CONCEPTUS INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the Fiscal Quarter Ended March 31, 2005

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

For the transition period from to .

Commission file number: 0-27596

CONCEPTUS, INC.

(Exact name of registrant as specified in its charter)

Delaware		94-3170244
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

1021 Howard Avenue

San Carlos, CA 94070

(Address of principal executive offices)

Registrant’s telephone number, including area code: (650) 628-4700

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 at least the past 90 days.

Yes ý ; &# 160; No o

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

As of April 30, 2005, 25,690,411 shares of the registrant’s Common Stock were outstanding.

PART I: FINANCIAL INFORMATION

ITEM 1. Condensed Consolidated Financial Statements

Conceptus, Inc.

Condensed Consolidated Balance Sheets

(Unaudited)

(In thousands)

	March 31, 2005			December 31, 2004

Assets
Current assets:
Cash and cash equivalents	$	1,751		$	2,002
Short-term investments	22,500			30,200
Restricted cash	69			69
Accounts receivable, net	2,102			2,067
Inventories, net	2,950			2,022
Other current assets	1,410			937

Total current assets	30,782			37,297

Property and equipment, net	1,355			1,322
Intangible assets, net	1,700			1,750
Other assets	1,752			1,808

Total assets	$	35,589		$	42,177

Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	1,841		$	2,713
Accrued compensation	1,794			1,347
Other accrued liabilities	948			1,072
Total current liabilities	4,583			5,132

Other long-term liabilities	29			51

Total liabilities	4,612			5,183

Contingencies (Note 11)	—			—

Stockholders’ equity:
Common stock and additional paid-in capital	222,111			221,960
Deferred stock-based compensation	(1,436		)	(1,637		)
Accumulated deficit	(189,698		)	(183,329		)
Treasury Stock, 74,000 and 72,000 shares, at cost, at March 31, 2005 and December 31, 2004, respectively	—			—

Total stockholders’ equity	30,977			36,994

Total liabilities and stockholders’ equity	$	35,589		$	42,177

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

Conceptus, Inc.

Condensed Consolidated Statements of Operations

(Unaudited)

(In thousands, except per share amounts)

	Three Months Ended March 31,
	2005			2004

Net sales	$	3,871		$	2,381

Cost of goods sold	1,727			2,120

Gross profit	2,144			261

Operating expenses:
Research and development	966			1,299
Selling, general and administrative	7,737			6,124

Total operating expenses	8,703			7,423

Operating loss	(6,559		)	(7,162		)

Interest and other income	190			34

Net loss	$	(6,369	)	$	(7,128	)

Basic and diluted net loss per share	$	(0.25	)	$	(0.31	)

Weighted-average shares used in computing basic and diluted net loss per share	25,687			23,099

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

Conceptus, Inc.

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(In thousands)

	Three Months Ended March 31,
	2005			2004
Cash flows from operating activities
Net loss	$	(6,369	)	$	(7,128	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization	287			331
Stock compensation expense	260			215
Allowance for doubtful accounts	12			(6		)
Provision for inventories	(24		)	742
Retirement of fixed assets	2			—
Changes in operating assets and liabilities:
Accounts receivable	(47		)	7
Inventories	(904		)	21
Other current assets	(473		)	(716		)
Other assets	56			129
Accounts payable	(872		)	(808		)
Accrued compensation	344			—
Other accrued liabilities	(42		)	(44		)
Other long term liabilities	(22		)	(20		)
Net cash used in operating activities	(7,792		)	(7,277		)

Cash flows from investing activities
Purchase of investments	(5,700		)	(23,884		)
Maturities of investments	13,400			7,900
Capital expenditures	(272		)	(108		)
Net cash provided by (used in) investing activities	7,428			(16,092		)

Cash flows from financing activities
Issuance of common stock from company stock plans	113			785
Issuance of common stock from equity financings, net	—			23,939
Net cash provided by financing activities	113			24,724

Effect of exchange rate changes on cash	—			17

Net increase (decrease) in cash and cash equivalents	(251		)	1,372
Cash and cash equivalents at beginning of period	2,002			5,844
Cash and cash equivalents at end of period	$	1,751		$	7,216

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

Conceptus, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the instructions to Form 10-Q and Article 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, considered necessary for a fair statement have been included.

