APPLIED IMAGING CORP - 10-K Annual Report

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 90 days. Yes x No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12 b-2 of the Act). Yes ¨ No x

The aggregate market value of voting stock held by non-affiliates of the Registrant, based upon the closing sale price of the Common Stock on June 28, 2002 (which is the last business day of Registrant’s most recently completed second fiscal quarter), as reported on the Nasdaq Market, was approximately $30,480,000. The number of shares of Common Stock outstanding as of March 31, 2003: 15,913,339.

Part III of this Form 10-K incorporates information by reference from the Registrant’s definitive proxy statement to be filed with the Securities and Exchange Commission within 120 days after the close of the fiscal year.

This report, including all exhibits and attachments, contains 65 pages. The exhibit index is on pages 58 & 59.

This annual report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include statements relating to product developments and launches, sales growth, operating performance, the adequacy of our current capital resources and the timing of future capital requirements. Our actual results could differ materially from those predicted in the forward-looking statements as a result of risks and uncertainties including, but not limited to, those discussed in this annual report under “Item 1—Business, Additional Factors That Might Affect Future Results”, below, and under “Item 7—Management’s Discussion And Analysis Of Financial Condition And Results Of Operations; Factors that Might Affect Future Results,” commencing on pages 46. These risks and uncertainties include, but are not limited to, competition, medical device regulation, continued adverse changes in general economic conditions in the United States and internationally, adverse changes in the specific markets for our products, adverse changes in customer order patterns, ability to raise funding, ability to manage our growth, risks associated with a consolidating industry, and the delay or failure to develop and launch our products. You should not rely on these forward-looking statements, which reflect our position as of the date of this report. We are under no obligation to revise or update any forward-looking statements.

Applied Imaging Corp. (“Applied Imaging”, the “Company”, “we” or “our”) was incorporated in California in July 1986, and reincorporated in Delaware in October 1996. In November 1996, we completed an initial public offering of common stock that is listed on the Nasdaq National Market under the symbol AICX. We are headquartered in Santa Clara, California, and have facilities in the United Kingdom (“U.K.”). We are the world’s leading provider of automated instrument systems for cytogenetics, the analysis of chromosomes in cells. Our products are sold worldwide through a direct sales force, third-party distributors and independent sales representatives. We employ approximately 84 people worldwide.

The Company was founded to develop, manufacture, and market automated genetic imaging systems for use in cytogenetic laboratories for cancer testing, prenatal testing and other genetic testing applications. We sell our products to government and private clinical laboratories, research institutions, universities, and pharmaceutical companies located in the United States (“U.S.”)., Canada, Europe, Japan and other countries. We also market imaging systems designed for use in plant and animal genetic research programs. In addition, in 2000, we introduced and received clearance from the U.S. Food and Drug Administration (“FDA”) for a clinical system to detect micrometastatic cancer cells in bone marrow from cancer patients. Micrometastic cancer cells are generally undetectable using routine cancer screening tests due to their rarity (low frequency of occurrence). This system and its research capabilities assists physicians in determining the initial staging of cancer cases, in detecting disease recurrence and in genetically characterizing cancer cells. This was the forerunner of our strategic thrust into the cancer pathology market with the MDS^™ system.

We have an installed base of over 3,000 instruments in over 1,000 laboratories and clinics in more than 60 countries. Our CytoVision^®, PowerGene^® and QUIPS^® systems are widely utilized because of their ability to analyze human chromosome preparations using powerful software classification algorithms and a specialized user interface. These systems also incorporate the capability to analyze and record images produced by advanced genetic research assays that employ fluorescent in situ hybridization (“FISH”), a technique to detect chromosomal changes in cells using fluorescent-tagged DNA segments, or comparative genomic hybridization (“CGH”) techniques to measure the amount of a given genetic sequence in a cell.

laboratories. The Ariol^™ system is designed to assist the pathologist and oncologist in their review of key breast cancer IHC tests. The system is also designed to detect micrometastatic cancer cells that may be found in bone marrow and other clinical samples. The Ariol^™ system is the second generation of the Company’s pioneering MDS^™ System.

The SPOT^™ genetic analysis system automatically detects and counts fluorescent-labeled DNA probe signals in cells. The system is designed for a range of applications, one of which is to assist in the detection of specific genetic abnormalities that identify which patients may respond to new molecularly targeted therapies. For example, the system is designed to automate the analysis of a fluorescent DNA probe assay that may be a factor in the selection of patients with chronic myelogenous leukemia to receive Novartis’ Gleevec^® therapy.

We are developing data on these uses and various applications of the Ariol^™ and SPOT^™ systems that will allow us to obtain additional clearances from the FDA for promotion of these applications with specific medical or diagnostic claims.

Our MDS^™ system combines the ability to find targeted cancer cells using brightfield microscopy techniques, in which microscopes use white light to illuminate tissues and cells, with our decade-long experience in fluorescence microscopy imaging and analysis, in which narrow wavelengths of light are used to detect fluorescent tags that have been inserted into the cells or tissue sections being examined under a microscope. Taken together, these technologies allow us to analyze the proteins on or within a cell while simultaneously assessing which genes within that cell have been activated or expressed. Both protein and gene expression data are emerging as required parameters when assessing the precise nature of a given tumor or cancer cell. Gene and protein expression data are increasingly being used to select the most effective cancer therapies for individual patients.

We pursued a prenatal genetic screening development program from 1996 through 1999 focused on the isolation of specific fetal cells from a blood sample taken from the expectant mother. While substantial research progress was made towards the development of a reliable method for non-invasive prenatal diagnosis, we concluded that our methods did not constitute a commercially viable system for this purpose. Accordingly, we shifted our research efforts and resources in 1999 to our cancer imaging programs, with a focus on the detection of rare micrometastatic cancer cells in a variety of sample types. However, we believe that certain of the cell enrichment and image analysis products we developed for fetal cell analysis may be directly applicable to these cancer-testing applications, such as the use of our imaging platform to detect circulating cancer cells in peripheral blood.

All genetic information in an organism is contained in its chromosomes, made up of strands of DNA and associated protein molecules. DNA is comprised of paired nucleotide bases and genetic information is encoded by the specific order of the nucleotide bases within units called genes. Genes are organized linearly along the chromosomes and carry the required information for the synthesis of the proteins that provide the structural components of cells and tissues, as well as the enzymes needed for the basic biochemical and physiological functions of the cells. Chromosomal studies allow clinicians to examine genetic rearrangements at both a macro level, while studying all chromosomes of a patient simultaneously, or at a micro level, while examining specific DNA probes for individual genes or chromosomes.

In the U.S., approximately 600,000 cytogenetic test procedures are performed annually. Cytogenetic testing includes prenatal screening for genetic disorders using amniotic fluid or chorionic villus sampling. The most rapidly growing segment of the cytogenetic testing market includes those tests for the diagnosis and prognosis of cancerous conditions using bone marrow, blood and tissue samples.

Chromosomal analyses are often performed for clinical and research purposes for the precise characterization of many different types of cancers. Cancer cells frequently demonstrate complex chromosomal abnormalities. The specific patterns of these chromosomal abnormalities may be associated with certain well-defined cancers. The chromosomal analysis of leukemias and lymphomas, for example, provides researchers with supplementary information useful in the staging or precise classification of the disease and may also provide useful indicators of patient prognosis. Similarly, advanced chromosomal analyses may allow a researcher to assess new disease in a patient to determine if it may be a recurrence of a previous cancer or an entirely different neoplasm.

As in cancer, prenatal chromosomal disorders may occur when genes or portions of genes move between chromosomes, when portions of chromosomes or the genes they contain are missing or when an abnormal number of chromosomes are present in the cell. Chromosomes can be seen with the aid of a microscope and, when stained with certain dyes, reveal light and dark bands reflecting regional variations in the DNA of the cell. Differences in size and banding pattern allow the chromosomes to be distinguished from each other or may help identify a chromosomal disorder. The most common prenatal chromosomal disorder, Down Syndrome, also known as trisomy 21, occurs when there are three copies of chromosome 21 in the human genome. Other prenatal clinical syndromes caused by the most common chromosomal abnormalities may result in mental retardation, impaired physical development and abnormal sexual development.

Prenatal testing is the process of detecting certain types of chromosomal disorders in a fetus at an early stage of pregnancy. Definitive prenatal testing is currently performed invasively, by extracting fetal cells and inspecting the chromosomes within such cells to diagnose specific genetic disorders. Fetal cells are obtained by one of two common procedures, amniocentesis or chorionic villus sampling. Once the sample is extracted it is forwarded to a cytogenetic laboratory, where the cells are cultured and deposited on a microscope slide. The slide is then examined under a microscope in order to locate and analyze a number of cells undergoing active cell division. At this point, the chromosome complement of an individual cell is visible under the microscope.

The CytoVision^® ChromoScan^™ is our most comprehensive system for automated chromosome analysis. The ChromoScan^™ integrates many of the key features of our earlier products into one system capable of automated microscope slide scanning, advanced chromosome analysis and fluorescent image processing. The ChromoScan^™ allows laboratories to automatically scan slides to locate specific cells for chromosome analysis or other genetic studies utilizing fluorescent DNA probes, thereby eliminating one of the most tedious and time-consuming aspects of cytogenetic analysis: that of manual slide scanning. The system accomplishes this in the background while simultaneously allowing the technologist to process and analyze images previously identified. We believe that no other commercially available system for cytogenetic analysis incorporates this same range of features in one integrated and automated package.

The CytoVision^® system is a comprehensive chromosome analysis system that integrates standard karyotyping capability, the capability of presenting a standard image of chromosomes, with advanced FISH imaging technologies, including color chromosome analysis techniques. The system’s computerized image capture and analysis capabilities incorporate pattern recognition and automated chromosome classification algorithms. The system provides automated karyotyping capabilities, a variety of user-defined image enhancement features, and report annotation capabilities and full screen display options. The DNA imaging capability of the CytoVision^® detects and analyzes signals from DNA probes that have been applied to cell nuclei. CytoVision^® systems enhance images of often-faint fluorescent DNA probes and provide the operator with a range of optimized analytical tools. The systems may also be upgraded to detect genetic amplifications and deletions in tumor cells utilizing a research technique known as CGH

The SPOT^™ genetic analysis system was introduced in 2002 and is based on the CytoVision architecture. The system is specifically designed to automatically detect and count fluorescent-labeled DNA probe signals in cells. The system is designed for a range of applications, one of which is to assist in the detection of specific genetic abnormalities that identify which patients may respond to new molecularly targeted therapies. For example, the system is designed to automate the analysis of a fluorescent DNA probe assay that may be a factor in the selection of patients with chronic myelogenous leukemia to receive Novartis’ Gleevec^® therapy.

All of the product modules in the CytoVision^® family are compatible with one another and can be easily integrated into a comprehensive network based system with common data management protocols.

Our PowerGene^® products are the integrated chromosome analysis systems most often used by the largest commercial clinical laboratories worldwide. With a powerful intuitive user interface that facilitates the training of cytogenetic technologists in a variety of settings, PowerGene^® systems take full advantage of the ease of use features associated with Apple^® Macintosh platforms. We acquired the PowerGene^® product line in July 2000 from International Remote Imaging Systems, Inc.

Our QUIPS^® systems offer advanced FISH imaging tools to researchers worldwide. These systems were among the first to incorporate high sensitivity digital imaging capabilities along with the ability to analyze new DNA probe techniques such as M-FISH and pre-implantation cytogenetics. Based on the Apple^® Macintosh platform, QUIPS^® systems allow researchers who have developed techniques on Apple systems to continue their research with the most current hardware and software solutions for the Macintosh. We acquired the QUIPS^® product line as one part of a 1999 strategic alliance with Vysis, Inc., the leading provider of DNA probe reagents for cancer and prenatal testing.

There are an increasing number of therapeutic products either being marketed or under development by the pharmaceutical industry that target specific abnormalities in genes or proteins found in cancer patients. Generally, these therapeutics require sophisticated diagnostic tests to determine which patients have a specific abnormality and would therefore be candidates for the therapy under consideration. This advance selection of patients is often required by the FDA before approval of a highly specific therapy. The necessary diagnostic tests are typically conducted on a tissue sample of the tumor and can utilize various staining techniques to detect a protein or gene expression of interest. These tests may require brightfield microscopy in order to interpret the protein expression or fluorescent microscopy to interpret DNA probe results. Interpretation and analysis of the tests can be conducted either manually through a microscope or with an instrument such as our Ariol^™ or MDS^™ systems that automates the imaging and interpretation of tissue-based pathology assays. We believe that the MDS^™ system is currently the only clinical imaging system capable of analyzing both protein and gene expression levels using both brightfield and fluorescence illumination on a single platform. The MDS^™ system provides the pathologist with the capability to automatically detect cells of interest in a tissue specimen and to precisely qualify the results of a wide range of tests.

The Ariol^™ and MDS^™ systems are designed to assist pathologists in their review of key breast cancer tests. These include breast cancer tests that examine the following biological factors:

The Ariol^™ and MDS^™ systems offers a broad range of multiparametric analyses to aid pathologists in the interpretation of complex test results. We expect that the Ariol^™ and MDS^™, with the SPOT^™ systems, and future variants of these systems may be the primary driver of our future sales growth.

In 2001, we introduced our PathVysion^™ Digital Scoring Application that provides the first automated imaging capability to assist in detecting amplification of the HER-2/neu gene in tissue. This application utilizes the MDS^™ system to automate the analysis of a complex fluorescent assay that is an important factor in the selection of certain breast cancer patients to receive Genentech’s Herceptin^®, a drug for treating certain types of breast cancer. The PathVysion^™ Digital Scoring Application automates the analysis of the results of the PathVysion HER-2 DNA Probe Kit developed by Vysis, Inc. to detect amplification of the HER-2/neu gene in breast cancer tissue using FISH techniques. (PathVysion is a trademark of Vysis, Inc. used under license by Applied Imaging. Herceptin is a registered trademark of Genentech, Inc.) The PathVysion^™ Digital Scoring Application is available on the MDS^™.

The IHC applications and the PathVysion^™ application are released to clinical and research sites for research use, pending application to the Food and Drug Administration for full clearance of the applications for routine clinical use. With regard to the above-described cancer pathology applications, we have developed, or are developing, data on these uses and other applications of the Ariol^™ and MDS^™ systems in various studies. However, until we submit and obtain clearances from the FDA, we cannot make medical or diagnostic claims for these applications.

Micrometastasis is the spread of cancer away from the primary tumor that is not detectable with routine testing methods. Typically, these metastases are too limited in size to be observed using routine examination techniques. The majority of micrometastases are attributable to a subset of cancer known as carcinomas, a malignant growth that arises from epithelial cells found in the skin or the lining of body organs. Carcinomas tend to infiltrate into adjacent tissue and then spread (metastasize) to distant organs such as bone, liver, lung or the brain. The initial application for micrometastases testing is found among patients at the time of initial diagnosis for breast, prostate, colorectal and gastric carcinomas. When micrometastatic cells are identified in distant locations, the staging of the patient’s disease will typically change to reflect the presence of distant metastases, an indication of much more advanced disease. This testing is expected to be performed in addition to normal staging parameters and will aid in the most appropriate diagnosis and treatment of these patients.

This market is large and developing with over 1.2 million new carcinoma cases diagnosed each year and approximately 6.2 million patients being monitored for the recurrence of cancer on an annual basis. Early detection and treatment of micrometastatic disease would result in improved patient outcomes and significant cost savings to the health care system.

We estimate the potential market for monitoring cancer patients for early disease recurrence encompasses the 2,500 primary cancer centers in the U.S., Europe and Japan and is estimated at $300 million annually. In addition, we have initiated pre-clinical trials of blood-based micrometastasis assays that may expand the potential market opportunity for the MDS^™ and related testing reagents to $500 million annually.

The MDS^™ consists of a custom scanning microscopy system that has been optimized for the analysis of bone marrow, lymph node and stem cell preparations to detect rare cancer cells that have been stained by a variety of laboratory techniques. The MDS^™ scans microscope slides to automatically detect the presence of rare cancer cells in the sample. Additionally, the MDS^™ can genetically characterize these cells for specific gene sequences to determine if a metastasizing cell comes from the patient’s primary tumor or if it is a biologically “aggressive” cell. It is capable of identifying cancer cells in concentrations as low as one cancer cell per one million normal cells.

Designed with fully integrated fluorescent detection capabilities, the MDS^™ allows researchers to apply an extraordinarily wide range of DNA probes to individual cells in order to characterize them at a molecular level. The system’s ability to automatically scan and characterize cancer cells is more accurate, consistent and efficient than manual screening. The ability to detect and characterize micrometastatic cancer cells provides the oncologist with important additional information for the selection of the most appropriate treatment for the patient. The detection of micrometastasis may lead to more aggressive treatment and follow-up than would otherwise be indicated.

