UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended September 30, 2004

OR

Commission File Number 000-49755

QUINTON CARDIOLOGY SYSTEMS, INC.

3303 Monte Villa Parkway
Bothell, Washington 98021
(Address of principal executive offices)

(425) 402-2000
(Registrant’s telephone number)

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

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YESx NOo

     The number of shares outstanding of the registrant’s common stock as of November 1, 2004 was 14,036,783.

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TABLE OF CONTENTS

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PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

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

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QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share amounts)

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

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QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

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

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QUINTON CARDIOLOGY SYSTEMS, INC.
AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Organization and Description of Business

     Quinton Cardiology Systems, Inc. (“QCS”) is a Delaware corporation. QCS and its subsidiary, Quinton Cardiology, Inc. (“Quinton”) and its majority owned Shanghai-Burdick joint venture are referred to herein as the Company. The Company develops, manufactures, markets and services a family of advanced cardiology products used in the diagnosis, monitoring and management of patients with heart disease.

2. Summary of Significant Accounting Policies

     Basis of Presentation

     The condensed financial statements present the Company on a consolidated basis. All significant intercompany accounts and transactions have been eliminated. The condensed consolidated balance sheet dated September 30, 2004, the condensed consolidated statements of operations for the three and nine-month periods ended September 30, 2003 and 2004 and the condensed consolidated statements of cash flows for the three and nine-month periods ended September 30, 2003 and 2004 have been prepared by the Company and are unaudited. The condensed consolidated balance sheet dated December 31, 2003 was derived from audited financial statements. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The notes to the audited consolidated financial statements included in the Company’s annual report on form 10-K for the fiscal year ended December 31, 2003 provide a summary of significant accounting policies and additional financial information that should be read in conjunction with this report. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position of the Company for the interim periods, have been made. The results of operations for such interim periods are not necessarily indicative of the results for the full year or any future period.

     Use of Estimates

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

     Recent Accounting Pronouncements

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

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installation obligations associated with the sales of our systems. During the three-month period ended September 30, 2004, this deferral increased approximately $3,000 to $226,000.

     In May 2003, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” The Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). The Company adopted this statement at the beginning of the three-month period ended September 30, 2003. While the adoption of this standard did not have a material impact on the Company’s consolidated financial statements as a whole, Note 4 contains additional disclosures as required by the standard.

     In December 2003, the FASB revised FASB Interpretation No. 46 (FIN 46R), “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51.” This interpretation addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and accordingly should consolidate the entity. FIN 46R requires that calendar year-end public companies apply the unmodified or revised provisions of FIN 46 to entities previously considered special purpose entities in the reporting period ended December 31, 2003. The interpretation is applicable to all other entities not previously considered special purpose entities in the quarter ended March 31, 2004. The adoption of FIN 46R did not have a material effect on the Company’s consolidated financial statements as a whole. Further, the adoption in 2004 as it relates to non-special purpose entities did not have an impact on the Company’s consolidated financial statements as a whole.

     Net Income (Loss) Per Share

     In accordance with Statement of Financial Accounting Standard No. 128, “Computation of Earnings Per Share,” basic income (loss) per share is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding during the period. Diluted income per share is computed by dividing net income by the weighted average number of common and dilutive potential common shares outstanding during the period. Dilutive potential common shares consist of shares issuable upon the exercise of stock options, including outstanding shares subject to repurchase, and warrants (using the treasury stock method). Potential common shares are excluded from the calculation if their effect is antidilutive.

     The following table sets forth the computation of basic and diluted weighted average common shares outstanding for the three and nine-month periods ended September 30, 2003 and 2004:

     For the three and nine-month periods ended September 30, 2004, 868,223 and 297,741, respectively, stock options were excluded from the computation of diluted income per share as their impact was antidilutive. For the three-month period ended September 30, 2003, 385,276 stock options were excluded from the computation of diluted income 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 nine-month period ended September 30, 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. The Company accounts for stock options issued to non-employees in accordance with the provisions of

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SFAS 123 and Emerging Issues Task Force consensus on Issue No. 96-18, “Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” (“EITF 96-18”).

     Had compensation cost been determined based on the fair value of the option awards at the grant dates during the three and nine-month periods ended September 30, 2003 and 2004, consistent with the provisions of SFAS 123, the Company’s reported net income (loss) would have been the pro forma amounts indicated below (amounts in thousands except per share amounts):

     The fair value of each employee option grant is established on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for grants during 2003 and 2004: zero dividend yield; risk-free interest rate of 3.5% and 3.8%, respectively; volatility of 85% and 70%, respectively; and expected lives of seven years. The weighted-average fair value of options granted in 2003 and 2004 was $4.89 and $6.40, respectively.

     The weighted average fair value of each employee stock purchase right under the Company’s 2002 Employee Stock Purchase Plan was $1.93 in 2003 and $2.54 in 2004. The following assumptions were used in the Black-Scholes option-pricing model to perform the calculation in 2003 and 2004: zero dividend yield; risk-free interest rate of 2.0%; volatility ranging from 70% to 85%; and expected lives from grant date of 0.75 years and 0.5 years, respectively.

     Goodwill

     Goodwill represents the excess of costs over the estimated fair values of net assets acquired in connection with our acquisitions of the medical treadmill manufacturing line in 2002 and Spacelabs Burdick, Inc. (“Burdick”) in 2003, which, in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” is not being amortized. Also in accordance with SFAS No. 142, the Company tests goodwill for impairment at the reporting unit level on an annual basis and between annual tests in certain circumstances. The Company has determined that it has two reporting units, consisting of the Quinton Cardiology reporting unit and the Shanghai-Burdick joint venture reporting unit.

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

     Intangible Assets

     The Company’s intangible assets are comprised primarily of a trade name, developed technology and customer relationships, most of which were acquired in our acquisition of Burdick. 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. Management also uses judgment to estimate the useful lives of each intangible asset. The Company believes the Burdick trade name, with a carrying value of $3,400,000, has an indefinite life, and accordingly does not amortize the trade name. The Company evaluates this conclusion annually and makes a judgment about whether

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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 $84,000 and $81,000 for the three-month periods ended September 30, 2003 and 2004, respectively, and $301,000 and $242,000 for the nine-month periods ended September 30, 2003 and 2004, respectively.

     Purchase Accounting

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

3. Public Equity Offering

     In June 2004, the Company consummated a public offering of its common stock as more fully described in its prospectus dated May 25, 2004 filed with the Securities and Exchange Commission. In the offering, the Company sold 1,605,976 shares of common stock at a price of $10.50 per share. Proceeds from the offering were approximately $15,451,000, net of underwriting discounts and offering expenses. In addition, a selling shareholder, as named in the prospectus, sold 1,394,024 shares of common stock in this offering. The Company did not receive any proceeds from the sale of shares by the selling shareholder.

