILITIES AND SHAREHOLDERS EQUITYCurrent Liabilities:Accounts payable
    
    $
    5,615
    
    
    $
    6,818Accrued liabilities
    
    
    6,220
    
    
    
    4,356Warranty liability
    
    
    2,093
    
    
    
    2,016Deferred revenue
    
    
    4,754
    
    
    
    4,729Total current liabilities
    
    
    18,682
    
    
    
    17,919Minority interest in consolidated entity
    
    
    159
    
    
    
    139Shareholders Equity:Preferred stock (10,000,000 shares authorized), $0.001 par
value, no shares outstanding in 2004 or 2005
    
    
    
    
    
    
    Common stock (65,000,000 shares authorized), $0.001 par
value, 14,057,195 and 14,082,519 shares issued and
outstanding at December 31, 2004 and March 31, 2005,
respectively
    
    
    14
    
    
    
    14Additional paid-in capital
    
    
    62,642
    
    
    
    62,833Deferred stock-based compensation
    
    
    (33
    )
    
    
    (15
    )Accumulated other comprehensive income (loss)
    
    
    22
    
    
    
    (4
    )Accumulated deficit
    
    
    (4,311
    )
    
    
    (3,332
    )Total shareholders equity
    
    
    58,334
    
    
    
    59,496Total liabilities and shareholders equity
    
    $
    77,175
    
    
    $
    77,554
 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 Three months endedMarch 31,2004
    
    
    2005(in thousands, except shareand per share amounts)Revenues:Systems
    
    $
    18,526
    
    
    $
    18,344Service
    
    
    3,126
    
    
    
    2,986Total revenues
    
    
    21,652
    
    
    
    21,330Cost of Revenues:Systems
    
    
    10,275
    
    
    
    9,682Service
    
    
    1,925
    
    
    
    1,882Total cost of revenues
    
    
    12,200
    
    
    
    11,564Gross profit
    
    
    9,452
    
    
    
    9,766Operating Expenses:Research and development
    
    
    1,831
    
    
    
    1,809Sales and marketing
    
    
    4,371
    
    
    
    4,657General and administrative
    
    
    2,106
    
    
    
    2,045Total operating expenses
    
    
    8,308
    
    
    
    8,511Operating income
    
    
    1,144
    
    
    
    1,255Other Income (Expense):Interest income (expense), net
    
    
    (41
    )
    
    
    113Other income, net
    
    
    
    
    
    
    61Total other income (expense)
    
    
    (41
    )
    
    
    174Income before income taxes and minority interest in consolidated entity
    
    
    1,103
    
    
    
    1,429Income taxes
    
    
    (35
    )
    
    
    (470
    )Income before minority interest in consolidated entity
    
    
    1,068
    
    
    
    959Minority interest in loss of consolidated entity
    
    
    20
    
    
    
    20Net income
    
    $
    1,088
    
    
    $
    979Net income per share  basic
    
    $
    0.09
    
    
    $
    0.07Net income per share  diluted
    
    $
    0.08
    
    
    $
    0.07Weighted average shares outstanding  basic
    
    
    12,244,515
    
    
    
    14,067,372Weighted average shares outstanding  diluted
    
    
    13,187,087
    
    
    
    14,777,899
 The accompanying notes are an integral part of these unaudited condensed consolidated financial
statements. 4




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QUINTON CARDIOLOGY SYSTEMS, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Three months endedMarch 31,2004
    
    
    2005(in thousands)Operating Activities:Net income
    
    $
    1,088
    
    
    $
    979Adjustments to reconcile net income to net cash flows from (used in) operating
activitiesDepreciation and amortization
    
    
    386
    
    
    
    404Deferred income taxes
    
    
    5
    
    
    
    434Stock-based compensation
    
    
    18
    
    
    
    24Minority interest in loss of consolidated entity
    
    
    (20
    )
    
    
    (20
    )Changes in operating assets and liabilities, net of businesses acquired:Accounts receivable
    
    
    68
    
    
    
    1,427Inventories
    
    
    (94
    )
    
    
    (692
    )Prepaid expenses and other current assets
    
    
    10
    
    
    
    13Accounts payable
    
    
    (365
    )
    
    
    397Accrued liabilities
    
    
    (1,529
    )
    
    
    (1,864
    )Warranty liability
    
    
    (24
    )
    
    
    (77
    )Deferred revenue
    
    
    (108
    )
    
    
    (25
    )Net cash flows from (used in) operating activities
    
    
    (565
    )
    
    
    1,000Investing Activities:Purchases of machinery and equipment
    
    
    (36
    )
    
    
    (187
    )Payments of acquisition related costs
    
    
    
    
    
    
    (79
    )Purchase of technology
    
    
    (125
    )
    
    
    Net cash flows used in investing activities
    
    
    (161
    )
    
    
    (266
    )Financing Activities:Proceeds from exercise of stock options and issuance of shares under employee
stock purchase plan
    
    
    226
    
    
    
    185Borrowings on bank line of credit, net
    
    
    569
    
    
    
    Payments of long term debt
    
    
    (91
    )
    
    
    Net cash flows from financing activities
    
    
    704
    
    
    
    185Net change in cash and cash equivalents
    
    
    (22
    )
    
    
    919Cash and cash equivalents, beginning of period
    
    
    185
    
    
    
    21,902Cash and cash equivalents, end of period
    
    $
    163
    
    
    $
    22,821Supplemental disclosure of cash flow information:Cash paid for interest
    
    $
    47
    
    
    $
    128Cash paid for income taxes
    
    
    7
    
    
    
    9Supplemental disclosure of non-cash investing and financing activities:Accounts payable recorded for acquisition related costs
    
    $
    
    
    
    $
    806Note issued in connection with purchase of technology
    
    
    125
    
    
    
    
 The accompanying notes are an integral part of these unaudited condensed consolidated financial
statements. 5




