QUINTON CARDIOLOGY SYSTEMS INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)


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

For the quarterly period ended September 30, 2003


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

For the transition period from __________to__________

Commission File Number 000-49755

QUINTON CARDIOLOGY SYSTEMS, INC.

(Exact name of registrant as specified in its charter)


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)

Indicated by check x whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No o

Indicated by check x whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.)

Yes o No x

As of November 7, 2003, 12,187,873 shares of the issuer’s common stock were outstanding.

TABLE OF CONTENTS


PART I - FINANCIAL INFORMATION
	Item 1. Unaudited Financial Statements
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
	Item 4. Controls and Procedures
PART II — OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 2. Changes in Securities and Use of Proceeds
	Item 3. Defaults Upon Senior Securities
	Item 4. Submission of Matters to a Vote of Security Holders
	Item 5. Other Information
	Item 6. Exhibits and Reports on Form 8-K
SIGNATURE
EXHIBIT 10.1
EXHIBIT 10.2
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

TABLE OF CONTENTS


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

PART I - FINANCIAL INFORMATION

Item 1. Unaudited Financial Statements

QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)


			December 31,			September 30,
			2002			2003

ASSETS
Current Assets:
	Cash and cash equivalents		$	19,382		$	451
	Accounts receivable, net of allowance for doubtful accounts			7,384			11,101
	Inventories			7,462			11,918
	Prepaid expenses and other current assets			528			574
	Income taxes receivable			206			—

		Total current assets		34,962			24,044
Machinery and equipment, net of accumulated depreciation and amortization				3,510			5,410
Intangible assets, net of accumulated amortization				393			5,751
Goodwill				860			9,953
Investment in unconsolidated entity				1,000			1,000
Restricted cash deposit				1,325			—

		Total assets	$	42,050		$	46,158

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
	Line of credit		$	—		$	883
	Current portion of long term debt			363			363
	Accounts payable			4,776			5,184
	Accrued liabilities			3,415			5,617
	Warranty liability			1,089			2,101
	Deferred revenue			4,407			4,630
	Putable warrants			328			—

		Total current liabilities		14,378			18,778
Long term debt, net of current portion				363			91
Deferred tax liability				—			1,156

		Total liabilities		14,741			20,025

Minority interest in consolidated entity				—			199
Shareholders’ Equity:
	Preferred stock (10,000,000 shares authorized), $0.001 par value, no shares outstanding in 2002 or 2003			—			—
	Common stock (65,000,000 shares authorized), $0.001 par value, 12,049,136 and 12,187,207 shares issued and outstanding at December 31, 2002 and September 30, 2003, respectively			12			12
	Additional paid-in capital			45,073			45,477
	Deferred stock-based compensation			(180	)		(126	)
	Accumulated deficit			(17,596	)		(19,429	)

		Total shareholders’ equity		27,309			25,934

		Total liabilities and shareholders’ equity	$	42,050		$	46,158

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

QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per share amounts)


			Three months Ended						Nine months ended
			September 30,						September 30,

			2002			2003			2002			2003

Revenues:
	Systems		$	9,380		$	17,747		$	26,609		$	52,308
	Service			2,275			3,287			6,694			9,715

		Total revenues		11,655			21,034			33,303			62,023

Cost of Revenues:
	Systems			5,959			10,669			16,701			31,793
	Service			1,109			1,777			3,485			5,356

		Total cost of revenues		7,068			12,446			20,186			37,149

		Gross profit		4,587			8,588			13,117			24,874

Operating Expenses:
	Research and development			1,205			1,969			3,892			6,045
	Write off of purchased in-process research and development projects			—			—			—			1,290
	Sales and marketing			2,460			4,519			7,379			13,336
	General and administrative, excluding stock-based compensation expense			1,434			1,838			4,023			5,807
	Stock-based compensation			23			18			93			54

		Total operating expenses		5,122			8,344			15,387			26,532

		Operating income (loss)		(535	)		244			(2,270	)		(1,658	)

Other Income (Expense):
	Interest income			97			—			143			10
	Interest expense			—			(63	)		(102	)		(221	)
	Interest income, putable warrants			161			—			294			32
	Other income (expense), net			(2	)		2			1			(7	)

		Total other income (expense)		256			(61	)		336			(186	)

Income (loss) before income taxes and minority interest in consolidated entity				(279	)		183			(1,934	)		(1,844	)
	Income tax provision			(2	)		(4	)		(16	)		(13	)

Income (loss) before minority interest in consolidated entity				(281	)		179			(1,950	)		(1,857	)
	Minority interest in loss of consolidated entity			—			4			—			24

Net income (loss)			$	(281	)	$	183		$	(1,950	)	$	(1,833	)

Net income (loss) per share – basic			$	(0.02	)	$	0.02		$	(0.30	)	$	(0.15	)

Net income (loss) per share – diluted			$	(0.02	)	$	0.01		$	(0.30	)	$	(0.15	)

Weighted average shares outstanding – basic				11,951,569			12,168,390			6,512,247			12,131,066

Weighted average shares outstanding – diluted				11,951,569			13,052,236			6,512,247			12,131,066

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

QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW

(in thousands)


					Three Months Ended						Nine Months Ended
					September 30,						September 30,

					2002			2003			2002			2003

Operating Activities:
	Net income (loss)				$	(281	)	$	183		$	(1,950	)	$	(1,833	)
	Adjustments to reconcile net income (loss) to net cash from operating activities –
		Depreciation and amortization				308			420			891			1,393
		Loss on disposal of equipment				5			—			14			6
		Amortization of deferred stock-based compensation				23			18			93			54
		Interest income, putable warrants				(161	)		—			(294	)		(32	)
		Write off of purchased in-process research and development				—			—			—			1,290
		Minority interest in loss of consolidated entity				—			(4	)		—			(24	)
		Changes in operating assets and liabilities, net of business acquired:
			Accounts receivable			608			(783	)		560			81
			Inventories			(752	)		158			3			2,315
			Prepaid expenses and other current assets			82			239			(7	)		344
			Accounts payable			91			336			228			(2,317	)
			Accrued liabilities			65			627			225			(508	)
			Warranty liability			(57	)		5			(229	)		(4	)
			Deferred revenue			306			183			589			(71	)

				Net cash flows from operating activities		237			1,382			123			694

Investing Activities:
	Purchases of machinery and equipment					(286	)		(275	)		(684	)		(1,067	)
	Proceeds from sale of machinery and equipment					—			—			—			108
	Purchase of Burdick, Inc., net of cash acquired					—			(13	)		—			(19,385	)

				Net cash flows from investing activities		(286	)		(288	)		(684	)		(20,344	)

Financing Activities:
	Borrowings (repayments) on bank line of credit, net					—			(1,591	)		(4,471	)		883
	Payments of long term debt					—			(90	)		—			(272	)
	Proceeds from exercise of stock options					3			10			42			73
	Redemption of putable warrants					(158	)		—			(158	)		(296	)
	Proceeds from (costs of) issuance of stock, net of issuance costs					(630	)		125			28,361			331

				Net cash flows from financing activities		(785	)		(1,546	)		23,774			719

Net change in cash and cash equivalents						(834	)		(452	)		23,213			(18,931	)
Cash and cash equivalents, beginning of period						24,265			903			218			19,382

Cash and cash equivalents, end of period					$	23,431		$	451		$	23,431		$	451

Supplemental disclosure of cash flow information:
	Cash paid for interest				$	—		$	84		$	131		$	224

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

QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Organization and Description of Business

Quinton Cardiology Systems, Inc. (“QCS”) is a Delaware corporation. QCS and its subsidiaries, Quinton Inc. (“Quinton”) and Burdick, Inc. (“Burdick”) are referred to herein as the Company. The Company develops, manufactures, markets and services a family of diagnostic cardiology systems used in the diagnosis, treatment and rehabilitation of patients with heart disease.

2. Summary of Significant Accounting Policies

     Basis of Presentation

     The condensed financial statements present the Company on a consolidated basis. All significant intercompany accounts and transactions have been eliminated. The condensed consolidated balance sheet dated September 30, 2003, the condensed consolidated statements of operations for the three and nine-month periods ended September 30, 2002 and 2003 and the condensed consolidated statements of cash flows for the three and nine-month periods ended September 30, 2002 and 2003 have been prepared by the Company and are unaudited. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The notes to the audited consolidated financial statements included in the Company’s annual report on form 10-K for the fiscal year ended December 31, 2002 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. All share information in these financial statements gives effect to a 1 for 2.2 reverse stock split, which was effected in April 2002.

     Use of Estimates

     The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the periods reported. These estimates include but are not limited to estimates affecting revenues and estimates assessing the collectability of accounts receivable, the salability and recoverability of inventory, the adequacy of warranty liabilities, the realizability of investments, the realization of deferred tax assets, the fair value of putable warrants and the useful lives of tangible and intangible assets. The market for the Company’s products is characterized by intense competition, rapid technological development and frequent new product introductions, all of which could affect the future realizability of the Company’s assets. The Company reviews estimates and assumptions periodically, and the effects of revisions are reflected in the consolidated financial statements in the period they are determined to be necessary. Actual results could differ from these estimates.

     Recent Accounting Pronouncements

     In November 2002, the Emerging Issues Task Force (EITF) reached a consensus on EITF 00-21, “Revenue Arrangements with Multiple Deliverables” with respect to determining when and how to allocate revenue from sales with multiple deliverables. The EITF 00-21 consensus provides a framework for determining when and how to allocate revenue from sales with multiple deliverables based on a determination of whether the multiple deliverables qualify to be accounted for as separate units of accounting. The consensus is effective prospectively for arrangements entered into in fiscal periods beginning after June 15, 2003. The Company adopted this consensus during the three-month period ended September 30, 2003. The adoption of this consensus resulted in the Company deferring approximately $150,000 of

revenues during the three-month period ending September 30, 2003, which represented the value of installation obligations associated with the sales of our systems.

     In April 2003, the FASB issued Statement of Financial Accounting Standard No. 149, “Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities.” This standard amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts, collectively referred to as derivatives, and for hedging activities under statement No. 133, “Accounting for Derivative Instruments and Hedging Relationships.” SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships after June 30, 2003. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements as a whole.

     In May 2003, the FASB issued Statement of Financial Accounting Standard No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” The Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). The Company adopted this statement at the beginning of the three-month period ended September 30, 2003. While the adoption of this standard did not have a material impact on the Company’s consolidated financial statements as a whole, footnote 3 contains additional disclosures as required by the standard.

