UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2005

OR

For the transition period from ___________ to _____________

Commission file number 000-30755

CEPHEID

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes þ No o

As of April 29, 2005, there were 42,457,808 shares of the registrant’s common stock outstanding.

REPORT ON FROM 10-Q FOR THE
QUARTER ENDED MARCH 31, 2005

INDEX

Cepheid®, the Cepheid logo, SmartCycler® and GeneXpert® are registered trademarks of Cepheid. All other trademarks, service marks or trade names referred to in this report are the property of their respective owners.

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ITEM 1. FINANCIAL STATEMENTS

CEPHEID

See accompanying notes

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CEPHEID

See accompanying notes.

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CEPHEID

See accompanying notes.

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CEPHEID

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

1. Organization and Summary of Significant Accounting Policies

Organization and Business

Cepheid (the Company) was incorporated in the State of California on March 4, 1996. The Company develops, manufactures, and markets fully-integrated systems that perform genetic analysis for the clinical genetic assessment, life sciences and biothreat markets. The Company’s systems enable rapid, sophisticated genetic testing of organisms by automating otherwise complex manual laboratory procedures.

The condensed consolidated balance sheet at March 31, 2005 and the condensed consolidated statements of operations and cash flows for the three months ended March 31, 2005 and 2004 are unaudited. In the opinion of management, these condensed consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) that are necessary for a fair presentation of the results for and as of the periods shown. The accompanying condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States. However, certain information or footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The results of operations for such periods are not necessarily indicative of the results expected for 2005 or for any future period. The condensed consolidated balance sheet information as of December 31, 2004 is derived from audited financial statements as of that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. These financial statements should be read in conjunction with the financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2004 filed with the Securities and Exchange Commission.

Principles of Consolidation

The consolidated financial statements of Cepheid include the accounts of the Company and its wholly-owned subsidiary in France. The functional currency of the French subsidiary is the U.S. dollar; accordingly, all gains and losses arising from foreign currency transactions in currencies other than the U.S. dollar are included in the consolidated statements of operations. All significant intercompany balances and transactions have been eliminated in the consolidation.

Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from these estimates.

Inventory

Inventory is stated at the lower of standard cost (which approximates actual cost) or market, with cost determined on the first-in-first-out (FIFO) method.

The Company maintains a reserve for inventory obsolescence. This reserve is established utilizing management’s estimate of the potential future obsolescence of inventory. The reserve for inventory obsolescence was $0.4 million and $0.7 million, respectively, at March 31, 2005 and December 31, 2004.

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     The components of inventory were as follows (in thousands):

Intangible Assets

As of March 31, 2005, intangible assets consisted primarily of rights to certain patented technologies licensed from Applera Corporation and F. Hoffmann-La Roche Ltd. (Roche). Amortization of intangible assets is included in cost of product sales in the accompanying consolidated statements of operations. The Company reviews its intangible assets for impairment at least annually, or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.

Intangible assets are recorded at cost, less accumulated amortization. Intangible assets are amortized over their estimated useful lives, ranging from 5 to 15 years, on a straight-line basis.

Amortization expense of intangible assets was $0.6 million and zero for the three months ended March 31, 2005 and 2004, respectively. The expected future annual amortization expense of intangible assets recorded on our balance sheet as of March 31, 2005 is as follows (in thousands):

Warranty Accrual

The Company warrants its instrument products to be free from defects for a period of 12 to 15 months from the date of sale. Accordingly, a provision for the estimated cost of warranty repair is recorded at the time revenue is recognized. The Company’s warranty accrual is established using management’s estimate for the future costs of repairing any instrument failures during the warranty period. As of March 31, 2005 and December 31, 2004, the accrued warranty liability was $0.3 million and $0.4 million, respectively. The activity in the warranty accrual for the three months ended March 31, 2005 and 2004 consisted of the following (in thousands):

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Revolving Line of Credit

In November 2004, the Company entered into an agreement with a financial lending institution for a revolving line of credit totaling $4.0 million of which up to $2.0 million may be used for letters of credit, which is collateralized by the Company’s accounts receivables and bears an annual interest rate equal to the lender’s prime rate. The interest rate at March 31, 2005 was 5.75%. The line of credit contains a financial covenant that requires the Company to maintain at least a $5.0 million balance in investments with the lender and a minimum of $25.0 million in unrestricted cash in total. The agreement contains a clause which indicates that if a material adverse event occurs, this could be considered to be an event of default which may cause the amount due under the agreement to be paid before maturity. No such event has occurred as of March 31, 2005. The line of credit expires in November 9, 2006, at which time any outstanding balance on the line of credit will be due. As of December 31, 2004 and March 31, 2005, we have $4.0 million outstanding under this line.

Revenue Recognition

The Company recognizes revenue from product sales and contract arrangements. From time to time, the Company enters into revenue arrangements with multiple deliverables. Multiple element revenue agreements entered into on or after July 1, 2003 are evaluated under Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables,” to determine whether the delivered item has value to the customer on a stand-alone basis and whether objective and reliable evidence of the fair value of the undelivered item exists. Deliverables in an arrangement that do not meet the separation criteria in Issue 00-21 must be treated as one unit of accounting for purposes of revenue recognition. Advance payments received in excess of amounts earned, such as funds received in advance of products to be delivered or services to be performed, are classified as deferred revenue until earned.

The Company recognizes revenue from product sales when there is persuasive evidence that an arrangement exists, delivery has occurred, the price is fixed or determinable and collectibility is reasonably assured. No right of return exists for the Company’s products except in the case of damaged goods. The Company has not experienced any significant returns of its products.

Contract revenues include fees for technology licenses and research and development services, royalties under license and collaboration agreements and fees for services rendered under research and development arrangements. Contract revenue related to technology licenses is generally fully recognized only after both the license period has commenced, the technology has been delivered and no further involvement of the Company is required. For example, the $10.0 million license execution fee from the bioMerieux collaboration in 2003 was deferred and is being amortized over the period of approximately five years from the effective date of the collaboration, which represents the estimated period of the Company’s continuing involvement under the collaboration agreement. Royalties are typically based on licensees’ net sales of products that utilize the Company’s technology, and royalty revenues are recognized as earned in accordance with the contract terms when the royalties can be reliably measured and their collectibility is reasonably assured, such as upon the receipt of a royalty statement from the customer.

Grant and government sponsored research revenue and contract revenue related to research and development services are recognized as the related services are performed based on the performance requirements of the relevant contract. Under such agreements, the Company is required to perform specific research and development activities and is

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compensated either based on the costs, or costs plus a mark-up, associated with each specific contract over the term of the agreement or when certain milestones are achieved.

Stock-Based Compensation

The Company accounts for its employee stock option and stock purchase plans using the intrinsic value method in accordance with Accounting Principle Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Accordingly, the Company does not recognize compensation expense for employee or director stock options granted with an exercise price of not less than fair market value of the stock when the option is granted. For purposes of disclosures pursuant to Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (SFAS 123), as amended by SFAS 148, “Accounting for Stock-Based Compensation, Transition and Disclosure,” the estimated fair value of options is amortized to expense over the options’ vesting periods. The following table illustrates the effect on net loss and net loss per share if the Company had applied the fair value recognition provision of SFAS 123 to stock-based employee compensation (in thousands, except per share data). Pro forma amounts may not be representative of future periods.

The fair value of these options was estimated at the date of grant using the Black-Scholes option pricing model, with the following weighted-average assumptions:

The weighted-average fair value of options granted during the three months ended March 31, 2005 and 2004 was $10.30 and $8.28, respectively. All options were granted with exercise prices which equaled the fair market value of the underlying common stock on the date of grant.