4. Acquisition of Burdick, Inc.

     On January 2, 2003, the Company purchased 100% of the stock of Burdick. The consolidated financial statements include Burdick’s results since January 2, 2003.

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

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

     The purchase price, including incremental costs directly related to the transaction, was allocated as follows (in thousands):

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     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 believed to be an appropriate risk adjusted rate given the nature of the projects, the project risks remaining at the time of acquisition and the uncertainty of the future cash flows.

     The first of the two projects, representing 87% of the total value of acquired in-process research and development, related to a new resting ECG monitor. This project was approximately 70% complete at the date of acquisition and was completed and the related product (the Atria 3000) was released, as expected, at the end of the first quarter of 2003. Margins on this product are in line with the Company’s historical margins. Costs to complete this project were expensed in the 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 assigned a low priority to this project and decided to postpone further development indefinitely. In the opinion of management, the indefinite postponement of further development of this project has not materially adversely affected the overall return on investment relating to the Burdick acquisition.

     All of the acquired in-process research and development was written off during the nine-month period ended September 30, 2003, resulting in a charge to operating expenses of $1,290,000.

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

     Goodwill in the amount of $9,027,000 represents the excess of the net purchase price over the fair value of the assets and liabilities acquired. Goodwill recorded in the Burdick acquisition relates to the long-standing nature of Burdick’s business, its substantial market share, its complementary fit with Quinton’s pre-existing business, and management’s expectations relating to future operating synergies and cost efficiencies that can be realized as a result of operating the businesses on a combined basis.

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

     Minority Interest

     As part of the acquisition of Burdick, the Company acquired 56% ownership of Shanghai Burdick Medical Instrument Co., LTD. (“Shanghai-Burdick”). The Shanghai-Burdick joint venture has a limited life of thirty years, terminating in 2030. If the joint venture is terminated, the Company would be required to liquidate the net assets of the joint venture and distribute proceeds to the partners. Assuming the joint venture was to have been terminated effective September 30, 2004,

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the Company estimates that such net proceeds allocable to the minority interest would approximate the carrying value of the minority interest recorded in the accompanying unaudited consolidated balance sheet, which was $163,000 at September 30, 2004.

5. Consolidation of Manufacturing Operations

     During the third quarter of 2003, the Company announced plans to consolidate its Deerfield, Wisconsin and Bothell, Washington manufacturing and production activities to its Deerfield location. As a result of the related transition activities, the Company recognized certain charges to cost of revenues relating to severance and other consolidation related activities of approximately $1,418,000 during the third and fourth quarters of 2003. The Company completed this consolidation by the end of 2003.

     Changes in the Company’s accrued liabilities for the nine-month period ended September 30, 2004 related to the consolidation of manufacturing operations were as follows (amounts in thousands):

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):

7. Borrowings

     In connection with the 2003 acquisition of Burdick, the Company established a line of credit on December 30, 2002. Borrowings under the line of credit are currently limited to the lesser of $12,000,000 or an amount based on eligible accounts receivable and eligible inventories. Substantially all of the Company’s assets are pledged as collateral for the line of credit. This line of credit bears interest at the greater of (i) a variable rate ranging from the bank’s prime rate plus a minimum of 0.5% to a maximum of 1.5% based on a funded debt to Earnings Before Interest, Taxes, Depreciation, and Amortization (“EBITDA”) ratio, which amounted to 5.25% at September 30, 2004, or (ii) $9,000 per month. In addition, unused balances under this facility bear monthly fees equal to 0.50% per annum on the difference between the maximum credit limit and the average daily principal balance during the month. The current line of credit expires on December 30, 2004. At September 30, 2004, the Company had no borrowings under this line of credit and had capacity to borrow $10,235,000 based on eligible accounts receivable and eligible inventory.

8. Putable Warrants

     In connection with a loan in 1998, the Company issued warrants to purchase 123,536 shares of Series A convertible preferred stock with an exercise price of $0.01 per share that were immediately exercisable. Upon completion of the Company’s initial public offering in 2002, the conversion rights associated with the Company’s Series A convertible preferred stock resulted in the warrants being exercisable for 63,092 shares of common stock at an exercise price equal to $0.02 per share. At the holders’ option, the Company was required to make a cash payment to the holder equal to the fair value of the shares issuable upon exercise of the warrants. On July 22, 2002, a holder of 21,632 putable warrants exercised a put option for cash when the fair value of the shares was approximately $158,000. On May 21, 2003, the

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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, 2004.

9. Warranty Liability

     Changes in the warranty liability for the nine months ended September 30, 2003 and 2004 were as follows (amounts in thousands):

10. Contingencies

     Legal Matters

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

11. Sale of Hemodynamic Monitoring Product Line

     On October 21, 2003, the Company sold its hemodynamic monitoring product line. As consideration, the Company received $1,000,000 in cash and a note payable for $750,000, which was paid on October 20, 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, of which approximately $77,000 in contingent consideration has been received through September 30, 2004.

     Based on the Company’s post-closing transition responsibilities, which extended into the second quarter of 2004, the Company deferred the recognition of any gain on the transaction until its transition responsibilities were fulfilled. The Company recognized a gain in the second quarter of 2004 of $633,000 on the transaction, including the effect of the contingent consideration received through June 30, 2004. Contingent consideration received after June 30, 2004 was recognized as income in the period in which it was earned.

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

     You should read the following discussion and analysis in conjunction with our unaudited condensed consolidated financial statements and related notes included elsewhere in this report. The following discussion contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact made in this Quarterly Report on Form 10-Q, including future results of operations or financial position, are forward-looking. We use words such as anticipate, believe, expect, future, intend and similar expressions to identify forward-looking statements. These forward-looking statements reflect management’s current expectations and involve risks and uncertainties. Our actual results could differ materially from results that may be anticipated by such forward-looking statements. The principal factors that could cause or contribute to such differences include, but are not limited to, those discussed in the section entitled “Certain Factors That May Affect Future Results or the Trading Price of our Common Stock” below, those discussed elsewhere in this report and those discussed in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 15, 2004. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to revise any forward-looking statements to reflect events or circumstances that may subsequently arise. Readers are urged to review and consider carefully the various disclosures made in this report and in our other filings made with the SEC that attempt to advise interested parties of the risks and factors that may affect our business, prospects and results of operations.

     Critical Accounting Estimates

     The discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial statements. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those affecting revenues, the allowance for doubtful accounts, the salability and recoverability of inventory, warranty liabilities, the carrying value of our investments, the useful lives of intangible assets and income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. A more complete description of our critical accounting estimates established prior to the end of the fiscal year ending December 31, 2003 is contained in our Annual Report on Form 10-K for the fiscal year ended December 31, 2003.