     Net Income (Loss) Per Share

     In accordance with Statement of Financial Accounting Standard No. 128, “Computation of Earnings Per Share,” basic income (loss) per share is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding during the period. Common stock that the Company has the right to repurchase is not included in the calculation of outstanding shares. Diluted income per share is computed by dividing net income by the weighted average number of common and dilutive potential common shares outstanding during the period. Dilutive potential common shares consist of shares issuable upon the exercise of stock options, including outstanding shares subject to repurchase, and warrants (using the treasury stock method). Potential common shares are excluded from the calculation if their effect is antidilutive.

     The following table sets forth the computation of basic and diluted weighted average common shares outstanding for the three and nine-month periods ended September 30, 2002 and 2003:


		Three months ended					Nine months ended
		September 30,					September 30,

		2002			2003		2002			2003

Shares (denominator):
	Weighted average common shares outstanding		11,953,912			12,168,390		6,523,151			12,131,066
	Less: weighted average shares subject to repurchase		(2,343	)		—		(10,904	)		—

	Weighted average shares for basic calculation		11,951,569			12,168,390		6,512,247			12,131,066
	Incremental shares from employee stock options		—			883,846		—			—

	Weighted average shares for diluted calculation		11,951,569			13,052,236		6,512,247			12,131,066

For the three and nine-month periods ended September 30, 2002, 1,556,901 shares of common stock subject to repurchase, stock options and warrants were excluded from the computation of diluted loss per share as their impact was antidilutive. For the nine-month period ended September 30, 2003, 1,398,890 stock options were excluded from the computation of diluted loss per share as their impact was antidilutive. If the Company had reported net income during the three-month period ended September 30, 2002 and the nine-month periods ended September 30, 2002 and 2003, the calculation of earnings per share would have included the dilutive effect of these potential common shares using the treasury stock method.

     Accounting for Stock-Based Compensation

     The Company has elected to apply the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” In accordance with the provisions of SFAS 123, the Company applies Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its stock option plans. Accordingly, compensation expense is recognized for options awarded to employees only to the extent that the exercise price of the option is less than the fair value of the underlying stock on the date of grant.

     Had compensation cost been determined based on the fair value of the options at the grant dates during the three and nine-month periods ended September 30, 2002 and 2003, consistent with the provisions of SFAS 123, the Company’s reported net loss would have been the pro forma amounts indicated below (amounts in thousands except per share amounts):


	Three months ended						Nine months ended
	September 30,						September 30,

	2002			2003			2002			2003

Net income (loss) – as reported	$	(281	)	$	183		$	(1,950	)	$	(1,833	)
Add back: Total stock-based employee compensation expense included in reported income (loss), net of related tax effects		23			18			93			54
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(111	)		(299	)		(370	)		(788	)

Net loss – pro forma	$	(369	)	$	(98	)	$	(2,227	)	$	(2,567	)

Net income (loss) per share – as reported – basic	$	(0.02	)	$	0.02		$	(0.30	)	$	(0.15	)
Net income (loss) per share – as reported – diluted	$	(0.02	)	$	0.01		$	(0.30	)	$	(0.15	)
Net loss per share – pro forma – basic and diluted	$	(0.03	)	$	(0.01	)	$	(0.34	)	$	(0.21	)

     The fair value of each employee option grant is established on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for grants during 2002 and 2003: zero dividend yield; risk-free interest rate of 4.2% and 3.5%, respectively; volatility of 90% and 85%, respectively; and expected lives of four years and seven years, respectively. The weighted-average fair value of options granted in 2002 and 2003 was $5.49 and $4.89, respectively.

     Goodwill

     Goodwill represents the excess of cost over the estimated fair value of net assets acquired in connection with our acquisitions of the medical treadmill manufacturing line and Spacelabs Burdick, Inc., which, in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” is not being amortized. Also in accordance with SFAS No. 142, the Company tests goodwill for impairment at the reporting unit level on an annual basis and between annual tests in certain circumstances. On the date of the Spacelabs Burdick acquisition, the Company determined that it had three reporting units, consisting of the Burdick line of products, the Quinton line of products and the Shanghai-Burdick joint venture, all of which operate in the diagnostic cardiology market and have similar operating and economic characteristics. As of the beginning of the fourth quarter of 2003, the Company decided to reorganize its reporting units and consolidate the Quinton and Burdick reporting units into one reporting unit. This was driven by the Company’s decision to consolidate its manufacturing operations into one facility in Deerfield, Wisconsin. After the consolidation of the manufacturing operations, the Company will manufacture its products under both the Quinton and the Burdick brands in one facility. In conjunction with this consolidation, the Company will modify its reporting structures and will no longer review Quinton and Burdick operations separately. The Shanghai-Burdick joint venture will remain as a separate reporting unit.

     SFAS No. 142 requires a two-step goodwill impairment test whereby the first step, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired, thus the second step of the goodwill impairment test used to quantify impairment is unnecessary. Management has estimated that the fair values of the Company’s reporting units to which goodwill has been allocated exceed their carrying amounts, and as a result, the second step of the impairment test, which would compare the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill, was unnecessary for the periods presented.

     Intangible Assets

     The Company’s intangible assets are comprised primarily of a trade name, developed technology and customer relationships, all of which were acquired in our acquisition of Burdick. Company management uses judgment to estimate the fair value of each of these intangible assets. The judgment about fair value is based on expectations of future cash flows and an appropriate discount rate. Company management also uses judgment to estimate the useful lives of each intangible asset. The Company believes the Burdick trade name has an indefinite life, and accordingly does not amortize the trade name. The Company evaluates this conclusion annually and makes a judgment about whether there are factors that would limit the ability to benefit from the trade name in the future. If there were such factors, the Company would start amortizing the trade name. The Company also tests the indefinite life trade name intangible asset for impairment on an annual basis or more frequently if events or changes in circumstances indicate that the asset might be impaired. With respect to developed technology and customer relationship intangible assets, the Company also evaluates the remaining useful lives annually to evaluate whether the intangible assets are impaired. For the trade name, this evaluation is performed annually or if events occur that suggest there may be an impairment loss, and involves comparing the carrying amount to the Company’s estimate of fair value. For developed technology and customer relationship intangible assets, this evaluation would be performed if events occur that suggest there may be an impairment loss. If we conclude that any of our intangible assets are impaired, we would record this as a loss on our statement of operations and as a reduction to the intangible asset. The Company recorded amortization expense for identifiable intangibles of $30,000 and $84,000 for the three-month periods ended September 30, 2002 and 2003, respectively, and $91,000 and $301,000 for the nine-month periods ended September 30, 2002 and 2003, respectively.

     Purchase Accounting

     SFAS No. 141, “Business Combinations,” requires that the purchase method of accounting be used for all business combinations and establishes specific criteria for the recognition of intangible assets separately from goodwill. In connection with the Company’s acquisitions of the medical treadmill manufacturing line and Spacelabs Burdick, Inc., the Company allocated the respective purchase prices plus transaction costs to estimated fair values of assets acquired and liabilities assumed. These purchase price allocation estimates were made based on our estimates of fair values.

3. Acquisition of Burdick, Inc.

     On January 2, 2003, the Company purchased 100% of the stock of Spacelabs Burdick, Inc. (“Burdick”). Burdick’s historical strength in ECG cardiographs, Holter monitors and cardiology information systems, combined with its distribution network focused on U.S. physicians’ offices, complements Quinton’s strength in cardiac stress testing and cardiac rehabilitation monitoring and its hospital focused direct sales force. The consolidated financial statements include Burdick’s results since January 2, 2003.

     The original purchase price of $24.0 million was funded with approximately $20.2 million in cash, a holdback of $1.3 million for working capital adjustments plus a partial draw down on our revolving bank credit facility. Transaction related costs were approximately $700,000.

     On April 21, 2003, an agreement was reached with the seller to adjust the purchase price to $20.4 million, based principally on the amount of Burdick’s net working capital at the date of acquisition. In accordance with this agreement, the Company kept the $1.3 million that was held back at closing and received a $2.3 million refund from the seller subsequent to the April 21, 2003 agreement. The refund was used to reduce borrowings against the Company’s line of credit.

     Further information was obtained during the three-month period ended September 30, 2003 regarding the value of Burdick’s and Shanghai-Burdick’s machinery and equipment. This information required an adjustment to the previously disclosed purchase price allocation which decreased goodwill by $104,000. The Company has now obtained all of the information the Company has arranged to obtain in order to finalize the purchase price allocation. The purchase price, including incremental costs directly related to the transaction, was allocated as follows (in thousands):


Cash and cash equivalents		$	386
Accounts receivable, net of allowance for doubtful accounts			3,798
Inventories			6,771
Prepaid expenses and other current assets			184
Machinery and equipment			2,104
In-process research and development			1,290
Intangible assets			5,660
Goodwill			9,027

	Total assets acquired		29,220
Current liabilities			(6,961	)
Deferred income taxes			(1,156	)

	Net assets acquired	$	21,103

     Inventories included an adjustment to Burdick’s historical cost to increase finished goods to fair market value less expected disposal costs and selling margin. This adjustment resulted in valuation of inventory of $300,000 in excess of Burdick’s historical cost. This increase in the inventory valuation was charged to cost of revenues in the nine-month period ended September 30, 2003, as the associated inventories were sold in the normal course of business.

     In-process research and development relates to two product development projects underway at the time of the acquisition. Neither project had received required regulatory approvals at the acquisition date, and each project had risks associated with achieving desired functionality and market acceptance. The value assigned to in-process research and development was determined using a discounted cash flow method applied to expected cash flows over a 15 year period commencing in 2003. In discounting expected future cash flows, the Company used an annual discount rate of 16%, which management believes is an appropriate risk adjusted rate given the nature of the projects, the remaining project risks and the uncertainty of the future cash flows.

     The first of the two projects, representing 87% of the total value of acquired in-process research and development, relates to a new resting ECG monitor. This project was approximately 70% complete at the date of acquisition and was completed and the related product (the Atria 3000) was released, as expected, at the end of the first quarter of 2003. Margins on this product are expected to be in line with the Company’s historical margins. In the opinion of management, failure to achieve expected market results and margins relating to this product could materially adversely affect the overall return on investment relating to the Burdick acquisition. Costs to complete this project were expensed in the nine-month period ended September 30, 2003.