The fair value option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

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In December 2004, the Financial Accounting Standard Board (FASB) issued SFAS 123R, “Share-Based Payment”, which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation”. SFAS 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and amends SFAS No. 95, “Statement of Cash Flows”. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. The new rules would be effective for the Company beginning January 1, 2006. The Company is currently evaluating option valuation methodologies and assumptions in light of SFAS 123R related to employee stock options.

Net Loss Per Share

Basic net loss per share has been calculated based on the weighted-average number of common shares outstanding during the period, less shares subject to the Company’s right of repurchase. Common stock equivalents consisting of stock options and warrants (calculated using the treasury stock method) have been excluded from the computation of diluted net loss per share, as their inclusion would be antidilutive for all periods presented.

The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share data):

Comprehensive Loss

Comprehensive loss includes net loss as well as other comprehensive income or loss. The Company’s other comprehensive income or loss consists of foreign currency translation adjustments and unrealized gains and losses on available-for-sale securities. Total accumulated other comprehensive income or loss is displayed as a separate component of shareholders’ equity in the accompanying consolidated balance sheets. The following table presents the calculation of comprehensive loss, including components of other comprehensive income (loss):

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Reclassifications

Certain prior period balances have been reclassified to conform to the current period presentation. This resulted as certain items became significant in the current year and were presented separately on the face of the financial statements.

2. Segment and Significant Concentrations

The Company and its wholly owned subsidiary operate in only one business segment.

The Company currently sells its products through its direct sales force and through third-party distributors. For the three months ended March 31, 2005, there were two direct customers that represented 68% and 12% of total product sales. For the three months ended March 31, 2004, there were two direct customers that represented 27% and 25% of total product sales. The Company has distribution agreements with Fisher Scientific Company L.L.C. to market the Cepheid SmartCycler system in the U.S. and Canada. The Company also has several regional distribution arrangements throughout Europe, Japan, South Korea, China, Mexico and other parts of the world. Information about sales through distributors for the three months ended March 31, 2005 and 2004 was as follows:

No single country outside of the United States represented more than 10% of the Company’s total revenues, total assets or total property, plant and equipment in any period presented.

3. Patent License Agreements

In April 2004, the Company entered into a patent license agreement with Applera Corporation, through its Applied Biosystems group (ABI) and its Celera Diagnostics joint venture, for a non-exclusive worldwide license to make, use, and sell the Company’s products incorporating technology covered by Applera patents. The Company also entered into a patent license agreement with F. Hoffmann-La Roche Ltd. (Roche), effective July 1, 2004, for a non-exclusive worldwide license to make, use, and sell the Company’s products incorporating technology covered by Roche patents. Under the license agreements, the Company agreed to pay aggregate license fees of $32.2 million, of which $13.5 million had been paid as of March 31, 2005, $10.0 million will be paid in the remainder of 2005, and $8.7 million will be paid in 2006. In connection with the license agreements, the Company recorded intangible assets of $31.1 million, representing the present value of license fee obligations net of imputed interest of $1.1 million. The intangible assets related to the Applera and Roche licenses are being amortized on a straight-line basis over their useful lives of approximately 10 and 15 years, respectively, with the amortization recorded as part of the cost of product sales. The Company also paid approximately $1.2 million in back royalties related to the Applera license. This amount was expensed during the quarter ended March 31, 2004.

The Company also agreed to pay Applera and Roche ongoing royalties on sales of any products incorporating the licensed patents. Resulting product royalties are recorded as part of the cost of product sales when the related product sales are recognized.

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4. Collaboration Profit Sharing

Collaboration profit sharing represents the amount the Company pays to ABI under its collaboration agreement to develop reagents for use in the BDS developed for the USPS. Under the agreement, a computed gross margin on anthrax cartridge sales is shared equally between the two parties. As of March 31, 2005 and 2004, the accrued profit sharing liability was $2.2 million and $0.7 million, respectively. Collaboration profit sharing expense was $3.6 million and $0.4 million for the three months ended March 31, 2005 and 2004, respectively. The total revenues and cost of sales related to these cartridge sales is included in the respective balances in the statement of operations.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “intend,” “potential” or “continue” or the negative of these terms or other comparable terminology. Forward-looking statements are based upon current expectations that involve risks and uncertainties. Our actual results and the timing of events could differ materially from those anticipated in our forward-looking statements as a result of many factors, including, but not limited to, the following: the scope and timing of actual USPS funding and deployment of the BDS; the rate of environmental testing using the BDS conducted by the USPS, which will affect the amount of consumable products sold; whether the BDS, as-built, performs to specifications; development and manufacturing problems, including with respect to the GeneXpert system and reagents; the need for additional licenses for new tests and other products and the terms of such licenses; our ability to successfully commercialize our stand-alone GeneXpert system; our ability to successfully sell products in the clinical market; lengthy sales cycles in certain markets; the performance and market acceptance of our new products; our ability to obtain regulatory approvals and introduce new products into the clinical market; our reliance on distributors to market, sell and support our products; the occurrence of unforeseen expenditures, asset impairments, acquisitions or other transactions; our success in increasing our direct sales; the impact of competitive products and pricing; our ability to manage geographically-dispersed operations; underlying market conditions worldwide; and the other risks set forth under “Risk Factors” and elsewhere in this report. We assume no obligation to update any of the forward-looking statements after the date of this report or to conform these forward-looking statements to actual results.

OVERVIEW

We develop, manufacture, and market fully-integrated systems that perform genetic analysis, including DNA or RNA analysis, for the clinical genetic assessment, life sciences and biothreat markets. Our systems enable rapid, sophisticated genetic testing of organisms and genetic based diseases by automating otherwise complex manual laboratory procedures. Genetic testing involves a number of complicated steps, including sample preparation, amplification and detection. Based on state-of-the-art microfluidic and microelectronic technologies, our easy-to-use systems integrate these steps and analyze complex biological samples in our proprietary test cartridges. We are focusing our efforts on those applications where rapid genetic testing is particularly important, such as the infectious disease, cancer and biothreat testing markets. In particular, we have designed our systems to be capable of use in clinical genetic assessment. We have designed our systems to perform a broad range of genetic tests that are used to identify infectious organisms, enhance cancer management and care and identify organisms that could be used as bio-terrorism agents.

Our two principal product platforms are our SmartCycler and GeneXpert systems. Our initial product platform, the SmartCycler, integrates DNA amplification and detection to allow rapid genetic analysis of a sample. We commenced sales of the SmartCycler in May 2000 and we have sold more than 2,000 units to date to a wide range of customers. Our second product platform, the GeneXpert, integrates automated sample preparation with our SmartCycler amplification and detection technology. We launched the GeneXpert system in the biothreat market in the third quarter of 2004 and anticipate its commercial launch in the clinical genetic assessment market in the first half of 2005. Development of our initial FDA product for detection of Group B Strep (GBS) continues on the GeneXpert system and

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a second generation version of GBS on the SmartCycler system is also being developed. We have modified our development and clinical plans to potentially enable simultaneous introduction of both the GeneXpert and SmartCycler versions of the product at the end of this year or early 2006. We sell our products through both direct sales and various distribution channels worldwide. In addition to our own activities, we are collaborating with strategic partners to co-develop assays for use on our instruments.

A Northrop Grumman-led consortium that includes Cepheid and other subcontractors has developed the Biohazard Detection System (BDS) for the United States Postal Service (USPS). This consortium was awarded a production contract with the USPS which has two phases which have both been exercised. We completed shipping GeneXpert modules to be utilized with phase 1 installations and began shipping GeneXpert modules to be utilized with phase 2 installations during the first quarter of 2005.