The condensed consolidated balance sheet at December 31, 2004 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. This financial data should be reviewed in conjunction with the audited consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004. The results of operations for the three months ended March 31, 2005 may not necessarily be indicative of the operating results for the full 2005 fiscal year or any other future interim periods.

2. Organization, Ownership and Business

In December 2004, the Company decided to close down its direct operations in Australia on January 31, 2005 and sell its product through a third party distributor. As a result, costs related to the closure were recorded in 2004 as selling, general and administrative expense and included approximately $22,000 for impaired fixed assets and $183,000 of termination benefits for the five employees, which were completely paid out on January 31, 2005. All fixed assets were disposed of by the end of March 2005.

3. Summary of Significant Accounting Policies

The Company’s significant accounting policies are disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004 that was filed with the Securities and Exchange Commission on March 31, 2005. The Company’s significant accounting policies have not materially changed since December 31, 2004.

4. Investments

The Company accounts for its marketable securities in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” Such investments are classified as “available-for-sale” and are reported at fair value in the Company’s consolidated balance sheets.

At March 31, 2005 and December 31, 2004, the amortized cost basis of the available-for-sale investments represents the fair value of the investments due to their short maturities. Gross realized gains and losses from the sale of securities classified as available-for-sale were not material for the periods ended March 31, 2005 and 2004.

Auction rate securities have been classified as short-term investments on the accompanying consolidated balance sheets. Auction rate securities are variable rate bonds tied to short-term interest rates with maturities on the face of the securities in excess of ninety days. Auction rate securities have interest rate resets through a modified Dutch auction, at pre-determined short-term intervals, usually every seven, twenty-eight or thirty-five days. They trade at par and are callable at par on any interest payment date at the option of the issuer. Interest paid during a given period is based upon the interest rate determined during the prior auction.

Although these securities are issued and rated as long-term bonds, they are priced and traded as short-term instruments because of the liquidity provided through the interest rate reset. The Company had historically

classified these instruments as cash equivalents if the period between interest rate resets was ninety days or less, which was based on the ability to either liquidate the holdings or roll the investment over to the next reset period.

Based upon the Company’s re-evaluation of these securities in connection with the preparation of its December 31, 2004 financial statements, the Company has reclassified its auction rate securities, previously classified as cash equivalents, as short-term investments on its consolidated balance sheets. The resulting impact of this reclassification on the statements of cash flows for the three month period ended March 31, 2004 was to increase purchases of investments by $6,450,000 and increase sales of investments by $7,900,000.

5. Inventories, net

Inventories are stated at the lower of cost or market. Cost is based on actual costs computed on a first-in, first-out basis. The components of inventories consist of the following (in thousands):

	March 31, 2005		December 31, 2004
Raw materials	$	169	$	250
Work-in-process	2,260		1,073
Finished goods	521		699
Total	$	2,950	$	2,022

6. Warranty

The Company offers warranties on its product and records a liability for the estimated future costs associated with warranty claims, which is based upon historical experience and the Company’s estimate of the level of future costs. Warranty costs are reflected in the statement of operations as a cost of goods sold. A reconciliation of the changes in the Company’s warranty liability for the three months ended March 31, 2005 and 2004 follows (in thousands):

	Three Months Ended March 31,
	2005			2004
Warranty accrual at the beginning of the period	$	68		$	99
Accruals for warranties issued during the period	25			81
Settlements made in kind during the period	(36		)	(58		)
Warranty accrual at the end of the period	$	57		$	122

7. Stock-based compensation

As permitted by SFAS No. 123, “Accounting for Stock-Based Compensation,” (SFAS No. 123), as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure – an amendment of FASB Statement No. 123,” the Company accounts for employee stock-based compensation in accordance with Accounting Principles Board Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its stock-based compensation plans.