     The second of the two projects, representing 13% of the total value of acquired in-process research and development relates to a product for the detection and preprocessing of low-level electrical signals generated by the heart. This project was approximately 50% complete at the date of acquisition. Management has assigned a low priority to this project and decided to postpone further development indefinitely, although the underlying technology may have application to other projects that the Company may pursue in the future. In the opinion of management, the indefinite postponement of further development of this project will not materially adversely affect the overall return on investment relating to the Burdick acquisition.

     All of the acquired in process research and development was written off during the first quarter of 2003.

     Intangible assets consist of the trade name of $3,400,000, developed technology of $860,000 and distributor relationships of $1,400,000, which were valued based on discounted cash flow methods applied to the estimated future cash flows attributable to the respective assets. The trade name was determined, by management, to have an indefinite useful life. Developed technology was assigned a seven year useful life, based on the estimated remaining economic life of the related products. Distributor relationships relate to long-standing contractual relationships with an extensive network of independent distributors, which represents the exclusive channel through which Burdick sells its products. The economic life of the distributor relationships has been determined to be 10 years, based on historical turnover experience and in consideration of the long standing and stable nature of these relationships.

     Goodwill represents the excess of the net purchase price over the fair value of the assets and liabilities acquired. Goodwill recorded in the Burdick acquisition relates to the long-standing nature of Burdick’s business, its substantial market share, its complementary fit with Quinton’s pre-existing business, and management’s expectations relating to future operating synergies and cost efficiencies that can be realized as a result of operating the businesses on a combined basis.

A deferred income tax liability was recorded related to the trade name, which has no tax basis. Because of the indefinite life of the trade name, this liability has not been used to reduce the valuation allowance against existing deferred income tax assets.

The following pro forma data summarizes the results of operations for the three and nine-month periods ended September 30, 2002 as if the Burdick acquisition had been completed on January 1, 2002. The pro forma data gives effect to actual operating results prior to the acquisition, adjusted to include the pro forma effect of depreciation of machinery and equipment, amortization of identified intangible assets and interest on cash balances. (in thousands, except per share amounts)


	Three Months Ended			Nine Months Ended
	September 30,			September 30,

	2002			2002

Revenues	$	20,798		$	62,320
Net loss	$	(2,734	)	$	(5,737	)
Basic and diluted net loss per share	$	(0.23	)	$	(0.88	)

Minority Interest

As part of the purchase acquisition of Burdick, the Company acquired 56% ownership of Shanghai Burdick Medical Instrument Co., LTD. (“Shanghai-Burdick”). The Shanghai-Burdick joint venture has a limited life of thirty years, terminating in 2030. If the joint venture is terminated, the Company would be required to liquidate the net assets of the joint venture and distribute proceeds to the partners. Assuming the joint venture were to have been terminated effective September 30, 2003, the Company estimates that such net proceeds would approximate the carrying value of the minority interest recorded in the accompanying consolidated balance sheet, which was $199,000 at September 30, 2003.

4. Consolidation of Manufacturing Operations

During the third quarter, the Company announced plans to consolidate its Deerfield, Wisconsin and Bothell, Washington manufacturing and production activities to its Deerfield location. As a result of the related transition activities, the Company recognized certain charges relating to severance and other consolidation related activities of approximately $271,000 during the three-month period ended September 30, 2003. The Company expects to recognize similar costs, plus moving costs and other related charges in the fourth quarter of 2003 of between $1,100,000 and $1,500,000, including possible non-cash write-offs of up to $400,000 relating to certain assets for which management is currently evaluating the future usefulness. The Company does not expect this consolidation to adversely affect revenues in the fourth quarter of 2003. The Company expects to complete this consolidation by the end of 2003.

Changes in the Company’s accrued liabilities for the three-month period ended September 30, 2003 related to the consolidation of manufacturing operations were as follows (amounts in thousands):


Manufacturing consolidation liabilities as of June 30, 2003		$	—
	Severance and other employee transition costs charged to systems cost of revenues		240
	Severance and other employee transition costs charged to service cost of revenues		22
	Severance and other employee transition costs charged to general and administrative expenses		5
	Professional services charged to general and administrative expenses		4
	Costs paid during the period		(43	)

Manufacturing consolidation liabilities as of September 30, 2003		$	228

5. Initial Public Offering

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

6. Inventories

Inventories were valued at the lower of cost, on an average cost basis, or market and were comprised of the following (amounts in thousands):


		December 31,		September 30,
		2002		2003

Raw materials		$	3,433	$	5,955
Work in progress			984		756
Finished goods			3,045		5,207

	Total inventories	$	7,462	$	11,918

7. Borrowings

In connection with the January 2003 acquisition of Burdick, the Company established a line of credit on December 30, 2002. Borrowings under the Company’s bank line of credit are 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 credit line carries an interest rate at the bank’s prime rate plus a minimum of 0.5% to a maximum of 1.5% based on a funded debt to earnings before interest, taxes, depreciation, and amortization (“EBITDA”) ratio (which amounted to 5.75% at September 30, 2003).

8. Putable Warrants

In connection with a loan in 1998, the Company issued warrants to purchase 123,536 shares of Series A convertible preferred stock with an exercise price of $0.01 per share that were immediately exercisable. Upon completion of the initial public offering in 2002, the conversion rights associated with the Company’s Series A convertible preferred stock resulted in the warrants being exercisable for 63,092 shares of common stock at an exercise price equal to $0.02 per share. At the holders’ option, the Company is required to make a cash payment to the holder equal to the fair value of the shares issuable upon conversion of the warrants. On July 22, 2002, a holder of 21,632 putable warrants exercised a put option for cash when the fair value of the shares was approximately $158,000. On May 21, 2003, the holder of the remaining 41,460 putable warrants exercised a put option for cash when the fair value of the shares was approximately $296,000. Changes in the fair value of this liability are recorded in the statements of operations as interest income (expense), putable warrants. There were no warrants outstanding as of September 30, 2003.

9. Warranty Liability

Changes in the warranty liability for the nine months ended September 30, 2003 were as follows (amounts in thousands):


Warranty liability as of December 31, 2002	$	1,089
Charged to cost of revenues		1,017
Warranty expenditures		(1,021	)
Warranty liability acquired from Burdick, Inc.		1,016

Warranty liability as of September 30, 2003	$	2,101

10. Contingencies

Legal Matters

The Company is a defendant in various legal matters arising in the normal course of business. In the opinion of management, the ultimate resolution of these matters is not expected to have a material effect on the Company’s consolidated financial statements as a whole.

11. Subsequent Event

Sale of Hemodynamic Monitoring Product Line

On October 21, 2003, the Company announced the sale of its hemodynamic monitoring product line. As consideration, the Company received $1,000,000 in cash on October 21, 2003 and a note receivable of $750,000, due October 21, 2004. The buyer may pay additional contingent consideration of up to $1,500,000 based on future sales of the buyer’s products to the Company’s previous hemodynamic products customers. Based on the Company’s post-closing transitional responsibilities, which extend into the second quarter of 2004, the Company will defer the recognition of any gain on the transaction. The Company expects to recognize a gain in the second quarter of 2004 of between $600,000 and $700,000 on the transaction, excluding the effect of any contingent consideration. Contingent consideration received during the period in which the Company is filling its post-closing transitional obligations will be deferred until these obligations are fulfilled. Contingent consideration received after this period will be recognized as income in the period in which it is received.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion and analysis in conjunction with our unaudited condensed consolidated financial statements and related notes included elsewhere in this report. Except for historical information, the following discussion contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact, including future results of operations or financial position, made in this Quarterly Report on Form 10-Q, are forward looking. We use words such as anticipate, believe, expect, future, intend and similar expressions to identify forward looking statements. These forward-looking statements reflect management’s current expectations and involve risks and uncertainties. Our actual results could differ materially from results that may be anticipated by such forward-looking statements. The principal factors that could cause or contribute to such differences include, but are not limited to, those discussed in the section entitled “Certain Factors That May Affect Future Results” below, those discussed elsewhere in this report and those discussed in our Annual Report on Form 10-K filed on March 18, 2003. 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 on-going basis, we evaluate our estimates including those affecting revenues, the allowance for doubtful accounts, the salability and recoverability of inventory, warranty liabilities, the carrying value of our investments, the useful lives of intangible assets and income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. A more complete description of our critical accounting estimates established prior to the end of the fiscal year ending December 31, 2002 is contained in our Annual Report on Form 10-K for the fiscal year ended December 31, 2002. In addition to those critical accounting estimates, since December 31, 2002, we have established the following critical accounting estimates:

Purchase Allocation Accounting

In connection with our acquisitions of the medical treadmill manufacturing line and Spacelabs Burdick, Inc., we have allocated the respective purchase prices plus transaction costs to estimated fair values of assets acquired and liabilities assumed. These purchase price allocation estimates were made based on our estimates of fair values. Had these estimates been different, reported amounts allocated to assets and liabilities and results of operations subsequent to the acquisitions could be materially impacted.

Useful Lives of Intangible Assets

Our intangible assets are comprised primarily of a trade name, developed technology and customer relationships, all of which were acquired in our acquisition of Burdick. We use our judgment to estimate the fair value of each of these intangible assets. Our judgment about fair value is based on our expectation of future cash flows and an appropriate discount rate. We also use our judgment to estimate the useful lives of each intangible asset. We believe there are presently no factors which would limit our ability to benefit from the Burdick trade name in the future, and accordingly do not amortize the trade name. We evaluate this conclusion annually and make a judgment about whether there are circumstances that would limit our ability to benefit from the trade name in the future. If we determine that such circumstances exist, we would amortize the trade name over the expected remaining period in which we believe it would continue to provide benefit. With respect to our developed technology and customer relationship intangible assets, we also evaluate the remaining useful lives annually. We also evaluate whether our intangible assets are impaired. For our trade name, this evaluation is performed annually, or more frequently if events occur that suggest there may be an impairment loss, and involves comparing the carrying amount to our estimate of fair value. For our developed technology and customer relationship intangible assets, this evaluation would be performed if events occur that suggest there may be an impairment loss. If we concluded any of our intangible assets is impaired, we would record this as a loss on our statement of operations and as a reduction to the intangible asset.

Goodwill

Goodwill represents the excess of cost over the estimated fair value of net assets acquired in connection with our acquisitions of the medical treadmill manufacturing line and Spacelabs Burdick, Inc. noted above. We test goodwill for impairment on an annual basis, and between annual tests in certain circumstances, for each reporting unit identified for purposes of accounting for goodwill. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, and determining the fair value of each reporting unit. Significant judgments required to estimate the fair value of reporting units include estimating future cash flows, determining appropriate discount rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value for each reporting unit, and potentially result in recognition of an impairment of goodwill, which would be reflected as a loss on our statement of operations and as a reduction in the carrying value of goodwill.