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QUINTON CARDIOLOGY SYSTEMS, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Description of Business Quinton Cardiology Systems, Inc. (QCS) is a Delaware corporation. QCS and its
subsidiary, Quinton Cardiology, Inc. (Quinton) and its majority owned subsidiary Shanghai
Quinton Medical Device Co., Ltd. (Shanghai-Quinton) are referred to herein as the Company.
The Company develops, manufactures, markets and services a family of advanced cardiology
products used in the diagnosis, monitoring and management of patients with heart disease. 2. Summary of Significant Accounting Policies Basis of Presentation The condensed financial statements present the Company on a consolidated basis. All
significant intercompany accounts and transactions have been eliminated. The condensed
consolidated balance sheet dated March 31, 2005, the condensed consolidated statements of
operations for the three-month periods ended March 31, 2004 and 2005 and the condensed
consolidated statements of cash flows for the three-month periods ended March 31, 2004 and 2005
have been prepared by the Company and are unaudited. The condensed consolidated balance sheet
dated December 31, 2004 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, 2004 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. Certain prior year amounts have been reclassified to conform to current period
presentation. 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 assessing the collectability of accounts receivable, the salability and
recoverability of inventory, the adequacy of warranty liabilities, the realizability of
investments, the calculation of our effective tax rate, the impairment of long-lived assets, the
likelihood of closing on a potential business combination 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 December 2004, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS No. 123R).
SFAS No. 123R requires the Company to measure the cost of employee services received in
exchange for an award of an equity instrument, such as stock options, based on the grant-date
fair-value of the award. The associated cost must be recognized over the period during which an
employee is required to provide service in exchange for the award (usually the vesting period).
In April 2005, the U.S. Securities and Exchange Commission adopted a new rule amending the
compliance dates for SFAS No. 123R. In accordance with the new rule, the accounting provisions
of SFAS No. 123R will be effective for the Company in the first 6




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quarter of 2006. SFAS No. 123R provides for a variety of implementation
alternatives, including accounting for the change prospectively or restating previously reported
amounts to reflect the compensation expense that would have been recorded under SFAS No. 123R.
The Company is in the process of evaluating the impact of adopting SFAS No. 123R and of
determining the impact on its results of operations and statements of cash flows. Net Income Per Share In accordance with SFAS No. 128, Computation of Earnings Per Share, basic income per
share is computed by dividing net income 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. Potential common shares consist of shares issuable upon the exercise of stock
options 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 net income per share: Three months endedMarch 31,2004
    
    
    2005(in thousands, exceptshare amounts)Numerator:Net income
    
    $
    1,088
    
    
    $
    979Denominator:Weighted average shares for basic calculation
    
    
    12,244,515
    
    
    
    14,067,372Incremental shares from employee stock options
    
    
    942,572
    
    
    
    710,527Weighted average shares for diluted calculation
    
    
    13,187,087
    
    
    
    14,777,899
 For the three-month periods ended March 31, 2004 and 2005, 25,000 and 75,000, respectively,
of shares issuable upon exercise of stock options were excluded from the computation of diluted
income per share as their impact was antidilutive. Accounting for Stock-Based Compensation The Company has elected to apply the disclosure-only provisions of SFAS No. 123,
Accounting for Stock-Based Compensation (SFAS No. 123). In accordance with the provisions
of SFAS No. 123, the Company applies Accounting Principles Board Opinion 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 No. 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. Had compensation cost been determined based on the fair value of the option awards at the
grant dates during the three-month periods ended March 31, 2004 and 2005, consistent with the
provisions of SFAS No. 123, the Companys reported net income would have been the pro forma
amounts indicated below: 7




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Three months endedMarch 31,2004
    
    
    2005(in thousands, exceptper share amounts)Net income  as reported
    
    $
    1,088
    
    
    $
    979Add back: Stock-based employee compensation
expense included in reported income, net
of related tax effects
    
    
    18
    
    
    
    24Deduct: Total stock-based employee
compensation expense determined under fair
value based method for all awards, net of
related tax effects of $0 and $57
    
    
    (422
    )
    
    
    (543
    )Net income  pro forma
    
    $
    684
    
    
    $
    460Net income per share  as reported  basic
    
    $
    0.09
    
    
    $
    0.07Net income per share  as reported  diluted
    
    $
    0.08
    
    
    $
    0.07Net income per share  pro forma  basic
    
    $
    0.06
    
    
    $
    0.03Net income per share  pro forma  diluted
    
    $
    0.05
    
    
    $
    0.03
 The following table sets forth, consistent with the provisions of SFAS No. 123, the
denominator for calculating pro forma diluted net income per share for each respective period: Three months endedMarch 31,2004
    
    
    2005Denominator:Pro forma weighted average shares for basic calculation
    
    
    12,244,515
    
    
    
    14,067,372Pro forma incremental shares from employee stock options
    
    
    245,742
    
    
    
    214,841Pro forma weighted average shares for diluted calculation
    
    
    12,490,257
    
    
    
    14,282,213
 The Company calculated the fair value of each option grant on the date of grant using the
Black-Scholes option-pricing model. The following assumptions were used for each respective
period: Three months endedMarch 31,2004
    
    
    2005Stock options plans:Volatility
    
    
    70.0
    %
    
    
    62.0
    %Risk-free interest rate
    
    
    3.8
    %
    
    
    4.5
    %Expected life
    
    7.00 years
    
    6.25 yearsDividend yield
    
    
    0.0
    %
    
    
    0.0
    %Employee stock purchase planVolatility
    
    
    70.0
    %
    
    
    64.6
    %Risk-free interest rate
    
    
    2.0
    %
    
    
    2.7
    %Expected life
    
    0.5 year
    
    0.5 yearDividend yield
    
    
    0.0
    %
    
    
    0.0
    %
 Goodwill Goodwill represents the excess of costs over the estimated fair values of net assets
acquired in connection with our acquisitions of a medical treadmill manufacturing line in 2002
and Spacelabs Burdick, Inc. (Burdick) in 2003, which, in accordance with SFAS No. 142,
Goodwill and Other Intangible Assets, (SFAS No. 142) are 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 general cardiology products, which
includes the service business, and the Shanghai-Quinton joint venture, both of which operate in
the cardiology market and have similar economic and operating characteristics. 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, thus the second step of the goodwill
impairment test used to quantify impairment is unnecessary. Management has estimated that the
fair 8




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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 and Other Long-Lived Assets The Companys intangible assets are comprised primarily of a trade name, developed
technology and customer relationships, all of which were acquired in our acquisition of Burdick
in 2003. Company management 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. Developed technology was assigned a seven year useful life, based
on the estimated remaining economic life of the related products. The useful 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. The Company annually re-evaluates its conclusion that the Burdick trade name has an
indefinite live 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 amortize the trade name. Company management annually reviews the trade name intangible
asset for impairment by comparing the fair value of the asset to its carrying value. The Company
uses judgment to estimate the fair value of the trade name. The judgment about fair value is
based on expectations of future cash flows and an appropriate discount rate. In accordance with Statement 144, long-lived assets, such as property, plant, and
equipment, and intangibles subject to amortization, are reviewed for impairment whenever events
or changes in circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of assets to be held and used is measured by a comparison of the
carrying amount of an asset to estimated undiscounted future cash flows expected to be generated
by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an
impairment charge is recognized on our statement of operations and as a reduction to the asset
by the amount by which the carrying amount of the asset exceeds the fair value of the asset.
Assets to be disposed of would be separately presented in the balance sheet and reported at the
lower of the carrying amount or fair value less costs to sell, and are no longer depreciated.
The assets and liabilities of a disposal group classified as held for sale would be presented
separately in the appropriate asset and liability sections of the balance sheet. The Company recorded amortization expense for identifiable intangibles of $81,000 in each
of the three-month periods ended March 31, 2004 and 2005. 3. Inventories Inventories were valued at the lower of cost, on an average cost basis, or market and
were comprised of the following: December 31,
    