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     Results of Operations

Three-Month Period Ended September 30, 2004 Compared to the Three-Month Period Ended September 30, 2003

     Revenues

     Revenues increased by $1,464,000, or 7.0%, to $22,498,000 for the three-month period ended September 30, 2004 from $21,034,000 for the comparable period in 2003. Revenues for the three-month period ended September 30, 2003 included sales of $918,000 related to the hemodynamic monitoring product line. We divested this product line in the third quarter of 2003, but continued to provide service to the related customers through April, 2004.

     Systems revenues increased by $1,687,000, or 9.5%, to $19,434,000 for the three-month period ended September 30, 2004 from $17,747,000 for the comparable period in 2003. Systems revenues for the three-month period ended September 30, 2003 included $641,000 related to our divested hemodynamic monitoring line. Systems revenues for the three-month period ended September 30, 2004 did not include any sales from the divested line. The growth in systems revenues was attributable to continued strong sales in most of our core product lines.

     Service revenues decreased by $223,000, or 6.8%, to $3,064,000 for the three-month period ended September 30, 2004 from $3,287,000 for the comparable period in 2003. Service revenues for the three-month period ended September 30, 2003 included $277,000 related to our divested hemodynamic monitoring product line. Service revenues for the three-month period ended September 30, 2004 did not include any sales from the divested line. The increase in service revenues apart from the decline related to the hemodynamic monitoring line was due to increases in services relating to our other product lines.

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     Gross Profit

     Gross profit increased by $1,312,000, or 15.3%, to $9,900,000 for the three-month period ended September 30, 2004, from $8,588,000 for the comparable period in 2003. Gross margin increased to 44.0% for the three-month period ended September 30, 2004 from 40.8% for the comparable period in 2003. The increase in gross margin was primarily attributable to the results of cost reductions that were realized after we completed the consolidation of our manufacturing operations at the end of the fourth quarter of 2003 and the results of product cost reduction initiatives, including design cost reductions and other reductions in the cost of purchased components of our products. A charge to cost of revenues of $262,000 related to the consolidation of our manufacturing operations was included in our cost of sales for the three-month period ended September 30, 2003, thereby reducing gross profit. This adversely impacted gross margin by 1.2 percentage points in that period.

     Gross profit from systems revenues increased by $1,556,000, or 22.0%, to $8,634,000 for the three-month period ended September 30, 2004 from $7,078,000 for the comparable period in 2003. Gross margin from systems revenues increased to 44.4% for the three-month period ended September 30, 2004 from 39.9% for the comparable period in 2003. The increase in gross margin was primarily attributable to the cost reductions relating to our manufacturing facility consolidation and the other product cost reduction measures referred to above. In addition, systems gross profit for the three-month period ended September 30, 2003 included a $240,000 charge related to the consolidation of our manufacturing operations, which is discuss above. There was no similar charge in the current year.

     Gross profit from service revenues decreased by $244,000, or 16.2%, to $1,266,000 for the three-month period ended September 30, 2004 from $1,510,000 for the comparable period in 2003. Gross margin from service revenues decreased to 41.3% for the three-month period ended September 30, 2004 from 45.9% for the comparable period in 2003. The decrease in gross margin was principally attributable to the combination of a change in the service parts sales mix, which fluctuated due to the sale of our hemodynamic monitoring business, and, to a lesser extent, to increases in service staffing levels to provide enhanced support to our customers. In addition, service gross profit for the three-month period ended September 30, 2003 included a $22,000 charge related to the consolidation of our manufacturing operations, which is discuss above. There was no similar charge in the current year.

     Operating Expenses

     Research and development expenses decreased by $87,000, or 4.4%, to $1,882,000 for the three-month period ended September 30, 2004 from $1,969,000 for the comparable period in 2003. This decrease was primarily the result of staffing reductions associated with the sale of our hemodynamic monitoring product line. As a percentage of revenues, research and development expenses decreased to 8.3% for the three-month period ended September 30, 2004 from 9.4% for the comparable period in 2003. This decrease was attributable to lower labor costs and higher revenues during the three-month period ended September 30, 2004 over the comparable period in 2003.

     Sales and marketing expenses increased by $249,000, or 5.5%, to $4,768,000 for the three-month period ended September 30, 2004 from $4,519,000 for the comparable period in 2003. This increase was due principally to variable selling expenses associated with higher sales volumes. As a percentage of revenues, sales and marketing expenses decreased to 21.2% for the three-month period ended September 30, 2004 from 21.5% for the comparable period in 2003. This primarily reflects an increase in revenues for the three-month period ended September 30, 2004 over the comparable period in 2003.

     General and administrative expenses, excluding stock-based compensation expense, increased by $136,000, or 7.4%, to $1,974,000 for the three-month period ended September 30, 2004, from $1,838,000 for the comparable period in 2003. This increase was principally the result of increased audit fees and consulting costs associated with documentation and testing of internal controls in compliance with Section 404 of the Sarbanes-Oxley Act. As a percentage of revenues, general and administrative expenses, excluding stock-based compensation, increased to 8.8% for the three-month period ended September 30, 2004 from 8.7% for the comparable period in 2003, due primarily to the increase in costs referred to above, offset by an increase in revenues for the three-month period ended September 30, 2004 over the comparable period in 2003.

     Stock-based compensation expense for the three-month period ended September 30, 2004 was $18,000, which was the same as the amount expensed for the comparable period in 2003. Stock-based compensation expense for both periods

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relates to the intrinsic value of stock options granted in 2001. We expect to record stock-based compensation expense in the fourth quarter of 2004 at a level similar to the amount recorded in the third quarter of 2004.

     Other Income and Expense

     Total other income was $55,000 for the three-month period ended September 30, 2004, compared to other expense of $61,000 for the comparable period in 2003. This change was principally the result of interest income earned on our substantially increased average cash balances for the three-month period ended September 30, 2004 as compared to interest paid on net borrowings during the comparable period in 2003. Other income during the three-month period ended September 30, 2004 also includes $17,000 in contingent consideration earned during the period relating to the sale of our divested hemodynamic monitoring line.

     Income Taxes

     During the three-month period ended September 30, 2004, net operating loss carryforwards were utilized to offset taxable income. We continue to provide a full valuation allowance against deferred tax assets. Based on a number of factors, including the Company’s prior history of operating losses, we have not determined that it is more likely than not that we will realize the future benefits of a significant portion of our deferred tax assets. Various factors, such as our operating results, may cause our conclusions to change in the future. The full impact of any adjustment to the valuation allowance will be recognized in the period of adjustment by adjusting goodwill, equity, and income from continuing operations, as appropriate. If and when the valuation allowance against deferred tax assets is eliminated, we will be required to recognize income tax expense at statutory rates.