Results of Operations


			Three Months Ended						Nine Months Ended
			September 30,						September 30,

			2002			2003			2002			2003

			(as a percentage of revenues)						(as a percentage of revenues)
Revenues:
	Systems			80.5	%		84.4	%		79.9	%		84.3	%
	Service			19.5			15.6			20.1			15.7

		Total revenues		100.0			100.0			100.0			100.0

Gross Profit:
	Systems (as a percentage of systems revenue)			36.5			39.9			37.2			39.2
	Service (as a percentage of service revenue)			51.3			45.9			47.9			44.9

		Gross profit		39.4			40.8			39.4			40.1

Operating Expenses:
	Research and development			10.3			9.4			11.7			9.8
	Write off of purchased in-process research and development			0.0			0.0			0.0			2.1
	Sales and marketing			21.1			21.5			22.2			21.5
	General and administrative, excluding stock-based compensation expense			12.3			8.7			12.1			9.4
	Stock-based compensation			0.2			0.0			0.3			0.0

		Total operating expenses		44.0			39.6			46.2			42.8

		Operating income (loss)		(4.6	)		1.2			(6.8	)		(2.7	)

		Total other income (expense)		2.2			(0.3	)		1.0			(0.3	)
		Income tax provision		(0.0	)		(0.0	)		(0.1	)		(0.0	)
		Minority interest in loss of consolidated entity		0.0			0.0			0.0			0.0

Net income (loss)				(2.4	)%		0.9	%		(5.9	)%		(3.0	)%

Three Month Period Ended September 30, 2003 Compared to the Three Month Period Ended September 30, 2002

Consolidated operating results for the three-month period ended September 30, 2003 include the operating results of Burdick, which we acquired on January 2, 2003.

Revenues

Revenues for the three-month period ended September 30, 2003 increased by $9,379,000, or 80.5%, to $21,034,000 from $11,655,000 for the comparable period in 2002. This increase was principally due to the addition of revenues from the Burdick business, which we acquired in January 2003. Pro forma combined revenues of Quinton and Burdick for the three-month period ended September 30, 2002, had the acquisition been completed as of January 1, 2002, would have been $20,798,000.

Because of significant uncertainty in Burdick’s distributor channels resulting from the pending sale of Burdick during the fourth quarter of 2002 and the earlier sale of Burdick’s parent on July 2, 2002, Burdick’s revenues were declining at the time of our acquisition. Management believes that uncertainties in the market relating to Burdick’s sale have been substantially resolved. Burdick’s revenues have stabilized, and management does not expect Burdick’s revenues to decline significantly in future periods.

The modest increase in revenues for the three-month period ended September 30, 2003 over the pro forma combined revenues for the three-month period ended September 30, 2002 is due to the success of the Company’s overall selling efforts.

Systems revenue increased by $8,367,000, or 89.2%, to $17,747,000 for the three-month period ended September 30, 2003 from $9,380,000 for the comparable period in 2002. This increase was primarily due to the addition of Burdick’s systems revenues.

Service revenues increased by $1,012,000, or 44.5%, to $3,287,000 for the three-month period ended September 30, 2003 from $2,275,000 for the comparable period in 2002. This increase was primarily due to the addition of Burdick’s service revenues.

Gross Profit

Gross profit for the three-month period ended September 30, 2003 increased by $4,001,000, or 87.2%, to $8,588,000 from $4,587,000 for the comparable period in 2002, primarily reflecting the addition of Burdick’s operating results. Gross profit, as a percentage of revenues, increased to 40.8% for the three-month period ended September 30, 2003 from 39.4% for the comparable period in 2002. The increase in gross profit, as a percentage of revenues, was primarily due to the results of product cost reduction initiatives, including design cost reductions and other reductions in purchased components of our products. For the three-month period ended September 30, 2003, we recognized a charge to cost of revenues of $262,000, reflecting charges related to the consolidation of our manufacturing operations. This charge to cost of revenues represented an adverse impact to gross profit of approximately 1.2 percentage points. We expect to incur similar charges in the fourth quarter of 2003 of between $1,100,000 and $1,500,000. Charges of this nature are not expected beyond the fourth quarter of 2003, as management expects the manufacturing consolidation to be completed during this period. We expect to realize cost savings of between $1,500,000 and $2,000,000 annually thereafter. Substantially all of the cost savings will be to cost of revenues.

Gross margin from systems revenues increased to 41.2% for the three-month period ended September 30, 2003, from 36.5% for the comparable period in 2002. This increase in gross margin, as a percentage of revenues, was primarily due to the product cost reduction measures referred to above. For the three-month period ended September 30, 2003, we recognized a charge to cost of revenues related to the consolidation of our manufacturing operations of $240,000, which was discussed above. This charge to cost of revenues represented an adverse impact to gross margin from systems revenues of approximately 1.4 percentage points.

Gross margin from service revenues decreased to 46.6% for the three-month period ended September 30, 2003, from 51.3% for the comparable period in 2002. This decrease in gross margin, as a percentage of revenues, was primarily due to the impact of Burdick’s lower gross margin on service revenues. For the three-month period ended September 30, 2003, we recognized a charge to cost of revenues related to the consolidation of our manufacturing operations of $22,000, which was discussed above. This charge to cost of revenues represented an adverse impact to gross margin from service revenues of approximately 0.7 percentage point.

Operating Expenses

Research and development expenses for the three-month period ended September 30, 2003 increased by $764,000 to $1,969,000 from $1,205,000 for the comparable period in 2002. This increase was primarily due to the impact of additional research and development expenses relating to the acquired Burdick business. As a percentage of revenues, research and development expenses decreased to 9.4% for the three-month period ended September 30, 2003 from 10.3% for the comparable period in 2002. This decrease principally reflects lower proportionate spending on research and development in the Burdick business and cost efficiencies of operating the Quinton and Burdick businesses on a combined basis.

Sales and marketing expenses for the three-month period ended September 30, 2003 increased by $2,059,000 to $4,519,000 from $2,460,000 for the comparable period in 2002. This increase was primarily due to the impact of additional sales and marketing expenses relating to the acquired Burdick business. As a percentage of revenues, sales and marketing expenses increased to 21.5% for the three-month period ended September 30, 2003 from 21.1% for the comparable period in 2002. This primarily reflects an increase in marketing expenses for the three-month period ended September 30, 2003 over the comparable period in 2002.

General and administrative expenses, excluding stock-based compensation, for the three-month period ended September 30, 2003, increased by $404,000 to $1,838,000 from $1,434,000 for the comparable period in 2002. This increase was primarily due to the impact of additional general and administrative expenses relating to the acquired Burdick business. As a percentage of revenues, general and administrative expenses, excluding stock-based compensation, decreased to 8.7% for the three-month period ended September 30, 2003 from 12.3% for the comparable period in 2002. This decrease primarily reflects lower proportionate spending in general and administrative areas in the Burdick business and cost efficiencies of operating the Quinton and Burdick businesses on a combined basis. For the three-month period ended September 30, 2003, general and administrative expenses, excluding stock-based compensation, included a charge related to the consolidation of our manufacturing operations of $9,000.

Stock-based compensation expense for the three-month period ended September 30, 2003 decreased by $5,000 to $18,000, from $23,000 for the comparable period in 2002. Stock-based compensation expense for both periods relates to the intrinsic value of stock options granted in 2001. We expect to record stock-based compensation expense in the fourth quarter of 2003 at a level similar to the amount recorded in the third quarter of 2003.

Operating Income (Loss)

Operating income for the three-month period ended September 30, 2003 was $244,000, compared to an operating loss of $535,000 for the comparable period in 2002. The period-over-period improvement was due to factors noted above, primarily higher gross profit percentage and lower general and administrative expenses as a percentage of revenues.

Other Income and Expense

Total other expense for the three-month period ended September 30, 2003 was $61,000, as compared to total other income of $256,000 for the comparable period in 2002. Interest income decreased by $97,000 for the three-month period ended September 30, 2003 primarily due to a decline in interest-earning assets over the comparable period in 2002. Interest expense increased by $63,000 for the three-month period ended September 30, 2003 from the comparable period in 2002, primarily due to an increase in average borrowings on our bank line of credit over the three-month period ended September 30, 2003, as compared to average borrowings over the comparable period in 2002. In addition, interest income related to putable warrants for the three-month period ended September 30, 2003 decreased by $161,000 from the comparable period in 2002. These warrants, held by a former lender, were adjusted to their fair market value at the end of each accounting period. Gains and losses reflected in the income statement represent the adjustment of the warrants to their fair market value during the related period. There were no warrants outstanding during the third quarter of 2003.

Income Taxes

Income tax provisions recorded in the three month periods ended September 30, 2003 and 2002 related to state income taxes.

Nine-Month Period Ended September 30, 2003 Compared to the Nine-Month Period Ended September 30, 2002

Consolidated operating results for the nine-month period ended September 30, 2003 include the operating results of Burdick, which we acquired on January 2, 2003.

Revenues

Revenues for the nine-month period ended September 30, 2003 increased by $28,720,000, or 86.2%, to $62,023,000 from $33,303,000 for the comparable period in 2002. This increase was principally due to the addition of revenues from the Burdick business, which we acquired in January 2003.

Pro forma combined revenues of Quinton and Burdick for the nine-month period ended September 30, 2002, had the acquisition been completed as of January 1, 2002, would have been $62,320,000. Because of significant uncertainty in

Burdick’s distributor channels resulting from the pending sale of Burdick during the fourth quarter of 2002 and the earlier sale of Burdick’s parent on July 2, 2002, Burdick’s revenues were declining at the time of our acquisition. During the nine-month period ended September 30, 2003, increases in Quinton’s revenues over the comparable period in 2002 were offset by a decline in Burdick’s revenues over the comparable period in 2002. Management believes that uncertainties in the market relating to Burdick’s sale have been substantially resolved. Burdick’s revenues have stabilized, and management does not expect Burdick’s revenues to decline significantly in future periods.

Systems revenue increased by $25,699,000, or 96.6%, to $52,308,000 for the nine-month period ended September 30, 2003 from $26,609,000 for the comparable period in 2002. This increase was primarily due to the addition of Burdick’s systems revenues. To a lesser extent, the growth in revenues was attributable to increases in sales of Quinton’s telemetry systems, including a new rehabilitation telemetry product released in May 2002, and various other products.