In 1999 and 2000, we conducted clinical evaluations that demonstrated significant improvements in the ability of pathologists to detect tumor cells when aided by the MDS^™. Performance has been consistent and reproducible across multiple instruments and sites. In August 2000, we received 510(k) clearance from the FDA to market the MDS^™ for in vitro diagnostic use as an aid to pathologists in the detection and classification of specific rare cancer cells based on size, shape intensity of staining patterns and other factors.

The Ariol^™ system was introduced in 2002 and is the second generation of the MDS^™ system. It is a high-throughput system designed to automate and standardize the analysis of IHC and FISH test results in clinical laboratories. The Ariol^™ system was designed to assist the pathologist and oncologist in their review of breast cancer tests. It is expected that additional applications, including automated FISH analysis for DNA probes, will be released in 2003, subject to appropriate FDA clearances regarding their promotion. The system is also designed to detect micrometastatic cancer cells that may be found in bone marrow and other clinical samples.

We have obtained an exclusive option from StemCell Technologies, Inc. (“STI”) for a technology that may allow for the detection of circulating tumor cells in peripheral blood samples. The option from STI has an initial term of five years, beginning on July 2, 2001. We maintain exclusivity on the technology through minimum purchases of the product amounting to $141,000 in the first year of the agreement, increasing to $360,000 in the last three years of the agreement. We met the minimum purchase requirements in the first year of the agreement. We initiated pre-clinical trials of this technology, in conjunction with our MDS^™ system, during 2001 and these trials were completed in 2002. We are evaluating the results of these trials and, if the results of these pre-clinical trials are positive, and if funding is available, we plan to develop a consumable reagent kit that will be used to isolate circulating tumor cells. We are evaluating licensing options, as well as strategic and product distribution relationships with companies offering specialized clinical and research reagents targeted at the cancer research market that we are pursuing for OncoPath^™ placements.

A highly active area of basic research and commercial product development is the advanced analysis of plant and animal genomes. Researchers apply chromosome analysis techniques to plants and animals that have

wide variations in the makeup of their chromosome complements. The analysis of chromosomes from animal and plant species has proven valuable in the development and testing of genetic improvements to crops, in cancer studies using animal models and in different veterinary applications. This market is currently growing and is served by our proprietary Genus^™ system. Genus^™ was adapted from technology pioneered on our CytoVision^® systems. Genus^™ incorporates flexible modules that allow researchers to customize the system, for studies of specific plant or animal species. Certain of these analytical capabilities have also been made available to Macintosh users of our PowerGene^® systems.

We currently sell our image analysis products to government and private clinical laboratories, hospital laboratories, research institutions, universities and pharmaceutical companies. In North America, we sell our products directly to end-users. As of March 10, 2003, the North American sales team is comprised of 20 sales and application support specialists. Outside of North America, we sell our products either directly, through independent distributors, or through local agents who are remunerated on a commission basis. We manage our international sales and distribution activities from Applied Imaging International Ltd., a wholly owned subsidiary located in the United Kingdom. As of March 10, 2003, the international sales team is comprised of 16 sales and application support professionals, based in the United Kingdom, France, Israel and Germany. Our primary distributors are located in France, China, Italy, Japan, South Korea and Spain. Our primary distributor in Spain, Tecnicas Medicas, is also an investor in our company.

Because our products are technically sophisticated, we employ scientifically qualified and highly trained product specialists to support the sales staff in all major markets. Additionally, we offer an annual instrument maintenance program to our customers. Our marketing activities include telemarketing, product advertising and participation in trade shows and product seminars.

Sales by segment and geographic region are included in Footnote (12) in the Notes to the Consolidated Financial Statements.

We assemble and test components and subassemblies made by outside vendors to our specifications and manufacture only when we believe significant value can be added. We order components and subassemblies to forecast and assemble specific configurations on receipt of firm orders. Our investigational and clinical products are subject to regulation by the FDA and all products are subject to regulation by the U.S. Department of Commerce export controls, primarily as they relate to the associated personal computers.

Under current law, if we manufacture finished devices in the U.S., we will be required to comply with the FDA’s Quality System Regulation and the State of California’s current Good Manufacturing Practice (“GMP”) regulations. In addition, the FDA and/or the California authorities may inspect our manufacturing facilities on a regular basis to determine such compliance. Our facilities in Newcastle, England and Santa Clara, California have successfully completed periodic third-party audits that resulted in certification under ISO 9001 guidelines for design, manufacture, installation and support of cancer and genetic testing equipment and under ISO 13485 for medical device companies.

Our research and development efforts include various research, product development, clinical evaluation and testing, quality assurance, regulatory and process development activities. The current focus of our research and development efforts is the continued enhancement of the OncoPath^™ systems, including new applications. Other research and development efforts include collaborating with outside investigators and other companies to develop new cancer testing applications for the micrometastasis platform. Our future research and development

efforts are expected to include development of additional applications of our current cytogenetic products, additional applications for the Ariol^™ and MDS^™ system and novel, high-throughput scanning platforms for tissue analysis.

In August 2001, we entered into a strategic alliance with DAKO Corporation, a fully integrated, global provider of cancer diagnostic and research products for pathology and oncology, for the development and marketing of image analysis applications for IHC and genetic probe assays. The agreement with DAKO has an initial term of three years and automatically renews after that for additional one-year terms unless cancelled by us or DAKO with 90-days notice. Any MDS^™ imaging analysis applications developed for use with DAKO assays will require FDA approval before we can market them for routine clinical use. However, the applications may be marketed and used by laboratories subject to the laboratories’ internal validation of the applications and appropriate labeling of the application by us.

In January 2002, we placed our first application, in alpha prototype, which will automatically image and interpret the results of tissue microarray studies on our MDS^™ system with one of our collaborators. Tissue microarray technology is entering widespread use as the most efficient method for rapidly testing large numbers of gene and protein targets in tissues for pharmaceutical development and basic research purposes. We expect to continue development of this technology in 2003 using the Ariol^™ system.

We have pursued patent protection and to date have been granted thirteen patents and have other patent applications pending in the U.S. Our patent portfolio also includes multiple patents and pending applications that protect our technology in other countries.

In addition to patents, we rely upon trade secrets, know-how and contractual arrangements to protect certain of our proprietary information and products. We also generally enter into confidentiality agreements with our employees and consultants designed to both protect our confidential information and prevent the disclosure of confidential information of prior employers and others.

We also rely upon trademarks to protect certain of our products, and hold U.S. trademark registrations for the marks “QUIPS”, “CYTOSCAN”, “PowerGene” and “RxFISH.” We hold registrations for these marks and the mark “CYTOVISION” in certain foreign jurisdictions. We also have certain other trademark rights in the U.S. and other foreign countries.

The market for our cytogenetic products is highly competitive. We believe that our primary competitors in this market include Metasystems, Leica Microsystems and Applied Spectral Imaging. The principal competitive factors in this market are product features offered, ease of use, clarity of output, customer service capabilities, price and installed base. We believe that we compete favorably with regard to these factors.

The market for the Ariol^™ and MDS^™ system in cancer pathology is new and under development. Our primary competitors in this market are ChromaVision Medical Systems, Inc. and Metasystems. We believe our systems’ ability to analyze both proteins and genes in cells distinguishes us from competition.

The testing, manufacturing, labeling, distribution, sales, and marketing of our products are subject to government regulation in the U.S. and in other countries. We believe that our future success will be significantly dependent upon commercial sales of our OncoPath^™ systems, consisting of our MDS^™, Ariol^™ and SPOT^™ systems. These systems are currently used for a number of applications. Before we can promote these systems for specific applications in the U.S., we will need to obtain FDA clearances. We have 510(k) clearance for our MDS^™, CytoVision^® and PowerGene^® systems in the U.S. We also have obtained FDA clearance from the FDA to market the MDS^™ for in vitro diagnostic use as an aid to pathologists in the detection and classification of specific rare cancer cells based on size, shape intensity of staining patterns and other factors. In the U.S., our products are also subject to regulation in the State of California whose requirements in this area include registration with the state and compliance with state GMP regulations.

In March 2003, we received a warning letter from the FDA regarding our promotional material for specific applications on the Ariol^™ system. The letter requires us to modify our promotional practices for specific applications of the Ariol^™ system until we obtain any required FDA clearances. We believe that we can satisfactorily meet the FDA requirements and are in the process of responding to the FDA letter. Failure to respond in a timely and adequate manner, however, may result in regulatory action being taken by the FDA. These actions could include seizure, injunction and/or civil monetary penalties.

Before a new medical device can be introduced into the market, the manufacturer must obtain FDA clearance of a 510(k) or Premarket Approval (“PMA”), unless the device is exempt from the requirement of such clearance or approval. A 510(k) clearance will be granted if the submitted information establishes that the device is substantially equivalent to a legally marketed Class I or II medical device or to a legally marketed Class III device that does not itself require an approved PMA prior to marketing (“predicate device”). A 510(k) must contain information to support a claim of substantial equivalence, which may include laboratory test results or the results of clinical studies of the device in humans. The FDA is required to review 510(k) submissions within 90 days, but it generally takes from five to twelve months from the date of submission to obtain 510(k) clearance from the FDA; it may take longer and 510(k) clearance may never be obtained. The FDA may determine that a device is not “substantially equivalent” to a predicate device, or that additional information is needed before a substantial equivalence determination can be made.

In addition to domestic regulation of medical devices, our current products and the products we have under development are subject to corresponding regulations governing safety processes, manufacturing processes and quality in foreign jurisdictions in which we operate or such products are sold. Upon the adoption of the In Vitro Diagnostic Medial Device Directive of October 27, 1998, the European Community and its member countries currently are imposing more substantial regulation on in vitro diagnostic devices and equipment-like medical devices, and such regulation may affect the Company’s current products and products under development.

Marketed devices are subject to pervasive and continuing regulatory oversight by the FDA and other agencies, including record-keeping requirements and reporting of adverse experiences with the use of the device. Device manufacturers are required to register their establishments and list their devices with the FDA and certain state agencies. The Federal Food, Drug and Cosmetic Act and certain state laws require that medical devices be manufactured in accordance with the Quality System Regulations (“QSregs”). Manufacturing facilities are subject to periodic inspection by the FDA and certain state agencies on a periodic basis to monitor compliance with GMP, QSregs and other requirements.

We are also subject to other federal, state, local and foreign laws, regulations and recommendations relating to safe working conditions and good laboratory practices. The extent of government regulation that might result from any future legislation or administrative action cannot be accurately predicted.

As of March 10, 2003, we employed a total of 84 people, including 21 in research and development, 8 in manufacturing, 46 in sales, marketing and customer service and 9 in finance and administration. As of March 10, 2003, 51 of our employees were based in the U.S., 28 in the United Kingdom, 2 in France, 1 in Germany, and 1 in Israel. We are not subject to any collective bargaining agreements and we believe that our relationship with our employees is good.

We are subject to the reporting requirements under the Securities Exchange Act of 1934. Consequently, we are required to file reports and information with the Securities and Exchange Commission (SEC), including reports on the following forms: annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. These reports and other information concerning us may be obtained at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549 or accessed through the SEC’s website at http://www.sec.gov. The SEC’s Public Reference Room phone number is 1-800-SEC-0330. In addition, electronic copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are posted to our website (http://www.aicorp.com). Such filings are placed on our website as soon as reasonably possible after they are filed with the SEC.

The following represent some of the factors that create risk and uncertainty for our business and us. If any of the following factors actually occur, our business, financial condition or results of operations could be materially adversely affected.

We have not been profitable on a fiscal year basis since our inception in 1986. We incurred net losses of $495,000 and $3.7 million in 2002 and 2001, respectively. We recorded profits in the second and third quarters of 2002 of $150,000 and $131,000, respectively. As of December 31, 2002, we had an accumulated deficit of $42.4 million. We will continue to incur significant costs as we continue our efforts to develop and market our OncoPath^™ systems. If we do achieve profitability in any period, we may not be able to sustain or increase our profitability on a quarterly or annual basis.

We have substantial funding requirements. Additional funding may not be available to us or may not be available on acceptable terms.

We have expended and will continue to expend substantial amounts of money for research and development, preclinical testing, planned clinical investigations, capital expenditures, working capital needs and manufacturing and marketing of our products. Our future research and development efforts, in particular, are expected to include development of additional applications of our current cytogenetic products and additional applications for the OncoPath^™ systems, which will likely require additional funds.

If we do not achieve our projected revenue targets or costs are higher than projected, we may incur negative cash flow from operations during 2003.

The exact timing and amount of spending required cannot be accurately determined and will depend on several factors, including:

To the extent necessary, we may seek to obtain additional funds through equity or debt financing, collaborative or other arrangements with other companies, bank financing and other sources. If we raise funds by issuing equity securities, you will experience dilution of your holdings in our common stock. We cannot assure you that additional financing will be available when needed or on terms acceptable to us. If adequate and acceptable financing is not available, we may have to delay development or commercialization of certain of our products or license to third parties the rights to commercialize certain of our products or technologies that we would otherwise seek to commercialize. We may also reduce our marketing, customer support or other resources devoted to our products. Any of these options could reduce our sales growth and result in continued net losses.

The marketing and sale of our products requires regulatory approval and on-going certifications. We have received a warning letter regarding our promotion of the Ariol system, to which we must adequately respond. Failure to obtain and maintain required regulatory approvals and certifications could prevent or delay our ability to market and sell our products and may subject us to significant regulatory fines or penalties.

The FDA regulates design, testing, manufacturing, labeling, distribution, marketing, sales and service of our products. Our products are marketed in the U.S. according to premarket notifications to the FDA under Section 510(k) of the U.S. Food, Drug and Cosmetic Act.

Unless an exemption applies, each medical device that we wish to market in the U.S. must first receive either 510(k) clearance or premarket approval from the FDA. The FDA’s 510(k) clearance process usually takes from three to 12 months, but may take longer. The premarket approval process generally takes from one to three years from the time FDA files the application, but it can be significantly longer and can be significantly more expensive. Although we have obtained the necessary 510(k) clearance for our products, our 510(k) clearance can be revoked if safety or effectiveness problems develop.

We may need to seek additional regulatory approval for clearances if we modify existing products or intend to market other products under development and cannot be certain that we would obtain 510(k) clearance or premarket approval in a timely manner or at all. If the FDA requires us to seek 510(k) clearance or premarket approval for any modification to a previously cleared product, we also may be required to cease marketing or recall the modified device until we obtain such clearance or approval. Delays in obtaining clearances or approvals will adversely affect our ability to market and sell our products and may subject us to significant regulatory fines or penalties, which would result in a decline in revenue and profitability.

We expect quarterly revenue and operating results to vary significantly in future periods, which could cause our stock price to fluctuate. If our operating results are below expectations, our stock price could drop.

We have experienced significant fluctuations in our quarterly operating results, and we expect to continue to experience fluctuations in the future. Our customers, who are primarily public and private clinical laboratories, research organizations and hospitals, generally operate on annual budgets. Their budgeting cycles and spending practices affect our revenues. Factors that may have an influence on our operating results in any particular quarter include:

In addition, because we develop applications for our imaging systems, a delay in the release of a system would result in the delay of applications for the system.

It is possible in the future that our operating results will be below the expectations of public market analysts and investors. If our operating results fall below market expectations, the price of our common stock could drop significantly.

We recently transferred our stock listing from the Nasdaq National Market to the Nasdaq SmallCap Market, which could adversely affect our ability to raise capital.

We recently transferred our stock listing from the Nasdaq National Market to the less followed Nasdaq SmallCap Market as of February 4, 2003 in order to meet the less stringent Nasdaq SmallCap listing requirements. This stock listings transfer could adversely affect the liquidity and price of our stock since the Nasdaq SmallCap Market is less followed by investors than the Nasdaq National Market. As a result, there may be less demand for our stock by investors and we may be unable to raise sufficient capital to fund our operations.

Nasdaq could remove our common stock from the Nasdaq SmallCap Market, which could materially adversely affect your investment in our common stock.

If we continue to experience losses from operations and are unable to raise additional capital, we may be unable to maintain the standards for continued listing on the Nasdaq SmallCap Market, and the shares of our common stock could be subject to delisting from the Nasdaq SmallCap Market. Trading in our common stock would therefore likely be subject to the so-called “penny stock” rules that impose additional sales practice and

market making requirements on broker-dealers who sell and/or make a market in those securities. Consequently, removal from the Nasdaq SmallCap Market, if it were to occur, could affect the ability or willingness of broker-dealers to sell and/or make a market on our common stock and the ability of purchasers of our common stock to sell their securities in the secondary market. Certain “penny stock” rules apply, however, even if our common stock is quoted on the Nasdaq SmallCap Market if our stock price is below $5.00 per share. These rules could further limit the market liquidity of our common stock and the ability of investors to sell our common stock in the secondary market.

We will need to effectively manage our growth in order to achieve and sustain profitability. Our failure to manage growth effectively could reduce our sales growth and result in continued net losses.