Nine-Month Period Ended September 30, 2004 Compared to the Nine-Month Period Ended September 30, 2003

     Revenues

     Revenues increased by $3,775,000, or 6.1% to $65,798,000 for the nine-month period ended September 30, 2004 from $62,023,000 for the comparable period in 2003. Revenues for the nine-month period ended September 30, 2003 included sales of $2,591,000 related to our hemodynamic monitoring product line. We divested this product line in the third quarter of 2003, but continued to provide service to the related customers through April 2004.

     Systems revenues increased by $4,194,000, or 8.0% to $56,502,000 for the nine-month period ended September 30, 2004 from $52,308,000 for the comparable period in 2003. Systems revenues for the nine-month period ended September 30, 2003 included $1,759,000 related to our divested hemodynamic monitoring product line. Systems revenues for the nine-month period ended September 30, 2004 did not include any sales from the hemodynamic monitoring product line. The growth in our systems revenues during the nine months ended September 30, 2004 was attributable to continued strong sales in most of our product lines.

     Service revenues decreased by $419,000, or 4.3%, to $9,296,000 for the nine-month period ended September 30, 2004 from $9,715,000 for the comparable period in 2003. This decrease was related primarily to the decline in service revenues relating to our divested hemodynamic monitoring line. Service revenues for the nine-month period ended September 30, 2003 included $832,000 related to this divested line, compared to $221,000 for the nine month period ended September 30, 2004.

     Gross Profit

     Gross profit increased by $3,702,000, or 14.9%, to $28,576,000 for the nine-month period ended September 30, 2004 from $24,874,000 for the comparable period in 2003. Gross margin increased to 43.4% for the nine-month period ended September 30, 2004 from 40.1% for the comparable period in 2003. The increase in gross margin was primarily attributable to the results of cost reductions that were realized from the consolidation of our manufacturing operations, which was completed at the end of the fourth quarter of 2003, partially offset by a decline in service margin. To a lesser extent, the increase in gross profit was due to the results of product cost reduction initiatives, including design cost

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reductions and other reductions in the cost of purchased components of our products. In addition, gross profit for the nine-month period ended September 30, 2003 included both a manufacturing consolidation charge of $262,000 and an acquisition-related charge of $300,000, reflecting an upward adjustment to Burdick’s inventory valuation from Burdick’s historical cost at the acquisition date. There were no similar charges in the nine-month period ended September 30, 2004.

     Gross profit from systems revenues increased by $4,321,000, or 21.1%, to $24,836,000 for the nine-month period ended September 30, 2004 from $20,515,000 for the comparable period in 2003. Gross margin from systems revenues increased to 44.0% for the nine-month period ended September 30, 2004 from 39.2% for the comparable period in 2003. This increase in gross margin resulted primarily from the cost reductions realized from our manufacturing facility consolidation and the product cost reduction measures referred to above. In addition, gross margin from systems revenues for the nine-month period ended September 30, 2003 included a manufacturing consolidation charge of $240,000 and an acquisition related charge of $300,000, collectively representing an adverse impact to gross margin from systems revenues of approximately 1.0 percentage point. There were no similar charges during the nine-month period ended September 30, 2004.

     Gross profit from service revenues decreased by $619,000, or 14.2%, to $3,740,000 for the nine-month period ended September 30, 2004 from $4,359,000 for the comparable period in 2003. Gross margin from service revenues decreased to 40.2% for the nine-month period ended September 30, 2004 from 44.9% for the comparable period in 2003. This decrease in gross margin was attributable to a combination of a reduction in service revenues associated with the sale of our hemodynamic monitoring business, increases in service staffing levels to provide enhanced support to our customers and the temporary effects in the first quarter of 2004 of inefficiencies relating to the conversion of our enterprise resource planning system.

     Operating Expenses

     Research and development expenses decreased by $536,000, or 8.9%, to $5,509,000 for the nine-month period ended September 30, 2004 from $6,045,000 for the comparable period in 2003. This decrease was primarily the result of staffing reductions associated with the sale of our hemodynamic monitoring product line. As a percentage of revenues, research and development expenses decreased to 8.4% for the nine-month period ended September 30, 2004 from 9.8% for the comparable period in 2003. This decrease was attributable to lower labor costs and higher revenues during the nine-month period ended September 30, 2004 over the comparable period in 2003.

     Sales and marketing expenses increased by $170,000, or 1.3%, to $13,506,000 for the nine-month period ended September 30, 2004 from $13,336,000 for the comparable period in 2003. This increase was primarily attributable to increases in commission expense associated with higher revenues, partially offset by staffing reductions associated with the sale of our hemodynamic monitoring product line. As a percentage of revenues, sales and marketing expenses decreased to 20.5% for the nine-month period ended September 30, 2004 from 21.5% for the comparable period in 2003. This primarily reflects an increase in revenues for the nine-month period ended September 30, 2004 over the comparable period in 2003.

     General and administrative expenses, excluding stock-based compensation expense, increased by $204,000, or 3.5%, to $6,011,000 for the nine-month period ended September 30, 2004, from $5,807,000 for the comparable period in 2003. This increase was principally the result of increased audit fees and consulting costs associated with documentation and testing of internal controls in compliance with Section 404 of the Sarbanes-Oxley Act. As a percentage of revenues, general and administrative expenses, excluding stock-based compensation, decreased to 9.1% for the nine-month period ended September 30, 2004 from 9.4% for the comparable period in 2003. This primarily reflects an increase in revenues for the nine-month period ended September 30, 2004 over the comparable period in 2003.

     Stock-based compensation expense for the nine-month period ended September 30, 2004 was $54,000, which was the same as the amount expensed for the comparable period in 2003. Stock-based compensation expense for both periods relates to the intrinsic value of stock options granted in 2001.

     Other Income and Expense

     Total other income was $628,000 for the nine-month period ended September 30, 2004, compared to other expense of $186,000 for the comparable period in 2003. The primary component of other income in 2004 was the gain recorded on the sale of our hemodynamic monitoring business of $650,000. During the nine-month period ended September 30, 2004,

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interest income largely offset interest expense, as interest paid on net borrowings during the first part of the period was largely offset by interest income earned on invested cash balances during the latter part of the period. During the same period of 2003, we incurred higher interest expense as our average borrowings were higher.