    
    March 31,2004
    
    
    2005(in thousands)Raw materials
    
    $
    7,879
    
    
    $
    8,627Finished goods
    
    
    3,168
    
    
    
    3,112Total inventories
    
    $
    11,047
    
    
    $
    11,739
 4. Credit Facility The Company established a line of credit in December 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 based on a
variable rate ranging from the banks prime rate plus a minimum of 0.0% to a maximum of 0.5%
based on a funded debt to Earnings Before Interest, Taxes, Depreciation, and Amortization
(EBITDA) ratio, which amounted to 5.25% and 5.75% at December 31, 2004 and March 31, 2005,
respectively. In addition, unused balances under this facility bear monthly 9




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fees equal to 0.25% per annum on the difference between the maximum credit limit and the sum of
(i) the average daily principal balance during the month and (ii) the face amount of any letters
of credit. The current line of credit expires on December 30, 2005. At December 31, 2004 and
March 31, 2005, the Company did not have any borrowings under this line of credit. As of March
31, 2005, the Company had capacity to borrow $9,049,000 based on eligible accounts receivable
and eligible inventory. The credit facility contains standard negative covenants and
restrictions on actions by the Company, including but not limited to, activity related to common
stock repurchases, liens, investments, capital expenditures, indebtedness, restricted payments
including cash payments of dividends, and fundamental changes in, or disposition of assets.
Certain of these actions may be taken with the consent of the lender. In addition, the credit
agreement requires that the Company meet certain financial covenants, namely a minimum tangible
net worth measure. As of December 31, 2004 and March 31, 2005, the Company was in compliance
with all covenants under the credit facility. 5. Warranty Liability Changes in the warranty liability for the three months ended March 31, 2004 and 2005
were as follows: Three months endedMarch 31,2004
    
    
    2005(in thousands)Warranty liability, beginning of the period
    
    $
    2,059
    
    
    $
    2,093Charged to cost of revenues
    
    
    453
    
    
    
    430Warranty expenditures
    
    
    (477
    )
    
    
    (507
    )Warranty liability at the end of the period
    
    $
    2,035
    
    
    $
    2,016
 6. Comprehensive Income The Company records all changes in equity during the period from non-owner sources as
other comprehensive income or loss, such as unrealized gains and losses on the Companys
available-for-sale securities. Comprehensive income, net of any related tax effects, was as
follows: Three months endedMarch 31,2004
    
    
    2005(in thousands)Net income
    
    $
    1,088
    
    
    $
    979Other comprehensive loss, net of related tax effects of $13
    
    
    
    
    
    
    (26
    )Total comprehensive income
    
    $
    1,088
    
    
    $
    953
 7. Contingencies Legal Matters The Company is a defendant in various legal matters arising in the normal course of
business. In the opinion of management, the ultimate resolution of these matters is not expected
to have a material effect on the Companys consolidated financial statements as a whole. 10




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8. Merger with Cardiac Science On February 28, 2005, the Company entered into a definitive agreement to combine with
Cardiac Science, Inc, a manufacturer of automated external defibrillators based in Irvine,
California. The transaction, which was unanimously approved by the boards of directors of both
companies, requires the approval of the Companys stockholders and Cardiac Sciences
stockholders and is subject to regulatory review and other customary closing conditions. The
Company anticipates that the merger will close during the third quarter of 2005. To effect the
combination, the parties have formed CSQ Holding Company, which is sometimes referred to herein as
Newco. Quinton Cardiology Systems and Cardiac Science will be merged with newly formed
acquisition subsidiaries of Newco. Upon the closing of the transaction, each
outstanding share of the Companys common stock will be converted to the right to receive
0.77184895 share of common stock of Newco and each outstanding share of Cardiac Sciences common
stock will be converted to the right to receive 0.10 share of common stock of Newco. In
connection with the transaction, the holders of Cardiac Sciences outstanding senior debt and
related warrants have agreed to cancel those securities in exchange for 2,843,915 shares of
Newco common stock and a cash payment in the amount of $20 million, pursuant to a note and
warrant conversion agreement between Newco, Cardiac Science and such holders. Based on the
exchange ratios and the companies outstanding shares at February 28, 2005, Newco will have
approximately 22.3 million shares of common stock outstanding after consummation of the
transaction, including shares issued in connection with the conversion of Cardiac Sciences senior notes and related warrants
pursuant to the note and warrant conversion agreement, of which our stockholders will hold
approximately 48.7% and Cardiac Sciences stockholders, together with the holders of its
outstanding senior debt and warrants, will hold approximately 51.3%. The common stock of
Newco, which will be renamed Cardiac Science Corporation at the time
of closing, is expected to trade on
the Nasdaq National Market under the symbol CSCX subject to the approval of the Nasdaq Stock
Market. The transaction will be accounted for as an acquisition of Cardiac Science by Quinton
Cardiology Systems under the purchase method of accounting in accordance with Statement of
Financial Accounting Standards No. 141, Business Combinations. Quinton Cardiology Systems
will be the acquiring entity for financial reporting purposes based on our review of the
criteria for determining the accounting acquirer as set forth in Statement 141. These criteria
include but are not limited to; relative share ownership of the combined entity, composition of
and ability to elect the board of directors, and the entity from which senior management
positions are filled. A majority of Newcos proposed board of directors will be comprised of
current Quinton Cardiology Systems directors. In addition, Quinton Cardiology Systems
executives will fill a majority of Newcos senior management positions, thereby directing
policies, strategic direction, and day-to-day operations. If the planned merger with Cardiac Science is not completed, the Company would be required
to expense the deferred acquisition related costs, which totaled $885,000 at March 31, 2005. In
addition, if the Company terminates the merger agreement with Cardiac Science under specified
conditions, the Company would be liable for $4.0 million in breakup fees. In the event that the transaction with Cardiac Science is consummated, the Company
anticipates that Newco will use approximately $20 million of our cash to make the cash payment
contemplated by the note and warrant conversion agreement to the holders of Cardiac Sciences
senior debt and related warrants. 11