The Company granted 312,020 shares of restricted stock to its employees and directors during 2004, of which 74,000 shares have been repurchased to date by the Company in accordance with the provisions of the grants (2,000 shares repurchased in the March 2005 quarter). The shares of restricted stock had a purchase price of $0.003 per share and the Company’s repurchase right with respect to such shares lapses either in equal installments over three years or at the end of the three years, depending on the terms on the respective shares. Certain of the grants include acceleration of vesting based upon the Company’s achievement of performance goals. The Company is amortizing the net total deferred restricted stock expense of $2.2 million, calculated based on the fair value of the stock on the date of the grants, less the purchase price of the repurchased shares, over the vesting term of three years on a straight-line basis. Of the total deferred restricted stock expense of $2.2 million, $0.4 million relates to research and development and $1.8 million relates to selling, general and administrative activities. Stock

compensation expense relating to employees was $183,000 and $80,000 for the three months ended March 31, 2005 and 2004, respectively.

The following table provides a reconciliation of net loss to pro forma net loss as if the fair value method, pursuant to SFAS No. 123, had been applied to all employee awards (in thousands, except per share data):

	Three Months Ended March 31,
	2005			2004

Net loss, as reported	$	(6,369	)	$		(7,128	)
Add: stock-based employee compensation expense
Included in reported net loss	183			80
Less: Total stock-based employee compensation expense determined under fair value based method for all awards	(1,344		)	(2,652			)
Pro forma net loss	$	(7,530	)	$	(9,700		)

Basic and diluted net loss per share

As reported	$	(0.25	)	$	(0.31		)
Pro forma	$	(0.29	)	$	(0.42		)

To comply with pro forma reporting requirements of SFAS No. 123, compensation cost is also estimated for the fair value of the Company’s Employee Stock Purchase Plan (ESPP) rights, which are included in the pro forma totals above.

Stock-based compensation arrangements to non-employees are accounted for in accordance with SFAS No. 123 and Emerging Issues Task Force Issue (EITF) No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” which requires that these equity instruments are recorded at their fair value on the measurement date. The measurement of stock-based compensation is subject to periodic adjustment as the underlying equity instruments vest. Stock-based compensation expense relating to non-employees was $77,000 and $135,000 for the three months ended March 31, 2005 and 2004, respectively.

8. Computation of Net Loss Per Share

Basic net loss per share excludes any potential dilutive effects of options, common stock shares subject to repurchase, warrants and convertible securities. Diluted net loss per share includes the impact of potentially dilutive securities. However, due to the Company’s net loss position, basic and diluted net loss per share are equivalent and are computed using the weighted average number of common shares outstanding.

The following outstanding options and restricted stock shares, which could potentially dilute basic net loss per share in the future were excluded from the computation of diluted net loss per share, as their effect would have been antidilutive (in thousands):

	As of March 31,
	2005	2004
Outstanding options	3,600	4,084
Restricted stock	238	237
Total	3,838	4,321

9. Comprehensive Loss

Comprehensive income (loss) generally represents all changes in stockholders’ equity except those resulting from investments or contributions by stockholders. The Company’s unrealized gains on available-for-sale securities, and cumulative translation adjustment, if material, represent the components of comprehensive loss that are excluded

from the net loss. These components are not significant, individually or in aggregate, for the periods ended March 31, 2005 and 2004.

10. Stockholder’s Equity

In March 2005, the Company repurchased 2,000 shares of restricted common stock at par value in accordance with the terms of a restricted stock agreement. These shares are recorded as treasury stock, and with the 72,000 shares repurchased in fiscal 2004, the Company now holds a total of 74,000 shares of treasury stock, valued at a cost basis of $222.

On February 25, 2004, the Company completed a private placement of approximately 3,000,000 shares of common stock at $8.50 per share. The net proceeds to the Company, after fees and other offering costs totaling $1,600,000, were approximately $23,900,000.

11. Contingencies

From time to time the Company is involved in legal proceedings arising in the ordinary course of business. The Company believes there is no litigation pending that could have, individually or in the aggregate, a material adverse effect on its financial position, result of operations or cash flows.

12. Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued (“SFAS”) No. 123 (R), “Share-Based Payments” (revised 2004). The provisions of SFAS 123(R) will require the Company to measure all stock-based compensation awards using a fair value method and record such expense in the consolidated financial statements, including grants of employee stock options. In addition, the adoption of SFAS 123(R) will require additional accounting related to the income tax effects and additional disclosure regarding the cash flow effects resulting from share-based payment arrangements. SFAS 123(R) is effective for all public companies for annual periods beginning after June 15, 2005. The Company will adopt SFAS 123 (R) effective January 1, 2006. The Company has not yet determined whether the adoption of FAS 123(R) will result in amounts that are similar to the current pro forma disclosures under SFAS 123. The Company is evaluating the requirements for FAS 123(R) and expects the adoption to have a significant adverse impact on the statement of operations and net loss per share.