     Income Taxes

     Income tax provisions recorded in the nine-month period ended September 30, 2004 were due principally to minimum state and local taxes

     During the nine-month period ended September 30, 2004, net operating loss carryforwards were utilized to offset taxable income. We continue to provide a full valuation allowance against deferred tax assets. Based on a number of factors, including the Company’s prior history of operating losses, we have not determined that it is more likely than not that we will realize the future benefits of a significant portion of our deferred tax assets. Various factors, such as our operating results, may cause our conclusions to change in the future. The full impact of any adjustment to the valuation allowance will be recognized in the period of adjustment by adjusting goodwill, equity, and income from continuing operations, as appropriate. If and when the valuation allowance against deferred tax assets is eliminated, we will be required to recognize income tax expense at statutory rates.

Liquidity and Capital Resources

     Net cash flows from operating activities were $2,498,000 for the three-month period ended September 30, 2004, compared to $1,382,000 for the comparable period in 2003. Net cash flows from operating activities of $2,498,000 for the three-month period ended September 30, 2004 was due primarily to net income, excluding non-cash income and non-cash expenses, of $1,727,000, a decrease in inventories of $563,000 and an increase in accrued liabilities of $372,000, which was partially offset by an increase in accounts receivable of $310,000.

     Net cash flows from operating activities were $2,621,000 for the nine-month period ended September 30, 2004, compared to $694,000 for the comparable period in 2003. Net cash flows from operating activities of $2,621,000 for the nine-month period ended September 30, 2004 was due primarily to net income, excluding non-cash income and non-cash expenses, of $4,673,000 and a decrease in inventories of $1,020,000, which was partially offset by an increase in accounts receivable of $1,368,000 and a decrease in accrued liabilities of $1,482,000.

     Cash and cash equivalents at September 30, 2004 increased from balances at December 31, 2003 due primarily to the receipt of proceeds from the completion of our public equity offering in June of 2004 and to cash generated from operations during the period. Cash and cash equivalents, net of debt, at September 30, 2004 was $17,683,000. This compares to total debt, net of cash, of $532,000 at December 31, 2003. Accounts receivable at September 30, 2004 increased from balances at December 31, 2003 due principally to an increase in revenues near the end of the third quarter of 2004, as compared to the end of the fourth quarter of 2003. Inventories decreased at September 30, 2004 from balances at December 31, 2003 due principally to the transfer of inventory related to the Company’s hemodynamic monitoring line to the purchaser of the line and to management’s implementation of inventory reduction measures. Accrued liabilities at September 30, 2004 decreased from balances at December 31, 2003 due principally to payments during the nine-month period ended September 30, 2004 of accrued year-end compensation relating to 2003 sales and operating results, accrued costs relating to the consolidation of manufacturing operations and other accrued liabilities.

     Net cash flows used in investing activities of $468,000 for the nine-month period ended September 30, 2004 consisted of $343,000 for capital expenditures and $125,000 for the purchase of technology for use in future products. In connection with a purchase of technology, we were obligated to pay an additional $125,000, which was paid during the third quarter of 2004. We also have a future royalty obligation related to the technology purchase for each unit sold. Such royalties will be expensed to cost of revenues when incurred. There are no minimum commitments under this obligation. Net cash flows used in investing activities of $20,344,000 for the nine-month period ended September 30, 2003 related primarily to our investment in Burdick of approximately $19,385,000 net of cash acquired, payments of acquisition costs and a refund from the reduction in the purchase price. In addition, during the nine-months ended September 30, 2003, we made capital equipment expenditures of $1,067,000, which were primarily for the purchase of our enterprise resource planning system, offset by proceeds received from sales of capital equipment of $108,000.

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     Net cash flows used in financing activities of $226,000 for the three-month period ended September 30, 2004 related primarily to payments of $340,000 in previously accrued issuance costs associated with our public equity offering, a debt payment of $90,000 related to the note payable issued in the treadmill manufacturing business acquisition and a payment of $125,000 related to an obligation issued in connection with a purchase of technology, partially offset by proceeds from exercises of stock options and the issuance of shares under our employee stock purchase plan aggregating $329,000. Net cash flows used in financing activities of $1,546,000 for the three-month period ended September 30, 2003 was primarily the result of 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, partially offset by proceeds from exercises of stock options and the issuance of shares under our employee stock purchase plan of $135,000.

     Net cash flows from financing activities of $15,436,000 for the nine-month period ended September 30, 2004 relate primarily to proceeds from our public equity offering of $15,451,000, net of payments of issuance costs, and proceeds from exercises of stock options and the issuance of shares under our employee stock purchase plan of $736,000, offset partially by net repayments on our credit line of $354,000, debt payments of $272,000 related to the note payable issued in the treadmill manufacturing business acquisition and a payment of $125,000 related to an obligation issued in connection with a purchase of technology. Net cash flows from financing activities of $719,000 for the nine-month period ended September 30, 2003 was primarily the result of net borrowings on our credit line of $883,000 and proceeds from exercises of stock options and the issuance of shares under our employee stock purchase plan of $404,000, which was partially offset by debt payments of $272,000 related to the note payable issued in the treadmill manufacturing business acquisition and a payment of $296,000 for the redemption of putable warrants.

     We anticipate that our future operating cash flow, existing cash balances and borrowings available to us under credit facilities will be sufficient to meet our operating expenses, working capital requirements, capital expenditures and other obligations for at least twelve months. We anticipate that our credit facility will be renewed or replaced upon its expiration on December 30, 2004. However, we believe that failure to renew or replace this facility will not have a material adverse effect on our liquidity.

Sale of Hemodynamic Monitoring Product Line

     On October 21, 2003, we announced the sale of our hemodynamic monitoring product line. As consideration, we received $1,000,000 in cash and a note payable for $750,000, which was paid on October 20, 2004. The buyer may pay additional contingent consideration of up to $1,500,000 based on future sales of the buyer’s products to our previous hemodynamic products customers. Based on our post-closing transitional responsibilities, which extended into the second quarter of 2004, we previously deferred the recognition of any gain on the transaction. During the second quarter of 2004, we completed all remaining substantive obligations related to the sale of this line and, accordingly, we recognized a gain of $633,000 on the transaction. In addition, during the three months ended September 30, 2004 we recognized $17,000 in additional contingent consideration which was earned during the period.

Public Equity Offering

     In June 2004, we consummated a public offering of our common stock as more fully described in our prospectus dated May 25, 2004 filed with the Securities and Exchange Commission. In the offering, we sold 1,605,976 shares of common stock at a price of $10.50 per share. Proceeds from the offering were $15,451,000, net of underwriting discounts and offering expenses. In addition, a selling shareholder, as named in the prospectus, sold 1,394,024 shares of common stock in this offering. We did not receive any proceeds from the sale of shares by the selling shareholder.