If we are able to achieve significant growth in our future sales and to expand the scope of our operations, our management, financial, manufacturing and other capabilities, procedures and controls could be strained. We cannot assure you that our existing or any additional capabilities, procedures, systems or controls will be adequate to support our operations. We may not be able to design, implement or improve our capabilities, procedures, systems or controls in a timely and cost-effective manner. Failure to implement, improve and expand our capabilities, procedures, systems and controls in an efficient and timely manner could reduce our sales growth and result in continued net losses.

The market for medical diagnostic equipment for cancer, prenatal and other genetic tests is extremely competitive. Our competitors may succeed in developing products, and obtaining related regulatory approvals, faster than us.

The medical diagnostic equipment industry is highly competitive and competition is likely to intensify. Certain of our competitors have greater financial and technical resources and production and marketing capabilities than us. We cannot assure you that these competitors will not succeed in developing technologies and products that are more effective, easier to use or less expensive than those which are currently offered or being developed by us or that would render our technology and products obsolete and noncompetitive. In addition, some of our competitors have significantly greater experience than we have in conducting clinical investigations of new diagnostic products and in obtaining FDA and other regulatory clearances and approvals of products. Accordingly, our competitors may succeed in developing and obtaining regulatory approvals for such products more rapidly than us.

We operate in a consolidating industry, which creates barriers to our market penetration.

The healthcare industry in recent years has been characterized by consolidation. Large hospital chains and groups of affiliated hospitals prefer to negotiate comprehensive supply contracts for all of their supply needs at once. Large suppliers can often equip an entire laboratory and offer these hospital chains and groups “one-stop shopping” for laboratory instruments, supplies and services. Larger suppliers also typically offer annual rebates to their customers based on the customer’s total volume of business with the supplier. The convenience and rebates offered by these larger suppliers are administrative and financial incentives that we do not offer our customers. The success of our future plans will depend in part on our ability to overcome these and any new barriers resulting from continued consolidation in the healthcare industry.

Any disruption or delay in the supply of components or custom subassemblies could require us to redesign our products or otherwise delay our ability to assemble our products, which could cause our sales to decline and result in continued net losses.

We assemble our products from a combination of (i) commodity technology components, such as computers and monitors, (ii) custom subassemblies, such as automated filter wheels, (iii) proprietary hardware for scanning microscopy and (iv) operating systems and proprietary applications software. While we typically use components and subassemblies that are available from alternate sources, any unanticipated interruption of the supply of these

components or subassemblies could require us to redesign our products or otherwise delay our ability to assemble our products, which could cause our sales to decline and result in continued net losses.

If we fail to comply with Quality System Regulations, our manufacturing operations could be delayed, and our product sales and profitability could suffer.

Our manufacturing processes and those of our suppliers are required to comply with the FDA’s Quality System Regulation, or QSR, which covers the procedures and documentation of the design, testing, production, control, quality assurance, labeling, packaging, storage and shipping of our products. The FDA enforces the QSR through inspections. We were subject to a QSR inspection in December 2001, as a result of which, the FDA made observations to which we responded. Following our response, the FDA informed us that it did not intend to take further action. We may be inspected in the future and we cannot assure you that we would pass any future inspections. If we fail a QSR inspection, our operations could be disrupted and our manufacturing delayed. Failure to take adequate corrective action in response to a QSR inspection could force a shutdown of our manufacturing operations and a recall of our products, which would cause our product sales and profitability to suffer.

The marketing and sale of our products outside of the U.S. is subject to regulations, which vary from those in the U.S. Failure to obtain and maintain required regulatory approvals could prevent or delay our ability to market and sell our products in international markets.

The regulatory environment for testing, manufacturing, labeling, distributing, marketing and sale of our products varies from country to country. Currently, some of our products, and modifications to these products, may be subject to pre-market approval in selected countries that are members of the European Union. Our products, and modifications to these products, are also subject to other regulatory requirements in those and other countries. Our failure to comply with applicable regulatory requirements could result in fines, injunctions, civil penalties, suspensions or loss of regulatory approvals, product recalls, seizure of products, operating restrictions and criminal prosecution.

Our products have been classified in Europe as in vitro diagnostic devices (“IVDs”), which are regulated under a different standard than medical devices. As such, our products are subject to the requirements of the In Vitro Diagnostic Medical Device Directive (IVDD). An IVD is defined as a device which is a reagent, reagent product, kit, instrument, equipment or system, whether used alone or in combination, intended by the manufacturer to be used in vitro for the examination of samples derived from the human body with a view to providing information on the physiological state, state of health or disease, or congenital abnormality. IVDs are specifically excluded from the provisions of the Medical Device Directive (“MDD”), although IVDs are subject to equally stringent but different controls under the IVDD and other directives. If it is determined that our products are marketed as or intended to be issued as equipment that can produce therapeutic effects or alleviate the symptoms of any disability, injury or illness, the equipment may then fall within the scope of the MDD and product registration and appropriate documentation, including possible clinical trials would be required prior to commercialization. That same medical equipment, if also intended and promoted by us for use in the examination of samples derived from the human body with a view to providing information on the physiological state, state of health or disease, or congenital, abnormality, would be regulated under the IVDD, requiring performance data, including where appropriate, analytical sensitivity, diagnostic sensitivity, analytical specificity, diagnostic specificity, accuracy, repeatability and reproducibility.

Although our products are currently regulated under the IVDD, European regulatory authorities may independently interpret our marketing and promotional claims as falling within the scope of the MDD, and require us to comply with its differing requirements, including substantiating any therapeutic claims. A redefinition could harm our marketing and sales if we were restricted from marketing or selling our products until we are able to comply with the MDD. Moreover, a member state of the EU or any other European country could adopt other laws or regulations that require approval to market and sell our products.

We depend on distributors to sell our products outside of North America and the United Kingdom. Sales through our distributors may be lower than direct sales efforts and the distributor arrangements could be terminated before the contract period ends.

We rely substantially on independent distributors and sales agents to market and sell our products outside of North America and the United Kingdom. We cannot assure you that distributors and agents will devote adequate resources to support sales of our products.

Under our distribution agreements, we indemnify the distributors against costs, expenses and liabilities relating to litigation regarding our products. Despite our obligations, our distributors may decide to reduce or end their selling efforts until an infringement dispute is resolved or settled.

Our international sales and operations are a significant portion of our business. Changes in international markets and currency fluctuations could lead to a decline in our revenues or result in continued net losses.

We have significant international operations based in the United Kingdom. As of March 10, 2003, approximately 32 employees, constituting approximately 38% of the total number of our employees, were based outside of the U.S. We generate a substantial portion of our revenues from outside of the U.S. In 2002 and 2001, we derived approximately 38% and 39% of our total revenues, respectively, from our customers and distributors outside of the U.S. We expect that international sales will continue to account for a significant portion of our revenues.

The international nature of our business subjects us and our representatives, agents and distributors to laws and regulations of the jurisdictions in which we operate and sell our products. Changes in overseas economic conditions, currency exchange rates, foreign tax laws or tariffs or other trade regulations could have an adverse effect on our financial condition or results of operations. For example, most of our international sales are denominated in U.S. dollars, U.K. pounds sterling or European Currency Units. We do not attempt to reduce the risk of currency fluctuations by hedging. Currency fluctuations against the U.S. dollar could substantially reduce our U.S. dollar revenue. Changes in currency exchange rates could also make the products of our competitors less expensive than ours, which could result in our customers purchasing our competitors’ products instead of ours.

Export controls could prevent us from exporting our products to foreign countries or customers, which could cause our sales to decline and result in continued net losses.

Our research, investigational and clinical products are subject to regulation by U.S. Department of Commerce export controls, primarily as they relate to the associated computers. These controls could prevent us from exporting our products to certain countries or customers, which could cause our sales to decline and result in continued net losses.

Our success depends, in part, on our ability to protect our intellectual property rights. We could lose sales and our competitive advantage could be harmed if we are not able to prevent infringement of our intellectual property rights.

We rely primarily on trade secret protection and on our unpatented proprietary know-how in the development and manufacturing of our products. Our trade secrets or proprietary technology could become known or be independently developed by our competitors. In addition, the patents we hold may not be sufficiently broad to protect what we believe to be our proprietary rights. Our issued patents could also be disallowed, challenged or circumvented by our competitors.

We cannot assure you that competitors or other parties have not filed or in the future will not file applications for, or have not received or in the future will not receive, patents or obtain additional proprietary rights relating to products or processes used or proposed to be used by us. In that case, our competitive position could be harmed and we may be required to obtain licenses to patents or proprietary rights of others.

Our products could infringe on the intellectual property rights of others, which may lead to costly litigation, lead to payment of substantial damages or royalties and/or prevent us from manufacturing and selling our current and future products.

The medical diagnostic equipment industry, in general, is extremely competitive. Litigation among the participants regarding patent and other intellectual property rights is common. Whether or not the litigation has merit, it could be time consuming and expensive for us and divert the attention of our technical and management personnel from other work. We may be involved in litigation to defend against claims of infringement, to enforce our patent rights or to protect our trade secrets. If any other party’s claims are upheld in any litigation or administrative proceeding, we could be prevented from exploiting the subject matter of those claims or forced to obtain licenses from the patent owners or to redesign our products or processes to avoid infringement. In the event of any infringement by us, we cannot assure you that we will be able to successfully redesign our products or processes to avoid infringement. Accordingly, an adverse determination in a judicial or administrative proceeding or failure to obtain necessary licenses could prevent us from manufacturing and selling our products and could require us to pay substantial damages and/or royalties and/or prevent us from manufacturing and selling our current and future products.

Our customers rely substantially on the availability of third-party reimbursement. Our customers’ failure to obtain sufficient reimbursement from third-party payors could cause our sales and the future growth of our business to decline.

Hospitals, physicians and other health care providers in the U.S. that purchase our products generally rely on third-party payors and other sources for reimbursement of health care costs to reimburse all or part of the cost of the procedures in which our products are used. If hospitals, physicians and other health care providers are unable to obtain adequate reimbursement from third-party payors for the procedures in which our products or products currently under development are intended to be used, our sales and future growth of our business could be adversely affected.

Market acceptance of our products and products under development in countries outside of the U.S. is also dependent on availability of reimbursement within prevailing health care payment systems in those countries. Reimbursement and health care payment systems in international markets vary significantly by country, and include both government-sponsored health care and private insurance. We cannot assure you that we will be able to obtain international reimbursement approvals in a timely manner, if at all. Failure to receive international reimbursement approvals could harm the market acceptance of our products in the international markets in which such approvals are sought.

We depend on key technical, scientific and management personnel. Any difficulty in retaining our current employees or in hiring new employees could harm our ability to maintain and build our business operations.

Our future success depends in significant part upon the continued service of key scientific, technical and management personnel, and our continuing ability to attract and retain highly qualified scientific, technical and managerial personnel. Competition for these personnel is intense, and we cannot assure you that we can retain our key scientific, technical and managerial personnel or that we can attract or retain other highly qualified scientific, technical and managerial personnel in the future. Our key employees include Carl Hull, our President and Chief Executive Officer, Barry Hotchkies, our Chief Financial Officer, Padraig O’Kelly, our Vice President-Operations and Diane Oates, our Vice President-Regulatory Affairs and Quality Assurance.

We have taken steps to retain our key employees, including the granting of stock options that vest over time, and we have entered into employment agreements with key employees. The loss of key personnel, especially if without advanced notice, or the inability to hire or retain qualified personnel, could harm our ability to maintain and build our business operations. Furthermore, we have no key man life insurance on any of our key employees.

In addition, some companies have adopted a strategy of suing or threatening to sue former employees and their new employers to discourage those employees from leaving. As we hire new employees from our current or potential competitors, we may become a party to one or more lawsuits involving our employees. Any future litigation against us or our employees, regardless of the merit or outcome, may result in substantial costs and expenses to us and may divert management’s attention away from the operation of our business.

Undetected errors or failures in our software could result in loss or delay in the market acceptance for our product, lost sales or costly litigation.

Our existing products and products under development involve one or more software components that facilitate the detection of chromosomal, genetic or protein abnormalities through the interaction of certain imaging algorithms with the sample under examination. This software, including any new versions that may be released, may contain undetected errors or failures. We cannot assure you that, despite testing by us and our customers, all errors will be found in the software components of our products. Errors in our software could result in loss or delay in the market acceptance for our products, lost sales or costly litigation.

A successful products liability claim brought in excess of our insurance coverage could require us to pay substantial damages and result in harm to our business reputation.

The manufacture and sale of our products involve the risk of product liability claims. We cannot assure you that the coverage limits of our insurance policies will be adequate in the event we are successfully sued. We evaluate our coverage limits on a regular basis and in connection with the introduction of products currently under development. However, liability insurance is expensive and may not be available on commercially reasonably terms, if at all, or in sufficient coverage amounts to cover all eventualities. A successful claim brought against us in excess of our insurance coverage could require us to pay substantial damages and result in harm to our business reputation.

Insiders have substantial control and could delay or prevent a change in corporate control.

Some of our stockholders, including some executive officers and directors and their affiliates, own over 50% of our outstanding common stock. These stockholders will, to the extent they act together, have the ability to exert significant influence and control over matters requiring the approval of our stockholders. Their interests may be different from yours. Matters that typically require stockholder approval include: (i) election of directors; (ii) approval of a merger or consolidation; and (iii) approval of a sale of all or substantially all of our assets. Accordingly, you may not be able to influence any action we take or consider taking, even if it requires a stockholder vote.

Our stock price has been volatile. It will likely be volatile in the future. You could lose all or a portion of your investment.

The market prices for securities, generally, and for medical diagnostic instrument companies, in particular, including our common stock, have historically been highly volatile. Investment in our common stock is risky, and you could lose all or part of your investment. Many factors could cause the market price of our stock to fluctuate, perhaps substantially, including the announcement of:

In addition, changes in our operating results may cause the market price of our common stock to fluctuate.

Any future sale of a substantial number of shares eligible for resale could depress the trading price of our stock, lower our value and make it more difficult for us to raise capital.

According to Forms 13D and 13G filed by our stockholders, approximately 6,262,193 shares of our common stock and warrants (representing approximately 37% of the total shares outstanding) are held by affiliates and are therefore subject to volume limitations pursuant to Rule 144. In the event any of such stockholders ceases to be an affiliate (for example, by resigning from the Board of Directors and holding less than 10% of the shares outstanding), (i) certain of the shares held by such stockholder will be eligible for immediate resale in the public market and (ii) pursuant to Rule 144(k), certain of such shares will no longer be subject to the manner of sale and volume limitations of Rule 144 and will be eligible for resale in the public market after 90 days from the date such stockholder ceases to be an affiliate. Any sale of a substantial number of shares may have the effect of depressing the trading price of our common stock. In addition, these sales could lower our value and make it more difficult for us to raise capital.

Our preferred shares rights plan, certificate of incorporation, bylaws and Delaware law contain provisions that could prevent or delay a takeover of Applied Imaging and negatively impact shareholder value.

On May 28, 1998, we adopted a preferred shares rights plan. The purpose of the plan is to assure fair value in the event of a future unsolicited business combination or similar transaction involving Applied Imaging. If an individual or entity accumulates or solicits a tender or exchange offer for 20% of our common stock, or 25% in the case of Special Situation Funds and affiliates, the rights become exercisable for additional shares of our preferred stock. The intent of these rights is to encourage a potential acquirer to negotiate with our Board of Directors to increase the consideration paid for our stock. The existence of this plan, however, may deter a potential acquirer, which could negatively impact stockholder value. We also are authorized to issue 6,000,000 shares of undesignated preferred stock, which we may issue without stockholder approval and upon such terms as our Board of Directors may determine.

In addition, our basic corporate documents and Delaware law contain provisions that might enable our management to resist a takeover. Any of these provisions might discourage, delay or prevent a change in the control of Applied Imaging or a change in our management. The existence of these provisions could adversely affect the voting power of holders of common stock and limit the price that investors might be willing to pay in the future for shares of our common stock.

Our corporate headquarters are located in an approximately 14,000 square foot facility in Santa Clara, California, under a lease, which terminates on August 31, 2004. In the United Kingdom, we lease an approximately 10,000 square foot facility in Newcastle under a lease that terminates in July 2008, with an option to cancel in July 2003. We also lease approximately 4,400 square feet in League City, Texas that we are in the process of closing. This lease expires on October 31, 2006.

The Company’s common stock traded on the Nasdaq National Market during 2002 and 2001 under the symbol “AICX.” The following table sets forth the range of the high and low sale prices by quarter as reported on the Nasdaq National Market for the periods indicated.

On January 31, 2002, we completed a private placement of 571,500 shares of our common stock to Special Situations Fund (purchasing for three separate funds) at a purchase price of $1.75 per share. This offering was exempt from registration under Section 4(2) of the Securities Act. The Stock Purchase Agreement between the investors and us was filed with the Securities & Exchange Commission on Form S-3, as amended, on October 3, 2002. In addition, on July 29, 2002 each investor received a warrant exercisable for the number of shares of our common stock equal to the number of shares of our common stock purchased by that investor in the January 31, 2002 financing. The warrants are exercisable for four years from July 29, 2002 at a price of $2.25 per share.