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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 with the Securities and Exchange Commission (SEC) on March 16, 2005,
as amended on Form 10-K/A filed on April 22, 2005. 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, the adequacy of warranty liabilities, the
realizability of investments, the calculation of our effective tax rate, the impairment of
long-lived assets, the useful
lives of tangible and intangible assets and the likelihood of closing
a potential business combination for which related transaction costs
have been deferred. 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 ended December 31, 2004 is
contained in our Annual Report on Form 10-K for the fiscal year ended December 31, 2004 filed
with the SEC on March 16, 2005, as amended on Form 10-K/A filed
on April 22, 2005. In addition to those critical accounting
estimates described in our Annual Report on Form 10-K, we have
established the following critical accounting estimate: Business
Combinations.  We must make an estimate of the
likelihood of closing our potential business combination with Cardiac
Science, Inc. Because we believe that we will consummate this
transaction, we have deferred certain costs incurred in connection
with the transaction until the combination is consummated, at which
time the deferred transaction related costs will be included in the
cost of the entity acquired. Changes in
our estimate of the likelihood of consummating this transaction may
cause us to charge the related deferred costs to operations, which
could have a material impact on our results of operations and
financial position. 12




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Results of Operations Three months endedMarch 31,2004
    
    
    2005(as a percentage of revenues)Revenues:Systems
    
    
    85.6
    %
    
    
    86.0
    %Service
    
    
    14.4
    
    
    
    14.0Total revenues
    
    
    100.0
    
    
    
    100.0Gross Profit:Systems (as a percentage of systems revenues)
    
    
    44.5
    
    
    
    47.2Service (as a percentage of service revenues)
    
    
    38.4
    
    
    
    37.0Gross profit
    
    
    43.7
    
    
    
    45.8Operating Expenses:Research and development
    
    
    8.5
    
    
    
    8.5Sales and marketing
    
    
    20.2
    
    
    
    21.8General and administrative
    
    
    9.7
    
    
    
    9.6Total operating expenses
    
    
    38.4
    
    
    
    39.9Operating income
    
    
    5.3
    
    
    
    5.9Total other income (expense)
    
    
    (0.2
    )
    
    
    0.8Income taxes
    
    
    (0.2
    )
    
    
    (2.2
    )Minority interest in loss of consolidated entity
    
    
    0.1
    
    
    
    0.1Net income
    
    
    5.0
    %
    
    
    4.6
    %
 Three-Month Period Ended March 31, 2005 Compared to the Three-Month Period Ended March 31,
2004 Revenues Revenues decreased by $322,000, or 1.5%, to $21,330,000 for the three-month period
ended March 31, 2005 from $21,652,000 for the comparable period in 2004. Systems revenues decreased by $182,000, or 1.0%, to $18,344,000 for the three-month period
ended March 31, 2005 from $18,526,000 for the comparable period in 2004. The decline was
primarily due to delays in order cycles in our acute care channel for our cardiac rehabilitation
systems and, to a lesser extent, to temporary problems in obtaining component parts for certain
versions of our electrocardiographs, resulting in lower than expected sales. This decline was
partially offset by stronger sales in our primary care and international channels. Service revenues decreased by $140,000, or 4.5%, to $2,986,000 for the three-month period
ended March 31, 2005 from $3,126,000 for the comparable period in 2004. Service revenues for
the three-month period ended March 31, 2004 included $154,000 related to our divested
hemodynamic monitoring product line. Service revenues for the three-month period ended March
31, 2005 did not include any sales from the divested line. Gross Profit Gross profit increased by $314,000, or 3.3%, to $9,766,000 for the three-month period
ended March 31, 2005, from $9,452,000 for the comparable period in 2004. Gross margin increased
to 45.8% for the three-month period ended March 31, 2005 from 43.7% for the comparable period in
2004. The increase in gross margin was primarily attributable to the 13




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results of ongoing cost reduction initiatives, including design cost reductions and other
reductions in the cost of purchased components of our products, combined with changes in product
mix, partially offset by a decrease in service margin. Gross profit from systems revenues increased by $411,000, or 5.0%, to $8,662,000 for the
three-month period ended March 31, 2005 from $8,251,000 for the comparable period in 2004.
Gross margin from systems revenues increased to 47.2% for the three-month period ended March 31,
2005 from 44.5% for the comparable period in 2004. The increase in gross margin was primarily
attributable to the results of ongoing cost reduction initiatives, combined with changes in
product mix. Gross profit from service revenues decreased by $97,000, or 8.1%, to $1,104,000 for the
three-month period ended March 31, 2005 from $1,201,000 for the comparable period in 2004.
Gross margin from service revenues decreased to 37.0% for the three-month period ended March 31,
2005 from 38.4% for the comparable period in 2004. The decrease in gross margin was principally
attributable to a decrease in service revenues, referred to above, without a corresponding
decrease in service staffing levels, which have been maintained to provide enhanced support to
our customers. Operating Expenses Research and development expenses decreased by $22,000, or 1.2%, to $1,809,000 for the
three-month period ended March 31, 2005 from $1,831,000 for the comparable period in 2004.
This decrease was the net effect of a variety of factors, none of which were individually
material. As a percentage of revenues, research and development expenses remained flat at 8.5%
for the three-month period ended March 31, 2005 and for the comparable period in 2004. Sales and marketing expenses increased by $286,000, or 6.5%, to $4,657,000 for the
three-month period ended March 31, 2005 from $4,371,000 for the comparable period in 2004. This
increase was due principally to increased sales and marketing headcount and related expenses in
2005 over the comparable period in 2004. As a percentage of revenues, sales and marketing
expenses increased to 21.8% for the three-month period ended March 31, 2005 from 20.2% for the
comparable period in 2004. This primarily reflects an increase in expenses in 2005 over the
comparable period in 2004. General and administrative expenses decreased by $61,000, or 2.9%, to $2,045,000 for the
three-month period ended March 31, 2005, from $2,106,000 for the comparable period in 2004.
This decrease was the net effect of a variety of factors, none of which were individually
material. As a percentage of revenues, general and administrative expenses decreased to 9.6%
for the three-month period ended March 31, 2005 from 9.7% for the comparable period in 2004. Other Income and Expense Total other income was $174,000 for the three-month period ended March 31, 2005,
compared to other expense of $41,000 for the comparable period in 2004. This change was
principally due to an increase in interest income earned on our substantially increased average
cash balances for the three-month period ended March 31, 2005 over the comparable period in 2004
and the result of a decrease in interest expense related to our credit line in 2005 as compared
to the same period in 2004. In addition, other income during the three-month period ended March
31, 2005 includes $61,000 in contingent consideration we earned during the period under the
terms of the definitive agreement relating to the October 2003 sale of our divested hemodynamic
monitoring line. Income Taxes Our year-to-date effective tax rate for the three-month period ended March 31, 2005
was 33.0%, and we reduced deferred income tax assets for the benefits of NOL carryforwards
actually used in the period. During the three-month period ended March 31, 2004, income taxes
were recorded for estimated federal alternative minimum tax and state income tax liabilities. During the fourth quarter of 2004, we reduced all of the valuation allowance against our
net deferred tax assets and liabilities. We will continue to evaluate our ability to utilize
our NOL carryforwards in future periods and, in compliance with SFAS No. 109, Accounting for
Income Taxes, record any resulting adjustments to deferred income tax expense. In addition, we
will reduce deferred income tax assets for the benefits of NOL carryforwards actually used in
future periods. 14