In December 2003, we entered into an agreement for a strategic commercial relationship with bioMerieux for bioMerieux to develop DNA testing products using their proprietary Nucleic Acid Sequence-Based Amplification (NASBA) technology to be run on systems employing our GeneXpert platforms. Under the agreement, bioMerieux has paid us a $10.0 million license fee, and an additional $5.0 million payment will become due when and if bioMerieux commercializes its first product based on our technology. We may also receive potential product purchases and royalty payments on end-user GeneXpert test cartridge sales under the agreement if any such products are introduced. The $10.0 million license fee received from bioMerieux was deferred and is being amortized over the period of approximately five years from the effective date, which represents the estimated period of our continuing involvement under the collaboration agreement.

During the second quarter of 2004, we entered into a patent license agreement with Applera Corporation, through its Applied Biosystems business group (ABI) and its Celera Diagnostics joint venture, and, effective July 1, 2004, we entered into a patent license agreement with F. Hoffmann-La Roche Ltd. (Roche), each of which provides for non-exclusive worldwide licenses to make, use, and sell our products incorporating technologies covered by Applera’s and Roche’s respective patents. Under the license agreements, we agreed to pay aggregate license fees of $32.2 million, of which $13.5 million had been paid as of March 31, 2005, $10.0 million will be paid in the remainder of 2005, and $8.7 million will be paid in 2006. We also agreed to pay Applera and Roche ongoing royalties on sales of products incorporating their licensed patents. In connection with the license agreements, we recorded intangible assets of $31.1 million, representing the present value of license fee obligations net of imputed interest of $1.1 million. The intangible assets related to the Applera and Roche licenses are being amortized on a straight-line basis over their useful lives of approximately 10 and 15 years, respectively, with the amortization recorded as part of the cost of product sales.

Sales Channels

We sell our products through both direct and other various distribution channels. In the United States, we sell through our direct sales force in the life sciences and clinical genetic assessment markets, as well as through a non-exclusive distributor, Fisher Scientific Company L.L.C. (Fisher), in the life sciences market. In Europe, we sell primarily through distributors. In Japan and other parts of the world, we sell solely through distributors. Through Cepheid SA, our French subsidiary, we have established additional distributors in Europe, the Middle East, India and South Africa, leading to increased product sales in those regions. We expect to continue to expand sales into other territories throughout the world by adding new distributors. For example, we added distributors in Mexico, Brazil and China in 2004.

Revenues

During the first quarter of 2005, we derived our revenues primarily from sales of GeneXpert anthrax cartridges and modules to Northrop Grumman and Smiths Detection for use in the USPS program, from sales of SmartCyclers and associated disposables and reagents and, to a lesser extent, from contract revenue primarily derived from the amortization of the up-front license payments in connection with our collaboration with bioMerieux described above. For the remainder of 2005, we expect sales of GeneXpert anthrax cartridges to contribute a substantial portion of our revenue as the USPS BDS program continues.

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CRITICAL ACCOUNTING POLICIES, ESTIMATES AND ASSUMPTIONS

We consider our accounting policies related to revenue recognition, impairment of intangible assets, inventory reserve, warranty accrual and stock based compensation to be critical accounting policies. Inherent in our determination of when to recognize revenue and how to evaluate our intangible assets, and in our calculation of our inventory reserve, warranty accrual and stock compensation expense, are a number of significant estimates, assumptions and judgments. These estimates, assumptions, and judgments include deciding whether the elements required to recognize revenue from a particular arrangement are present, estimating the fair value of an intangible asset, which represents the future undiscounted cash flows to be derived from the intangible asset, and estimating the amount of inventory obsolescence and warranty costs associated with shipped products and estimating the useful life and volatility of stock awards granted. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates. There have been no material changes to our critical accounting policies since we filed our 2004 Annual Report on Form 10-K with the Securities and Exchange Commission. For a description of our critical accounting policies, please refer to our 2004 Annual Report on Form 10-K.

Results of Operations

Comparison of the Three Months Ended March 31, 2005 and 2004

Revenues

Total revenues increased 169% to $19.6 million in the first three months of 2005 from $7.3 million for the same period in the prior year. This increase in total revenues was primarily due to an overall increase in product sales which was driven in large part by sales related to the USPS BDS arrangement.

Product Sales

Total product sales increased 182% to $18.8 million in the first three months of 2005 from $6.6 million for the same period in the prior year. The increase was primarily due to increased sales volume of GeneXpert modules and cartridges to Smiths Detection and Northrop Grumman for deployment of BDS units in major USPS mail processing centers throughout the United States. In the first three months of 2005, product sales to these two direct customers represented 68% and 12% of total product sales. In the first three months of 2004, product sales to these two direct customers represented 27% and 25% of total product sales. In the three months ended March 31, 2005 and 2004, product sales through distributors represented 10% and 32%, respectively, of our total product sales (including instruments, reagents and disposables). The following table provides a breakdown of our product sales by geographic regions:

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No single country outside of the United States represented more than 10% of our total revenues in any period presented.

Contract Revenues

Contract revenues remained constant at $0.6 million during the first three months of 2005 when compared to the same period in the prior year. These revenues related to the amortization of license fees in conjunction with our collaboration agreement with bioMerieux, Inc. We do not expect contract revenue to be a significant component of 2005 revenue.

Costs and Operating Expenses

Cost of Product Sales

Cost of product sales consists of raw materials, direct labor, manufacturing overhead, facility costs and warranty costs. Cost of product sales also includes royalties on product sales and amortization of intangible assets related to technology licenses. As a result of the increased product sales discussed above, cost of product sales increased 240% to $10.3 million during the three months ended March 31, 2005 compared to $3.0 million during the same period in the prior year. Our product gross margin percentage on product sales for the three months ended March 31, 2005 was 45% compared to 55% during the same period in the prior year. The decrease in gross margin percentage compared to the prior year quarter results primarily from increased royalty expense of 7% due to the execution of our license agreement with Roche and ABI in Q2 2004 and Q3 2003, respectively, a decrease in standard manufacturing margin of 2% due to one-time favorable product pricing during the prior year period and an increase in inventory reserves which accounted

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for a 1% change. We expect our gross margin percentage on product sales for future quarters in 2005 to be in the range of 45% — 49%.

Collaboration Profit Sharing

Collaboration profit sharing represents the amount that we pay to ABI under our collaboration agreement to develop reagents for use in the BDS developed for the USPS. Under the agreement, computed gross margin on anthrax cartridge sales are shared equally between the two parties. The collaboration profit sharing was $3.6 million and $0.4 million in the three months ended March 31, 2005 and 2004, respectively. The increase in collaboration profit sharing was the result of increased anthrax cartridge sales under the USPS BDS program and this expense will remain proportional to the sales of anthrax cartridges under the USPS BDS program.

Research and Development Expenses

Research and development expenses consist of salaries and personnel-related expenses, research and development materials, facility costs and depreciation. Research and development expenses increased 24% to $4.5 million for the three months ended March 31, 2005 from $3.6 million for the same period in the prior year. This increase resulted primarily from a $0.4 million increase in salaries and personnel-related expenses and a $0.5 million increase in supplies, both needed for clinical product development. We expect that our quarterly research and development expenses will increase during the remainder of 2005 compared to the three months ended March 31, 2005 as we increase our assay development costs and incur additional clinical trial costs related to the clinical trials for our GBS, GeneXpert and SmartCycler systems and Enterovirus test for use on our GeneXpert system.

Selling, General and Administrative Expenses

Selling, general and administrative expenses consist primarily of salaries and personnel-related expenses, travel, facility, legal, accounting and other professional fees. Selling, general and administrative expenses increased 49% to $4.6 million in the first three months of 2005 from $3.1 million in the same period from the prior year. The increase included a $0.6 million increase in salaries and personnel -related expenses, a $0.2 million increase in advertising, a $0.2 million increase in travel expenses, a $0.1 million in recruiting expenses and $0.3 million increase in other expenses. These increases were due to an expansion of our direct sales force, increased marketing and product support personnel, and promotional costs to support the clinical genetic assessment market. We expect our selling and marketing costs to increase during the remainder of 2005 as we expand our efforts in the clinical genetic assessment market.