Effective at the opening of the market on Tuesday, February 4, 2003, our common stock listing was transferred from The Nasdaq National Market to The Nasdaq SmallCap Market and continued trading under the same symbol: AICX.

As of March 31, 2003, the number of common stockholders of record was 120, and the number of beneficial stockholders exceeded 2,000. The Company currently intends to retain any earnings for use in its business and has not in the past, nor does it anticipate paying in the foreseeable future any cash dividends.

The following selected consolidated financial data should be read in conjunction with the Company’s audited consolidated financial statements and related notes thereto and with Management’s Discussion and Analysis of Financial Condition and Results of Operations, which are included elsewhere in this Form 10-K. The consolidated statement of operations data for the years ended December 31, 2002, 2001 and 2000 and the consolidated balance sheet data at December 31, 2002 and 2001 are derived from, and are qualified by reference to, the consolidated financial statements that are included elsewhere in this document. The consolidated statement of operations data for the years ended December 31, 1999 and 1998 and the consolidated balance sheet data at December 31, 2000, 1999 and 1998 are derived from consolidated financial statements that are not included in this Form 10-K.

The information in this Item 7 contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of risks and uncertainties, including, but not limited to, those discussed below under “Factors That Might Affect Future Results,” those discussed under Item 1 in this document, including “Additional Factors That Might Affect Future Results,” and those discussed in other reports filed with the Securities and Exchange Commission. You should not rely on these forward-looking statements, which reflect our position as of the date of this report. We are under no obligation to revise or update any forward-looking statements.

The Company was founded in 1986 to develop, manufacture, and market automated genetic imaging systems for use in cytogenetic laboratories for cancer testing, prenatal testing and other genetic testing applications. We sell our products to government and private clinical laboratories, research institutions, universities, and pharmaceutical companies located in the United States, Canada, Europe, Japan and other countries. We also market imaging systems designed for use in plant and animal genetic research programs. In addition, we have received FDA clearance for a clinical system to detect micrometastatic cancer cells in bone marrow from cancer patients. This system and its research capabilities assists physicians in determining the initial staging of cancer cases, in detecting disease recurrence and in genetically characterizing cancer cells.

We are headquartered in Santa Clara, California, and have facilities in the United Kingdom. We are the world’s leading provider of automated cytogenetic instrument systems. Our products are sold worldwide through a direct sales force, third-party distributors and independent sales representatives. We employ 84 people worldwide.

We have an installed base of over 3,000 instruments in over 1,000 laboratories and clinics in more than 60 countries. Our CytoVision^®, PowerGene^® and QUIPS^® systems are widely utilized because of their ability to analyze human chromosome preparations using powerful software classification algorithms and a specialized user interface. These systems also incorporate the capability to analyze and record images produced by advanced genetic research assays that employ fluorescent in situ hybridization (“FISH”) or comparative genomic hybridization (“CGH”) methods.

In 2002, we released two new genetic analysis systems, Ariol^™ and SPOT^™, that combine with our MDS^™ systems to form the OncoPath^™ series of systems. The Ariol^™ system is a high-throughput system designed to automate and standardize the analysis of immunohistochemistry (“IHC”) and FISH test results in clinical laboratories. The Ariol^™ system is designed to assist the pathologist and oncologist in their review of key breast cancer IHC tests. The system is also designed to detect micrometastatic cancer cells that may be found in bone marrow and other clinical samples. The Ariol system is the second generation of the Company’s pioneering MDS^™ System.

The SPOT^™ genetic analysis system automatically detects and counts fluorescent-labeled DNA probe signals in cells. The system is designed for a range of applications, one of which is to assist in the detection of specific genetic abnormalities that identify which patients may respond to new molecularly targeted therapies. For example, the SPOT AX system is designed to automate the analysis of a fluorescent DNA probe assay that may be a factor in the selection of patients with chronic myelogenous leukemia to receive Novartis’ Gleevec^® therapy.

Our MDS^™ system combines the ability to find targeted cancer cells using brightfield microscopy techniques with our decade-long experience in fluorescence microscopy imaging and analysis. Taken together, these technologies allow us to analyze the proteins on or within a cell while simultaneously assessing which genes within that cell have been activated or expressed. Both protein and gene expression data are emerging as required parameters when assessing the precise nature of a given tumor or cancer cell. Gene expression data are increasingly being used to determine appropriate cancer therapies.

We achieved a number of important operational and financial milestones in 2002. Sales for the year were a record at $21.2 million, an increase of 16% over the $18.3 million recorded in 2001. Our net loss for the year was $495,000, a decrease of $3.2 million or 87% from the net loss of $3.7 million recorded in 2001.

In December 2002, we became aware that some of our sales employees had given verbal undertakings to certain distributors in Asia and Europe that were not in compliance with our revenue recognition policies. These verbal undertakings affected a limited number of transactions beginning in December 2001. On further investigation, we determined that these verbal undertakings, had they been known at the time, would have served to defer the recognition of the related revenue by, generally, one or two quarters. The impact of the revenue deferral on our previously-issued financial statements is to: (i) reduce revenue in the fourth quarter and full year 2001 by $250,000, reduce revenue in the first quarter of 2002 by $152,000, increase revenue in the second quarter of 2002 by $26,000 and reduce revenue in the third quarter of 2002 by $239,000, and (ii) increase the net loss in the fourth quarter and full year 2001 by $193,000, increase the net loss in the first quarter of 2002 by $111,000, increase the net profit in the second quarter of 2002 by $35,000 and reduce the net profit in the third quarter of 2002 by $176,000. There was also a small impact on inventories, accounts receivables and deferred revenue in the quarters under discussion. While we concluded that the impact of the revenue recognition matter on each quarter in question was not necessarily material, we decided to restate our financial results for fiscal year 2001 and the first three quarters of fiscal 2002. The restated quarterly financial information is shown in the Footnote 16—Quarterly Financial Data (unaudited) in the Notes to Consolidated Financial Statements.

We have revised our internal controls and procedures related to revenue recognition. Some of our new internal controls and procedures include: requiring sub-certifications from all sales managers and officers regarding revenue recognition, additional communication to sales employees to reinforce our revenue recognition policy, clarification of certain parts of our revenue recognition policy, and requiring a counter signature by the Chief Financial Officer of significant sales orders.

Our operating results have fluctuated significantly in the past on an annual and quarterly basis. We expect that operating results will fluctuate significantly from quarter to quarter and year to year in the future and will depend on a number of factors. These factors include, but are not limited to, demand for our products, release and acceptance of new systems and new applications, timing of capital equipment orders and shipments, competition and its related pricing pressures, and seasonal factors, many of which are outside of our control.

Revenues. Revenues increased to $21.2 million in 2002 from $18.3 million in 2001, an increase of 16%. This reflected a revenue increase of 20% in North America and an increase of 10% in the rest of the world. Growth in sales in North America was due primarily to the unit growth in the OncoPath^™ series of products. The slower growth experienced in the rest of the world was due to the impact of phasing out one of our genetics systems (approximately $1 million) and the completion of a grant program that had generated $400,000 of revenue in 2001 and no revenue in 2002. For 2002 and 2001 revenues derived outside of North America were approximately 38% and 39% of total revenues, respectively, reflecting the growth in North American system sales during 2002 and the slower growth in the rest of the world markets discussed previously. We expect that our OncoPath^™ systems may be the primary driver of our future sales growth.

Sales of systems were $16.5 million in 2002, an increase of 20% over the $13.7 million achieved in 2001, primarily due to unit growth in North American markets discussed previously.

Software maintenance, service contract and grant revenues at $4.8 million in 2002 increased 4% from the $4.6 million recorded in 2001. Excluding the impact of the completion of the grant program discussed previously, service contract revenues increased by 14% to $3.3 million in 2002 from $2.9 million in 2001, primarily due to growth in service contract revenues reflecting the increased emphasis placed on marketing service contracts to our customers. Grant proceeds were zero in 2002 compared to $400,000 in 2001. Grant revenues fluctuate based on the completion of programs, with revenue being recognized as the work is performed.

Cost of Revenues. Cost of revenues includes direct material and labor costs, manufacturing overhead, warranty-related expenses and post-warranty service and application support expenses. Cost of revenues as a percentage of revenues was 39% in 2002 compared to 42% in 2001. The lower costs as a percent of revenues are due to reduced manufacturing costs (primarily lower material costs of components such as personal computers, monitors and flat panel displays) and the consolidation of manufacturing facilities in Santa Clara, California that was completed in the first quarter of 2002. Cost of system revenues increased from $5.7 million in 2001 to $6.2 million in 2002 (or by 9%) and as a percentage of revenues decreased from 42% in 2001 to 38% in 2002 due primarily to reduced manufacturing costs and the consolidation of manufacturing facilities discussed previously. Cost of service contract, software maintenance and grant revenues increased from $2.0 million in 2001 to $2.1 million in 2002 (or by 5%) and as a percentage of revenues was 43% in 2002, the same level as in 2001. Grant revenues did not have a significant impact on cost of revenues in either 2002 or 2001.

Research and Development Expenses. Research and development expenses decreased from $3.9 million in 2001 to $3.4 million in 2002, or by 12% due primarily to the consolidation of software support operations in January 2002 that resulted in the elimination of five personnel positions. Research and development costs were 16% of total revenues in 2002 compared to 21% of total revenues in 2001.

Sales and Marketing Expenses. Sales and marketing expenses decreased to $7.2 million in 2002 from $7.5 million in 2001, or by 4%. Sales and marketing expenses as a percentage of total revenues were 34% in 2002 and 40% in 2001. The decrease is primarily related to reduced international sales expenses reflecting a reduced number of personnel. Included in the sales and marketing expenses for 2002 was $108,000 for the termination of an under-performing sales distributor in Europe.

General and Administrative Expenses. General and administrative expenses decreased to $2.6 million in 2002 from $2.7 million in 2001, a decrease of 4%. As a percentage of revenue, general and administrative costs were 12% of total revenues in 2002 compared to 14% of total revenues in 2001. The reduction in the absolute dollar amount of spending and percentage of sales ratio is due primarily to reduced expenditures on our investor relations program ($56,000) and consulting ($43,000.)

Amortization of Goodwill. Amortization of goodwill amounted to $306,000 for 2001 with no such expenses in 2002. With the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets” in 2002, our goodwill is no longer being amortized in 2002. The amortization expenses in 2001 represent the amortization of goodwill resulting from the acquisition of the cytogenetic imaging business of Vysis, Inc. in July 1999 and the acquisition of the United States-based PowerGene^® business of Perceptive Scientific Instruments, LLC in July 2000.

Restructuring Costs. Restructuring costs amounted to $220,000 in 2002 with no such costs in 2001. In January 2002, we instituted a series of actions to rationalize our operations to provide a lower operating cost while increasing efficiencies. We are closing our League City, Texas office and have consolidated our manufacturing and engineering facilities. We recorded a restructuring charge of $220,000 in 2002 that was due to the costs of terminating 12 employees ($130,000 – five employees in engineering, three in manufacturing, two in administration and two in sales and support) and closing the League City, Texas office ($90,000.)

Other Income (Expense), Net. The increase in other expense from $18,000 in 2001 to $64,000 in 2002 was due primarily to the increase in net interest expense from $10,000 in 2001 to $87,000 in 2002 reflecting an increase in our borrowings that were $1.7 million at the end of 2001 compared to $2.2 million at the end of 2002.

Revenues. Revenues increased to $18.3 million in 2001 from $16.7 million in 2000, an increase of 10%. This reflected a revenue increase of 19% in North America and a decrease of 3% in the rest of the world. Sales, particularly in North America, benefited from the purchase of the PowerGene^® instrument business from International Remote Imaging Systems, Inc. on July 6, 2000. As a result, we had a full year of PowerGene^® sales in 2001 compared to six months in 2000 that provided an additional $0.5 million and $0.3 million of revenues, in North America and the rest of the world, respectively. In addition, sales in North America benefited from growth in our base cytogenetic markets ($0.6 million, excluding the increase in PowerGene revenues noted above) and related service revenues ($0.6 million). For 2001 and 2000 revenues derived outside of North America were approximately 39% and 44% of total revenues, respectively, reflecting the growth in North American instrument and service sales during 2001 discussed previously. We expect that the OncoPath^™ systems may be the primary driver of our future sales growth

Sales of systems were $13.7 million in 2001, an increase of 5% over the $13.0 million achieved in 2000, primarily due to growth in North American markets.

Service contract, software maintenance and grant revenues at $4.6 million in 2001 increased 25% from the $3.7 million recorded in 2000 primarily due to growth in service contract revenues that amounted to $2.9 million in 2001 compared to $2.2 million in 2000, reflecting the increased emphasis placed on marketing service contracts to our customers. In addition, grant proceeds amounted to $400,000 in 2001 compared to $213,000 in 2000. Grant revenues fluctuate based on the completion of milestones for existing programs, with revenue being recognized as the work is performed.

Cost of Revenues. Cost of revenues as a percentage of revenues was 42% in 2001 compared to 45% in 2000. The lower costs as a percent of revenues are due to reduced manufacturing costs (primarily lower material costs of components such as personal computers, monitors and flat panel displays) and the increase in grant revenues discussed above. Cost of system revenues decreased from $5.9 million in 2000 to $5.7 million in 2001 (or by 3%) and as a percentage of revenues from 45% in 2000 to 42% in 2001 due primarily to reduced manufacturing costs. Cost of service contract, software maintenance and grant revenues increased from $1.7 million in 2000 to $2.0 million in 2001 (or by 18%) and as a percentage of revenues decreased from 46% in 2000 to 43% in 2001 due primarily to the addition of personnel in the service function. Grant revenues did not have a significant impact on cost of revenues in either 2000 or 2001.

Research and Development Expenses. Research and development expenses of $3.9 million in 2001 increased approximately $0.4 million, or 11%, from 2000 levels. The increase is primarily due to increased personnel and consulting expenses related to the development of new applications for the MDS^™ system and the development of a second generation MDS^™ system as we focus our product development efforts on the cancer research and cancer pathology markets. Research and development costs were 21% of total revenues in both 2001 and 2000.

Sales and Marketing Expenses. Sales and marketing expenses increased to $7.5 million in 2001 from $6.4 million in 2000, or by 16%. In 2001 and 2000 sales and marketing expenses as a percentage of total revenues were 40% and 38%, respectively. The increase in spending in 2001 is due primarily to an increase in sales personnel ($0.4 million) and marketing expenses ($0.1 million) related to the introduction of the new MDS^™ applications, and higher commission expenses ($0.3 million) as a result of increased sales in North America.

General and Administrative Expenses. General and administrative expenses in 2001 amounted to $2.7 million compared to $3.0 million in 2000, a decrease of 10%. As a percentage of revenue, general and administrative costs were 14% of total revenues for 2001 compared to 18% of total revenues in 2000. The reduction in the absolute dollar amount of spending and percentage of sales ratio is due to our continued focus on cost control. We instituted controls on discretionary expenses such as travel (down $94,000 from 2000 to 2001) as well as selected salary reductions that resulted in a $74,000 reduction in compensation expenses from 2000 to 2001. There were also limited one-time operational costs in 2000 ($48,000) related to the post-acquisition integration of the U.S.-based PowerGene^® business acquired from Perceptive Scientific Instruments, LLC in July 2000.

Amortization of Goodwill. Amortization expense amounted to $306,000 in 2001 and $280,000 in 2000. Amortization expense relates to the amortization of the intangible assets that included goodwill and intellectual and software property in connection with our acquisition of the cytogenetic imaging business of Vysis Inc. on July 16, 1999 and the PowerGene^® product line on July 6, 2000. The increase in 2001 versus 2000 is due to the inclusion of a full year of amortization related to the PowerGene^® acquisition in 2001 compared to six months amortization in 2000.

Other Income (Expense), Net. In 2001, other expense amounted to $18,000 compared to other expense of $140,000 in 2000. This reduction of $122,000 in 2001 when compared to the prior year is due primarily to reduced foreign currency exchange losses due to the strengthening of the U.S. dollar versus the pound sterling and other foreign currencies that occurred primarily in the first quarter of 2000. There was a swing from net interest income in 2000 of $41,000 to a net interest expense in 2001 of $10,000, primarily reflecting a lower cash and investment position in 2001.

We have experienced significant fluctuations in our quarterly operating results in the past, and we expect to experience fluctuations in the future. Our customers, who are primarily public and private clinical laboratories, research organizations and hospitals, generally operate on annual budgets. Their spending practices, business cycles and budgeting cycles affect our revenues. Factors that may have an influence on our operating results in any particular quarter include: demand for our products, seasonality of our sales, new product introductions by us or our competitors, and the costs and time required for a transition to the new products, timing of orders and shipments for capital equipment sales, our mix of sales between our distributors and our direct sales force, competition (including pricing pressures), timing and amount of research and development expenses (including clinical trial-related expenditures), foreign currency fluctuations, delays between our incurrence of expenses to develop new products (including expenses related to marketing and service capabilities), and the timing of sales and payments received for the new products and the uncertainty of FDA or other domestic and international regulatory clearances or approvals.