Service revenues increased by $3,021,000, or 45.1%, to $9,715,000 for the nine-month period ended September 30, 2003 from $6,694,000 for the comparable period in 2002. This increase was primarily due to the addition of Burdick’s service revenues and, to a lesser extent, an increase in Quinton’s service revenues for the nine-month period ended September 30, 2003 over the comparable period in 2002. The increase in Quinton’s service revenues was related to the growth of our installed customer base.

Gross Profit

Gross profit for the nine-month period ended September 30, 2003 increased by $11,757,000, or 89.6%, to $24,874,000 from $13,117,000 for the comparable period in 2002. This increase was primarily due to the addition of gross profit from the Burdick business. Gross profit, as a percentage of revenues, increased to 40.1% for the nine-month period ended September 30, 2003 from 39.4% for the comparable period in 2002. During the nine-month period ended September 30, 2003, we recognized an acquisition-related charge to cost of revenues of $300,000, reflecting an upward adjustment to Burdick’s inventory valuation from Burdick’s historical cost at the acquisition date that was expensed in the quarter ended March 31, 2003. In addition, for the nine-month period ended September 30, 2003, we recognized a charge to cost of revenues of $262,000, reflecting charges related to the consolidation of our manufacturing operations. These charges to cost of revenues represented an adverse impact to gross profit of approximately 0.9 percentage point. Charges relating to the Burdick acquisition are not expected to recur. We expect to incur additional charges relating to the consolidation of the manufacturing operations in the fourth quarter of 2003 of between $1,100,000 and $1,500,000. Charges of this nature are not expected to recur beyond the fourth quarter of 2003, as management expects the manufacturing consolidation to be completed during this period. We expect to realize cost savings of between $1,500,000 and $2,000,000 annually thereafter. Substantially all of the cost savings will be to cost of revenues.

Gross margin from systems revenues increased to 39.2% for the nine-month period ended September 30, 2003, from 37.2% for the comparable period in 2002. The increase in gross profit, as a percentage of revenues, was primarily due to the results of product cost reduction initiatives, including design cost reductions and other reductions in purchased components of our products. For the nine-month period ended September 30, 2003, we recognized an acquisition related charge to cost of revenues of $300,000 which was discussed above. In addition, for the nine-month period ended September 30, 2003, we recognized a charge to cost of revenues related to the consolidation of our manufacturing operations of $240,000 which was discussed above. These charges to cost of revenues represented an adverse impact to gross margin from systems revenues of approximately 1.0 percentage point.

Gross margin from service revenues of 44.9% for the nine-month period ended September 30, 2003 decreased from 47.9% for the comparable period in 2002. This decrease in gross margin, as a percentage of revenues, was primarily due to the impact of Burdick’s lower gross margin on service revenues. For the nine-month period ended September 30, 2003, we recognized a charge to cost of revenues related to the consolidation of our manufacturing operations of $22,000, which was discussed above. This charge to cost of revenues represented an adverse impact to gross margin from service revenues of approximately 0.2 percentage point.

Operating Expenses

Research and development expenses for the nine-month period ended September 30, 2003 increased by $2,153,000 to $6,045,000 from $3,892,000 for the comparable period in 2002. This increase was primarily due to the impact of additional research and development expenses relating to the acquired Burdick business. As a percentage of revenues,

research and development expenses decreased to 9.8% for the nine-month period ended September 30, 2003 from 11.7% for the comparable period in 2002. This decrease principally reflects lower proportionate spending on research and development in the Burdick business and cost efficiencies of operating the Quinton and Burdick businesses on a combined basis.

During the nine-month period ended September 30, 2003, we recorded a charge of $1,290,000 to write off in-process research and development acquired in the Burdick acquisition. See Note 3 to Unaudited Condensed Consolidated Financial Statements. In future periods, we do not expect to incur additional in-process research and development write-offs relating to the Burdick acquisition.

Sales and marketing expenses for the nine-month period ended September 30, 2003 increased by $5,957,000 to $13,336,000 from $7,379,000 for the comparable period in 2002. This increase was primarily due to the impact of additional sales and marketing expenses relating to the acquired Burdick business. As a percentage of revenues, sales and marketing expenses decreased to 21.5% for the nine-month period ended September 30, 2003 from 22.2% for the comparable period in 2002. This decrease primarily reflects lower proportionate spending on sales and marketing in the Burdick business and cost efficiencies of operating the Quinton and Burdick businesses on a combined basis.

General and administrative expenses, excluding stock-based compensation, for the nine-month period ended September 30, 2003, increased by $1,784,000 to $5,807,000 from $4,023,000 for the comparable period in 2002. This increase was primarily due to the impact of additional general and administrative expenses relating to the acquired Burdick business. As a percentage of revenues, general and administrative expenses, excluding stock-based compensation, decreased to 9.4% for the nine-month period ended September 30, 2003 from 12.1% for the comparable period in 2002. This decrease primarily reflects lower proportionate spending in general and administrative areas in the Burdick business and cost efficiencies of operating the Quinton and Burdick businesses on a combined basis. For the nine-month period ended September 30, 2003, general and administrative expenses, excluding stock-based compensation, included a charge related to the consolidation of our manufacturing operations of $9,000.

Stock-based compensation expense for the nine-month period ended September 30, 2003 decreased by $39,000 to $54,000, from $93,000 for the comparable period in 2002. Stock-based compensation expense for both periods relates to the intrinsic value of stock options granted in 2001.

Operating Loss

Operating loss for the nine-month period ended September 30, 2003 decreased by $612,000, or 27.0%, to $1,658,000 from $2,270,000 for the comparable period in 2002. As a percentage of revenues, operating loss for the nine-month period ended September 30, 2003 decreased to 2.7% from 6.8% for the comparable period in 2002. Operating loss for the nine-month period ended September 30, 2003 included a $1,290,000 write off of purchased in-process research and development and an acquisition related charge included in cost of revenues of $300,000, both of which were recognized in the quarter ended March 31, 2003. In addition, operating loss for the nine-month period ended September 30, 2003 included a charge to cost of revenues of $262,000 and a charge to general and administrative expenses of $9,000, reflecting charges related to the consolidation of our manufacturing operations

Other Income and Expense

Total other expense for the nine-month period ended September 30, 2003 was $186,000, as compared to total other income of $336,000 for the comparable period in 2002. Interest income decreased by $133,000 to $10,000 for the nine-month period ended September 30, 2003 from $143,000 for the comparable period in 2002 primarily due to a decline in interest-earning assets over the comparable period in 2002. Interest expense increased by $119,000 to $221,000 for the nine-month period ended September 30, 2003 from $102,000 for the comparable period in 2002 primarily due to an increase in average borrowings on our bank line of credit over the nine-month period ended September 30, 2003 as compared to average borrowings over the comparable period in 2002. In addition, interest income related to putable warrants decreased by $262,000 to $32,000 for the nine-month period ended September 30, 2003 from $294,000 for the comparable period in 2002. These warrants, held by a former lender, were adjusted to their fair market value at the end of each accounting period. Gains and losses reflected in the income statement represent the adjustment of the warrants to their fair market value during the related period. There were no warrants outstanding as of September 30, 2003.

Income Taxes

Income tax provisions recorded in the nine-month periods ended September 30, 2003 and 2002 relate to state income taxes.

Liquidity and Capital Resources

For the three-month period ended September, 2003, we generated cash from operating activities of $1,382,000, primarily from income, excluding non-cash expenses of $618,000, a reduction of inventories of $158,000, a reduction in prepaid and other assets of $239,000, an increase to accounts payable of $336,000 and an increase in accrued liabilities of $627,000, which were partially offset by an increase in accounts receivable of $783,000. Inventories at September 30, 2003 decreased from balances at June 30, 2003 primarily due to inventory reduction measures. Accrued liabilities at September 30, 2003 increased from the balance at June 30, 2003 due to higher period-ending payroll and payroll related accruals and accrued severance costs related to our consolidation of our manufacturing facilities. Accounts receivable at September 30, 2003 increased from the balance at June 30, 2003 primarily due to an increase in revenues compared to the three month-period ended June 30, 2003.

For the nine-month period ended September 30, 2003, we generated cash from operating activities of $694,000. This cash flow resulted primarily from working capital reductions of the newly acquired Burdick business.

Net cash used for investing activities was $288,000 for the three-month period ended September 30, 2003. This related primarily to purchases of a telephone system and other machinery and equipment.

Net cash used in investing activities was $20,344,000 for the nine-month period ended September 30, 2003 compared to $684,000 for the comparable period in 2002 primarily due to our investment in Burdick of $19,385,000, net of cash acquired, payments of acquisition costs and a refund from the reduction in the purchase price. For the nine-month period ended September 30, 2003, capital equipment expenditures increased by $383,000 over the comparable period in 2002. The increase was primarily due to the purchase and conversion of an enterprise resource planning system and the purchase of a telephone system.

Net cash used for financing activities for the three-month period ended September 30, 2003 of $1,546,000 related primarily to net repayments on our credit line of $1,591,000 and a debt payment of $90,000 related to the note payable issued in the treadmill manufacturing business acquisition, which was partially offset by proceeds from exercises of stock options of $10,000 and proceeds from the issuance of common stock in accordance with our employee stock purchase plan of $125,000. Net cash used for financing activities of $785,000 for the three-month period ended September 30, 2002 was primarily the result of payments of offering expenses related to our initial public offering.

Net cash from financing activities for the nine-month period ended September 30, 2003 of $719,000 resulted primarily from net borrowings on our credit line of $883,000, proceeds from exercises of stock options of $73,000 and proceeds from issuance of common stock in accordance with our employee stock purchase plan of $331,000, partially offset by debt payments of $272,000 related to the note payable issued in the treadmill manufacturing business acquisition and a payment for the redemption of putable warrants of $296,000. Net borrowings on our credit line for the nine-month period ended September 30, 2003 were partially used to fund part of the purchase price of acquiring Burdick and partially for working capital requirements. Net cash from financing activities of $23,774,000 for the nine-month period ended September 30, 2002 was the result of proceeds from our initial public offering, including the over-allotment shares, of approximately $28,361,000, net of underwriting discounts and offering expenses, offset by net repayments on our bank line of credit of $4,471,000 and a payment of $158,000 for the redemption of putable warrants. Additional offering expenses of approximately $160,000 related to the initial public offering were accrued as of September 30, 2002 but were paid in later periods. The net proceeds from our initial public offering, after payment of all offering expenses and underwriting discounts was $28,200,000.