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Liquidity and Capital Resources Net cash flows from operating activities were $1,000,000 for the three-month period
ended March 31, 2005, compared to net cash flows used in operating activities of $565,000 for
the comparable period in 2004. Net cash flows from operating activities of $1,000,000 for the
three-month period ended March 31, 2005 resulted primarily from net income, excluding non-cash
income and non-cash expenses, of $1,821,000, a decrease in accounts receivable of $1,427,000 and
an increase in accounts payable of $397,000, which were partially offset by an increase in
inventories of $692,000 and a decrease in accrued liabilities of $1,864,000. Cash and cash equivalents at March 31, 2005 increased from balances at December 31, 2004
due primarily to cash generated from operations during the three-month period ended March 31,
2005. Accounts receivable balances at March 31, 2005 decreased from balances at December 31,
2004 due principally to a decline in revenues during the first quarter of 2005, as compared to
the fourth quarter of 2004. Inventories increased at March 31, 2005 from balances at December
31, 2004 due principally to lower than expected sales resulting from delays in order cycles for
cardiac rehabilitation systems and, to a lesser extent, to temporary problems in obtaining
component parts for certain versions of our electrocardiographs. Accounts payable balances at
March 31, 2005 increased from balances at December 31, 2004 due primarily to accrued merger
costs related to the proposed merger with Cardiac Science, Inc., which we announced on February
28, 2005. Accrued liabilities at March 31, 2005 decreased from balances at December 31, 2004
due principally to payments during the three-month period ended March 31, 2005 of accrued
year-end compensation relating to 2004 sales and operating results and other accrued
liabilities. Net cash flows used in investing activities of $266,000 for the three-month period ended
March 31, 2005 consisted of $187,000 for capital expenditures and $79,000 for payments of costs
related to the proposed merger with Cardiac Science. Capital expenditures primarily consist of
leasehold improvements made within our corporate headquarters in Bothell, Washington. Net cash
flows used in investing activities of $161,000 for the three-month period ended March 31, 2004
related primarily to our purchase of technology and, to a lesser extent, to purchases of capital
equipment. Net cash flows from financing activities of $185,000 for the three-month period ended March
31, 2005 resulted from proceeds from exercises of stock options and issuances of common stock
under our employee stock purchase plan. Net cash flows from financing activities of $704,000
for the three-month period ended March 31, 2004 resulted primarily from net borrowings on our
line of credit and, to a lesser extent, proceeds from exercises of stock options and issuances
of common stock under our employee stock purchase plan, which were offset slightly by a debt
payment related to a note payable issued in connection with the purchase of the treadmill
manufacturing business acquisition. 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, 2005. However, we believe that failure to renew or replace this facility would
not have a material adverse effect on our liquidity. Merger Agreement with Cardiac Science, Inc. On February 28, 2005, we entered into a definitive agreement to combine with Cardiac
Science, Inc, a manufacturer of automated external defibrillators, or AEDs, based in Irvine,
California. The transaction, which was unanimously approved by the boards of directors of both
companies, requires the approval of our stockholders and Cardiac Sciences stockholders and is
subject to regulatory review and other customary closing conditions. We currently anticipate
that the merger will close during the third quarter of 2005. To effect the combination, the
parties have formed CSQ Holding Company, which we sometimes refer to herein as Newco. Quinton
Cardiology Systems and Cardiac Science will be merged with newly formed acquisition subsidiaries
of Newco. Upon the closing of the transaction, each outstanding share of our common stock will
be converted to the right to receive 0.77184895 share of common stock of Newco and each
outstanding share of Cardiac Sciences common stock will be converted to the right to receive
0.10 share of common stock of Newco. In connection with the transaction, the holders of Cardiac
Sciences outstanding senior debt
and related 15




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warrants have agreed to cancel those securities in exchange for 2,843,915
shares of Newco common stock and a cash payment in the amount of $20 million, pursuant to a note
and warrant conversion agreement between Newco, Cardiac Science and such holders. Based on the
exchange ratios and the companies outstanding shares at February 28, 2005, Newco will have
approximately 22.3 million shares of common stock outstanding after consummation of the
transaction, including shares issued in connection with the conversion of Cardiac Sciences
senior notes and related warrants pursuant to the note and warrant conversion agreement, of
which our stockholders will hold approximately 48.7% and Cardiac Sciences stockholders,
together with the holders of its outstanding senior debt and warrants, will hold approximately
51.3%. The common stock of Newco, which will be renamed Cardiac Science Corporation at the
time of closing, is expected to trade on the Nasdaq National Market under the symbol CSCX
subject to the approval of the Nasdaq Stock Market. The transaction will be accounted for as an acquisition of Cardiac Science by Quinton
Cardiology Systems under the purchase method of accounting in accordance with Statement of
Financial Accounting Standards No. 141, Business Combinations. Quinton Cardiology Systems
will be the acquiring entity for financial reporting purposes based on our review of the
criteria for determining the accounting acquirer as set forth in Statement 141. These criteria
include but are not limited to; relative share ownership of the combined entity, composition of
and ability to elect the board of directors, and the entity from which senior management
positions are filled. A majority of Newcos proposed board of directors will be comprised of
current Quinton Cardiology Systems directors. In addition, Quinton Cardiology Systems
executives will fill a majority of Newcos senior management positions, thereby directing
policies, strategic direction, and day-to-day operations. Our liquidity may be affected in future periods due to legal, accounting, financial expert
and other expenses relating to the our proposed transaction with Cardiac Science, Inc. As of
March 31, 2005, $885,000 of acquisition related costs were incurred, of which $806,000 were
unpaid. In addition, if we terminate the merger agreement with Cardiac Science under specified
conditions, we would be liable for $4.0 million in breakup fees. The payment of the breakup
fees may adversely affect our liquidity. In the event that the transaction with Cardiac Science is consummated, we anticipate that
Newco will use approximately $20 million of our cash to make the cash payment contemplated by
the note and warrant conversion agreement to the holders of Cardiac Sciences senior debt and
related warrants. 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 or could cause
the trading price of our common stock to decline. Additional risks and uncertainties not
presently known to us or that we currently deem immaterial also may impair our business
operations or negatively impact the trading price of our common stock. The unpredictability of our quarterly revenues and operating results may cause the
trading price of our stock to decrease. Our quarterly revenues and operating results have varied in the past and may continue to
vary in the future due to a number of factors, many of which are outside of our control.
Factors contributing to these fluctuations may include:  
    the impact of acquisitions, divestitures, strategic alliances, and other significant
corporate events;
    changes in our ability to obtain products and product components that are
manufactured for us by third parties, such as Holter monitors, as well as variations in
prices of these products and product components;
    delays in the development or commercial introduction of new versions of products and
systems;
    the ability to attain and maintain production volumes and quality levels for our
products and product components;
    effects of domestic and foreign economic conditions on our industry and/or customers; 16