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

The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes thereto. This discussion contains forward-looking statements, including references to 2005 revenues and other forecasted items, that involve risks and uncertainties such as limited operating and sales history; the uncertainty of market acceptance of our product; dependence on obtaining and maintaining reimbursement; effectiveness and safety of our product over the long-term; our ability to obtain and maintain the necessary governmental clearances or approvals to market our product; our ability to develop and maintain proprietary aspects of our technology; our ability to manage our expansion; our limited history of manufacturing our product; our dependence on single source suppliers, third party manufacturers and co-marketers; intense competition in the medical device industry; the inherent risk of exposure to product liability claims and product recalls and other factors referenced in this Form 10-Q. Our actual results could differ materially from those expressed or implied in these forward-looking statements as a result of various factors, including those discussed in “Risk Factors” and elsewhere in this Form 10-Q.

OVERVIEW

We develop, manufacture and market Essure^®, an innovative and proprietary non-incisional permanent birth control device for women that was approved for marketing in the United States in November 2002 by the United States Food and Drug Administration, or FDA. Essure is a soft and flexible micro-insert delivered into a woman’s fallopian tubes designed to provide permanent birth control by causing a benign tissue in-growth that blocks the fallopian tubes. A successfully placed Essure micro-insert prohibits the egg from traveling through the fallopian tubes and therefore prevents fertilization.

The Essure Procedure

The Essure placement procedure is typically performed as an outpatient procedure and is intended to be a less invasive and a less costly alternative to tubal ligation, the leading form of birth control in the United States and worldwide. Laparoscopic tubal ligation and tubal ligation by laparotomy typically involve abdominal incisions and/or punctures, general or regional anesthesia, four to ten days of normal recovery time and the risks associated with an incisional procedure. The Essure placement procedure does not require cutting or penetrating the abdomen, which lowers the likelihood of post-operative pain due to the incisions/punctures, and is typically performed in an outpatient setting without general or regional anesthesia. In the Pivotal trial of Essure, the total procedure time averaged 35 minutes, with an average of 13 minutes of hysteroscopic time to place the Essure micro-insert. A patient is typically discharged approximately 45 minutes after the Essure placement procedure. No overnight hospital stay is required. Furthermore, Essure is effective without drugs or hormones. There is a three-month waiting period after the procedure during which the woman must use another form of birth control while tissue in-growth occurs. At 90 days following the procedure, the patient completes a follow-up examination called a hysterosalpingogram (HSG), which can determine whether the device was placed successfully and whether the fallopian tubes are occluded.

We believe that Essure is also an attractive alternative to tubal ligation for physicians, hospitals and payors. Essure is a less invasive permanent birth control option for physicians to offer to their patients; hospitals are able to utilize their facilities more cost effectively with the Essure placement procedure compared with tubal ligation, and payors are able to experience cost reductions resulting from the elimination of overhead and procedural costs related to anesthesia and post-operative hospital stays associated with tubal ligations. We also believe Essure is a viable alternative to other temporary methods of birth control being used when there is no intention of having children in the future. In addition, payors may also benefit from the reduction of unplanned pregnancies associated with non-permanent methods of birth control used by patients who have chosen to avoid the drawbacks of traditional permanent birth control methods but who may elect to use Essure.

Published reports estimate that 700,000 tubal ligation procedures are performed each year in the United States and 13 million procedures worldwide. We intend to tap into this market and establish the Essure procedure as the standard of care for permanent birth control.

Essure is currently being marketed in multiple countries. In November 2002 we received approval from the FDA to market Essure in the United States. In 2001, we were given approval to affix the CE Mark to Essure,

indicating that Essure is certified for sale throughout the European Union, subject to compliance with local regulations such as registration with health ministries and/or particular requirements regarding labeling or distribution. In 1999, Essure was listed with Australia’s Therapeutic Goods Administration, which allows us to market and sell Essure in Australia. In December 2004, we made the decision to terminate our direct subsidiary operations in Australia and convert to an independent distributor. This decision was largely a cost reduction measure in lieu of the small size of the Australian market and our inability to manage a direct operation to a cash-flow positive position. We have entered into a distribution agreement and the transition was completed in January 2005. In Canada, we received clearance from Health Canada to market Essure in Canada in November 2001. We now have distributors in Australia, Canada, New Zealand and France, which covers Europe, Middle East, Africa, Mexico, Central America and South America.