Expense for Patent-Related Matter

In March 2004, before we reached a final and definitive license agreement with Applera, we recorded a charge and accrued a corresponding liability in the amount of $1.3 million related to royalties on past product sales based on agreed-upon royalty rates. The amount was fully paid in the second quarter of 2004 upon execution of the license agreement in that quarter.

Other Income (Expenses), Net

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Other income (expenses), net consists of interest income, interest expense and foreign exchange gain or loss. Interest income increased to $0.3 million in the first three months of 2005 from $0.1 million for the same period in 2004. The increase was primarily due to our higher average cash and cash equivalents and marketable securities balances and higher interest rates during the quarter ended March 31, 2005 when compared to the same period of 2004. Interest expense increased to $0.3 million in the first three months of 2005 from $0.1 million for the same period in 2004. The increase was primarily due to a $0.2 million amortization of imputed interest related to license fee payments. Foreign exchange loss increased as the U.S. dollar has weakened against the Euro since the 2004 period.

LIQUIDITY AND CAPITAL RESOURCES

Cash and Cash Flow

As of March 31, 2005, we had $55.6 million in cash and cash equivalents and marketable securities (including $0.7 million in restricted cash). Our total cash used in the first quarter of 2005 was $2.6 million. We maintain our portfolio of cash equivalents and marketable securities in short-term commercial paper, auction rate securities and money market funds in order to minimize market risk and preserve principal.

Net cash used in operating activities was $1.1 million and $3.6 million in the quarters ended March 31, 2005 and 2004, respectively. In the quarter ended March 31, 2005, net cash used in operating activities primarily consisted of $9.3 million in cost of sales, $4.3 million in research and development costs, $4.3 million in selling, general and administration expenses, a $3.6 million payment on collaboration profit sharing, a $1.5 million increase in prepaid and other current assets, a $1.4 million increase in inventory, largely offset by $20.6 million in cash received from customers , $2.7 million increase in accounts payable and accrued liabilities. In the quarter ended March 31, 2004, net cash used in operating activities primarily consisted of $2.9 million in cost of sales, $3.3 million in research and development costs, $3.0 million in selling, general and administration expenses, a $1.4 million increase in prepaid and other current assets and a $1.1 million increase in inventory, largely offset by $6.5 million in cash received from customers and a $1.6 million increase in accounts payable and accrued liabilities.

Net cash used in investing activities was $1.7 million and $0.7 million in the quarters ended March 31, 2005 and 2004, respectively and primarily consisted of capital expenditures.

Net cash provided by financing activities was $0.9 million and $58.4 million in the quarters ended March 31, 2005 and 2004, respectively. The $0.9 million provided in the quarter ended March 31, 2005 consisted of proceeds from sales of common stock under our employee equity incentive plans partially offset by $0.6 million in payments on our equipment loans. The $58.4 million provided in the quarter ended March 31, 2004 consisted of proceeds of $58.2 million from sales of common stock, including net proceeds of $57.7 million from our February 2004 common stock offering and $0.5 million from sales of common stock under our employee equity incentive plans, and $0.7 million in proceeds from equipment loans, partially offset by repayments of $0.5 million on our equipment loans.

Off-Balance-Sheet Arrangements

As of March 31, 2005, we did not have any significant off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

Financial Condition Outlook

We plan to continue to make expenditures to expand our manufacturing capacity, to support our activities in sales and marketing and research and development, to support our working capital needs, and to obtain technology licenses. For

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the remainder of 2005, we expect to spend approximately $6.0 million for capital equipment. We expect to have negative cash flow from operations through at least the end of 2005. We used $2.6 million in cash in our operations and investing activities during the first quarter of 2005. We anticipate that our existing capital resources will enable us to maintain currently planned operations for the next several years. This expectation is based on our current and long-term operating plan and may change as a result of many factors, including our future capital requirements and our ability to increase revenues and reduce expenses, which, in many instances, depend on a number of factors outside our control. For example, our future cash use will depend on, among other things, market acceptance of our products, the resources we devote to developing and supporting our products, continued progress of our research and development of potential products, the need to acquire licenses to new technology or to use our technology in new markets, and the availability of other financing.

In the future, we may seek additional funds to support our strategic business needs and may seek to raise such additional funds through private or public sales of securities, strategic relationships, bank debt, lease financing arrangements, or other available means. If additional funds are raised through the issuance of equity or equity-related securities, stockholders may experience additional dilution, or such equity securities may have rights, preferences, or privileges senior to those of the holders of our common stock. If adequate funds are not available or are not available on acceptable terms to meet our business needs, our business may be harmed.

RISK FACTORS

You should carefully consider the risks and uncertainties described below, together with all of the other information included in this report, in considering our business and prospects. The risks and uncertainties described below are not the only ones facing Cepheid. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. The occurrence of any of the following risks could harm our business, financial condition or results of operations.

We may not achieve profitability.

We have incurred operating losses in each year since our inception and expect to have negative cash flow from operations through at least the end of 2005. We experienced net losses of approximately $19.7 million in 2002, $17.5 million in 2003, $13.8 million in 2004 and $3.5 million in the three months ended March 31, 2005. As of March 31, 2005, we had an accumulated deficit of approximately $97.4 million. Our ability to become profitable will depend on our ability to increase our revenues, which is subject to a number of factors including our ability to successfully penetrate the clinical genetic assessment market, our ability to successfully commercialize the GeneXpert system and develop effective GeneXpert assays, the extent of our participation in the USPS BDS program and what the operating parameters of any phase of the BDS program will be, which will affect the rate of our consumable products sold, the success of our other collaborative programs, and global economic and political conditions. Our ability to become profitable also depends on our expense levels and product costs, which are also influenced by a number of factors, including the resources we devote to developing and supporting our products, the continued progress of our research and development of potential products, our ability to improve manufacturing efficiencies, license fees or royalties we may be required to pay, and the potential need to acquire licenses to new technology or to use our technology in new markets, which could require us to pay unanticipated license fees and royalties in connection with these licenses. If we fail to grow our revenue and manage our expenses and product costs, we may never achieve profitability.

Our participation in the USPS Biohazard Detection System program and other similar programs may not result in predictable contracts or revenues.

Our participation in government contracting programs, including the USPS BDS program, involves significant uncertainties related to governmental decision-making and timing of deployment, and is highly sensitive to changes in national and international priorities and budgets. The world geopolitical climate in the wake of the September 11, 2001 terrorist attacks has created substantial public interest in the BDS and our potential revenues from participating in the USPS program. However, we cannot be certain that actual funding, deployment and operating parameters, or product purchases, will occur at currently expected levels or in the currently expected timeframe. In this and any similar future programs, there may be no obligation on the part of the eventual customer to buy a minimum number of units or tests,

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so, even though we have been awarded a production contract, we may be subject to future spending patterns and budgetary cycles. Furthermore, if we participate in any other collaborations bidding for government contracts, the bidding and evaluation process could be lengthy and involve significant expense, and may never result in a contract or a contract with acceptable terms. Accordingly, our participation in the USPS BDS program and other similar programs is subject to a number of risks and uncertainties and may never yield the currently expected revenues.

If we cannot successfully commercialize our products, our business could be harmed.