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     Certain Factors that May Affect Future Results or the Trading Price of our Common Stock

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

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

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

•

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

•

changes in our ability to obtain products and product components that are manufactured for us by third parties, such as Holter monitors, as well as variations in prices of these products and product components;

•

delays in the development or commercial introduction of new versions of products and systems;

•

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

•

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

•

the successful implementation of our system-oriented sales approach;

•

changes in the demand for our products and systems;

•

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

•

changes in the mix of products and systems we sell, which could affect our revenue levels as well as our gross margins;

•

unpredictable budgeting cycles of our customers;

•

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

•

increased product and price competition;

•

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

•

the loss of key personnel;

•

the loss of key distributors or distribution companies; and

•

seasonality in the sales of our products and systems.

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

We may make future acquisitions, which involve numerous risks that could impact our business and results of operations.

          As part of our growth strategy, we intend to selectively acquire other businesses, product lines, assets, or technologies. Successful execution of our acquisition strategy depends upon our ability to identify, negotiate, complete and integrate suitable acquisitions. Acquisitions involve numerous risks, including the following:

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•

difficulties in integrating the operations, technologies, and products of the acquired companies;

•

the risk of diverting management’s attention from normal daily operations of the business;

•

potential difficulties in completing projects associated with in-process research and development;

•

risks of entering markets in which we have no or limited direct prior experience and where competitors in such markets have stronger market positions;

•

initial dependence on unfamiliar supply chains or relatively small supply partners;

•

insufficient revenues to offset increased expenses associated with acquisitions;

•

the risk that acquired lines of business may reduce or replace the sales of existing products; and

•

the potential loss of key employees of the acquired companies.

Mergers and acquisitions of high-technology companies are inherently risky, and no assurance can be given that our previous or future acquisitions will be successful and will not materially adversely affect our business, operating results, or financial condition. We must also manage any growth effectively. Failure to manage growth effectively and successfully integrate acquisitions we make could harm our business and operating results in a material way.

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

          Successful continued execution of our acquisition strategy also depends upon our ability to obtain satisfactory debt or equity financing. We may require additional debt or equity financing to make any further significant acquisitions. Such financing may not be available on terms that are acceptable to us or at all. If we are required to incur additional indebtedness to fund acquisitions in the future, our cash flow may be negatively affected by additional debt servicing requirements and the terms of such indebtedness may impose covenants and restrictions that provide us less flexibility in how we operate our business. Fluctuations in our stock price may make it difficult to make acquisitions using our stock as consideration. Moreover, use of our stock to fund acquisitions may have a significant dilutive effect on existing shareholders.

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

          The marketplace for diagnostic cardiology systems is characterized by rapid change and technological innovation, requiring suppliers in the market to regularly update product features and incorporate new technologies in order to remain competitive. In developing and enhancing our products we have made, and will continue to make, assumptions about which features, technology standards and performance criteria will be attractive to, or demanded by, our customers. If we implement features, standards and performance criteria that are different from those required by our customers or if our competitors introduce products and systems that better address these needs, our products may suffer declines in market acceptance or may become obsolete. In that event, our market share and revenues would likely decrease.

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

          To be successful, we must develop and commercialize new versions of our products for both domestic and international markets. Our products are technologically complex and must keep pace with rapid and significant technological change, comply with rapidly evolving industry standards and government regulations, and compete effectively with new product introductions of our competitors. Accordingly, many of our products require significant planning, design, development and testing at the technological, product and manufacturing process levels. Our success in developing and commercializing new versions of our products is affected by our ability to:

•

accurately assess customer needs;

•

develop products that are easy to use;

•

minimize the time required to obtain, as well as the costs of, required regulatory clearance or approval;

•

price competitively;

•		manufacture and deliver on time;
•		accurately predict and control costs associated with manufacturing, installation, warranty and maintenance;

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•

manage customer acceptance and payment;

•

limit demands by our customers for retrofits;

•

access new interface standards needed for product connectivity;

•

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

•

anticipate and compete effectively with our competitors’ efforts.

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

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

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

•

lengthening of buying or selling cycles;

•

the introduction of competing products;

•

price reductions by our competitors;

•

development of more effective products by our competitors;

•

hospital budgetary constraints; and

•

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

          If such conditions force us to sell our products and systems at lower prices, or if we are unable to effectively develop and market competitive products, our market share, margins and operating results will likely decrease.

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

          Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets” requires that we cease amortization of goodwill and other intangible assets determined to have indefinite lives, and established a method of testing these assets for impairment on an annual or on an interim basis if certain events occur or circumstances change that would reduce the fair value of a reporting unit below its carrying value or if the fair value of intangible assets with indefinite lives falls below their carrying value. We also evaluate intangible assets determined to have finite lives for recoverability whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, sale or disposition of a significant portion of the business, or other factors such as a decline in our market value below our book value for an extended period of time. In the case of intangible assets with indefinite lives, we evaluate whether events or circumstances continue to support an indefinite useful life. We evaluate the estimated lives of all intangible assets on an annual basis, including those with indefinite lives, to determine if events and circumstances continue to support an indefinite useful life or the remaining useful life, as applicable, or if a revision in the remaining period of amortization is required. The amount of any such annual or interim impairment charge could be significant, and could have a material adverse effect on our reported financial results for the period in which the charge is taken.

          We own preferred equity securities of a privately held company, ScImage, Inc., which we account for using the cost method. The fair value of our investment is not readily determinable from published market data, so we use our judgment to estimate the fair value. There can be no assurance that the estimated fair value of this investment will not decline to an amount below its carrying amount, in which case we would be required to record a loss on this investment.

If we fail to maintain our relationships with distribution organizations, our sales and operating results may suffer.

          We sell our products to the domestic primary care market and to substantially all international markets principally

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through third party distribution organizations. While we have well established relationships with these distribution organizations, the underlying agreements are generally for periods of one year or less. One of these domestic distribution organizations, Physicians Sales and Service, Inc., accounted for 14% of our revenues in 2003. If these agreements are cancelled or if we are unable to renew them as they expire, our sales and operating results may suffer materially.

          Our international distribution relationships may be terminated on little or no notice because we do not generally have long-term contracts with these distributors. Consequently, our success in expanding international sales may be limited if our international distributors lack, or are unable to develop, relationships with important target customers in international markets.

          If our relationships change with any significant distribution organization, or if any of our distribution organizations devote more effort to selling competing products and systems, our sales and operating results may suffer and our growth may be limited.

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

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

•

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

•

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

•

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

•

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

If suppliers discontinue production of purchased components of our products and we are unable to secure alternative sources for these components on a timely basis, our ability to ship products to our customers may be adversely affected, our revenues may decline and our costs may increase as a result.