Due to the factors noted above, our future earnings and stock price may be subject to significant volatility, particularly on a quarterly basis. It is possible that our future operating results will be below the expectations of public market analysts and investors. If our operating results fall below market expectations, the price of our common stock could decline significantly.

As of December 31, 2002, we had cash, cash equivalents, restricted cash and short-term investments of $3.1 million compared to $3.4 million at December 31, 2001. We maintain our cash equivalents primarily in securities with maturities of 90 days or less. Restricted cash, which collateralizes various credit and bank guarantees in the United Kingdom, amounted to $156,000 at December 31, 2002 compared to $245,000 at December 31, 2001. The reduction in cash, cash equivalents and short-term investments in 2002 was due primarily to increases in inventory and accounts receivable following sales growth. Working capital amounted to $3.3 million at December 31, 2002 compared to $2.8 million at December 31, 2001.

Cash used in operations for the year ended December 31, 2002 was $1.1 million compared to $2.1 million for 2001. The $1.0 million decrease in cash used in operations was primarily due to a $3.2 million reduction in the operating loss for the year discussed above and a $1.4 million increase in the needs for accrued expenses (an increase of $163,000 in 2002 compared to a decrease of $1.2 million in 2001.) These were partially offset by increased requirements for accounts receivables of $3.0 million (an increase of $1.7 million in 2002 versus a decrease of $1.3 million in 2001) and for inventories of $1.3 million (an increase of $697,000 in 2002 versus a decrease of $565,000), reflecting increased sales. The increase in accrued expenses is due primarily to increased accruals for compensation ($305,000) and audit/legal ($259,000).

Trade accounts receivable as a percent of fourth quarter sales were 130% in 2002 compared to 108% in 2001 and 145% in 2000. This strong relationship between year-end receivables and last quarter sales is primarily due to the fact that most of our sales occur late in the quarter as is typical of capital equipment businesses. Although our payment terms are net 30 days, our customers, specifically government, university, Japanese, Chinese and European customers tend to take longer to pay their receivable balances. We do not experience significant collection issues with our accounts, but many of our customers take longer than the stated 30-day payment period. At December 31, 2002, approximately 33% of the receivables were outstanding for greater than 90 days and at December 31, 2001, approximately 27% were older than 90 days.

Cash used in investing activities was $86,000 in 2002 compared to $335,000 in 2001. This change was primarily due to a decrease in our short-term investments of $650,000 in 2002 versus a decrease of $247,000 in 2001. This was partially offset by an increase in the amount we invested for purchases of capital equipment to $710,000 in 2002 compared to $581,000 in 2001.

Cash provided by financing activities was $1.6 million in 2002 compared to $503,000 in 2001. We received $1.0 million from the issuance of common stock in 2002 primarily from a private placement of our common stock in January, 2002 compared to $102,000 in 2001, primarily from the exercise of employee stock options. Bank debt increased by $488,000 in 2002 to fund our working capital requirements compared to a decrease in bank and other loans in 2001 of $1.0 million that included the repayment of a loan from Vysis, Inc. of $250,000 in 2001. Restricted cash was reduced by $89,000 in 2002 compared to a reduction of $1.4 million in 2001. We had restricted cash at December 31, 2000 of $1.7 million, representing cash collateralizing our bank loans. This was reduced to $245,000 at the end of 2001 as we entered into new loan agreements in 2001.

On January 31, 2002, we completed a private placement of 571,500 shares of our common stock to an institutional investor (purchasing for three separate funds) at a purchase price of $1.75 per share. Additional shares may be issuable to the investors under provisions contained in the Stock Purchase Agreement between the investors and us, which we filed with the Securities & Exchange Commission on Form S-3 on October 3, 2002, as amended. On July 29, 2002, each investor received a warrant exercisable for the number of shares of our common stock equal to the number of shares of common stock purchased by that investor in the January 31, 2002 financing. A total of 571,500 warrants were issued. The warrants are exercisable for four years from July 29, 2002 at a price of $2.25 per share. All of the warrants remain outstanding as of December 31, 2002.

On December 14, 2000, we completed a private placement of $3.5 million with the sale of 1,280,908 shares of our common stock to two institutional investors (purchasing for five separate funds) at a purchase price of $2.75 per share. The Company received proceeds of $3.2 million from the private placement net of issuance costs of $0.3 million. Warrants were also issued to the investors entitling them to purchase an additional 422,700 shares of our common stock at an exercise price of $3.75 per share. Additional shares and warrants may be issuable to the investors under anti-dilution provisions of the Stock Purchase Agreement between the Company and the investors, and terms of the warrants issued to the investors. No such additional shares or warrants have been issued. All of the warrants remain outstanding as of December 31, 2002.

On July 6, 2000 we acquired the United States-based genetic imaging business of PSI from International Remote Imaging Systems, Inc. (“IRIS”). The consideration paid was 385,371 shares of common stock valued at

$915,000, the assumption of certain liabilities, and potential future cash payments to a maximum of $0.9 million based on the future performance of the business. We paid $11,000 to IRIS in 2002 and no such performance payments were paid in 2001 and 2000.

In November 1999, we raised $2.0 million of additional equity via a private placement of one million shares of our Common Stock at a price of $2.00 per share. The investors also entered into an exclusive distribution agreement for the Company’s products. The price exceeded the closing price of our common stock as reported on the Nasdaq National Market System. As part of the private placement, we recognized deferred revenue of $720,000 to be amortized over 50 months, the term of the distribution agreement. As of December 31, 2002, the remaining balance of the deferred revenue as a result of this private placement was $173,000.

We had a £750,000 ($1,087,500) gross and £500,000 ($725,000) net unsecured revolving line of credit with an international bank in the United Kingdom that expired on March 31, 2001. The line of credit was guaranteed by the U.S. Corporation. The international bank subsequently provided us with a £750,000 ($1,087,500) gross and net zero borrowing facility with various renewals through October 31, 2001. The line of credit expired at that time and we had no loans under that facility at December 31, 2001. We collateralized various credit card and bank guarantees (used for customs clearance purposes) with cash deposits at the international bank amounting to £100,000 ($160,000) at December 31, 2002.

In September 1999, we established a $2.0 million, three-year term loan with Silicon Valley Bank (“SVB”). The loan had monthly principal payments of $55,556 plus interest at SVB prime rate plus one and a quarter percent. In June 2000, we expanded the loan agreement to include a $500,000 revolving line of credit.

We executed a new loan agreement with SVB on September 28, 2001. This new facility replaced the three-year term loan and the revolving line of credit that had an outstanding balance of $1.2 million on September 28, 2001. The new loan agreement provided the capability to borrow up to $2.0 million based on the level of certain of our North American accounts receivable and inventories. On August 15, 2002 and on October 4, 2002, the loan agreement was amended to extend the term of the loan for an additional year, through September 27, 2003, to increase borrowing capability to $3.5 million (based on the level of certain of our North American accounts receivable) and to increase the requirement for us to maintain a minimum level of tangible net worth. At December 31, 2002 we had used $2,175,000 of the facility with $1,049,000 available but not used. The interest rate on the facility was 6.25% at December 31, 2002, computed as the SVB prime rate plus 2 percent. The loan is collateralized by substantially all of the assets of the U.S. Corporation and requires us to maintain a minimum level of tangible net worth amounting to $4.8 million at December 31, 2002. Other loan covenants include the need to maintain insurance on our property, monthly reporting to SVB, the need to obtain SVB approval for any extraordinary action and a limitation on the U.S. Corporation’s ability to transfer more than $600,000 to a subsidiary. We were not in compliance with the covenant requiring us to maintain $4.8 million in minimum tangible net worth at December 31, 2002 and we have subsequently obtained a waiver for this covenant violation.

In July 1999, we acquired certain cytogenetic instrumentation assets of Vysis, Inc. Total consideration paid was $2,350,000 consisting of 497,368 shares of the Company’s common stock, a cash payment of one million dollars and installment payments of $500,000 paid July 16, 2000 and $250,000 paid January 16, 2001.

Since our formation in July 1986 through December 2002, we have generated an accumulated deficit of approximately $42.4 million. We expect negative cash flow from operations to continue through at least 2003, as we continue the development of our OncoPath^™ system, conduct clinical trials required for FDA clearance of new products, expand our marketing, sales and customer support capabilities, and add additional administrative infrastructure. In January 2002, we instituted a series of actions to rationalize our operations to provide a lower operating cost while increasing efficiencies. We believe that our capital resources will enable us to meet our short-term capital needs through at least 2003.

capital needs may require us to seek to obtain additional funds through equity or debt financing, collaborative or other arrangements with other companies, bank financing and other sources. We have expended and will continue to expend substantial amounts of money for research and development, preclinical testing, planned clinical investigations, capital expenditures, working capital needs and manufacturing and marketing of our products. Our future research and development efforts, in particular, are expected to include development of additional applications of our current cytogenetic products and additional applications for the OncoPath^™ system, which will likely require additional funds.

The exact timing and amount of spending required cannot be accurately determined and will depend on several factors, including:

To the extent necessary, we may seek to obtain additional funds through equity or debt financing, collaborative or other arrangements with other companies, bank financing and other sources. If we raise funds by issuing equity securities, you will experience dilution of your holdings in our common stock. We cannot assure you that additional financing will be available when needed or on terms acceptable to us. If adequate and acceptable financing is not available, we may have to delay development or commercialization of certain of our products or license to third parties the rights to commercialize certain of our products or technologies that we would otherwise seek to commercialize. We may also reduce our marketing, customer support or other resources devoted to certain of our products. Any of these actions could have a material adverse effect on our business, financial condition or results of operations.

Future payments due under debt and lease obligations as of December 31, 2002 is as follows (in thousands):

Our discussion and analysis of our financial position and results of operations is based on our financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America. This requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

We recognize revenue on product sales upon shipment, provided that, at the time of shipment, there is evidence of contractual arrangement with the customer, the fee is fixed and determinable, collection of the resulting receivable is probable and there are no significant remaining obligations. Concurrent with shipment, we accrue for expected hardware warranty expenses and establish reserves, based on our historical experience, for

product returns. We establish an accounts receivable allowance for estimated amounts that may not be collectible from customers. When the Company sells products to distributors, it recognizes revenue at the time of shipment, net of any discount, provided that there is evidence of contractual arrangement with the distributor, the fee is fixed or determinable, collection of the resulting receivable is probable and there are no significant remaining obligations. The distributor agreements do not provide a right of return. Revenue attributable to software maintenance and support is deferred and recognized ratably over the term of the maintenance agreement, generally one year. Grant revenues are recognized as the work is performed.

We use the asset and liability method of accounting for income taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases. We have not recorded an income tax benefit in 2002, 2001 and 2000 due to the recording of a valuation allowance as an offset to net deferred tax assets. A valuation allowance is provided due to uncertainties surrounding the realization of deferred tax assets due to our history of operating losses.

In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”. SFAS No. 146 addresses significant issues regarding the recognition, measurement, and reporting of costs that are associated with exit and disposal activities, including restructuring activities that are currently accounted for under Emerging Issues Task Force (“EITF”) No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The scope of SFAS No. 146 also includes costs related to terminating a contract that is not a capital lease and termination benefits that employees who are involuntarily terminated receive under the terms of a one-time benefit arrangement that is not an ongoing benefit arrangement or an individual deferred-compensation contract. SFAS No. 146 will be effective for exit or disposal activities that are initiated after December 31, 2002 and early application is encouraged. We will adopt SFAS No. 146 during the first quarter ending March 31, 2003. We do not expect the adoption to have a significant impact on our financial statements.

In November 2002, the FASB issued Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”, which clarifies disclosure and recognition/measurement requirements related to certain guarantees. The disclosure requirements are effective for financial statements issued after December 15, 2002 and the recognition/measurement requirements are effective on a prospective basis for guarantees issued or modified after December 31, 2002. The application of the requirements of FIN 45 did not have a material impact on our financial position or results of operations.

In December 2002, the FASB issued SFAS No. 148 “Accounting for Stock-Based Compensation—Transition and Disclosure”. SFAS No. 148 amends SFAS No. 123, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition guidance and annual disclosure provisions of SFAS No. 148 are effective for fiscal years ending after December 15, 2002. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002. As we did not make a voluntary change to the fair value based method of accounting for stock-based employee compensation in 2002, the adoption of SFAS No. 148 did not have a material impact on our financial position and results of operations.

characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The Company does not have any ownership in any variable interest entities as of December 31, 2002. The Company will apply the consolidation requirement of FIN 46 in future periods if we should own any interest in any variable interest entity.

We transact business in various foreign currencies. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. This exposure is primarily related to revenues and operating expenses in the U.K. denominated in the respective local currency.

We currently do not use financial instruments to hedge operating expenses in the U. K. denominated in the respective local currency. Instead, we believe that a natural partial hedge exits, because local currency revenues will substantially offset the operating expenses denominated in the respective local currency. We assess the need to utilize financial instruments to hedge currency exposure on an ongoing basis. We did not engage in hedging activities in 2002 and 2001 and, as of December 31, 2002, we had no hedging contracts outstanding.

We do not use derivative financial instruments for speculative trading purposes, nor do we hedge our foreign currency exposure in a manner that entirely offsets the effects of changes in foreign exchange rates. We regularly review our hedging program and may as a part of this review determine at any time to change our hedging program.

Our exposure to market risks due to changes in interest rates relates primarily to investments in debt securities issued by U.S. government agencies and corporate debt securities. Our general policy is to limit the risk of principal loss and ensure the safety of invested funds by limiting market and credit risk. We place our investments with high credit quality issuers and, by policy, limit the amount of the credit exposure to any one issuer. All highly liquid investments with maturity of three months or less at the date of purchase are considered to be cash equivalents and not subject to interest rate risks. Investments with maturities over three months and less than one year are considered to be short-term investments. At December 31, 2002 we did not have any short-term investments.

In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) on page 57 present fairly, in all material respects, the financial position of Applied Imaging Corp. and its subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) on page 57 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

As discussed in Note 14 to the financial statements, effective January 1, 2002, the Company changed its method of accounting for goodwill.

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

Applied Imaging Corp (the “Company”) was incorporated in California in July 1986 and subsequently reincorporated in Delaware in October 1996 to develop, manufacture, and market automated genetic imaging systems for use in cytogenetic laboratories for cancer testing, prenatal testing and other genetic testing applications. The Company sells products to government and private clinical laboratories, research institutions, universities, and pharmaceutical companies located in the United States, Canada, Europe, Japan and other countries. The Company also markets imaging systems designed for use in plant and animal genetic research programs. In addition, the Company has received clearance from the Food and Drug Administration (“FDA”) for a clinical system to detect micrometastatic cancer cells in bone marrow from cancer patients. This system and its research capabilities allows physicians to better determine the initial staging of cancer cases, to detect disease recurrence earlier than is currently possible and to genetically characterize cancer cells. The Company is headquartered in Santa Clara, California, and has facilities in the United Kingdom. The Company’s products are sold worldwide through a direct sales force, third-party distributors and independent sales representatives.

The Company generally warrants its products against defects for a period of one year and records a liability for such product warranty obligations at the time of sale based upon historical experience. The Company does not provide separately priced extended warranty coverage. However, the Company sells separately priced service contracts to provide additional service coverage on its systems when the warranty period expires. The related revenue on the service contracts is recognized on a straight-line basis over the life of the service contract, which is generally one year. Costs associated with services performed under the service contract obligation are expensed as incurred.

Changes in product warranty obligations for the year ended December 31, 2002 are as follows (in thousands):

These consolidated financial statements contemplate the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred net losses in fiscal 2002 and 2001 and there can be no assurance that the Company will attain profitability.

At December 31, 2002, the Company had aggregate consolidated net losses of $42.4 million. The Company expects negative cash flow from operations to continue through at least 2003, with the need for funding additional development of the OncoPath system, conducting clinical trials required for FDA clearance of new products, expanding marketing, sales and customer support capabilities, and adding additional administrative infrastructure. The Company raised $1.0 million in January 2002 with a private placement of 571,500 shares of its common stock at a price of $1.75 per share. In January 2002, the Company instituted a series of actions to rationalize its operations to provide a lower operating cost. The Company is closing its League City, Texas office

and has consolidated its manufacturing and engineering facilities. As a result of these actions, management believes that its existing cash balances will be sufficient to meet the Company’s capital and operating requirements through at least 2003.

However, expenditures required to achieve growth and profitability in the long term may be greater than projected or the cash flow generated from operations may be less than projected. As a result, the Company’s long-term capital needs may require the Company to seek to obtain additional funds through equity or debt financing, collaborative or other arrangements with other companies, bank financing and other sources. There can be no assurance that the Company will be able to obtain additional debt or equity financing on terms acceptable to the Company, or at all. If adequate funds are not available, the Company could be required to delay development or commercialization of certain products, to license to third parties the rights to commercialize certain products or technologies that the Company would otherwise seek to commercialize internally, or to reduce the marketing, customer support, or other resources devoted to product development. Accordingly, the failure of the Company to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on the Company’s ability to achieve its longer term business objectives.