In July 2004, we announced that the FDA had approved labeling changes allowing concomitant use of Essure with Johnson & Johnson’s GYNECARE THERMACHOICE Uterine Balloon Therapy system. As a condition of FDA approval, Conceptus and GYNECARE agreed to provide the FDA with investigational data from a prospective study of 50 women to assess whether the THERMACHOICE endometrial ablation procedure causes intrauterine scarring and/or adhesions that could prevent or interfere with an effective HSG at three-months post-Essure placement. In addition, the study will assess tubal occlusion three months after concomitant Essure/THERMACHOICE procedures. A final report should be submitted to the FDA within three months of completion of the study. Information provided in this report will be used to assess the effectiveness of concomitant Essure/THERMACHOICE procedures.

Effectiveness of Essure

Based on clinical trial data filed with the FDA in November 2003, Essure has been demonstrated to be 99.80% effective at three years of follow-up. As of January 2005, we have accumulated sufficient patient follow-up data from the Phase II and Pivotal clinical trials to file a PMA supplement with the FDA for a four and five year effectiveness claim consistent with the three year claim.

Penetration

Doctors are required to be preceptored for between 3 and 5 cases by a certified trainer before they can perform procedures independently. As of March 31, 2005, Conceptus has trained or is in the process of training 1,849 physicians in the United States on the Essure procedure. This represents an increase of 168 physicians over the number of physicians at December 31, 2004 and an increase of 880 physicians over the number of physicians at March 31, 2004. The level of sales for Essure, particularly in this early period of adoption, is highly dependent on the number of physicians trained to perform the procedure.

Reimbursement of Essure

Market acceptance of Essure also depends in part upon the availability of reimbursement within prevailing healthcare payment systems. We believe that physician advocacy of our product will be required to continue to obtain reimbursement. As of March 31, 2005, we received positive reimbursement decisions for Essure from private insurers covering a total of 154 million covered lives, which represents 73% of all the insured, non-Medicare population of the United States. We intend to continue our effort to educate payors of the cost-effectiveness of our product, and to establish further programs to help physicians to navigate reimbursement issues.

In early November 2004, the Centers for Medicare and Medicaid Services (“CMS”) released the Final Rule for the 2005 Physician Fee schedule. For the Essure CPT code, the CMS has provided for a national physician payment of $2,198.34 for procedures performed in the office and $458.94 for physician payment when the procedure is performed in the hospital. This compares to a CPT code physician payment of $361.16 for a laparascopic tubal ligation, the current standard of care for permanent female sterilization. In addition, the CMS released the Final Rule for the 2005 OPPS, which assigns hospital outpatient reimbursement amounts. The Essure CPT code was assigned a 2005 payment level of $2,260.37, which is consistent with payments by CMS to hospitals when they perform a laparoscopic tubal ligation, normally performed in a higher cost hospital operating room. We believe these values are very favorable for the Essure procedure and will help in establishing increased utilization of the device amongst doctors. We expect that the new code, once the process to establish it at all private payors that have given a

favorable coverage decision is complete, will significantly ease the burden on a physician’s office in obtaining reimbursement for Essure, and accelerate the coverage of Essure by private insurance companies and Medicaid. This process is not automatic following receipt of the new CPT code, however, and we anticipate continuing to focus on reimbursement issues for sometime in the future both to secure our code and payment schedule into the payors’ databases, as well as to help the physician negotiate a favorable contract for payment off that schedule.

In mid-August 2004, the Australian Department of Health, Medical Services Advisory Committee (MSAC) division recommended against public funding for the Essure procedure, citing insufficient evidence for safety, effectiveness and cost effectiveness. The overall market for female sterilization in Australia is very small and we believe that our market penetration will remain limited by the MSAC decision until such time as we are able to submit sufficient long-term data to obtain public funding.