          For a variety of reasons, including but not limited to relatively low volumes, our suppliers may discontinue production of component parts for our products. Alternative sources of these components may result in higher costs. In addition, if we are unable to secure alternative sources for these components, significant delays in product shipments may result while we re-engineer our products to utilize available components. This could result in reduced revenues, higher costs or both.

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

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

•

failure to achieve market acceptance;

•

loss of customers, revenues, and market share;

•

diversion of development resources;

•		increased service and warranty costs;
•		legal actions by our customers; and

•

increased insurance costs.

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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.

Recent and future federal and state regulations in the U.S. relating to patient privacy could impose burdens on us.

          Federal and state laws regulate the confidentiality of certain patient health information, including patient records, and the use and disclosure of that “protected health information.” We are subject to these regulations when we access, collect, and analyze patient data. Our compliance obligations with these regulations would include agreeing, typically by contract, to use that protected health information only for certain purposes, to safeguard that information from misuse and to help those providers comply with their duties to provide patients with access to their health information. Failure to comply with these regulations could restrict our ability to sell products to customers and could result in penalties, which could negatively impact our financial results. In addition, our products must have features that permit health care providers to comply with these regulations. We continually evaluate the applicability of these regulations to our existing and new products and services and our compliance obligations. To the extent these regulations change in the future, we may need to devote additional resources in the future in order to comply with these regulations.

We depend on the expertise of key personnel to manage our businesses effectively in a changing market, and if we lose one or more members of our senior management team or if our management team does not work together effectively, our business could be harmed.

          The success of our business depends in part on key managerial, sales and technical personnel, as well as our ability to continue to attract and retain additional highly qualified personnel. We compete for such key personnel with other companies, academic institutions, government entities, and other organizations. We do not have agreements whereby our employees agree not to compete with us, nor do we maintain key person life insurance on any of our executive officers. Our ability to maintain and expand our business may be impaired if we are unable to retain our current key personnel, hire or retain other qualified personnel in the future, or if our key personnel decided to join a competitor or otherwise compete with us.

          Several of our existing management personnel have held their current positions for less than two years, including our Vice President, Acute Care, Vice President, Marketing and Vice President, Operations. Our future success depends to a significant extent on the ability of our executive officers and other members of our management team to operate effectively, both individually and as a group. Our business may be harmed if we do not successfully allocate responsibilities among our management team or if some of our management do not succeed in their roles.

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Competition may decrease our market share and cause our revenues to decrease.

          The diagnostic cardiology systems market is highly competitive and we expect competition to intensify in the future. Some of our competitors are larger companies, such as General Electric Company and Koninklijke Philips Electronics N.V., and may have:

•

greater financial and other resources;

•

greater variety of products;

•

greater pricing flexibility;

•

more extensive technical capabilities;

•

patent portfolios that may present an obstacle to our conduct of business;

•

stronger name recognition; and

•

larger distribution networks.

          As a result, we may be unable to offer products similar to, or more desirable than, those offered by our competitors, market our products as effectively as our competitors, price our products competitively or otherwise respond successfully to competitive pressures. In addition, our competitors may be able to offer discounts on competing products as part of a “bundle” of non-competing products, systems, and services that they sell to our customers, and we may not be able to profitably match those discounts. Our competitors may develop technologies and products that are more effective than those we currently offer or that render our products obsolete or noncompetitive. In addition, the timing of the introduction of competing products into the market could affect the market acceptance and market share of our products. If we are unable to develop competitive products, gain regulatory approval or clearance and supply sufficient quantities of such products to the market as quickly and effectively as our competitors, market acceptance of our products may be limited, and our revenues and operating results may suffer.

If we do not maintain or grow revenues from our support services or consumables, our operating and financial results may be negatively impacted.

          A significant portion of our revenues is generated from post-sale support services we provide for our products and from the sale of ancillary cardiology products and consumables related to our products and systems, such as patented electrodes, pads, cables, leads, and thermal chart paper. As hospitals expand their in-house capabilities to service diagnostic equipment and systems, they may be able to service our products without additional support from us. In addition, our customers may express an increasing preference for ancillary cardiology products and consumables that are manufactured or provided by other vendors. Any of these events could result in a decline in our revenues and a resulting adverse effect on our financial and operating results.

Failure to adequately protect our intellectual property rights will cause our business to suffer.

          Our success depends in part on obtaining, maintaining, and enforcing our copyrights, patents and other proprietary rights, and our ability to avoid infringing the proprietary rights of others. We take precautionary steps to protect our technological advantages and intellectual property and rely in part on patent, trade secret, copyright, know-how, and trademark laws, license agreements and contractual provisions to establish our intellectual property rights and protect our products. The precautionary steps we have taken may not adequately protect our intellectual property rights.

          Our patents may not provide commercially meaningful protection, as competitors may be able to design around our patents. We may not be able to protect our rights in unpatented technology, trade secrets, and confidential information effectively. We require our new employees, consultants, and corporate partners to execute a confidentiality agreement at the commencement of their employment or consulting relationship with us. However, these agreements may not provide effective protection of our information or, in the event of unauthorized use or disclosure, they may not provide adequate remedies.

If third parties claim that our products infringe their intellectual property rights, we may be forced to expend significant financial resources and management time and our operating results would suffer.

          Third parties may claim that our products and systems infringe on third-party patents and other intellectual property rights. Identifying third-party patent rights can be particularly difficult because, in the U.S., patent applications are maintained

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in secrecy for up to eighteen months after their filing dates. Moreover, patent applications can be maintained in secrecy until they issue, if they were filed before November 29, 2000, are not subject to publication in any country, or have otherwise properly requested maintaining secrecy to issuance. Some companies in the medical device industry have used intellectual property infringement litigation to gain a competitive advantage. In the event a competitor were to challenge our patents or licenses, or assert that our products infringe its patent or other intellectual property rights, we could incur substantial litigation costs, be forced to make expensive changes to our product designs, license rights in order to continue manufacturing and selling our products, or pay substantial damages. Third-party infringement claims, regardless of their outcome, would not only drain our financial resources but also divert the time and effort of our management and could result in our customers or potential customers deferring or limiting their purchase or use of the affected products until resolution of the litigation.

If we fail to successfully enter into strategic alliances to generate growth, our operating results may be negatively affected.

          A component of our growth strategy is to enter into strategic alliances in order to complement and expand our current product and service offerings and distribution. There can be no assurances that a strategic alliance will perform as expected or generate significant revenues or profits. If we do not identify potential strategic alliances or enter into strategic alliances that fail to generate additional revenue, our operating and financial results may be negatively impacted.

Our reliance on a principal manufacturing facility may impair our ability to respond to natural disasters or other unforeseen catastrophic events.