The consolidated financial statements include the accounts of the Company and its subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.

The preparation of financial statements 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 and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

All investments with original maturities at date of purchase of three months or less are considered by the Company to be cash equivalents.

At December 31, 2002 cash of $156,000 was restricted from withdrawal and held at the Company’s international bank in the U.K. as collateral for various credit and bank guarantees (used for customs clearance purposes). Restricted cash at December 31, 2001 amounted to $245,000.

Short-term investments consist of investments acquired with maturities exceeding three months and less than one year. While the Company’s intent is to hold debt securities to maturity, consistent with Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities”, the Company has classified all securities as available-for-sale, as the sale of such securities may be required prior to maturity to implement management strategies. Such securities are reported at fair value with unrealized gains or losses excluded from earnings and reported as a separate component of stockholders’ equity, net of applicable taxes.

As of December 31, 2002, the Company had no short-term investments. As of December 31, 2001, the Company’s short-term investments consisted of the following (in thousands):

Inventories are stated at the lower of cost (determined on a first in, first out) or market. The Company records provisions to write down its inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and its estimated market value based upon assumptions about future market demand and market conditions. If future demand or market conditions are less favorable than currently expected, additional inventory provisions may be required.

Property and equipment are stated at cost less accumulated depreciation. Depreciation is provided using the straight-line method over the estimated useful lives of the respective assets, generally three to five years. When assets are disposed of, the cost and related accumulated depreciation are removed from the accounts and the resulting gains or losses are included in other income or loss. Equipment under capital leases are amortized over the lesser of their estimated useful lives or the term of the lease. Maintenance and repairs are charged to expense as incurred.

Net intangible assets amounted to $2.4 million at December 31, 2002. Intangible assets include goodwill and intellectual property in connection with the acquisition of the cytogenetic imaging instrumentation businesses of Vysis, Inc. and Perceptive Scientific Instruments, LLC (“PSI”). With the adoption of SFAS No. 142, “Goodwill and Other Intangible Assets” in 2002, the Company is no longer amortizing goodwill. Goodwill is assessed for impairment based on a fair value model on an annual basis and whenever there are indications that impairment may have occurred.

The Company accounts for long-lived assets under SFAS No. 144 , “Accounting for the Impairment or Disposal of Long-Lived Assets” which requires the Company to review for impairment of long-lived assets, whenever events or changes in circumstances indicate that the carrying amount of an asset might not be recoverable. When such an event occurs, management determines whether there has been an impairment by comparing the anticipated undiscounted future net cash flows to the related asset’s carrying value. If an asset is considered impaired, the asset is written down to fair value, which is determined based either on discounted cash flows or appraised value, depending on the nature of the asset.

Financial instruments consist principally of cash equivalents, short-term investments, trade receivables, accounts payable, and bank debt. The carrying amounts of these financial instruments approximate fair value.

Financial instruments that potentially subject the Company to concentrations of credit risk are accounts receivable, cash equivalents and short-term investments which the Company places with high-credit qualified financial institutions and, by policy, limits the amount of credit exposure to any one financial institution. The Company sells its products to government and private clinical cytogenetic laboratories, research institutions, universities, and pharmaceutical companies located primarily in the United States, Canada, Europe, Japan and other countries. The Company’s credit risk is concentrated primarily in the United States and Europe. The Company does not have a significant concentration of credit risk with any single customer. The Company performs on-going credit evaluations of its customer’s financial condition and, generally requires no collateral from its customers. The Company maintains an allowance for doubtful accounts to cover potential credit losses.

The Company recognizes revenue on product sales upon shipment, provided that, at the time of shipment, there is evidence of contractual arrangement with the customer, the fee is fixed or determinable, collection of the resulting receivable is probable and there are no significant remaining obligations. Concurrent with shipment, the Company accrues for expected hardware warranty expenses and establishes reserves, based on the Company’s historical experience, for product returns.

When the Company sells products to distributors, it recognizes revenue at the time of shipment, net of any discount, provided that there is evidence of contractual arrangement with the distributor, the fee is fixed or determinable, collection of the resulting receivable is probable and there are no significant remaining obligations. The distributor agreements do not provide a right of return.

Revenue attributable to software maintenance and support is deferred and recognized ratably over the term of the maintenance agreement, generally one year. Grant revenues are recognized as the work is performed.

Computer software development costs incurred subsequent to the determination of product technological feasibility are capitalized in accordance with the provisions of SFAS No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed”. Amortization of these capitalized costs is provided using the greater of the ratio of revenues generated in the period over total future revenues of the product, or the straight-line method over the estimated market life of the related products, generally three years, commencing when the product becomes generally available to customers. For the years ended December 31, 2002, 2001 and 2000, software development costs incurred subsequent to the establishment of technological feasibility have not been material. The net book value of capitalized costs is not significant and is included in other assets in the consolidated balance sheets.

The Company uses the intrinsic-value method to account for its stock-based compensation arrangements. The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 “Accounting for Stock-based Compensation” and EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction With Selling Goods and Services.”

The Company has adopted the pro forma disclosure provisions of SFAS No. 148 for the 1998 Stock Plan and Employee Stock Purchase Plan. The fair value of the stock options granted to employees is calculated using

the Black-Scholes option pricing model as of the date of grant. Had compensation cost for the Company’s stock-based compensation plans been determined in a manner consistent with the fair value approach described in SFAS No. 123, the Company’s net loss and pro forma net loss per share as reported would have been increased to the pro forma amounts indicated below (in thousands, except per share data):

The fair value of each option is estimated on the date of grant using the fair value method with the following weighted-average assumptions:

All of the above assumptions were used for the Employee Stock Purchase Plan except that the expected life is six months.

The Company accounts for its foreign operations in accordance with SFAS No. 52, “Foreign Currency Translation”. Prior to April 1994, the functional currency for Applied Imaging International Limited was the British pound and, accordingly, translation adjustments resulting from the conversion of the subsidiary’s financial statements into U.S. dollars were accumulated and reported as a separate component of stockholders’ equity. Beginning in April 1994, certain operational and organizational changes within the Company caused the functional currency for the Company’s subsidiary to become the U.S. dollar. Therefore, monetary assets and liabilities of the subsidiary are remeasured to the U.S. dollar at year-end exchange rates while nonmonetary items are remeasured at historical rates. Revenue and expense accounts related to monetary assets and liabilities are remeasured at the average rates in effect during the year. Revenue and expenses related to non-monetary assets and liabilities are translated at historical rates. Foreign currency gains and losses resulting from the conversion of the subsidiary’s financial statements into U.S. dollars are recognized in the consolidated statement of operations and comprehensive loss in other income and expense. The functional currency of Applied Imaging Limited is also the U.S. dollar.

The Company uses the asset and liability method of accounting for income taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. A valuation allowance is provided to reduce the deferred tax assets when it is more likely than not that all or a portion of the deferred tax assets will not be realized.

Basic and diluted net loss per share is computed using the weighted average number of outstanding shares of common stock. There were no reconciling items of the numerators and denominators of the basic and diluted EPS computation. Shares excluded from the computation of EPS because their effect on EPS was antidilutive, but could dilute basic EPS in future periods are as follows:

In June 2002, The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 146 (“SFAS 146”), Accounting for Costs Associated with Exit or Disposal Activities, which supersedes EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). This new standard requires companies to recognize costs associated with exit or disposal activities when the costs are incurred rather than at the date of a commitment to an exit disposal plan. Costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operations, plant closing, or other exit or disposal activity. This standard is effective for exit or disposal activities that are initiated after December 31, 2002. The Company will adopt SFAS No. 146 as of January 1, 2003 and does not believe that the adoption will have a significant impact on the financial position or results of operations.

In November 2002, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. The Company believes that the adoption of this standard will have no material impact on its financial statements.

In November 2002, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 provides guidance on how to

account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The Company believes the adoption of this standard will have no material impact on the Company’s financial statements.

In December 2002, the FASB issued SFAS No. 148, which provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, SFAS No. 148 requires disclosure of the pro forma effect in interim financial statements. The transition and annual disclosure requirements of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The interim disclosure requirements are effective for interim periods beginning after December 15, 2002. The adoption of this standard did not have a material impact on the Company’s financial statements.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The Company does not have any ownership in any variable interest entities as of December 31, 2002. The Company will apply the consolidation requirement of FIN 46 in future periods if it should own any interest in any variable interest entity.

As of December 31, 2002 and 2001, the Company had $0 and $41,000 respectively, of equipment under capital lease net of accumulated amortization of $0 and $124,000, respectively. Depreciation expense was $677,000, $622,000, and $420,000 for 2002, 2001 and 2000, respectively.

The Company had a £750,000 ($1,087,500) gross and £500,000 ($725,000) net unsecured revolving line of credit with an international bank in the United Kingdom that was guaranteed by the U.S. Corporation. The line of credit expired on March 31, 2001. The international bank subsequently provided the Company with a £750,000 ($1,087,500) gross and net zero borrowing facility with various renewals through October 31, 2001. The line of credit expired at that time and the Company had no loans under that facility at December 31, 2001. The Company collateralized various credit card and bank guarantees (used for customs clearance purposes) with cash deposits at the international bank amounting to £100,000 ($156,000) at December 31, 2002.

In September 1999, the Company established a $2.0 million, three-year term loan with Silicon Valley Bank (“SVB”). The loan had monthly principal payments of $55,556 plus interest at SVB prime rate plus one and a quarter percent. In June 2000, the Company expanded the loan agreement to include a $500,000 revolving line of credit.

The Company executed a loan agreement with SVB on September 28, 2001. This new facility replaced the three-year term loan and the revolving line of credit that had an outstanding balance of $1.2 million on September 28, 2001. The new loan agreement provided the capability to borrow up to $2.0 million based on the level of certain of our North American accounts receivable and inventories. On August 15, 2002 and on October 4, 2002, the loan agreement was amended to extend the term of the loan for an additional year, through September 27, 2003, to increase borrowing capability to $3.5 million (based on the level of certain of our North American accounts receivable) and to increase the requirement for us to maintain a minimum level of tangible net worth. At December 31, 2002 we had used $2,175,000 of the facility with $1,049,000 available but not used. The interest rate on the facility was 6.25% at December 31, 2002, computed as the SVB prime rate plus 2 percent. The loan is collateralized by substantially all of the assets of the U.S. Corporation and requires us to maintain a minimum level of tangible net worth amounting to $4.8 million at December 31, 2002. Other loan covenants include the need to maintain insurance on our property, monthly reporting to SVB, the need to obtain SVB approval for any extraordinary action and a limitation on the U.S. Corporation’s ability to transfer more than $600,000 to a subsidiary. We were not in compliance with the covenant requiring us to maintain $4.8 million in minimum tangible net worth at December 31, 2002 and we have subsequently obtained a waiver for this covenant violation.

As part of the payment terms to Vysis Inc., for the acquisition by the Company of the intellectual and software property related to the former’s cytogenetic imaging instrumentation business, the Company agreed to a note obligation of $750,000 payable in two installments each at 7% interest rate: the first for $500,000 was paid in July 2000 and the second for $250,000 was paid in January 2001.

The Company has various noncancelable operating leases for equipment, vehicles, and facilities expiring through 2006. The facility leases generally contain renewal options for periods ranging from two to five years and require the Company to pay all executory costs such as maintenance, property taxes, and insurance. Rent expense under operating leases aggregated $829,000, $853,000, and $535,000 during 2002, 2001 and 2000, respectively. The Company’s primary lease commitments are for its facilities in Santa Clara, California, which aggregated approximately $541,000 for 2002. The lease on the Santa Clara facilities is effective April 1, 2001 through August 31, 2004 at a monthly rent of $52,100, including operating expenses. In addition, the Company leases facilities in the United Kingdom, which aggregate approximately £97,000 ($155,000) per year through 2008. The lease in the United Kingdom also provides that the landlord may increase the rent to market rates in July 2003. The amount, if any, of the increase cannot be determined at this time.

The Company leases approximately 4,400 square feet of office space in League City, Texas. The lease is effective November 1, 2001 through October 31, 2006 at a monthly rent of $7,000, including operating expenses.

The Company has future minimum lease payments under non-cancelable operating leases as follows (in thousands):

The Company has entered into a non-cancelable purchase agreement with a company for the purchase of components to be used in the assembly of the Company’s imaging systems. The balance of the purchase commitment amounted to $53,000 at December 31, 2002.

The Company has obtained an exclusive option from StemCell Technologies, Inc. (“STI”) for a technology that may allow for the detection of circulating tumor cells in peripheral blood samples. The option from STI has an initial term of five years, beginning on July 2, 2001. The Company maintains exclusivity on the technology through minimum purchases of the product amounting to $141,000 in the first year of the agreement, increasing to $360,000 in the last three years of the agreement. The Company met the minimum purchase requirements in the first year of the agreement.

As of December 31, 2002, the Company had no off-balance sheet financing arrangements or commitments other than those disclosed above.

In October 2001, the Company established The Applied Imaging, Corp. Retention Incentive Program (the “Program”) to provide retention incentives to officers and outside directors in the event of a change in control of the Company.

The Company is subject to claims and assessments from time to time in the ordinary course of business. Management does not believe that any such matters, individually or in the aggregate, will have a material adverse effect on the Company’s financial condition, results of operations or cash flows.

The Company is authorized to issue 50,000,000 shares of common stock. As of December 31, 2002, there were 15,913,339 shares of common stock outstanding and warrants outstanding to purchase 422,700 shares of common stock at $3.75 per share, 100,000 shares at $3.67 and 128,090 shares at $3.10 per share. These warrants expire in 2005. In addition, there are warrants outstanding to purchase 571,500 shares of common stock at $2.25 per share that expire in 2006.

On January 31, 2002, the Company completed a private placement of 571,500 shares of its common stock to an institutional investor (purchasing for three separate funds) at a purchase price of $1.75 per share. Additional shares may be issuable to the investors under provisions contained in the Stock Purchase Agreement between the investors and the Company, which the Company filed with the Securities & Exchange Commission on Form S-3 on October 3, 2002. On July 29, 2002, each investor received a warrant exercisable for the number of shares of common stock equal to the number of shares of common stock purchased by that investor in the January 31, 2002 financing. A total of 571,500 warrants were issued and are exercisable for four years from July 29, 2002 at a price of $2.25 per share. The Company has assigned a value, determined using the Black-Scholes pricing model, of $391,000 to these warrants, assuming volatility of 96%, a maximum contractual life of four years, a risk-free interest rate of 3.29% and dividends are not expected. All warrants remain outstanding as of December 31, 2002.

On December 14, 2000, the Company completed a private placement of $3.5 million with the sale of 1,280,908 shares of its common stock to two institutional investors (purchasing for five separate funds) at a purchase price of $2.75 per share. The Company received net proceeds of $3.2 million from the private placement after deducting fees and costs of $0.3 million . The purchase price was negotiated with the investors and represented a discount from the previous day’s closing price of $3.00 per share as reported by the Nasdaq National Market System. Warrants were also issued to the investors entitling them to purchase an additional 422,700 shares of common stock at an exercise price of $3.75 per share. The Company has assigned a value, determined using the Black-Scholes pricing model, of $747,000 to these warrants, assuming volatility of 75%, a maximum contractual life of five years, a risk-free interest rate of 5.18% and no expected dividends. Additional shares and warrants may be issuable to the investors under anti-dilution provisions of the Stock Purchase Agreement between the Company and the investors, and terms of the warrants issued to the investors. No such additional shares or warrants have been issued. All the warrants remain unexercised as of December 31, 2002.

On November 3, 1999, the Company consummated a private sale of one million shares of its common stock to certain accredited investors at a purchase price of $2.00 per share. One of the investors, Tecnicas Medicas, also entered into a distribution agreement for the Company’s products in Spain. The price exceeded the closing price of the Company’s common stock as reported on the Nasdaq National Market System. As part of the private placement, the Company recognized deferred revenue of $720,000 to be amortized over 50 months. The total recognized to date is $547,000.

As of December 31, 2002, the Company has reserved for issuance 2,651,788 shares of common stock under its 1998 Incentive Stock Option Plan (“1998 Stock Plan”), 3,354,795 shares reserved for issuance under all plans. This represents the maximum aggregate number of shares that remain to be optioned or sold under the 1998 Stock Plan. A total of 2,293,870 options are outstanding at December 31, 2002 under the 1998 Stock Plan (2,993,439 options under all plans). Under the 1998 Stock Plan, stock options may be granted to Board members, officers, key employees, and consultants at the fair market value of the common stock at the date of the grant, as determined by the Board of Directors. Options are exercisable over 10 years from the date of grant, and typically vest ratably over 4 years. An amendment of the Company’s 1998 Stock Plan was approved by the Company’s stockholders on May 16, 2001 to increase the total number of shares authorized for issuance under the 1998 Stock Plan to 2,850,000 shares, an increase of 950,000 shares. As of December 31, 2002, there were 357,918 options available for grant under the 1998 Stock Plan.