If our tests for use on the SmartCycler and GeneXpert platforms do not gain market acceptance, we will be unable to generate significant sales, which will prevent us from achieving profitability. We are in the process of researching and developing several tests, including GBS, MRSA and Enterovirus tests, for our GeneXpert and SmartCycler systems. Many factors may affect the market acceptance and commercial success of our products, including:

	•	timely development of a menu of tests and reagents for use on our SmartCycler and GeneXpert systems;
	•	the results of clinical trials needed to support regulatory approvals of our tests;
	•	our ability to obtain United States Food and Drug Administration (FDA) and any other regulatory clearances or approvals for our tests;
	•	demand for the tests and reagents we are able to introduce;
	•	the timing of market entry of our GeneXpert system relative to competitive products;
	•	the timing of market entry for various tests for the GeneXpert and the SmartCycler systems;
	•	our ability to convince our potential customers of the advantages and economic value of our systems and tests over competing technologies and products;
	•	the breadth our test menu relative to competitors;
	•	our ability to obtain necessary intellectual property protection;
	•	the extent and success of our marketing and sales efforts; and
	•	publicity concerning our systems and tests.

In particular, we believe that the success of our business will depend in large part on our ability to commercialize our products for the clinical genetic assessment market. Our current reliance on revenues from the USPS BDS program has resulted in substantial revenue concentrations in recent periods. However, as discussed above, revenues from the BDS program are subject to substantial risks, including potential delays in implementation or changes in governmental budgeting priorities. We cannot assure you what the operating parameters of the BDS program will be. In part because of the risks associated with our current reliance on the BDS program, we believe that successfully building our business in the clinical genetic assessment market is critical to our long-term goals and success. We have limited experience operating in the clinical market and, as a result, we have limited ability to forecast future demand for our products in this market. In addition, we have committed substantial funds to licenses that are required for us to enter the clinical market. If we cannot successfully penetrate the clinical market to exploit these licenses, ongoing payments that we have agreed to make under them could significantly harm our business and operating results in future periods.

The regulatory approval process is expensive, time-consuming, and uncertain and may prevent us from obtaining required approvals for the commercialization of some of our products.

In the clinical genetic assessment market, our products may generally be regulated as medical devices by the FDA and comparable agencies of other countries. In particular, FDA regulations govern activities such as product development, product testing, product labeling, product storage, premarket clearance or approval, manufacturing, advertising, promotion, product sales, reporting of certain product failures and distribution. Some of our products, depending on their intended use, will require either premarket approval (PMA) or 510(k) clearance from the FDA prior to marketing. The 510(k) clearance process usually takes from two to twelve months from submission, but can take longer. The premarket approval process is much more costly, lengthy, uncertain and generally takes from one to two years or longer from submission. Clinical trials are generally required to support both PMA and 510(k) submissions. Certain of our tests for use on our SmartCycler and GeneXpert systems, when used for clinical diagnostic purposes, may require premarket approval and all such tests will most likely, at a minimum, require 510(k) clearance. We are planning clinical trials for several of our proposed test products. Clinical trials are expensive and time consuming. In addition, the commencement or completion of any clinical trials may be delayed or halted for any

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number of reasons, including product performance, changes in intended use, changes in medical practice and issues with evaluator Institutional Review Boards.

Failure to comply with the applicable requirements can result in, among other things, warning letters, administrative or judicially imposed sanctions such as injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, refusal to grant premarket clearance or premarket approval for devices, withdrawal of marketing clearances or approvals, or criminal prosecution. To date, only the GBS and MRSA tests developed by Infectio Diagnostics, Inc. (IDI) for use on the SmartCycler have received FDA clearance. Approval or clearance from the FDA or any other governmental body has not been sought for other tests for the SmartCycler or GeneXpert. Any failure or material delay to obtain 510(k) clearance or premarket approval from the FDA for future products could harm our business. In addition, it is possible that the current regulatory framework could change or additional regulations could arise at any stage during our product development or marketing, which may adversely affect our ability to obtain or maintain approval of our products and could harm our business.

Our manufacturing facilities, where we assemble and produce the SmartCycler system and the GeneXpert system, cartridges and reagents, are subject to periodic regulatory inspections by the FDA and other federal and state regulatory agencies. For example, these facilities are subject to Quality System Regulations (QSR) of the FDA and are subject to annual inspection and licensing by the State of California. If we fail to maintain these facilities in accordance with the QSR requirements, international quality standards or other regulatory requirements, our manufacturing process could be suspended or terminated, which would harm our business.

We rely on licenses of key technology from third parties and will require additional licenses for many of our new products or product features.

We rely on third party licenses to be able to sell many of our products, and we could lose any of our third party licenses for a number of reasons, including, for example, early terminations of such agreements due to breaches or alleged breaches by either party to the agreement or expirations according to the terms of a license. If we are unable to enter into a new agreement for licensed technologies, either on terms that are acceptable to us or at all, we may be unable to sell some of our products or access some geographic or industry markets. We also need to introduce new products and product features in order to market our products to a broader customer base and grow our revenues, and many new products and product features could require us to obtain additional licenses and pay additional license fees and royalties. For example, in 2004, we signed patent license agreements with Applera Corporation and F. Hoffman-La Roche Ltd. that involve aggregated license fee payments of $32.2 million over a period of two years and require us to record resulting royalty obligations as part of the cost of product sales when the related product sales are recognized. Furthermore, for some markets, we intend to manufacture reagents and assays for use on our instruments. We believe that manufacturing reagents and developing assays for our instruments is important to our business and growth prospects, but will require additional licenses, which may not be available on commercially reasonable terms or at all. Our ability to develop, manufacture and sell products, and our strategic plans and growth, could be impaired if we are unable to obtain these licenses or if these licenses are terminated or expire and cannot be renewed. We may not be able to obtain or renew licenses for a given product or product feature, or for some reagents, on commercially reasonable terms, if at all. Furthermore, some of our competitors have rights to technologies and reagents that we do not have, which may put us at a competitive disadvantage in certain circumstances and could adversely affect our performance.

We expect that our operating results will fluctuate significantly, and any failure to meet financial expectations may result in a decline in our stock price.

We expect that our quarterly operating results will fluctuate in the future as a result of many factors, such as those described elsewhere in this section, many of which are beyond our control. Because our revenue and operating results are difficult to predict, we believe that period-to-period comparisons of our results of operations are not a good indicator of our future performance. Our operating results may be affected by the inability of some of our customers to consummate anticipated purchases of our products, whether due to changes in internal priorities or, in the case of governmental customers, problems with the appropriations process and variability and timing of orders. If revenue declines in a quarter, whether due to a delay in recognizing expected revenue or otherwise, our results of operations

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will be harmed because many of our expenses are relatively fixed. In particular, research and development and selling, general and administrative expenses are not significantly affected by variations in revenue.

If we are unable to manufacture our products in sufficient quantities and in a timely manner, our operating results will be harmed and our ability to generate revenue could be diminished.

Our revenues and other operating results will depend in large part on our ability to manufacture and assemble our products in sufficient quantities and in a timely manner. Any interruptions we experience in the manufacturing or shipping of our products could delay our ability to recognize revenues in a particular quarter. We have limited experience in manufacturing large volumes of products and manufacturing problems could arise or we may be unable to adequately scale-up manufacturing in a timely manner or on a commercially reasonable basis if we experience increased demand. In the past, we have experienced delays in our ability to ship finished products as a result of delays in production. We may not be able to react quickly enough to ship products and recognize anticipated revenues for a given quarter or other fiscal period if we experience significant delays in the manufacturing process. If we are unable to manufacture our products consistently and on a timely basis, our revenues from product sales and our other operating results will be materially and adversely affected.

If our single source suppliers fail to deliver key product components in a timely manner, our manufacturing ability would be impaired and our product sales could suffer.