          Our principal manufacturing facility is located in a single building in Deerfield, Wisconsin. Despite precautions taken by us, a natural disaster or other unanticipated catastrophic events at this building could significantly impair our ability to manufacture our products and operate our business. Our facility and certain manufacturing equipment would be difficult to replace and could require substantial replacement lead-time. Such catastrophic events may also destroy any inventory of product or components. While we carry insurance for natural disasters and business interruption, the occurrence of such an event could result in losses that exceed the amount of our insurance coverage, which would impair our financial results.

Compliance with changing regulation of corporate governance, public disclosure and accounting matters may result in additional expenses.

          Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002 and new rules subsequently implemented by the SEC and The NASDAQ Stock Market, as well as new accounting pronouncements, are creating uncertainty and additional complexities for companies. To maintain high standards of corporate governance, public disclosure and financial reporting, we continue to invest resources to comply with evolving standards. This investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue generating and cost management activities.

We are dependent upon licensed and purchased technology for some of our products, and we may not be able to renew these licenses or purchase agreements in the future.

          We license and purchase technology from third parties for features in some of our products. We anticipate that we will need to license and purchase additional technology to remain competitive. We may not be able to renew our existing licenses and purchase agreements or to license and purchase other technologies on commercially reasonable terms or at all. If we are unable to renew our existing licenses and purchase agreements or we are unable to license or purchase new technologies, we may not be able to offer competitive products.

Delaware law and provisions in our charter could make the acquisition of our company by another company more difficult.

          Certain provisions of our certificate of incorporation and bylaws may make it more difficult for a third party to acquire, or discourage a third party from attempting to acquire us. This could limit the price that certain investors might be willing to pay in the future for shares of our common stock. Our certificate of incorporation and bylaws allow us to issue preferred stock without any vote or further action by the stockholders, eliminate the right of stockholders to act by written consent without a meeting, provide that special meetings of stockholders may be called only by our board of directors, the chairman of our board, or our president, specify advance notice procedures for director nominations by stockholders and submission of other proposals for consideration at stockholder meetings, and eliminate cumulative voting in the election of

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directors. Moreover, our board of directors is divided into three classes, with directors in each class elected to staggered three year terms, and directors may only be removed by the stockholders for cause. Some provisions of Delaware law could also delay or make more difficult a third party’s efforts to effect a merger with or tender offer for us, including Section 203 of the Delaware General Corporation Law, which prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years unless certain conditions are met. Similar provisions under Washington law may also apply. The possible issuance of preferred stock, our classified board, procedures required for director nominations and stockholder proposals and Delaware law could have the effect of delaying, deferring or preventing a change in control of our company, including without limitation, discouraging a proxy contest or making more difficult the acquisition of a substantial block of our common stock.

Future changes in the accounting treatment for employee stock options may cause adverse unexpected fluctuations and affect our reported results of operations.

          We currently elect to apply the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” In accordance with the provisions of SFAS 123, we apply Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for our stock option plans. Under this election, we account for stock options granted to employees using the intrinsic value method of accounting. Under this method, employee stock-based compensation expense is based on the difference, if any, between the fair value of our stock and the exercise price of the award on the grant date. On March 31, 2004, the Financial Accounting Standards Board, or FASB, the principle United States accounting standards setting organization, issued a draft accounting pronouncement, referred to as the exposure draft, which, if implemented, will require us to record an expense for all outstanding unvested stock options and grants of new stock options effective for fiscal periods beginning after June 15, 2005. The exposure draft would also require us to record an expense for our employee stock purchase plan. There is considerable uncertainty as to how the final pronouncement will deal with those issues and certain portions of the exposure draft may change. If we are required to change our accounting policy in accordance with this exposure draft, our reported earnings, beginning in the third quarter of 2005, would most likely be significantly negatively impacted.

If we eliminate the valuation allowance against our deferred tax assets, we will be required to recognize income tax expense at statutory rates in future periods, which will materially adversely impact our net income.

          We account for income taxes pursuant to the provisions of SFAS No.109, “Accounting for Income Taxes.” We have recorded a valuation allowance for the net balance of our deferred tax assets as a result of uncertainties regarding realization of these assets, including our historical lack of profitability, until recently, and the uncertainty as to the sustainability of our recently achieved profitability. The deferred income tax assets primarily relate to net operating losses, “NOL”, we have incurred in prior years and tax credits, both of which are available to reduce income taxes in future periods. As we continue to periodically assess our future operating plans and prospects, we may become convinced that we will remain profitable into the foreseeable future and that the recognition of the benefit of our deferred tax asses has become “more likely than not”, in which case, we would remove some or all of the remaining valuation allowance and recognize on our deferred tax assets. After the valuation allowance has been removed, we would be required to recognize and record federal income tax expense at statutory rates in subsequent periods, which would have an adverse impact on net income. Until our NOL and tax credit carryforwards are exhausted, we will not be required to make cash payments for income taxes other than for federal alternative minimum taxes and some state minimum taxes.

The market price of our stock may be highly volatile.

          During the nine months ended September 30, 2004, our common stock traded between a range of $7.06 and $14.00 per share. The market price of our common stock could continue to fluctuate substantially due to a variety of factors, including:

•		quarterly fluctuations in results of our operations;
•		our ability to successfully commercialize our products;

•

changes in coverage or earnings estimates by analysts;

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•

impact of acquisitions, divestitures, strategic alliances, and other significant corporate events;

•

changes in the mix of products and systems we sell, which could affect our gross margins;

•

the loss of key distributors or distribution companies; and

•

seasonality in the sales of our products and systems.

          The market price for our common stock may also be affected by our ability to meet analysts’ expectations. Any failure to meet such expectations, even slightly, could have an adverse effect on the market price and volume fluctuations. This volatility has had a significant effect on the market prices of securities issued by many companies for reasons unrelated to the operating performance of these companies. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against the company. If similar litigation were instituted against us, it could result in substantial costs and a diversion of our management’s attention and resources, which could have an adverse effect on our business, results of operations and financial condition. See “Item 5: Market for Company’s Common Stock and Related Shareholder Matters” in our Form 10-K for the year ended December 31, 2003 for more information regarding fluctuations in the price of our common stock.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

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

Item 4. Controls and Procedures

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

     There has been no change in our internal control over financial reporting during the three-month period ended September 30, 2004 in connection with this evaluation that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II — OTHER INFORMATION

Item 1. Legal Proceedings

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

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

          None.

Item 3. Defaults Upon Senior Securities

          None.

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

          None.

Item 5. Other Information

          None.

Item 6. Exhibits

     (a) Exhibits

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SIGNATURE

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

	QUINTON CARDIOLOGY SYSTEMS, INC.
	By:	/s/ Michael K. Matysik
		Michael K. Matysik
		Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)

Date: November 9, 2004

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