Adoption of Essure

Essure is a novel product in the contraception market, which is dominated by procedures that are well established among physicians and patients and are routinely taught to new physicians. As a result, we believe that recommendations and endorsements by physicians will be essential for market acceptance of our product. Physicians are traditionally slow to adopt new products and treatment practices, partly because of perceived liability risks. Our biggest challenge is to speed up the adoption process to make the Essure procedure the standard of care for permanent birth control. The following discussion summarizes our program in the United States to increase adoption of the Essure procedure.

First, we have developed a field based tactical reimbursement group aimed at educating the physician and office staff regarding payor procedures following a declined claim, including appeals and petitioning procedures. Typically a newly covered product will go through a period where claims are either inadvertently declined or are paid at the incorrect amount. In either instance, the physician is reluctant to perform additional procedures until payment has been secured for earlier cases, causing a decline in utilization. Our tactical reimbursement focus is intended to give the physician and his/her staff the tools to ensure that claims will ultimately be paid and thereby encourages the physician to continue performing the Essure procedure despite reimbursement issues. This tactical reimbursement group is generally targeting specific accounts with the aim of eventually meeting with all of our accounts so as to provide them with the knowledge of how to file and follow up on claims on a payor by payor basis.

Second, we are expanding our sales territories and channels of distribution so as to increase our call frequency on physicians. Already in 2005 we have added 8 sales positions and are expecting to add another 12 before the end of the year. Also, we have engaged regional distributors of women’s gynecology products to market and sell Essure. Among other responsibilities, our sales representatives are attempting to increase utilization of the Essure procedure in the office environment.

Third, we have entered into certain strategic partnerships in the past. The agreements we have entered into include the co-promotion agreement with GYNECARE Worldwide Division of Ethicon, Inc, a Johnson & Johnson company., and with Olympus America, Inc., a manufacturer of hysteroscopy equipment. We intend for these agreements to provide us with the ability to increase awareness, gain market presence and credibility, accelerate our ability to train doctors, as well as expand our market opportunity by driving adoption among a group of physicians not previously targeted by our marketing programs. The success of these joint marketing campaigns will depend upon the effectiveness of our sales force training programs, market demand for Essure in conjunction with the products marketed by the strategic partner and the efforts and commitment of the strategic partner to the program. We cannot be certain how successful these programs will be, if at all.

Fourth, we are attempting to increase patient awareness, so as to increase the number of women that will ask for information about the Essure procedure. In late July 2004 we announced that we initiated an extensive direct to consumer advertising campaign in the Chicago, Illinois metropolitan area which commenced in August 2004 and ran for 6 months. The campaign involved radio, direct mail and print media (magazine) advertisements aimed at increasing consumer awareness. In February 2005, the radio portion of the campaign was extended through the end of 2005. Depending on the success of this marketing effort, we will be evaluating additional major metropolitan markets in which to conduct a similar advertising campaign in 2005. This program was partially responsible for the increase in selling, general and administration expense during the last half of 2004. Applying this program to additional markets will therefore result in further increases in our expenses.

We have experienced significant operating losses since inception and, as of March 31, 2005, had an accumulated deficit of $189.7 million. We expect our operating losses to continue into at least the calendar year 2006 as we continue to expend substantial resources in the selling and marketing of Essure in the United States. Due to the unpredictable nature of these activities, we do not know whether we will achieve or sustain profitability in the future. We will continue to be in a net loss position until sufficient revenues can be generated to offset expenses. In February 2004, we completed a private placement of common stock to generate enough cash to help fund our operations. In the future, depending upon a variety of factors, we will likely need to raise additional funds through bank facilities, debt or equity offerings or other sources of capital.

Results of Operations - Three Months Ended March 31, 2005 and 2004

Net Sales

Net sales were $3.9 million for the three months ended March 31, 2005 as compared to $2.4 million for the three months ended March 31, 2004. The increase of $1.5 million, or 63%, in net sales is the result of the continued commercialization of Essure worldwide. While we raised prices in the U.S. in January 2005 by 17%, our worldwide average selling price decreased from $763 for the year in 2004 to $730 for the first quarter of 2005, due to the significant level of sales to our European distributor, which has a lower selling price.

We expect net sales to increase on a quarterly basis during fiscal 2005 and have put in place sales, marketing and reimbursement programs to help us to reach our revenue goal. However, as we have noted elsewhere in this Form 10-Q, our expected revenue growth is dependant on market acceptance of Essure and third party reimbursement for the device, which involves factors that are outside of our control.