We depend on several single source suppliers that supply components used in the manufacture of the SmartCycler system, the GeneXpert modules and system, disposable reaction tubes, and cartridges. If we need alternative sources for key component parts for any reason, these component parts may not be immediately available. If alternative suppliers are not immediately available, we will have to identify and qualify alternative suppliers, and production of these components may be delayed. We may not be able to find an adequate alternative supplier in a reasonable time period, or on commercially acceptable terms, if at all. For example, we have, in the past, experienced problems with the delivery of certain parts from an existing supplier, and had to shift to an alternative supplier. Shipments of affected products have been limited or delayed as a result of such problems in the past, and similar problems could occur in the future. Our inability to obtain our key source supplies for the manufacture of our products may require us to delay shipments of products, harm customer relationships or force us to curtail or cease operations.

If a catastrophe strikes our manufacturing facilities, we may be unable to manufacture our products for a substantial amount of time and we would experience lost revenue.

Our manufacturing facilities are located in Sunnyvale, California. Although we have business interruption insurance, our facilities and some pieces of manufacturing equipment are difficult to replace and could require substantial replacement lead-time. Various types of disasters, including earthquakes, fires, floods and acts of terrorism, may affect our manufacturing facilities. Earthquakes are of particular significance since the manufacturing facilities are located in an earthquake-prone area. In the event our existing manufacturing facilities or equipment is affected by man-made or natural disasters, we may be unable to manufacture products for sale, meet customer demands or sales projections. If our manufacturing operations were curtailed or ceased, it would seriously harm our business.

If our products fail to obtain an adequate level of reimbursement from third-party payers, our ability to sell products in the clinical genetic assessment market would be harmed.

Our ability to sell our products in the clinical genetic assessment market will depend in part on the extent to which reimbursement for tests using our products will be available from:

	•	government health administration authorities;
	•	private health coverage insurers;
	•	managed care organizations; and
	•	other organizations.

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If appropriate reimbursement for our products in the clinical genetic assessment market cannot be obtained, our business could be harmed.

There are efforts by governmental and third-party payers to contain or reduce the costs of health care through various means. Additionally, third-party payers are increasingly challenging the price of medical products and services. If purchasers or users of our products are not able to obtain adequate reimbursement for the cost of using our products, they may forego or reduce their use. Significant uncertainty exists as to the reimbursement status of newly approved health care products and whether adequate third-party coverage will be available.

If our competitors and potential competitors develop superior products and technologies, our competitive position and results of operations would suffer.

We face intense competition from a number of companies that offer products in our target markets. These competitors include:

	•	companies developing and marketing sequence detection systems for life sciences research products;
	•	healthcare companies that manufacture laboratory-based tests and analyzers;
	•	diagnostic and pharmaceutical companies;
	•	companies developing drug discovery technologies; and
	•	companies developing or offering biothreat detection technologies.

Several companies provide instruments and reagents for DNA amplification or detection. Applied Biosystems, F. Hoffmann-La Roche, Bio-Rad Laboratories and Stratagene sell systems integrating amplification and detection (sequence detection systems) to the commercial market. Idaho Technologies sells sequence detection systems to the military market. F. Hoffmann-La Roche, Abbott Laboratories and GenProbe sell large sequence detection systems, some with separate robotic batch DNA purification systems and sell reagents to the clinical genetic assessment market. Other companies, including Becton, Dickson and Company, Bayer and bioMerieux, offer molecular tests.

In order to compete effectively, we will need to demonstrate the advantages of our products over alternative well-established technologies and products. We will also need to demonstrate the potential economic value of our products relative to these competing technologies and products.

We also face competition from both established and development-stage companies that continually enter these markets. Several companies are currently making or developing products that may or will compete with our products. Our competitors may succeed in developing, obtaining FDA approval for, or marketing technologies or products that are more effective or commercially attractive than our potential products, or that render our technologies and potential products obsolete. As these companies develop their technologies, they may develop proprietary positions that prevent us from successfully commercializing our products.

In many instances, particularly in the clinical area, our competitors have substantially greater financial, technical, research and other resources, and larger, more established marketing, sales, distribution and service organizations than we have. Moreover, these competitors may offer broader product lines and tactical discounts and have greater name recognition. If we fail to compete effectively against these and other competitors, we will lose sales and our business will be harmed.

If our products do not perform as expected, or the reliability of the technology on which our products are based is questioned, we could experience lost revenue, delayed or reduced market acceptance of our products, increased costs and damage to our reputation.

Our success depends on the market’s confidence that we can provide reliable, high quality genetic testing systems. We believe that customers in the life sciences, biothreat and clinical markets are likely to be particularly sensitive to product defects and errors. Our reputation and the public image of our products or technologies may be impaired for any of the following reasons:

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	•	failure of products to perform as expected;
	•	any perception that our products are difficult to use; or
	•	litigation concerning the performance of our products or our technology.

Despite testing, defects or errors could occur in our products or technologies, which could result in loss or delay of revenues, delayed market acceptance, damaged reputation, diversion of development resources, legal claims, increased insurance costs or increased service and warranty costs, any of which could harm our business.

Furthermore, with respect to the BDS, our products are incorporated into larger systems that are built and delivered by others. We cannot control many aspects of the final product, and any failure in the overall system, even if it is unrelated to our products, could harm our business. Any news of failures or defects in the BDS could have a negative impact on our stock because of the publicity surrounding the BDS. Even after any underlying concerns or problems are resolved, any widespread concerns regarding our technology or any manufacturing defects or performance errors in our products could result in lost revenue, delayed market acceptance, damaged reputation, increased service and warranty costs, and claims against us.

If product liability lawsuits are successfully brought against us, we may face reduced demand for our product and incur significant liabilities.

We face an inherent risk of exposure to product liability claims if our technologies or systems are alleged to have caused harm or do not perform in accordance with specifications, in part because our products are used for sensitive applications. We cannot be certain that we would be a able to successfully defend any product liability lawsuit brought against us. Regardless of merit or eventual outcome, product liability claims may result in:

	•	decreased demand for our products;
	•	injury to our reputation;
	•	costs of related litigation; and
	•	substantial monetary awards to plaintiffs.

If we become the subject of a successful product liability lawsuit, we could incur substantial liabilities, which could harm our business.

We rely on relationships with collaborative partners and other third parties for development, supply and marketing of products and potential products, and such collaborative partners or other third parties could fail to perform sufficiently.

We believe that our success in penetrating our target markets and in bidding for certain kinds of contracts depends in part on our ability to develop and maintain collaborative relationships with other companies. Relying on collaborative relationships is risky to our future success because, among other things:

	•	our collaborative partners may not devote sufficient resources to the success of our collaboration;
	•	our collaborative partners may not obtain regulatory approvals necessary to continue the collaborations in a timely manner;
	•	our collaborative partners may be acquired by another company and decide to terminate our collaborative partnership or become insolvent;
	•	our collaborative partners may develop technologies or components competitive with our products;
	•	components developed by collaborators could fail to meet specifications, possibly causing us to lose potential projects and subjecting us to liability;
	•	disagreements with collaborators, which could result in the termination of the relationship or litigation;
	•	collaborators may not have sufficient capital resources;
	•	collaborators may pursue tests or other products that will not generate significant volume for us, but may consume significant research and development and manufacturing resources;
	•	our existing collaborations may preclude us from entering into additional future arrangements; or
	•	we may not be able to negotiate future collaborative arrangements, or renewals of existing collaborative agreements, on acceptable terms.

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Currently, our significant collaborative partners include:

	•	Northrop Grumman Corp.’s Automation and Information Systems Division, Sceptor Industries and Smiths Detection, which are purchasing the GeneXpert module for incorporation into the BDS for the USPS program;
	•	Applied Biosystems Group, in a collaboration to develop and sell reagents to detect biothreat agents for use with our GeneXpert system and cartridges;
	•	bioMerieux, Inc., in a collaboration to develop and sell DNA testing products using its NASBA technology on our GeneXpert system; and
	•	IDI, in an agreement to distribute IDI tests for GBS and MRSA, that have been configured for use with the SmartCycler system, and to apply IDI proprietary genetic sequences for GBS and MRSA in the development and commercialization of Cepheid tests to be used in the GeneXpert system.