Accounts receivable, inventories, and prepaid expenses and other current assets at September 30, 2003 increased $3,717,000, $4,456,000, and $46,000, respectively, from balances at December 31, 2002 due primarily to the acquisition

of Burdick. Cash and cash equivalents declined from $19,382,000 at December 31, 2002 to $451,000 at September 30, 2003, due primarily to the use of cash to fund the Burdick acquisition. Accounts payable, accrued liabilities and warranty liability increased $408,000, $2,202,000 and $1,012,000, respectively, from balances at December 31, 2002 due primarily to the acquisition of Burdick. The balance on our line of credit at September 30, 2003 was $883,000. This indebtedness was incurred to pay part of the purchase price for our acquisition of Burdick.

We anticipate that our future operating cash flow 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 12 months. We periodically evaluate potential acquisitions of technology or businesses that complement or expand our existing business or that may enable us to expand into new markets. Future acquisitions may require additional debt, equity financing or both. We may not be able to obtain any additional financing, or may not be able to obtain additional financing on acceptable terms.

Consolidation of Manufacturing Operations

During the third quarter, we announced plans to consolidate our Deerfield, Wisconsin and Bothell, Washington manufacturing and production activities to the Deerfield location. As a result of the related transition activities, we incurred certain charges relating to severance and other consolidation related activities of approximately $271,000 during the three-month period ended September 30, 2003. We expect to incur similar costs, plus moving costs and other related charges in the fourth quarter of 2003 of between $1,100,000 and $1,500,000, including possible non-cash write-offs of up to $400,000 relating to certain assets for which management is currently evaluating the future usefulness. We do not expect this consolidation to adversely affect revenues in the fourth quarter of 2003. We expect to complete this consolidation by the end of 2003. We expect to realize cost savings of between $1,500,000 and $2,000,000 annually thereafter. Substantially all of this cost savings will be to cost of revenues.

Sale of Hemodynamic Monitoring Product Line

On October 21, 2003, we announced the sale of our hemodynamic monitoring product line. As consideration, we received $1,000,000 in cash on October 21, 2003 and a note receivable of $750,000, due October 21, 2004. The buyer may pay additional contingent consideration of up to $1,500,000 based on future sales of the buyer’s products to our previous hemodynamic products customers. Based on our post-closing transitional responsibilities, which extend into the second quarter of 2004, we will defer the recognition of any gain on the transaction. We expect to recognize a gain in the second quarter of 2004 of between $600,000 and $700,000 on the transaction, excluding the effect of any contingent consideration. Contingent consideration received during the period in which we are filling our post-closing transitional obligations will be deferred until these obligations are fulfilled. Contingent consideration received after this period will be recognized as income in the period in which it is received.

The hemodynamic monitoring product line represented approximately $3 million of the Company’s revenues for the nine-month period ended September 30, 2003. The loss of revenues associated with the hemodynamic product line may have a material adverse affect on operating income in the fourth quarter of 2003. During the fourth quarter of 2003, however, the Company expects to make cost adjustments, principally in the form of staffing reductions, and accordingly, management does not expect the loss of these revenues to have a materially adverse impact on operating income in 2004 and beyond.

Certain Factors that May Affect Future Results

In addition to the other information contained in this report, the following risk factors could affect our actual results and could cause our actual results to differ materially from those achieved in the past or expressed in our forward-looking statements. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations.

The unpredictability of our quarterly revenues and operating results may cause the trading price of our stock to decrease.

Our quarterly revenues and operating results have varied in the past and may continue to vary in the future due to a number of factors, many of which are outside of our control. Factors contributing to these fluctuations include:

• 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;

• our ability to attain and maintain production volumes and quality levels for our products and product components;

• the impact of acquisitions, divestitures and other significant corporate events;

• effects of domestic and foreign economic conditions on our industry and/or customers;

• adoption of our system-oriented sales approach;

• changes in the demand for our products and systems;

• varying sales cycles that can take up to a year or more;

• changes in the mix of products and systems we sell;

• unpredictable budgeting cycles of our customers;

• delays in obtaining regulatory clearance for new versions of our products and systems;

• increased product and price competition;

• the impact of regulatory changes on the availability of third-party reimbursement to customers of our products and systems;

• the loss of key sales personnel or distributors; and

• seasonality in the sales of our products and systems.

Due to the factors summarized above, we believe that period-to-period comparisons of our operating results are not a good indication of our future performance and should not be relied on to predict future operating results. Also, it is possible that, in future periods, our operating results will not meet the expectations of public market analysts or investors. In that event, the price of our common stock may decrease.

Failure to keep pace with changes in the marketplace may cause us to lose market share and our revenues may decrease.

The marketplace for diagnostic cardiology systems is characterized by rapid change and technological innovation, requiring suppliers in the market to regularly update product features and incorporate new technologies in order to remain

competitive. In developing and enhancing our products we have made, and will continue to make, assumptions about which features, technology standards and performance criteria will be attractive to, or demanded by, our customers. If we implement features, standards and performance criteria that are different from those required by our customers or if our competitors introduce products and systems that better address these needs, market acceptance of our offerings may suffer or may become obsolete. In that event, our market share and revenues would likely decrease.

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,

• anticipate and meet demands of our international customers for products featuring local language capabilities; and

• anticipate and compete effectively with our competitors’ efforts.

The rate of market acceptance of our current or future products and systems may impact our operating results. In addition, we may experience design, manufacturing, marketing or other difficulties that could delay or prevent our development, introduction or marketing of new versions of our products. Such difficulties and delays could cause our development expenses to increase and harm our operating results.

If market conditions cause us to reduce the selling price of our products and systems, or our market share is negatively affected by the activities of our competitors, our margins and operating results will decrease.

The selling price of our products and systems and the extent of our market share are subject to market conditions. Market conditions that could impact these aspects of our operations include:

• delays in product launches;

• lengthening of buying or selling cycles;

• the introduction of competing products;

• price reductions by our competitors;

• development of more effective products by our competitors;

• hospital budgetary constraints; and

• changes in the reimbursement policies of government and third-party 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.

A number of factors could adversely affect our operating performance during and after the transition period required to consolidate the Quinton manufacturing operations into the Deerfield location.

We have decided to consolidate the Bothell, Washington and Deerfield, Wisconsin manufacturing operations into the Deerfield location and to consolidate our corporate headquarters in Bothell into a smaller space. This transition began during the third quarter of 2003 and will continue into the fourth quarter of 2003. We expect cost savings will come from a combination of a reduction in facilities space and a reduction in staffing requirements due to consolidation of the two previously separate manufacturing and production organizations. In connection with the transition activities, we incurred certain charges relating to severance and other related charges in the third quarter of 2003 and expect to incur certain charges relating to severance and retention of certain employees, moving costs and other related charges in the fourth quarter of 2003. Given the magnitude and complexity of these changes, a number of factors could adversely affect our performance during and after the transition process. These factors could increase the magnitude of the charges we expect to incur, could cause significant and costly operating inefficiencies, could adversely impact our ability to deliver products to our customers on a timely basis and could reduce the level of overall cost savings that we ultimately achieve through the consolidation. These factors include, but are not limited to, our possible inability to retain key manufacturing and operations personnel in Bothell through the transition period, possible delays in hiring key new personnel in Deerfield, unexpected costs in consolidating our manufacturing operations, unexpected delays in the manufacturing process after the consolidation of the manufacturing operations and disruptions in supplies or increases in prices of certain components used in our manufacturing operations.

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

As part of our growth strategy, we intend to selectively acquire other businesses, product lines, assets, or technologies. Successful execution of our acquisition strategy depends upon our ability to identify, negotiate, complete and integrate suitable acquisitions and, if necessary, to obtain satisfactory debt or equity financing. If we acquire complementary businesses or assets but fail to successfully integrate them, our financial condition or results of operations may suffer.

Our future financial results could be adversely impacted by asset impairments or other charges.

We have adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.’’ As a result, we are required to test both acquired goodwill and other indefinite-lived intangible assets, consisting of a trade name for impairment on an annual basis based upon a fair value approach, rather than amortizing them over time. We are also required to test goodwill for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of our reporting units below their book value. 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. Additionally, our other indefinite-lived intangible assets must be tested between annual tests if events or changes in circumstances indicate that the assets might be impaired. Additionally, we evaluate the estimated lives of all intangible assets on an annual basis, including those with indefinite lives, to determine if events and circumstances warrant a revision in the remaining period of amortization. In the case of intangible assets with indefinite lives, we evaluate whether events or circumstances continue to support an indefinite useful life. 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.

If we fail to maintain our distributor relationships our sales and operating results may suffer.

Burdick sells its products, both domestically and internationally, principally through third party distributors, and Quinton sells its products internationally through third party distributors. While both Burdick and Quinton have well established relationships with these distributors, the underlying agreements are generally for periods of one year or less. If

these agreements are cancelled or if we are unable to renew them as they expire, our sales and operating results may suffer materially.

We may need additional capital to continue our acquisition growth strategy.

Successful continued execution of our acquisition strategy depends upon our ability to identify, negotiate, complete and integrate suitable acquisitions and, if necessary, to obtain satisfactory debt or equity financing. We are likely to 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. Recent performance of 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.

Our lack of customer purchase contracts and our limited order backlog make it difficult to predict sales and plan manufacturing requirements, which can lead to lower revenues, higher expenses and reduced margins.

We do not generally have long-term purchase contracts with customers who order products on a purchase order basis. In limited circumstances, customer orders may be cancelled, changed or delayed on short notice. Lack of significant order backlog makes it difficult for us to forecast future sales with certainty. Long and varying sales cycles with our customers make it difficult to accurately forecast component and product requirements. These factors expose us to a number of risks:

• if we overestimate our requirements we may be obligated to purchase more components or third-party products than is required;

• if we underestimate our requirements, our third-party manufacturers and suppliers may have an inadequate product or product component inventory, which could interrupt manufacturing of our products and result in delays in shipments and revenues;

• we may also experience shortages of product components from time to time, which also could delay the manufacturing of our products; and

• over or under production can lead to higher expense, lower than anticipated revenues, and reduced margins.

If 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 supplies 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.

If we do not develop or maintain successful relationships with international distributors, our growth may be limited, sales of our products and systems may decrease and our operating results may suffer.