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
    the successful implementation of our system-oriented sales approach;
    changes in the demand for our products and systems;
    varying sales cycles that can take up to a year or more;
    changes in the mix of products and systems we sell, which could affect our revenue
levels as well as our gross margins;
    unpredictable budgeting cycles of our customers;
    delays in obtaining regulatory clearance for new versions of our products and systems;
    increased product and price competition;
    the impact of regulatory changes on the availability of third-party reimbursement to
customers of our products and systems;
    the loss of key personnel;
    the loss of key distributors or distribution companies; and
    seasonality in the sales of our products and systems. Due to the factors summarized above, we believe that period-to-period comparisons of our
operating results are not a good indication of our future performance and should not be relied
on to predict future operating results. Also, it is possible that, in future periods, our
operating results will not meet the expectations of public market analysts or investors. In
that event, the price of our common stock may decrease. 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 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 17




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
    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 business and results of operations may be affected by our announced merger with
Cardiac Science, Inc. Our announcement of the transaction with Cardiac Science, Inc. may create uncertainty among
customers such that one or more large customers, or a significant group of small customers,
delays purchase decisions pending consummation of the planned transaction, which could
negatively affect our results of operations in future quarters. Decreased revenue could have a
variety of adverse effects, including negative consequences to our relationships with, and
ongoing obligations to, customers, suppliers, business partners, and others with whom we have
business relationships. In addition, our quarterly operating results and revenue could be
substantially below the expectations of market analysts, which could cause a decline in our
stock price. Cardiac Sciences operations could be similarly impacted by uncertainties created
by the pending transaction, which could negatively impact the future operating results of the
combined entity assuming the transaction is consummated. We may suffer additional adverse consequences if the proposed transaction with Cardiac
Science is not completed. If the planned merger with Cardiac Science is not completed, we could suffer a number of
consequences that may adversely affect our business, results of operations and stock price,
including the following:  
    we would not realize the benefits we expect from becoming part of a combined company
with Cardiac Science, such as the potentially enhanced financial position, enhanced
product diversity and sales, marketing and distribution capabilities;
    activities relating to the merger and related uncertainties may divert our
managements attention from our day-to-day business and other potential acquisition
opportunities, cause disruptions among our employees and negatively impact our
relationships with customers and business partners, thus detracting from our ability to
increase revenue and minimize costs and possibly leading to a loss of revenue and
market position that we may not be able to regain if the transaction does not occur;
    the market price of our common stock could decline following an announcement that
the merger has been abandoned, to the extent that the current market price reflects a
market assumption that the merger will be completed;
    we could be required to pay Cardiac Science a $4.0 million termination fee if the
merger agreement is terminated under certain specified conditions;
    we would be required to expense approximately $1.0 million or more in transaction
related costs that would otherwise be treated as part of the purchase price;
    we would remain liable for certain costs related to the transaction, such as legal,
accounting, financial advisor and financial printing fees; and
    we may not be able to take advantage of alternative business opportunities or
effectively respond to competitive pressures. Even if we consummate our pending transaction with Cardiac Science, the combined company
may experience difficulties in integrating the two companies and may not achieve the
anticipated benefits of the combination. Achieving the benefits of our pending transaction with Cardiac Science will depend on the
ability of management of the combined company to successfully integrate the operations of the
two companies. The integration of Quinton Cardiology Systems and Cardiac Science will be a
complex, time-consuming and expensive process and may disrupt
both 18




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companies businesses if not completed in a timely and efficient manner. Risks to the
successful integration of the companies include:  
    the impairment of relationships with employees, customers, distributors, strategic
partners and suppliers as a result of integration of management and other key
personnel;
    the potential disruption of the combined companys ongoing business and distraction
of its management;
    the difficulty of incorporating acquired technology and rights into the product
offerings of the combined company;
    not achieving expected synergies; and
    unanticipated expenses related to integration of the two companies. The combined company may not succeed in addressing these risks or any other
problems encountered in connection with the transaction, may not grow at a rate
equivalent to the historical growth rates of the two companies, and may not achieve any
other benefits anticipated from the merger. We may make future acquisitions, which involve numerous risks that could impact our
business and results of operations. As part of our growth strategy, we intend to selectively acquire other businesses, product
lines, assets, or technologies. Successful execution of our acquisition strategy depends upon
our ability to identify, negotiate, complete and integrate suitable acquisitions. Acquisitions
involve numerous risks, including the following:  
    difficulties in integrating the operations, technologies, and products of the acquired companies;
    the risk of diverting managements attention from normal daily operations of the business;
    potential difficulties in completing projects associated with in-process research and development;
    risks of entering markets in which we have no or limited direct prior experience and
where competitors in such markets have stronger market positions;
    initial dependence on unfamiliar supply chains or relatively small supply partners;
    insufficient revenues to offset increased expenses associated with acquisitions;
    the risk that acquired lines of business may reduce or replace the sales of existing products; and
    the potential loss of key employees of the acquired companies. Mergers and acquisitions of high-technology companies are inherently risky, and no
assurance can be given that our previous or future acquisitions will be successful and will not
materially adversely affect our business, operating results, or financial condition. We must
also manage any growth effectively. Failure to manage growth effectively and successfully
integrate acquisitions we make could harm our business and operating results in a material way. We may need additional capital to continue our acquisition growth strategy. Successful continued execution of our acquisition strategy also depends upon our ability to
obtain satisfactory debt or equity financing. We likely would 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. 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 19