If our direct selling efforts for our products fail, our business expansion plans could suffer and our ability to generate revenue will be diminished.

We have a relatively small sales force compared to our competitors. We may need to expand our sales organization in order to increase market awareness of our products to a greater number of organizations and, in turn, to generate increased revenue. We are in the process of developing our direct sales force in the clinical genetic assessment market, and we may require additional qualified sales personnel. Competition for these individuals, particularly those with the technical expertise needed to understand and sell our products, is intense, and we may not be able to hire the type and number of sales personnel we need. Moreover, even after we hire these individuals, they require extensive training and time to become productive. If our direct sales force is not successful, we may not be able to increase market awareness and sales of our products. If we fail to establish our systems in the marketplace, it could have a negative effect on our ability to sell subsequent systems and hinder the planned expansion of our business.

If our distributor relationships are not successful, our ability to market and sell our products would be harmed and our financial performance will be adversely affected.

We depend on relationships with distributors for the marketing and sales of our products in the life sciences and clinical markets in various geographic regions and we have a limited ability to influence their efforts. Product sales through distributors represented 20% and 10% of total product sales in fiscal 2004 and the quarter ended March 31, 2005. Our distributors in North America, Europe, and Japan accounted for 6%, 3% and 1%, respectively, of total product sales in the quarter ended March 31, 2005. While sales through distributors accounted for a smaller percentage of our total revenues in recent periods because of the increase in direct sales in connection with the BDS program, we expect to continue to rely substantially on our distributor relationships for sales into other markets or geographic regions, which is key to our long-term growth potential. Fisher Scientific is our major non-exclusive distributor in the United States and Canada. Other than our reserved right to sell directly to some end user customers, Takara Bio, Ltd. is the non-exclusive distributor of SmartCycler in the life sciences markets in Japan, South Korea and China (including Hong Kong and Taiwan). We also rely on various distributors for our sales of SmartCycler in Europe, China, Mexico and other parts of the world. Relying on distributors for our sales and marketing could harm our business for various reasons, including:

	•	agreements with distributors may terminate prematurely due to disagreements or may result in litigation between the partners;
	•	our distributors may not devote sufficient resources to the sale of products;
	•	our distributors may be unsuccessful;
	•	our existing relationships with distributors may preclude us from entering into additional future arrangements; and
	•	we may not be able to negotiate future distributor agreements on acceptable terms.

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We may be subject to third-party claims that we require additional licenses for our products and we could face costly litigation, which could cause us to pay substantial damages and limit our ability to sell some or all of our products.

Our industry is characterized by a large number of patents, claims of which appear to overlap in many cases. As a result, there is a significant amount of uncertainty regarding the extent of patent protection and infringement. Companies may have pending patent applications (which are typically confidential for the first eighteen months following filing) that cover technologies we incorporate in our products. As a result, we may be subjected to substantial damages for past infringement or be required to modify our products or stop selling them if it is ultimately determined that our products infringe a third party’s proprietary rights. Moreover, from time to time, we receive correspondence and other communications from companies that ask us to evaluate the need for a license of patents they hold, and indicating or suggesting that we need a license to their patents in order to offer our products and services or to conduct our business operations. For example, we recently received and are evaluating correspondence from a company relating to aspects of our reagent manufacturing process. Although we do not believe that any of this company’s patents preclude us from continuing our reagent manufacturing process, this company may elect to assert a claim of patent infringement against us. Any such litigation could consume our resources and lead to significant damages, royalty payments or an injunction on the sale of certain products. Furthermore, any additional licenses could obligate us to pay substantial additional royalties, which could adversely impact our product costs and harm our business.

We may need to initiate lawsuits to protect or enforce our patents, which would be expensive and, if we lose, may cause us to lose some, if not all, of our intellectual property rights, and thereby impair our ability to compete.

We rely on patents to protect a large part of our intellectual property. To protect or enforce our patent rights, we may initiate patent litigation against third parties, such as infringement suits or interference proceedings. These lawsuits could be expensive, take significant time and divert management’s attention from other business concerns. They would also put our patents at risk of being invalidated or interpreted narrowly, and our patent applications at risk of not issuing. We may also provoke these third parties to assert claims against us. Patent law relating to the scope of claims in the technology fields in which we operate is still evolving and, consequently, patent positions in our industry are generally uncertain. We cannot assure you that we would prevail in any of these suits or that the damages or other remedies awarded, if any, would be commercially valuable. During the course of these suits, there may be public announcements of the results of hearings, motions and other interim proceedings or developments in the litigation. Any public announcements related to these suits could cause our stock price to decline.

If we fail to maintain and protect our intellectual property rights, our competitors could use our technology to develop competing products and our business will suffer.

Our competitive success will be affected in part by our continued ability to obtain and maintain patent protection for our inventions, technologies and discoveries, including our intellectual property that include technologies that we license. Our ability to do so will depend on, among other things, complex legal and factual questions. We have patents related to some technology and have licensed some of our technology under patents of others. We cannot assure you that our patents and licenses will successfully preclude others from using our technology. Our pending patent applications may lack priority over others’ applications or may not result in the issuance of patents. Even if issued, our patents may not be sufficiently broad to provide protection against competitors with similar technologies and may be challenged, invalidated or circumvented.

In addition to patents, we rely on a combination of trade secrets, copyright and trademark laws, nondisclosure agreements, licenses and other contractual provisions and technical measures to maintain and develop our competitive position with respect to intellectual property. Nevertheless, these measures may not be adequate to safeguard the technology underlying our products. For example, employees, consultants and others who participate in the development of our products may breach their agreements with us regarding our intellectual property and we may not have adequate remedies for the breach. We also may not be able to effectively protect our intellectual property rights in some foreign countries, as many countries do not offer the same level of legal protection for intellectual property as the United States. Furthermore, for a variety of reasons, we may decide not to file for patent, copyright or trademark

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protection outside of the United States. Our trade secrets could become known through other unforeseen means. Notwithstanding our efforts to protect our intellectual property, our competitors may independently develop similar or alternative technologies or products that are equal or superior to our technology. Our competitors may also develop similar products without infringing on any of our intellectual property rights or design around our proprietary technologies. Furthermore, any efforts to enforce our proprietary rights could result in disputes and legal proceedings that could be costly and divert attention from our business.

Our sales cycle, particularly in the life sciences market, can be lengthy, which can cause variability and unpredictability in our operating results.

The sales cycles for our products, particularly in the life sciences market and the clinical genetic assessment market, can be lengthy, which makes it more difficult for us to accurately forecast revenues in a given period, and may cause revenues and operating results to vary significantly from period to period. Sales of our products to the life sciences market often involves purchasing decisions by large public and private institutions, and any purchases can require many levels of pre-approval. In addition, many of these sales depend on these institutions receiving research grants from various federal agencies, which grants vary considerably from year to year in both amount and timing due to the political process. As a result, we may expend considerable resources on unsuccessful sales efforts or we may not be able to complete transactions on the schedule anticipated.

Our international operations subject us to additional risks and costs.

Our international operations are subject to a number of difficulties and special costs, including:

	•	compliance with multiple, conflicting and changing governmental laws and regulations;
	•	laws and business practices favoring local competitors;
	•	potential for exchange and currency risks;
	•	potential difficulty in collecting accounts receivable;
	•	import and export restrictions and tariffs;
	•	difficulties staffing and managing foreign operations;
	•	greater difficulties and expense in enforcing intellectual property rights;
	•	business risks, including fluctuations in demand for our products and the cost and effort to conduct international operations and travel abroad to promote international distribution, and global economic conditions;
	•	multiple conflicting tax laws and regulations; and
	•	political and economic instability.