In October 1998, the Company’s 1988 Amended and Restated Incentive Stock Option Plan (“1988 Stock Plan”), expired. No options were granted after October 1998. As of December 31, 2002, 589,569 options were outstanding under the 1988 Plan.

In 1994, the Company enacted a Directors Option Plan designed to encourage participation on the Company’s Board of Directors. Under this plan, 10,000 shares per year are automatically granted to non-employee directors. The terms of the plan allow the granting of stock options upon initial election to the Board of Directors and for each subsequent term on the Board of Directors. As of December 31, 2002 there were 113,438 shares reserved for issuance under this plan and a total of 110,000 options have been granted and are outstanding at December 31, 2002.

A summary of the status of the Company’s stock option activity for the years ended December 31, 2002, 2001 and 2000 is as follows:

The following table summarizes information about stock options outstanding as of December 31, 2002:

The number of options exercisable increased 373,821 from December 31, 2001 to December 31, 2002 and 226,527 from December 31, 2000 to December 31, 2001.

On June 19, 1996, the Board adopted, effective upon the closing of the IPO, the Company’s Employee Stock Purchase Plan (the “Plan”) which has a term of 10 years whereby eligible employees may purchase common stock through payroll deductions of up to 10% of compensation, at a per share price of 85% of the fair market value of the Company’s common stock on the enrollment date or the exercise date six months later, whichever is lower. As of December 31, 2002 there were 194,440 shares issued and 5,560 shares reserved for issuance under the Plan. There were 49,862 shares issued under the Plan in 2002.

In 1996, the Company recorded a deferred charge of $1,473,000, representing the difference between the exercise price and the deemed fair value of the Company’s common stock for 246,750 shares subject to common stock options granted in the 12-month period preceding the IPO. As of December 31, 2001, all related deferred stock compensation has been amortized to compensation expense.

Stock-based compensation expense related to stock options granted to non-employees is recognized as the stock options are earned. The Company believes that the fair value of the stock options is more readily

measurable than the fair value of the services received. The fair value of the stock options granted is calculated at each reporting date using the Black-Scholes option pricing model. The stock-based compensation expense will fluctuate as the fair market value of the common stock fluctuates. In connection with the grant of stock options to non-employees, the Company did not incur any stock-based compensation charges for non-employees in 2002 and recorded a reduction in deferred stock compensation of $17,000 in 2001 and an increase of $34,000 in 2000, of which $7,000 was amortized to expense in 2002, $6,000 in 2001 and $4,000 in 2000.

On July 6, 2000 the Company acquired the United States-based genetic imaging business of PSI from International Remote Imaging Systems, Inc. (“IRIS”). The acquisition was accounted for as a purchase. The consideration paid was 385,371 shares of common stock valued at $915,000. There are additional potential future cash payments to a maximum of $883,000 based on the future performance of the business which are contingent and will be accounted for upon resolution of the contingencies. The Company paid $11,000 to IRIS in 2002 and no such performance payments were required in 2001 and 2000. The Company has recorded goodwill of $578,000. The purchase price, including $170,000 of costs incurred by the Company, was allocated as follows (in thousands):

On July 16, 1999, the Company acquired the intellectual and software property related to the cytogenetic imaging instrumentation business of Vysis Inc. The acquisition was accounted for as a purchase. The consideration paid was $2,350,000 consisting of a cash payment of $1.0 million, $500,000 in cash paid in July 2000, $250,000 in cash paid in January 2001 and 497,368 shares of the Company’s common stock issued at $1.206 per share. The installment payments bear interest at the annual rate of seven percent. The interest is due and payable at the time the installment is due. In addition, the Company recorded a liability of approximately $100,000 for the estimated costs associated with certain warranties and service contracts that the Company has taken responsibility for. In addition, the Company incurred approximately $32,000 in legal expenses directly related to this acquisition. The Company has recorded goodwill of $2,482,000. The goodwill was originally amortized over a ten year life but, with the adoption of SFAS No. 142 in 2002, the Company is no longer amortizing goodwill.

The Company has not recorded an income tax benefit in 2002, 2001 and 2000 due to the recording of a valuation allowance as an offset to net deferred tax assets. A valuation allowance is provided due to uncertainties surrounding the realization of deferred tax assets due to the history of operating losses incurred by the Company. The tax effects of temporary differences that give rise to significant portions of deferred tax assets amount to $18,000 at December 31, 2002 and $0 at December 31, 2001 due to current state tax payments.

As of December 31, 2002, the Company had net operating loss carryforwards for U.S. federal, California and foreign tax return purposes of approximately $35.0 million, $11.0 million and $3.5 million respectively. In addition, the Company has federal and state credit carryforwards of approximately $800,000 and $650,000 available to offset future tax liabilities. The Company’s federal net operating loss carryforwards, as well as credit carryforwards, will expire at various dates beginning in 2004 through 2020 if not utilized. The Company’s state net operating loss carryforwards expire in the years between 2002 and 2006.

Under the Internal Revenue Code, the amounts of, and benefits from, net operating loss carryforwards may be impaired or limited in certain circumstances. Events which cause limitations in the amount of net operating losses that the Company may utilize in any one year include, but are not limited to, a cumulative ownership change of more than 50%, as defined, over a three year period.

Reconciliation of the statutory federal income tax to the Company’s effective tax rate follows:

In January 1994, the Company implemented a retirement savings and investment plan that is intended to qualify under Section 401(k) of the Internal Revenue Code (the “401(k) Plan”) covering all of the Company’s United States-based employees. An employee may elect to defer, in the form of contributions to the 401(k) Plan on his or her behalf, up to 15% of the total compensation that would otherwise be paid to the employee, not to exceed the amount allowed by applicable Internal Revenue Service guidelines. The Company matches 100% of the amounts deferred by the employee participants up to 3% of such employee’s total compensation and such matching amounts vest over a three-year period from the initial participation date. The Company contributed $84,000, $63,000 and $72,000 in 2002, 2001 and 2000, respectively.

The Company’s United Kingdom-based employees are covered by retirement savings plans (the “International Retirement Plans”). Under such plans, an employee may elect to make contributions of 3.5% of such employee’s earnings. Amounts contributed by the Company range from 5.5% to 6.0% of such employee’s earnings. During 2002, 2001 and 2000, respectively, the Company made contributions to the International Retirement Plans totaling $80,000, $61,000, and $66,000, respectively.

The Company operates in one segment. The Company’s chief operating decision maker is considered to be the Company’s Chief Executive Officer (“CEO”). The CEO reviews financial information presented on a consolidated basis for purposes of making operating decisions and assessing financial performance. The consolidated financial information is identical to the information presented in the accompanying consolidated statements of operations. The following table presents revenues by geographic area, since it is impracticable for the Company to present the information by individual country except where noted (in thousands):

No single customer accounted for greater than 10% of revenues or accounts receivable for each of the years ended December 31, 2002, 2001 and 2000.

To focus the Company on the execution of its sales and marketing strategy and to transition from working in fetal cell research to work in cancer metastasis, and to reduce operating costs, the Company eliminated 15 positions in 1999 at both its United States and United Kingdom facilities. The Company recorded a net restructuring charge for the year of $818,000. The charge is related to the severance costs of the terminated employees ($516,000) and certain costs ($302,000) associated with discontinued products. In December 1999, the Company decided to exit the RxFish reagent business and this resulted in the $302,000 restructuring charge, consisting of $234,000 in costs to be paid to contracted researchers, $48,000 in prepaid license fee and $20,000 in inventory write-off. In 2001 all amounts have been paid against the liability related to the termination benefits for the terminated employees and $289,000 has been paid against the discontinued product liability. During 2002, the final payments of $13,000 were paid.

In January 2002, we instituted a series of actions to rationalize our operations to provide a lower operating cost while increasing efficiencies. We are closing our League City, Texas office and have consolidated our manufacturing and engineering facilities. We recorded a restructuring charge of $220,000 in the first quarter of 2002 that was reflected in the Condensed Consolidated Statement of Operations an Comprehensive Loss as a separate line item under operating expenses. This charge is due to the costs of terminating 12 employees

($130,000—five employees in engineering, three in manufacturing, two in administration and two in sales and support) and closing the League City, Texas office ($90,000.) The employee separation costs were all cash and the costs related to the closure of the League City office were made up of $40,000 in cash charges and $50,000 in non-cash charges. As of December 31, 2002, all payments had been made and the reserve balance was zero.

The following table summarizes the restructuring reserve balances through December 31, 2002 (in thousands):

In July 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets,” which establishes financial accounting and reporting for acquired goodwill and other intangible assets and supersedes APB Opinion No. 17, “Intangible Assets”. The Company has adopted SFAS No. 142 beginning with the first quarter of fiscal 2002. SFAS No. 142 requires that goodwill and intangible assets that have indefinite useful lives will not be amortized but rather they will be tested at least annually for impairment. Intangible assets that have finite useful lives will continue to be amortized over their useful lives. The goodwill test for impairment consists of a two-step process that begins with an estimation of the fair value of a reporting unit. The first step is a screen for potential impairment and the second step measures the amount of impairment, if any. SFAS No. 142 requires an entity to complete the first step of the transitional goodwill impairment test within six months of adopting the Statement. The Company has completed the adoption of SFAS No. 142 and has determined that no impairment of the recorded goodwill exists.

The following table reconciles the Company’s fiscal 2002 and 2001 net loss, net loss per share—basic and diluted adjusted to exclude goodwill amortization pursuant to SFAS No. 142 to amounts previously reported (in thousands, except per share data):

In December 2002, the Company became aware that some of its sales employees had given verbal undertakings to certain distributors in Asia and Europe that were not in compliance with the Company’s revenue recognition policies. These verbal undertakings affected a limited number of transactions beginning in December 2001. On further investigation, the Company determined that these verbal undertakings, had they been known at the time, would have served to defer the recognition of the related revenue by, generally, one or two quarters. The impact of the revenue deferral on the Company’s previously-issued financial statements is to: (i) reduce revenue in the fourth quarter and full year 2001 by $250,000, reduce revenue in the first quarter of 2002 by $152,000, increase revenue in the second quarter of 2002 by $26,000 and reduce revenue in the third quarter of 2002 by $239,000, and (ii) increase the net loss in the fourth quarter and full year 2001 by $193,000, increase the net loss in the first quarter of 2002 by $111,000, increase the net profit in the second quarter of 2002 by $35,000 and reduce the net profit in the third quarter of 2002 by $176,000. There was also a small impact on inventories, accounts receivables and deferred revenue in the quarters under discussion.

The following table shows selected unaudited quarterly financial data for the years ended December 31, 2002 and 2001 (in thousands, except per share data). In the opinion of the Company’s management, this quarterly information has been prepared on the same basis as the financial statements and included all adjustments necessary to present fairly the information for the periods presented.

The financial data for the quarters ended December 31, 2001, March 31, 2002, June 30, 2002 and September 30, 2002 have been restated to reflect the impact of some verbal undertakings that had been made to certain distributors in Asia and Europe on revenue recognition in those quarters. The impact on the Company’s previously-issued financial statements is to: (i) reduce revenue in the fourth quarter and full year 2001 by $250,000, reduce revenue in the first quarter of 2002 by $152,000, increase revenue in the second quarter of 2002 by $26,000 and reduce revenue in the third quarter of 2002 by $239,000, and (ii) increase the net loss in the fourth quarter and full year 2001 by $193,000, increase the net loss in the first quarter of 2002 by $111,000, increase the net profit in the second quarter of 2002 by $35,000 and reduce the net profit in the third quarter of 2002 by $176,000. There was also a small impact on inventories, accounts receivables and deferred revenue in the quarters under discussion.

Certain information required by Part III is omitted from this Report on Form 10-K in that the Registrant will file a definitive proxy statement within 120 days after the end of its fiscal year pursuant to Regulation 14A with respect to the 2002 Annual Meeting of Stockholders (the “Proxy Statement”) and certain information included therein is incorporated herein by reference.

The information required by this item relating to directors and executive officers is incorporated by reference to the information under the caption “Proposal No. 1—Election of Directors” and “Executive Officers”, respectively, in the Proxy Statement.

The information required by this item is incorporated by reference to the information under the caption “Executive Compensation” in the Proxy Statement.

The information required by this item is incorporated by reference to the information under the caption “Record Date and Stock Ownership” in the Proxy Statement.

The information required by this item is incorporated by reference to the information under the caption “Certain Transactions” in the Proxy Statement.

Our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, performed an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures. This evaluation was performed within 90 days before the filing date of this annual report. Our disclosure controls and procedures are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Based on their evaluation, the CEO and CFO concluded that the company’s disclosure controls and procedures were effective in timely alerting them to material information required to be included in our periodic SEC reports. There have been no significant changes in our internal controls or, to the knowledge of management, in other factors that could significantly affect internal controls since their evaluation, with exception of the additional controls and procedures related to revenue recognition discussed in Item 7 above.

The following Financial Statements of Applied Imaging Corp. and Report of PricewaterhouseCoopers LLP, have been provided as Item 8, above:

Report of Independent Accountants		33
Consolidated Balance Sheets		34
Consolidated Statements of Operations and Comprehensive Loss		35
Consolidated Statements of Stockholders’ Equity		36
Consolidated Statements of Cash Flows		37
Notes to Consolidated Financial Statements		38

The financial statement schedule entitled “Valuation and Qualifying Accounts” is included at page 64 of this Form 10-K.

All other schedules are omitted because they are not applicable or the required information is shown in the Consolidated Financial Statements or the notes thereto.

Pursuant to the requirements of Section 13 or 15(d) 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.

APPLIED IMAGING CORP.

By:		/s/ CARL HULL
		Carl Hull President and Chief Executive Officer

By:		/s/ BARRY HOTCHKIES
		Barry Hotchkies Vice President, Chief Financial Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.

I, Carl Hull, certify, pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Annual Report of Applied Imaging Corp. on Form 10-K for the year ended December 31, 2002 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such annual report fairly presents in all material respects the financial condition and results of operations of Applied Imaging Corp.

I, Barry Hotchkies, certify, pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Annual Report of Applied Imaging Corp. on Form 10-K for the year ended December 31, 2002 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such annual report fairly presents in all material respects the financial condition and results of operations of Applied Imaging Corp.

Delaware		77-0120490
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

2380 Walsh Avenue, Building B, Santa Clara, California (Address of principal executive offices)		95051 (Zip Code)

	High	Low
2002
First Quarter	$2.79	$1.67
Second Quarter	3.09	2.05
Third Quarter	3.00	1.78
Fourth Quarter	2.37	1.45
2001
First Quarter	4³/8	1⁹/16
Second Quarter	2.53	1.72
Third Quarter	2.70	1.01
Fourth Quarter	3.11	1.25

	Year Ended December 31,
	2002			2001			2000			1999			1998
	(In thousands, except per share data)
Consolidated Statement of Operations Data:
Revenues:
Product sales	$	16,454		$	13,704		$	13,037		$	11,533		$	9,077
Software maintenance, service and grant revenues		4,780			4,583			3,652			2,655			2,650

Total revenues		21,234			18,287			16,689			14,188			11,727
Cost of revenues		8,271			7,669			7,564			6,744			6,053

Gross profit		12,963			10,618			9,125			7,444			5,674

Operating expenses:
Research and development		3,416			3,900			3,525			4,299			6,662
Sales and marketing		7,191			7,457			6,409			5,232			4,950
General and administrative		2,567			2,662			2,964			3,138			2,721
Amortization of goodwill		—			306			280			124			—
Restructuring costs		220			—			—			818			353

Total operating expenses		13,394			14,325			13,178			13,611			14,686

Operating loss		(431	)		(3,707	)		(4,053	)		(6,167	)		(9,012	)
Other income (expense), net		(64	)		(18	)		(140	)		158			541

Net loss	$	(495	)	$	(3,725	)	$	(4,193	)	$	(6,009	)	$	(8,471	)

Net loss per share—basic and diluted	$	(0.03	)	$	(0.25	)	$	(0.31	)	$	(0.50	)	$	(0.86	)

Shares used to calculate basic and diluted net loss per share		15,817			15,191			13,594			11,930			9,850


	December 31,
	2002			2001			2000			1999			1998
	(In thousands)
Balance Sheet Data:
Cash, cash equivalents, restricted cash and short-term investments	$	3,053		$	3,435		$	7,012		$	8,406		$	11,728
Working capital		3,267			2,841			6,505			7,132			10,753
Total assets		15,696			13,877			19,442			19,744			18,808
Bank debt, less current portion		—			—			500			1,167			—
Deferred revenue, non-current		333			396			345			518			—
Non-current of notes payable		—			—			—			250			—
Capital lease obligation, net of current portion		—			—			9			37			64
Accumulated deficit		(42,426	)		(41,931	)		(38,206	)		(34,013	)		(28,004	)
Total stockholders’ equity		6,374			5,866			9,483			8,612			12,343