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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. Future changes in the accounting treatment for employee stock options may cause adverse
fluctuations and affect our reported results of operations. We currently elect to apply the disclosure-only provisions of SFAS No. 123,
Accounting for Stock-Based Compensation (SFAS No. 123). In accordance with the
provisions of SFAS No. 123, we apply Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees, and related interpretations in accounting
for our stock option plans. Under this election, we account for stock options granted
to employees using the intrinsic value method of accounting. Under this method,
employee stock-based compensation expense is based on the difference, if any, between
the fair value of our stock and the exercise price of the award on the grant date. In
December 2004, the Financial Accounting Standards Board, or
FASB, the principal United
States accounting standards setting organization, issued SFAS 123 (revised 2004),
Share-Based Payment, (SFAS No. 123R) which, will require us to record an expense for
all outstanding unvested stock options and grants of new stock options. In April 2005,
the U.S. Securities and Exchange Commission adopted a new rule amending the compliance
dates for SFAS No. 123R. In accordance with the new rule, the accounting provisions of
SFAS No. 123R will be effective for us in the first quarter of 2006. The pronouncement
will also require us to record an expense for our employee stock purchase plan. As a
result of changing our accounting policy in accordance with this pronouncement, our
reported earnings, beginning in the first quarter of 2006, will be significantly
negatively impacted. Compliance with changing regulation of corporate governance, public disclosure and accounting
matters may result in additional expenses. Changing laws, regulations and standards relating to corporate governance and public
disclosure, including the Sarbanes-Oxley Act of 2002 and new rules subsequently implemented by
the SEC and The NASDAQ Stock Market, as well as new accounting pronouncements, are creating
uncertainty and additional complexities for companies. To maintain high standards of corporate
governance, public disclosure and financial reporting, we continue to invest resources to comply
with evolving standards. This investment may result in increased general and administrative
expenses and a diversion of management time and attention from revenue generating and cost
management activities. 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. 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% and 15% of our revenues in
2003 and
2004, respectively, and 21% of our revenues in the first quarter of 2005. If these
agreements are cancelled or if we are unable to renew them as they expire, our sales and
operating results may suffer materially. Our international distribution relationships may be
terminated on little or no notice because we do not generally have long-term contracts with
these distributors. Consequently, our success in expanding international sales may be limited
if our international distributors lack, or are unable to develop, relationships with important
target customers in international markets. If our relationships change with any significant
distribution organization, or if any of our distribution organizations devote more effort to
selling competing products and systems, our sales and operating results may suffer and our
growth may be limited. 20




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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;
    access new interface standards needed for product connectivity;
    anticipate and meet demands of our international customers for products featuring
local language capabilities; and
    anticipate and compete effectively with our competitors efforts. The rate of market acceptance of our current or future products and systems may impact our
operating results. In addition, we may experience design, manufacturing, marketing or other
difficulties that could delay or prevent our development, introduction or marketing of new
versions of our products. Such difficulties and delays could adversely affect our gross profit
expectations and/or cause our development expenses to increase and harm our operating results. 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, Engineering. 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. 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 21




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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. Competition may decrease our market share and cause our revenues to decrease. The diagnostic cardiology systems market is highly competitive and we expect competition to
intensify in the future. Some of our competitors are larger companies, such as General Electric
Company and Koninklijke Philips Electronics N.V., and may have:  
    greater financial and other resources;
    greater variety of products;
    greater pricing flexibility;
    more extensive technical capabilities;
    patent portfolios that may present an obstacle to our conduct of business;
    stronger name recognition; and
    larger distribution networks. As a result, we may be unable to offer products similar to, or more desirable than, those
offered by our competitors, market our products as effectively as our competitors, price our
products competitively or otherwise respond successfully to competitive pressures. In addition,
our competitors may be able to offer discounts on competing products as part of a bundle of
non-competing products, systems, and services that they sell to our customers, and we may not be
able to profitably match those discounts. Our competitors may develop technologies and products
that are more effective than those we currently offer or that render our products obsolete or
noncompetitive. In addition, the timing of the introduction of competing products into the
market could affect the market acceptance and market share of our products. If we are unable to
develop competitive products, gain regulatory approval or clearance and supply sufficient
quantities of such products to the market as quickly and effectively as our competitors, market
acceptance of our products may be limited, and our revenues and operating results may suffer. If 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. 22




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Our future financial results could be adversely impacted by asset impairments or other
charges. Statement of Financial Accounting Standards 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 and other long-lived assets 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. Inadequate levels of reimbursement from governmental or other third-party payers for
procedures using our products and systems may cause our revenues to decrease. Significant changes in the healthcare systems in the U.S. or elsewhere could have a
significant impact on the demand for our products and services as well as the way we conduct
business. Federal, state, and local governments have adopted a number of healthcare policies
intended to curb rising healthcare costs. In the U.S., healthcare providers that purchase our
products and systems generally rely on governmental and other third-party payers, such as
Federal Medicare, state Medicaid, and private health insurance plans, to pay for all or a
portion of the cost of heart-monitoring procedures and consumable products utilized in those
procedures. The availability of such reimbursement affects our customers decisions to purchase
capital equipment. Denial of coverage or reductions in levels of reimbursement for procedures
performed using our products and systems by governmental or other third-party payers would cause
our revenues to decrease. We are unable to predict whether Federal, state or local healthcare
reform legislation or regulation affecting our business may be proposed or enacted in the
future, or what effect any such legislation or regulation would have on our business. If we fail to obtain or maintain applicable regulatory clearances or approvals for our
products, or if clearances or approvals are delayed, we will be unable to commercially
distribute and market our products in the U.S. and other jurisdictions. Our products are medical devices that are subject to significant regulation in the U.S. and
in foreign countries where
we do business. The processes for obtaining regulatory approval can be lengthy and
expensive, and the results are unpredictable. If we are unable to obtain clearances or
approvals needed to market existing or new products, or obtain such clearances or approvals in a
timely fashion, it could adversely affect our revenues and profitability. 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 23