During 2000, 2001, and 2002, we generated, on average, approximately 8% of our revenues from international sales and our growth strategy contemplates expanded efforts to increase international sales. All of our international sales in recent periods were attributable to third-party distributors, and our success in expanding international sales in the future will depend on our ability to develop and manage a network of international distributors and the performance of our distributors. Because we do not generally have long-term contracts with our distributors, our distribution relationships may be terminated on little or no notice. If we lose any significant international distributors, or if any of our distributors devote more effort to selling competing products and systems, our international sales and operating results may suffer and our growth may be limited. Consequently, our success in expanding international sales may be limited if our distributors lack, or are unable to develop, relationships with important target customers in international markets.

Undetected product errors or defects could result in increased warranty costs, loss of revenues, product recalls, delayed market acceptance and claims against us.

Any errors or defects in our products discovered after commercial release could result in:

• failure to achieve market acceptance;

• loss of customers, revenues and market share;

• diversion of development resources;

• increased service and warranty costs;

• legal actions by our customers; and

• increased insurance costs.

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.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We develop products in the U.S. and sell them worldwide. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. Since our products are currently priced in U.S. dollars and are translated to local currency amounts, a strengthening of the dollar could make our products less competitive in foreign markets. Interest income is sensitive to changes in the general level of U.S. interest rates, particularly since our investments are in short-term investments calculated at variable rates.

Item 4. Controls and Procedures

We maintain disclosure controls and procedures designed to ensure that information required to be disclosed in our filings under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Our chief executive officer and chief financial officer have evaluated our disclosure controls and procedures as of the end of the period covered by this quarterly report of Form 10-Q and have determined that such disclosure controls and procedures are effective.

There has been no change in our internal control over financial reporting in connection with this evaluation that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

We are not currently a party to any material legal proceedings.

Item 2. Changes in Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Submission of Matters to a Vote of Security Holders

None.

Item 5. Other Information

None.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits


Exhibit 10.1		Form of Indemnification Agreement between Quinton Cardiology Systems, Inc. and each of its directors and executive officers.

Exhibit 10.2		Lease Agreement between Quinton Cardiology Systems, Inc. and Hibbs/Woodinville Associates, L.L.C. regarding premises at Bothell, Washington, dated August 29, 2003.

Exhibit 31.1		Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934 of Item 601 of Regulation S-K.

Exhibit 31.2		Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934 of Item 601 of Regulation S-K.

Exhibit 32.1		Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 (Section 906 of the Sarbanes-Oxley Act of 2002).

Exhibit 32.2		Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 (Section 906 of the Sarbanes-Oxley Act of 2002).

(b) Reports on Form 8-K

On July 24, 2003, we filed a Form 8-K related to the press release discussing the Company’s results for the second quarter of 2003.

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


		QUINTON CARDIOLOGY SYSTEMS, INC.

		By: /s/ Michael K. Matysik

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

Date: November 14, 2003

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	Basis of Presentation

	The condensed financial statements present the Company on a consolidated basis. All significant intercompany accounts and transactions have been eliminated. The condensed consolidated balance sheet dated September 30, 2003, the condensed consolidated statements of operations for the three and nine-month periods ended September 30, 2002 and 2003 and the condensed consolidated statements of cash flows for the three and nine-month periods ended September 30, 2002 and 2003 have been prepared by the Company and are unaudited. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The notes to the audited consolidated financial statements included in the Company’s annual report on form 10-K for the fiscal year ended December 31, 2002 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. All share information in these financial statements gives effect to a 1 for 2.2 reverse stock split, which was effected in April 2002.

	Use of Estimates

	The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the periods reported. These estimates include but are not limited to estimates affecting revenues and estimates assessing the collectability of accounts receivable, the salability and recoverability of inventory, the adequacy of warranty liabilities, the realizability of investments, the realization of deferred tax assets, the fair value of putable warrants and the useful lives of tangible and intangible assets. The market for the Company’s products is characterized by intense competition, rapid technological development and frequent new product introductions, all of which could affect the future realizability of the Company’s assets. The Company reviews estimates and assumptions periodically, and the effects of revisions are reflected in the consolidated financial statements in the period they are determined to be necessary. Actual results could differ from these estimates.

	Recent Accounting Pronouncements

	In November 2002, the Emerging Issues Task Force (EITF) reached a consensus on EITF 00-21, “Revenue Arrangements with Multiple Deliverables” with respect to determining when and how to allocate revenue from sales with multiple deliverables. The EITF 00-21 consensus provides a framework for determining when and how to allocate revenue from sales with multiple deliverables based on a determination of whether the multiple deliverables qualify to be accounted for as separate units of accounting. The consensus is effective prospectively for arrangements entered into in fiscal periods beginning after June 15, 2003. The Company adopted this consensus during the three-month period ended September 30, 2003. The adoption of this consensus resulted in the Company deferring approximately $150,000 of


	revenues during the three-month period ending September 30, 2003, which represented the value of installation obligations associated with the sales of our systems.

	In April 2003, the FASB issued Statement of Financial Accounting Standard No. 149, “Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities.” This standard amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts, collectively referred to as derivatives, and for hedging activities under statement No. 133, “Accounting for Derivative Instruments and Hedging Relationships.” SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships after June 30, 2003. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements as a whole.

	In May 2003, the FASB issued Statement of Financial Accounting Standard No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” The Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). The Company adopted this statement at the beginning of the three-month period ended September 30, 2003. While the adoption of this standard did not have a material impact on the Company’s consolidated financial statements as a whole, footnote 3 contains additional disclosures as required by the standard.

	Net Income (Loss) Per Share

	In accordance with Statement of Financial Accounting Standard No. 128, “Computation of Earnings Per Share,” basic income (loss) per share is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding during the period. Common stock that the Company has the right to repurchase is not included in the calculation of outstanding shares. Diluted income per share is computed by dividing net income by the weighted average number of common and dilutive potential common shares outstanding during the period. Dilutive potential common shares consist of shares issuable upon the exercise of stock options, including outstanding shares subject to repurchase, and warrants (using the treasury stock method). Potential common shares are excluded from the calculation if their effect is antidilutive.

	The following table sets forth the computation of basic and diluted weighted average common shares outstanding for the three and nine-month periods ended September 30, 2002 and 2003:


	Accounting for Stock-Based Compensation

	The Company has elected to apply the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” In accordance with the provisions of SFAS 123, the Company applies Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its stock option plans. Accordingly, compensation expense is recognized for options awarded to employees only to the extent that the exercise price of the option is less than the fair value of the underlying stock on the date of grant.

	Had compensation cost been determined based on the fair value of the options at the grant dates during the three and nine-month periods ended September 30, 2002 and 2003, consistent with the provisions of SFAS 123, the Company’s reported net loss would have been the pro forma amounts indicated below (amounts in thousands except per share amounts):


	The fair value of each employee option grant is established on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for grants during 2002 and 2003: zero dividend yield; risk-free interest rate of 4.2% and 3.5%, respectively; volatility of 90% and 85%, respectively; and expected lives of four years and seven years, respectively. The weighted-average fair value of options granted in 2002 and 2003 was $5.49 and $4.89, respectively.

	Goodwill

	Goodwill represents the excess of cost over the estimated fair value of net assets acquired in connection with our acquisitions of the medical treadmill manufacturing line and Spacelabs Burdick, Inc., which, in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” is not being amortized. Also in accordance with SFAS No. 142, the Company tests goodwill for impairment at the reporting unit level on an annual basis and between annual tests in certain circumstances. On the date of the Spacelabs Burdick acquisition, the Company determined that it had three reporting units, consisting of the Burdick line of products, the Quinton line of products and the Shanghai-Burdick joint venture, all of which operate in the diagnostic cardiology market and have similar operating and economic characteristics. As of the beginning of the fourth quarter of 2003, the Company decided to reorganize its reporting units and consolidate the Quinton and Burdick reporting units into one reporting unit. This was driven by the Company’s decision to consolidate its manufacturing operations into one facility in Deerfield, Wisconsin. After the consolidation of the manufacturing operations, the Company will manufacture its products under both the Quinton and the Burdick brands in one facility. In conjunction with this consolidation, the Company will modify its reporting structures and will no longer review Quinton and Burdick operations separately. The Shanghai-Burdick joint venture will remain as a separate reporting unit.

	SFAS No. 142 requires a two-step goodwill impairment test whereby the first step, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired, thus the second step of the goodwill impairment test used to quantify impairment is unnecessary. Management has estimated that the fair values of the Company’s reporting units to which goodwill has been allocated exceed their carrying amounts, and as a result, the second step of the impairment test, which would compare the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill, was unnecessary for the periods presented.


	Intangible Assets

	The Company’s intangible assets are comprised primarily of a trade name, developed technology and customer relationships, all of which were acquired in our acquisition of Burdick. Company management uses judgment to estimate the fair value of each of these intangible assets. The judgment about fair value is based on expectations of future cash flows and an appropriate discount rate. Company management also uses judgment to estimate the useful lives of each intangible asset. The Company believes the Burdick trade name has an indefinite life, and accordingly does not amortize the trade name. The Company evaluates this conclusion annually and makes a judgment about whether there are factors that would limit the ability to benefit from the trade name in the future. If there were such factors, the Company would start amortizing the trade name. The Company also tests the indefinite life trade name intangible asset for impairment on an annual basis or more frequently if events or changes in circumstances indicate that the asset might be impaired. With respect to developed technology and customer relationship intangible assets, the Company also evaluates the remaining useful lives annually to evaluate whether the intangible assets are impaired. For the trade name, this evaluation is performed annually or if events occur that suggest there may be an impairment loss, and involves comparing the carrying amount to the Company’s estimate of fair value. For developed technology and customer relationship intangible assets, this evaluation would be performed if events occur that suggest there may be an impairment loss. If we conclude that any of our intangible assets are impaired, we would record this as a loss on our statement of operations and as a reduction to the intangible asset. The Company recorded amortization expense for identifiable intangibles of $30,000 and $84,000 for the three-month periods ended September 30, 2002 and 2003, respectively, and $91,000 and $301,000 for the nine-month periods ended September 30, 2002 and 2003, respectively.

	Purchase Accounting

	SFAS No. 141, “Business Combinations,” requires that the purchase method of accounting be used for all business combinations and establishes specific criteria for the recognition of intangible assets separately from goodwill. In connection with the Company’s acquisitions of the medical treadmill manufacturing line and Spacelabs Burdick, Inc., the Company allocated the respective purchase prices plus transaction costs to estimated fair values of assets acquired and liabilities assumed. These purchase price allocation estimates were made based on our estimates of fair values.