We intend to expand our international sales and marketing activities, including through our European subsidiary, and enter into relationships with additional international distribution partners. We may not be able to attract international distribution partners that will be able to market our products effectively.

Our international operations could also increase our exposure to international laws and regulations. If we cannot comply with foreign laws and regulations, which are often complex and subject to variation and unexpected changes, we could incur unexpected costs and potential litigation. For example, the governments of foreign countries might attempt to regulate our products and services or levy sales or other taxes relating to our activities. In addition, foreign countries may impose tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers, any of which could make it more difficult for us to conduct our business.

The nature of our products may also subject us to export control regulation by the U.S. Department of State and the Department of Commerce. Violations of these regulations can result in monetary penalties and denial of export privileges.

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If we fail to retain key members of our staff, our ability to conduct and expand our business would be impaired.

We are highly dependent on the principal members of our management and scientific staff. The loss of services of any of these persons could seriously harm our product development and commercialization efforts. In addition, we will require additional skilled personnel in areas such as microbiology, clinical and sales and marketing. Retaining and training personnel with the requisite skills remains challenging, and, as general economic conditions improve, is becoming increasingly competitive, particularly in the Silicon Valley area of California where our main office is located. If at any point we are unable to hire, train and retain a sufficient number of qualified employees to match our growth, our ability to conduct and expand our business could be seriously reduced.

Compliance with new regulations governing public company corporate governance and reporting is complex and expensive.

Many new laws and regulations, notably those adopted in connection with the Sarbanes-Oxley Act of 2002 by the SEC and the NASDAQ National Market, impose obligations on public companies, such as ours, which have increased the scope, complexity, and cost of corporate governance, reporting, and disclosure practices. Our implementation of these reforms and enhanced new disclosures necessitates substantial management time and oversight and requires us to incur significant additional accounting and legal costs. Any failure to timely implement the reforms required by these new laws and regulations could significantly harm our business, operating results, and financial condition.

Changes in the accounting treatment of stock options will adversely affect our results of operations.

In December 2004, the Financial Accounting Standard Board issued a new statement, which requires all share-based payments to employees, including grants of employee stock options, to be recognized as expense in the financial statements based on their fair values. The new rules would be would be effective for us beginning January 1, 2006. We are currently evaluating option valuation methodologies and assumptions permitted by the FASB for purposes of implementing the change in accounting treatment. This change will materially and adversely affect our reported results of operations and our timing to achieve profitability. For an illustration of the effect of such a change in our recent results of operations, see Note 1 of the Notes to the Consolidated Financial Statements.

If we acquire companies, products or technologies, we may face risks associated with those acquisitions.

If we are presented with appropriate opportunities, we may acquire or make other investments in complementary companies, products or technologies. We may not realize the anticipated benefit of any acquisition or investment. If we acquire companies or technologies, we will likely face risks, uncertainties and disruptions associated with the integration process, including difficulties in the integration of these operations and services of an acquired company, integration of acquired technology with our products, diversion of our management’s attention from other business concerns and the potential loss of key employees or customers of the acquired businesses. If we fail to successfully integrate other companies that we may acquire, our business could be harmed. Furthermore, we may have to incur debt or issue equity securities to pay for any additional future acquisitions or investments, the issuance of which could be dilutive to our existing shareholders or us. In addition, our operating results may suffer because of acquisition-related costs or amortization expenses or charges relating to acquired intangible assets.

We might require additional capital to support business growth, and such capital might not be available.

We intend to continue to make investments to support business growth and may require additional funds to respond to business challenges, which include the need to develop new products or enhance existing products, conduct clinical trials, enhance our operating infrastructure and acquire complementary businesses and technologies. Accordingly, we may need to engage in equity or debt financing to secure additional funds. Equity and debt financing, however, might not be available when needed or, if available, might not be available on terms satisfactory to us. In addition, to the extent that additional capital is raised through the sale of equity or convertible debt securities, the issuance of these securities could result in dilution to our shareholders. In addition, these securities may be sold at a discount from the market price of our common stock, and may include right preferences or privileges senior to those of our common stock. If we are unable to obtain adequate financing or financing on terms satisfactory to us, our ability to continue to support our business growth and to respond to business challenges could be significantly limited.

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If we become subject to claims relating to improper handling, storage or disposal of hazardous materials, we could incur significant cost and time to comply.

Our research and development processes involve the controlled storage, use and disposal of hazardous materials, including biological hazardous materials. We are subject to federal, state and local regulations governing the use, manufacture, storage, handling and disposal of materials and waste products. We may incur significant costs complying with both existing and future environmental laws and regulations. In particular, we are subject to regulation by the Occupational Safety and Health Administration (OSHA) and the Environmental Protection Agency (EPA), and to regulation under the Toxic Substances Control Act and the Resource Conservation and Recovery Act. OSHA or the EPA may adopt regulations that may affect our research and development programs. We are unable to predict whether any agency will adopt any regulations that would have a material adverse effect on our operations.

The risk of accidental contamination or injury from hazardous materials cannot be eliminated completely. In the event of an accident, we could be held liable for any damages that result, and any liability could exceed the limits or fall outside the coverage of our insurance. We may not be able to maintain insurance on acceptable terms, if at all. We could be required to incur significant costs to comply with current or future environmental laws and regulations.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Our investments in interest-bearing assets are subject to interest rate risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline. To minimize this risk, we maintain our interest-bearing portfolio, which consists of cash and cash equivalents and marketable securities, in short-term commercial paper, auction rate securities and money market funds. Due to the short-term nature of the investments, we believe we have no material exposure to interest rate risk arising from our investments. Further, we do not believe a 1% change in interest rates would have a material impact on our financial position. Therefore we have not included quantitative tabular disclosure in this Form 10-Q.

We do not enter into financial investments for speculation or trading purposes and are not a party to financial or commodity derivatives.

We have operated primarily in the United States and a majority of our revenue, cost, expense and capital purchasing activities are transacted in U.S. Dollars. Accordingly, we do not have material exposure to foreign currency rate fluctuations.

ITEM 4. CONTROLS AND PROCEDURES

EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

Regulations under the Securities Exchange Act of 1934 require public companies, including our company, to maintain “disclosure controls and procedures,” which are defined to mean a company’s controls and other procedures that are designed to ensure that information required to be disclosed in the reports that it files or submits 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 our Chief Financial Officer, based on their evaluation of our disclosure controls and procedures as of the end of the period covered by of this report, concluded that our disclosure controls and procedures were effective for this purpose.

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CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

Regulations under the Securities Exchange Act of 1934 require public companies, including our company, to evaluate any change in our “internal control over financial reporting,” which is defined as a process to provide reasonable assurance regarding the reliability of financial reporting and preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States. In connection with their evaluation of our disclosure controls and procedures as of the end of the period covered by this report, our Chief Executive Officer and Chief Financial Officer did not identify any change in our internal control over financial reporting during the three months ended March 31, 2005 that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Not Applicable

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Not Applicable

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not Applicable

ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS

Not Applicable

ITEM 5. OTHER INFORMATION

Not Applicable

ITEM 6. EXHIBITS

(a) Exhibits

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*These certifications accompany this report pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of the Company under the Securities Act of 1933 or the Securities Exchange Act of 1934 (whether made before or after the date of the Report), irrespective of any general incorporation language contained in such filing.

SIGNATURES

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, in the City of Sunnyvale, State of California on this 9th day of May, 2005.

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Exhibit Index