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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. We are dependent upon licensed and purchased technology for some of our products, and we may not
be able to renew these licenses or purchase agreements in the future. We license and purchase technology from third parties for features in some of our products.
We anticipate that we will need to license and purchase additional technology to remain
competitive. We may not be able to renew our existing licenses and purchase agreements or to
license and purchase other technologies on commercially reasonable terms or at all. If we are
unable to renew our existing licenses and purchase agreements or we are unable to license or
purchase new technologies, we may not be able to offer competitive products. Our reliance on a principal manufacturing facility may impair our ability to respond to natural
disasters or other unforeseen catastrophic events. Our principal manufacturing facility is located in a single building in Deerfield,
Wisconsin. Despite precautions taken by us, a natural disaster or other unanticipated
catastrophic events at this building could significantly impair our ability to
manufacture our products and operate our business. Our facility and certain
manufacturing equipment would be difficult to replace and could require substantial
replacement lead-time. Such catastrophic events may also destroy any inventory of
product or components. While we carry insurance for natural disasters and business
interruption, the occurrence of such an event could result in losses that exceed the
amount of our insurance coverage, which would impair our financial results. 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. 24




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Delaware law and provisions in our charter could make the acquisition of our company by another
company more difficult. Certain provisions of our certificate of incorporation and bylaws may make it more
difficult for a third party to acquire, or discourage a third party from attempting to acquire
us. This could limit the price that certain investors might be willing to pay in the future for
            shares of our common stock. Our certificate of incorporation and bylaws allow us to issue
preferred stock without any vote or further action by the stockholders, eliminate the right of
stockholders to act by written consent without a meeting, provide that special meetings of
stockholders may be called only by our board of directors, the chairman of our board, or our
president, specify advance notice procedures for director nominations by stockholders and
submission of other proposals for consideration at stockholder meetings, and eliminate
cumulative voting in the election of directors. Moreover, our board of directors is divided into
three classes, with directors in each class elected to staggered three year terms, and directors
may only be removed by the stockholders for cause. Some provisions of Delaware law could also
delay or make more difficult a third partys efforts to effect a merger with or tender offer for
us, including Section 203 of the Delaware General Corporation Law, which prohibits a Delaware
corporation from engaging in any business combination with any interested stockholder for a
period of three years unless certain conditions are met. Similar provisions under Washington
law may also apply. The possible issuance of preferred stock, our classified board, procedures
required for director nominations and stockholder proposals and Delaware law could have the
effect of delaying, deferring or preventing a change in control of our company, including
without limitation, discouraging a proxy contest or making more difficult the acquisition of a
substantial block of our common stock. The market price of our stock may be highly volatile. During the twelve months ended March 31, 2005, our common stock traded between a range of
$6.80 and $14.80 per share. The market price of our common stock could continue to fluctuate
substantially due to a variety of factors, including:  
    uncertainties created by our pending transaction with Cardiac Science;
    quarterly fluctuations in results of our operations;
    our ability to successfully commercialize our products;
    changes in coverage or earnings estimates by analysts;
    impact of other acquisitions, divestitures, strategic alliances, and other significant corporate events;
    changes in the mix of products and systems we sell, which could affect our gross margins;
    the loss of key distributors or distribution companies; and
    seasonality in the sales of our products and systems. The market price for our common stock may also be affected by our ability to meet analysts
expectations. Any failure to meet such expectations, even slightly, could have an adverse effect
on the market price and volume fluctuations. This volatility has had a significant effect on the
market prices of securities issued by many companies for reasons unrelated to the operating
performance of these companies. In the past, following periods of volatility in the market price
of a companys securities, securities class action litigation has often been instituted against
the company. If similar litigation were instituted against us, it could result in substantial
costs and a diversion of our managements attention and resources, which could have an adverse
effect on our business, results of operations and financial condition. 25




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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 revenues are currently priced in U.S. dollars
and are translated to local currency amounts, a strengthening of the dollar could make our
products less competitive in foreign markets. Interest income and expense is sensitive to
changes in the general level of U.S. interest rates, particularly since our investments are in
short-term investments calculated at variable rates. We own marketable equity securities which we classify as available-for-sale and, as such,
carry the investments at fair value. At March 31, 2005, the fair value was $607,000. These
investments are exposed to market risks. Unrealized holding gains or losses related to
fluctuations in fair values are reflected in other accumulated comprehensive income or loss. If
we had a decline in fair value that was judged to be other than temporary, we would record a
loss. 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. If the estimated
fair value of this investment were to decline to an amount below its carrying amount, and we
considered the decline other than temporary, we would record a loss. We believe that our $1.0
million carrying amount of this investment is appropriate, though our belief is necessarily
based on our estimate of fair value. 
 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 on 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 March 31, 2005 in connection with this evaluation that has materially
affected, or is reasonably likely to materially affect, our internal control over financial
reporting. 26




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PART II  OTHER INFORMATION 
 Item 1. Legal Proceedings We are subject to various legal proceedings arising in the normal course of business.
In the opinion of management, the ultimate resolution of these proceedings is not expected to
have a material effect on the Companys consolidated financial position, results of operations
or cash flows. 
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds None. 
 Item 3. Defaults Upon Senior Securities None. 
 Item 4. Submission of Matters to a Vote of Security Holders None. 
 Item 5. Other Information None. 
 Item 6. Exhibits Exhibits2.1
    
    
    Agreement and Plan of Merger dated February 28, 2005 by and among Quinton
Cardiology Systems, Inc., CSQ Holding Company, Heart Acquisition Corporation, Rhythm
Acquisition Corporation and Cardiac Science, Inc. (1)10.38
    
    
    Senior Executives  Base Compensation Adjustments  2005 dated as of February 28, 2005. (2)10.39
    
    
    Summary of Non-Employee Director Compensation. (2)10.40
    
    
    2004 Sales Bonus Plan for Darryl Lustig, as amended on March 14, 2005. (2)10.41
    
    
    2004 Sales Bonus Plan for Allan Criss, as amended on March 14, 2005. (2)10.42
    
    
    2005 Sales Incentive Plan for Darryl Lustig. (2)10.43
    
    
    2005 Sales Incentive Plan for Allan Criss. (2)31.1
    
    
    Certification of Chief Executive Officer pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.31.2
    
    
    Certification of Chief Financial Officer pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.32.1
    
    
    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 2002.32.2
    
    
    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.
   (1)
    
    Incorporated by reference to our Current Report on Form 8-K filed on February
28, 2005.(2)
    
    Incorporated by reference to our Annual Report on Form 10-K for the year ended
December 31, 2004 filed March 16, 2005, as amended April 22, 2005. 27




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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: May 9, 2005
 28