	December 31,
	2002			2001
ASSETS
Current assets:
Cash and cash equivalents	$	2,897		$	2,538
Restricted cash		156			245
Short-term investments		—			652
Trade accounts receivable, net of allowance for doubtful accounts of $306 and $222, respectively		7,155			5,412
Inventories		1,759			1,062
Prepaid expenses and other current assets		289			547

Total current assets		12,256			10,456
Property and equipment, net		1,014			1,021
Goodwill		2,364			2,344
Other assets		62			56

Total assets	$	15,696		$	13,877


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Bank debt	$	2,175		$	1,687
Capital lease obligation		—			14
Accounts payable		2,372			1,758
Accrued expenses		1,562			1,399
Deferred revenue, current		2,880			2,757

Total current liabilities		8,989			7,615
Deferred revenue, non-current		333			396

Total liabilities		9,322			8,011


Commitments and contingencies (Note 6)

Stockholders’ equity:
Preferred stock; $0.001 par value; 6,000,000 shares authorized; none issued and outstanding at December 31, 2002 and 2001		—			—
Common stock; $0.001 par value; 50,000,000 shares authorized; 15,913,339 and 15,242,417 issued and outstanding December 31, 2002 and 2001, respectively		16			15
Additional paid-in capital		49,151			48,154
Accumulated deficit		(42,426	)		(41,931	)
Deferred stock compensation		—			(7	)
Accumulated other comprehensive loss		(367	)		(365	)

Total stockholders’ equity		6,374			5,866

Total liabilities and stockholders’ equity	$	15,696		$	13,877

	Year Ended December 31,
	2002			2001			2000
Revenues:
Product sales	$	16,454		$	13,704		$	13,037
Software maintenance, service and grant revenues		4,780			4,583			3,652

Total revenues		21,234			18,287			16,689

Cost of revenues:
Product sales		6,197			5,691			5,891
Software maintenance, service and grant revenues		2,074			1,978			1,673

Total cost of revenues		8,271			7,669			7,564

Gross profit		12,963			10,618			9,125

Operating expenses:
Research and development		3,416			3,900			3,525
Sales and marketing		7,191			7,457			6,409
General and administrative		2,567			2,662			2,964
Amortization of goodwill		—			306			280
Restructuring costs		220			—			—

Total operating expenses		13,394			14,325			13,178

Operating loss		(431	)		(3,707	)		(4,053	)
Other income (expense), net		(64	)		(18	)		(140	)

Net loss		(495	)		(3,725	)		(4,193	)
Other comprehensive loss, net of tax:
Change in unrealized loss on short-term investments		(2	)		1			13

Comprehensive loss	$	(497	)	$	(3,724	)	$	(4,180	)

Net loss per share—basic and diluted	$	(0.03	)	$	(0.25	)	$	(0.31	)

Shares used to calculate basic and diluted net loss per share		15,817			15,191			13,594

	Bank Loans		Operating Leases
2003	$	2,175	$	864
2004		—		656
2005		—		239
2006		—		225
2007		—		155

Total	$	2,175	$	2,139

	Common stock			Additional paid-in capital			Accumulated deficit			Deferred stock compensation			Accumulated other comprehensive loss			Total stockholders’ equity
	Shares	Amount		Additional paid-in capital			Accumulated deficit			Deferred stock compensation			Accumulated other comprehensive loss			Total stockholders’ equity
Balances as of December 31, 1999	13,055	$	13	$	43,034		$	(34,013	)	$	(43	)	$	(379	)	$	8,612
Exercise of common stock options	398		1		857			—			—			—			858
Private placement—net proceeds	1,281		1		3,183			—			—			—			3,184
Employee stock purchase	22		—		47			—			—			—			47
PSI Asset Purchase	385		—		915			—			—			—			915
Deferred stock compensation	—		—		34			—			(34	)		—			—
Amortization of deferred stock compensation	—		—		—			—			47			—			47
Change in unrealized loss from short-term investments	—		—		—			—			—			13			13
Net loss	—		—		—			(4,193	)		—			—			(4,193	)

Balances as of December 31, 2000	15,141		15		48,070			(38,206	)		(30	)		(366	)		9,483
Exercise of common stock options	34		—		53			—			—			—			53
Private placement expenses	—		—		(58	)		—			—			—			(58	)
Employee stock purchase	67		—		106			—			—			—			106
Deferred stock compensation	—		—		(17	)		—			17			—			—
Amortization of deferred stock compensation	—		—		—			—			6			—			6
Change in unrealized gain from short-term investments	—		—		—			—			—			1			1
Net loss	—		—		—			(3,725	)		—			—			(3,725	)

Balances as of December 31, 2001	15,242		15		48,154			(41,931	)		(7	)		(365	)		5,866
Exercise of common stock options	50		—		95			—			—			—			95
Private placement—net proceeds	571		1		814			—			—			—			815
Employee stock purchase	50		—		88			—			—			—			88
Amortization of deferred stock compensation	—		—		—			—			7			—			7
Change in unrealized loss from short-term investments	—		—		—			—			—			(2	)		(2	)
Net loss	—		—		—			(495	)		—			—			(495	)

Balances as of December 31, 2002	15,913	$	16	$	49,151		$	(42,426	)	$	—		$	(367	)	$	6,374

	For the Year Ended December 31,
	2002			2001			2000
Cash flows from operating activities:
Net loss	$	(495	)	$	(3,725	)	$	(4,193	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		642			955			706
Provision for doubtful accounts		(84	)		—			162
Amortization related to deferred stock compensation		7			6			47
Loss on sale of fixed assets		75			37			—
Changes in operating assets and liabilities:
Trade accounts and related party receivable		(1,659	)		1,320			(355	)
Inventories		(697	)		565			(64	)
Prepaid expenses and other current assets		258			(308	)		(42	)
Accounts payable		614			(71	)		(474	)
Accrued expenses		163			(1,247	)		(578	)
Deferred revenue		60			391			719

Net cash used in operating activities		(1,116	)		(2,077	)		(4,072	)

Cash flows from investing activities:
Purchase of short-term investments		—			(9,306	)		(27,493	)
Proceeds from sale and maturities of investments		650			9,553			32,182
Goodwill		(20	)		—			—
Acquisition of assets		—			—			(170	)
Purchases of property and equipment		(710	)		(581	)		(304	)
Other assets		(6	)		(1	)		25

Net cash provided by (used in) investing activities		(86	)		(335	)		4,240

Cash flows from financing activities:
Net proceeds from issuance of common stock		998			102			4,089
Bank and other loan proceeds		13,675			3,899			1,296
Bank and other loan payments		(13,187	)		(4,891	)		(2,243	)
Capital lease payments, principal portion		(14	)		(29	)		(28	)
Restricted cash		89			1,422			(1,667	)

Net cash provided by financing activities		1,561			503			1,447

Net increase (decrease) in cash and cash equivalents		359			(1,909	)		1,615
Cash and cash equivalents at beginning of year		2,538			4,447			2,832

Cash and cash equivalents at end of year	$	2,897		$	2,538		$	4,447

Supplemental disclosure of cash flow information:
Cash paid for interest during the period	$	114		$	189		$	362

Cash paid for taxes during the period	$	28		$	23		$	15

Supplemental disclosure of non-cash investing and financing activities:
Accrual recorded for business acquired	$	—		$	—		$	90

Stock issued in connection with acquisition	$	—		$	—		$	915

Change in unrealized loss from short-term investments	$	(2	)	$	1		$	13

Deferred stock compensation	$	—		$	(17	)	$	34

Balance as of January 1, 2002	$	144
Add accruals for warranties issued		25
Less costs incurred under warranties issued		(42	)

Balance as of December 31, 2002	$	127

	2001
	Amortized Cost		Unrealized Gain		Fair Value
Corporate bonds	$	650	$	2	$	652

	Shares		Weighted- average exercise price		Weighted- average fair value
Outstanding at December 31, 1999	1,988,568		$	2.10
Granted	670,300			3.64	$	1.77
Cancelled	(247,724	)		2.22
Exercised	(398,753	) (a)		2.15

Outstanding at December 31, 2000	2,012,391		$	2.59
Granted	735,000			2.68	$	1.36
Cancelled	(196,018	)		3.50
Exercised	(33,900	)		1.71

Outstanding at December 31, 2001	2,517,473		$	2.56
Granted	635,875			2.38	$	1.62
Cancelled	(110,349	)		2.90
Exercised	(49,560	)		1.82

Outstanding at December 31, 2002	2,993,439		$	2.52

	Options Outstanding				Options Exercisable
Range of exercise prices	Number of options	Weighted average remaining contractual life	Weighted average exercise price		Number of options	Weighted average exercise price
From $0.72 to $1.19	227,000	6.69 years	$	1.06	185,749	$	1.06
From $1.44 to $1.80	158,750	4.27 years		1.69	137,750		1.72
From $1.84 to $1.88	422,246	6.77 years		1.87	328,891		1.87
From $2.03 to $2.40	739,292	8.86 years		2.37	113,746		2.28
From $2.44 to $2.64	451,056	5.54 years		2.46	404,056		2.44
From $2.75 to $3.44	609,095	7.41 years		3.03	324,661		2.98
From $3.63 to $4.03	386,000	7.55 years		3.97	187,231		3.97

	2,993,439		$	2.52	1,682,084	$	2.38

Accounts receivable	$	209
Inventories		194
Other assets		10
Property and equipment		229
Liabilities		(135	)
Goodwill		578

Total purchase price	$	1,085

	2002		2001
	%		%

Tax at Federal Statutory Rate	-34.0	%	-34.0	%
State, Net of Federal Benefit	-6.0	%	-6.0	%
Deferred Tax Assets Not Benefited	39.1	%	46.9	%
Federal Research and Development Credit	0.0	%	-10.2	%
Permanent Differences	3.3	%	0.7	%
Other—Effect of foreign rates	1.2	%	2.6	%

Provision for Taxes	3.6	%	—	%

	North America			International— Principally Europe			Consolidated
Revenues
2002	$	13,260		$	7,974		$	21,234
2001		11,068			7,219			18,287
2000		9,277			7,412			16,689
Identifiable Assets
2002	$	11,176		$	4,520		$	15,696
2001		9,704			4,173			13,877
2000		11,586			7,856			19,442
Long Lived Assets
2002	$	2,968	(a)	$	472	(b)	$	3,440
2001		3,134	(a)		287	(b)		3,421
2000		3,399	(a)		433	(b)		3,832
Notes: (1) All in the U.S. (2) Primarily in the U.K.

	Restructuring Costs
Restructuring reserve balances at December 31, 1999	$	516
Cash payments		(349	)
Non cash charges		(25	)

Restructuring reserve balances at December 31, 2000		142
Cash payments		(129	)

Restructuring reserve balances at December 31, 2001		13
Restructuring charge in 2002		220
Cash payments		(143	)
Non cash charges		(90	)

Restructuring reserve balances at December 31, 2002	$	—

	2002			2001
Reported net loss	$	(495	)	$	(3,725	)
Add back: goodwill amortization		—			306

Adjusted net loss	$	(495	)	$	(3,419	)

Net loss per share—basic and diluted:
— as reported	$	(0.03	)	$	(0.25	)
— adjusted	$	(0.03	)	$	(0.23	)
Weighted average shares outstanding:
— basic and diluted		15,817			15,191

	Fiscal 2002 Quarter Ended
	March 31,						June 30,				September 30,
	(Previously Reported)			(Restated)			(Previously Reported)		(Restated)		(Previously Reported)		(Restated)		December 31,
Total revenues	$	4,999		$	4,847		$	5,319	$	5,345	$	5,780	$	5,541	$	5,501
Operating income (loss)		(324	)		(435	)		89		124		344		168		(288	)
Net income (loss)		(381	)		(492	)		115		150		307		131		(284	)
Net loss per share—basic and diluted		(0.02	)		(0.03	)		0.01		0.01		0.02		0.01		(0.02	)

	Fiscal 2001 Quarter Ended
										December 31,
	March 31,			June 30,			September 30,			(Previously Reported)		(Restated)
Total revenues	$	3,930		$	4,528		$	4,827		$	5,252	$	5,002
Operating loss		(1,811	)		(875	)		(857	)		29		(164	)
Net loss		(1,762	)		(868	)		(932	)		30		(163	)
Net loss per share—basic and diluted		(0.12	)		(0.06	)		(0.06	)		0.00		(0.01	)

Exhibit No.		Description

3.1(1)		Restated Certificate of Incorporation of the Registrant.

3.2(2)		Bylaws of the Registrant as amended.

3.3(12)		Certificate of Amendment of the Certificate of Incorporation of the Registrant.

4.1(1)		Specimen Common Stock Certificate.

4.3(3)		Preferred Shares Rights Agreement dated as of May 29, 1998, between the Registrant and Norwest Bank Minnesota, N.A. including the form of Rights Certificate, the Certificate of Designation and the summary of Rights attached thereto as Exhibits A, B, and C, respectively.

10.1(1)		Form of Indemnification Agreement for directors and officers.

10.2(b)(4)		1998 Incentive Stock Option Plan and form of Stock Option Agreement thereunder.

10.4(1)		Employee Stock Purchase Plan.

10.5(1)		Amended and Restated Registration Rights Agreements.

10.9(9)		Lease dated July 1998 between Bio Science Center and Applied Imaging International Ltd.

10.18(1)		Development Agreement dated February 5, 1996 between EM Industries and Registrant.

10.21(2)		License Agreement dated October 24, 1997 between Cambridge University and the Registrant.

10.23(b)(5)		Stock and Warrant Purchase Agreement dated May 22, 1997 between the registrant and certain investors

10.24(6)		Form of Stock Purchase Agreement between the Registrant and certain investors used in connection with sales of Common Stock on July 7 and July 15, 1998.

10.25(7)		Asset Purchase, License and Distribution Agreement between the Company and Vysis, Inc. dated July 16,1999.

10.26(8)		Form of Stock Purchase Agreement between Applied Imaging Corp. and certain investors dated October 27, 1999 and October 29, 1999.

10.27(8)		Form of Stock Purchase Agreement between Applied Imaging Corp. and certain investors, dated December 13, 2000.

10.28(8)		Form of Warrant between Applied Imaging Corp. and certain investors, dated December 14, 2000.

10.34(10)		Lease renewal to the Registrant’s headquarters in Santa Clara, CA dated April 10, 2001.

10.35(10)		Loan Modification Agreement dated June 21, 2001 between Registrant, Applied Imaging International Limited and Silicon Valley Bank.

10.36(11)		Loan and Security Agreement dated September 28, 2001 between Registrant and Silicon Valley Bank.

10.37(11)		Amendment to Loan Documents dated September 28, 2001 between Registrant and Silicon Valley Bank.

10.38(12)		Intellectual Property Mortgage and Security Agreement dated September 28, 2001 between Registrant and Silicon Valley Bank.

10.39(12)		Employment Letter Agreement dated October 19, 2001 between the Company and Carl Hull.

10.40(12)		Employment Letter Agreement dated October 19, 2001 between the Company and Jack Goldstein.

10.41(12)		Form of Employment Letter Agreement dated October 19, 2001 between the Company and its Vice Presidents.

10.42(12)		Retention Agreement

10.43(13)		Amendment to Loan Documents dated August 15, 2002 between Registrant and Silicon Valley Bank.

Exhibit No.		Description

10.44(13)		Amendment to Loan Documents dated September 28, 2001 between Registrant and Silicon Valley Bank.

21.1(1)		List of Subsidiaries of the Registrant.

23.1		Consent of PricewaterhouseCoopers LLP, Independent Accountants.

24.1*		Power of Attorney.

Signatures	Title	Date

/s/ CARL HULL (Carl Hull)	Chief Executive Officer and Director (Principal Executive Officer)	April 15, 2003

/s/ BARRY HOTCHKIES (Barry Hotchkies)	Chief Financial Officer (Principal Accounting Officer)	April 15, 2003

/s/ JOHN F. BLAKEMORE, JR.* (John F. Blakemore, Jr.)	Director	April 15, 2003

/s/ JACK GOLDSTEIN* (Jack Goldstein)	Director	April 15, 2003

/s/ ANDRE MARION* (Andre Marion)	Director	April 15, 2003

/s/ G. KIRK RAAB* (G. Kirk Raab)	Director and Chairman of the Board	April 15, 2003

/s/ PABLO VALENZUELA* (Pablo Valenzuela)	Director	April 15, 2003

	Balance at Beginning of Year		Charged to Costs and Expenses		Write-offs Net of Recoveries			Balance at End of Year
Allowance for doubtful accounts
Year ended December 31, 2002	$	222	$	84	$	—		$	306

Year ended December 31, 2001	$	289	$	—	$	(67	)	$	222

Year ended December 31, 2000	$	251	$	162	$	(124	)	$	289


Provision for excess and obsolete inventory
Year ended December 31, 2002	$	874	$	68	$	(123	)	$	819

Year ended December 31, 2001	$	830	$	65	$	(21	)	$	874

Year ended December 31, 2000	$	1,011	$	73	$	(254	)	$	830