	On January 2, 2003, the Company purchased 100% of the stock of Spacelabs Burdick, Inc. (“Burdick”). Burdick’s historical strength in ECG cardiographs, Holter monitors and cardiology information systems, combined with its distribution network focused on U.S. physicians’ offices, complements Quinton’s strength in cardiac stress testing and cardiac rehabilitation monitoring and its hospital focused direct sales force. The consolidated financial statements include Burdick’s results since January 2, 2003.

	The original purchase price of $24.0 million was funded with approximately $20.2 million in cash, a holdback of $1.3 million for working capital adjustments plus a partial draw down on our revolving bank credit facility. Transaction related costs were approximately $700,000.

	On April 21, 2003, an agreement was reached with the seller to adjust the purchase price to $20.4 million, based principally on the amount of Burdick’s net working capital at the date of acquisition. In accordance with this agreement, the Company kept the $1.3 million that was held back at closing and received a $2.3 million refund from the seller subsequent to the April 21, 2003 agreement. The refund was used to reduce borrowings against the Company’s line of credit.

	Further information was obtained during the three-month period ended September 30, 2003 regarding the value of Burdick’s and Shanghai-Burdick’s machinery and equipment. This information required an adjustment to the previously disclosed purchase price allocation which decreased goodwill by $104,000. The Company has now obtained all of the information the Company has arranged to obtain in order to finalize the purchase price allocation. The purchase price, including incremental costs directly related to the transaction, was allocated as follows (in thousands):


	Inventories included an adjustment to Burdick’s historical cost to increase finished goods to fair market value less expected disposal costs and selling margin. This adjustment resulted in valuation of inventory of $300,000 in excess of Burdick’s historical cost. This increase in the inventory valuation was charged to cost of revenues in the nine-month period ended September 30, 2003, as the associated inventories were sold in the normal course of business.

	In-process research and development relates to two product development projects underway at the time of the acquisition. Neither project had received required regulatory approvals at the acquisition date, and each project had risks associated with achieving desired functionality and market acceptance. The value assigned to in-process research and development was determined using a discounted cash flow method applied to expected cash flows over a 15 year period commencing in 2003. In discounting expected future cash flows, the Company used an annual discount rate of 16%, which management believes is an appropriate risk adjusted rate given the nature of the projects, the remaining project risks and the uncertainty of the future cash flows.

	The first of the two projects, representing 87% of the total value of acquired in-process research and development, relates to a new resting ECG monitor. This project was approximately 70% complete at the date of acquisition and was completed and the related product (the Atria 3000) was released, as expected, at the end of the first quarter of 2003. Margins on this product are expected to be in line with the Company’s historical margins. In the opinion of management, failure to achieve expected market results and margins relating to this product could materially adversely affect the overall return on investment relating to the Burdick acquisition. Costs to complete this project were expensed in the nine-month period ended September 30, 2003.

	The second of the two projects, representing 13% of the total value of acquired in-process research and development relates to a product for the detection and preprocessing of low-level electrical signals generated by the heart. This project was approximately 50% complete at the date of acquisition. Management has assigned a low priority to this project and decided to postpone further development indefinitely, although the underlying technology may have application to other projects that the Company may pursue in the future. In the opinion of management, the indefinite postponement of further development of this project will not materially adversely affect the overall return on investment relating to the Burdick acquisition.

	All of the acquired in process research and development was written off during the first quarter of 2003.

	Intangible assets consist of the trade name of $3,400,000, developed technology of $860,000 and distributor relationships of $1,400,000, which were valued based on discounted cash flow methods applied to the estimated future cash flows attributable to the respective assets. The trade name was determined, by management, to have an indefinite useful life. Developed technology was assigned a seven year useful life, based on the estimated remaining economic life of the related products. Distributor relationships relate to long-standing contractual relationships with an extensive network of independent distributors, which represents the exclusive channel through which Burdick sells its products. The economic life of the distributor relationships has been determined to be 10 years, based on historical turnover experience and in consideration of the long standing and stable nature of these relationships.

	Goodwill represents the excess of the net purchase price over the fair value of the assets and liabilities acquired. Goodwill recorded in the Burdick acquisition relates to the long-standing nature of Burdick’s business, its substantial market share, its complementary fit with Quinton’s pre-existing business, and management’s expectations relating to future operating synergies and cost efficiencies that can be realized as a result of operating the businesses on a combined basis.


	You should read the following discussion and analysis in conjunction with our unaudited condensed consolidated financial statements and related notes included elsewhere in this report. Except for historical information, the following discussion contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact, including future results of operations or financial position, made in this Quarterly Report on Form 10-Q, are forward looking. We use words such as anticipate, believe, expect, future, intend and similar expressions to identify forward looking statements. These forward-looking statements reflect management’s current expectations and involve risks and uncertainties. Our actual results could differ materially from results that may be anticipated by such forward-looking statements. The principal factors that could cause or contribute to such differences include, but are not limited to, those discussed in the section entitled “Certain Factors That May Affect Future Results” below, those discussed elsewhere in this report and those discussed in our Annual Report on Form 10-K filed on March 18, 2003. 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


	and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates including those affecting revenues, the allowance for doubtful accounts, the salability and recoverability of inventory, warranty liabilities, the carrying value of our investments, the useful lives of intangible assets and income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. A more complete description of our critical accounting estimates established prior to the end of the fiscal year ending December 31, 2002 is contained in our Annual Report on Form 10-K for the fiscal year ended December 31, 2002. In addition to those critical accounting estimates, since December 31, 2002, we have established the following critical accounting estimates:

	Purchase Allocation Accounting


	In connection with our acquisitions of the medical treadmill manufacturing line and Spacelabs Burdick, Inc., we have allocated the respective purchase prices plus transaction costs to estimated fair values of assets acquired and liabilities assumed. These purchase price allocation estimates were made based on our estimates of fair values. Had these estimates been different, reported amounts allocated to assets and liabilities and results of operations subsequent to the acquisitions could be materially impacted.

	Useful Lives of Intangible Assets


	Consolidated operating results for the three-month period ended September 30, 2003 include the operating results of Burdick, which we acquired on January 2, 2003.

	Revenues


	Service revenues increased by $1,012,000, or 44.5%, to $3,287,000 for the three-month period ended September 30, 2003 from $2,275,000 for the comparable period in 2002. This increase was primarily due to the addition of Burdick’s service revenues.

	Gross Profit


	Gross margin from service revenues decreased to 46.6% for the three-month period ended September 30, 2003, from 51.3% for the comparable period in 2002. This decrease in gross margin, as a percentage of revenues, was primarily due to the impact of Burdick’s lower gross margin on service revenues. For the three-month period ended September 30, 2003, we recognized a charge to cost of revenues related to the consolidation of our manufacturing operations of $22,000, which was discussed above. This charge to cost of revenues represented an adverse impact to gross margin from service revenues of approximately 0.7 percentage point.

	Operating Expenses


	Stock-based compensation expense for the three-month period ended September 30, 2003 decreased by $5,000 to $18,000, from $23,000 for the comparable period in 2002. Stock-based compensation expense for both periods relates to the intrinsic value of stock options granted in 2001. We expect to record stock-based compensation expense in the fourth quarter of 2003 at a level similar to the amount recorded in the third quarter of 2003.

	Operating Income (Loss)


	Operating income for the three-month period ended September 30, 2003 was $244,000, compared to an operating loss of $535,000 for the comparable period in 2002. The period-over-period improvement was due to factors noted above, primarily higher gross profit percentage and lower general and administrative expenses as a percentage of revenues.

	Other Income and Expense


	Stock-based compensation expense for the nine-month period ended September 30, 2003 decreased by $39,000 to $54,000, from $93,000 for the comparable period in 2002. Stock-based compensation expense for both periods relates to the intrinsic value of stock options granted in 2001.

	Operating Loss


	Income tax provisions recorded in the nine-month periods ended September 30, 2003 and 2002 relate to state income taxes.

	Liquidity and Capital Resources


	We anticipate that our future operating cash flow 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 12 months. We periodically evaluate potential acquisitions of technology or businesses that complement or expand our existing business or that may enable us to expand into new markets. Future acquisitions may require additional debt, equity financing or both. We may not be able to obtain any additional financing, or may not be able to obtain additional financing on acceptable terms.

	Consolidation of Manufacturing Operations


	During the third quarter, we announced plans to consolidate our Deerfield, Wisconsin and Bothell, Washington manufacturing and production activities to the Deerfield location. As a result of the related transition activities, we incurred certain charges relating to severance and other consolidation related activities of approximately $271,000 during the three-month period ended September 30, 2003. We expect to incur similar costs, plus moving costs and other related charges in the fourth quarter of 2003 of between $1,100,000 and $1,500,000, including possible non-cash write-offs of up to $400,000 relating to certain assets for which management is currently evaluating the future usefulness. We do not expect this consolidation to adversely affect revenues in the fourth quarter of 2003. We expect to complete this consolidation by the end of 2003. We expect to realize cost savings of between $1,500,000 and $2,000,000 annually thereafter. Substantially all of this cost savings will be to cost of revenues.

	Sale of Hemodynamic Monitoring Product Line

	•		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;

	•		our ability to attain and maintain production volumes and quality levels for our products and product components;

	•		the impact of acquisitions, divestitures and other significant corporate events;

	•		effects of domestic and foreign economic conditions on our industry and/or customers;

	•		adoption of our system-oriented sales approach;

	•		changes in the demand for our products and systems;

	•		varying sales cycles that can take up to a year or more;

	•		changes in the mix of products and systems we sell;

	•		unpredictable budgeting cycles of our customers;

	•		delays in obtaining regulatory clearance for new versions of our products and systems;

	•		increased product and price competition;

	•		the impact of regulatory changes on the availability of third-party reimbursement to customers of our products and systems;

	•		the loss of key sales personnel or distributors; and

	•		seasonality in the sales of our products and systems.

	•		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,

	•		anticipate and meet demands of our international customers for products featuring local language capabilities; and

	•		anticipate and compete effectively with our competitors’ efforts.

	•		delays in product launches;

	•		lengthening of buying or selling cycles;

	•		the introduction of competing products;

	•		price reductions by our competitors;

	•		development of more effective products by our competitors;

	•		hospital budgetary constraints; and

	•		changes in the reimbursement policies of government and third-party payers.


	these agreements are cancelled or if we are unable to renew them as they expire, our sales and operating results may suffer materially.

	We may need additional capital to continue our acquisition growth strategy.

	•		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.

	•		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.