For the three months ended March 31, 2005, net sales to one distributor accounted for 14% of our total consolidated net sales. Accounts receivable from one distributor accounted for 25% of our total accounts receivables outstanding as of March 31, 2005. For the three months ended March 31, 2004, net sales to one distributor accounted for 14% of our total consolidated net sales. Accounts receivable from one distributor accounted for 19% of our total accounts receivables outstanding as of March 31, 2004.

Net product sales by geographic region as a percentage of net sales in tabular form is as follows:

	March 31,
	2005			2004
Net Sales (in thousands)	$	3,871		$	2,381
United States of America	83		%	81		%
Europe	14		%	14		%
Other	3		%	5		%

Net sales are attributed to each region based on the shipping location of the external customers.

As of March 31, 2005, we have a total of 1,849 doctors that have either completed or are in the process of completing preceptorship. This represents an increase of 880 doctors over the number of doctors at March 31, 2004. Our accomplishment in obtaining the number of physicians trained is very important because it not only provides us with a strong referral base within major metropolitan areas we have targeted, but it will also create the leverage to help us gain additional reimbursement coverage. We understand that a strong base of trained physicians does not necessarily correlate to an increase in revenue proportionately.

We are working closely with private payers and physicians across the U.S. to implement the CPT code into their systems and establish payment schedules. This is important in order for physicians to be able to utilize the benefits of the CPT code in filing claims electronically rather than manually. It is expected that electronic filing will result in fewer claim denials or incorrect payments and increase the physician’s confidence in the procedure.

In January 2005, we announced our expected net sales for 2005 to be approximately $17.0 million to $18.0 million, which represents more than 45% growth from 2004. This increase in revenues includes the effect of the 17% price increase we announced in January 2005 for customers in the United States. We expect net sales from the United States will continue to be the major contributor of our global net sales. We have established three primary goals to achieve our revenue growth. We expect to complete the implementation of the new CPT code, increase sales coverage and physician utilization of the Essure procedure and work with our strategic partners. We believe our revenue growth in 2005 will be significantly influenced by how successful we are in achieving those objectives.

Gross Profit

Cost of goods sold for the three months ended March 31, 2005 was $1.7 million as compared to $2.1 million for the three months ended March 31, 2004. The decrease of $0.4 million, or 19%, is primarily due to the cost reductions achieved through higher production volumes and the outsourcing of production. Gross profit margin improved from 11% to 55%, quarter-over-quarter, which is the result of our outsourcing effort and increased volume. During 2004, we transitioned our manufacturing activities to a third party manufacturer. This outsourcing effort decreased our production costs and increased gross profit. In April 2004, we received FDA approval for the process at the third party manufacturer. Although we expect lower production costs and the price increase in the United States to improve our gross profit in 2005, our anticipated gross profits will fluctuate in correlation to revenue growth and channel mix.

Operating Expenses

Research and development expenses, which includes expenditures related to product development, clinical research and regulatory affairs, decreased to $1.0 million for the three months ended March 31, 2005 from $1.3 million for the three months ended March 31, 2004. The decrease of $0.3 million, or 26%, was primarily due to completion of activities pertaining to the PMA application process and completion of certain research and development projects. Research and development costs in 2005 are expected to be slightly higher than 2004 levels as we complete our Pivotal and Phase II clinical trials and continue to invest in product development of new and alternative product designs.

Selling, general and administrative spending for the three months ended March 31, 2005 was $7.7 million as compared to $6.1 million for the three months ended March 31, 2004. The increase of $1.6 million, or 26%, resulted from an increase of $0.4 million related to consulting expenses for the direct to consumer marketing campaign, an increase of $0.2 million to set up a strategic sales effort to focus on reimbursement and utilization and an increase of $1.0 million in consulting and audit expenses for Sarbanes-Oxley compliance. For 2005, we expect to have limited international expenditures since we completed the divestiture of our French subsidiary in January 2004 and the closure of our direct operations in Australia in January 2005. We recorded expenses of approximately $205,000 in December 2004 related to the closing down of our Australia operations, which included $183,000 of severance costs and $22,000 for impairment of fixed assets. All severance costs were completely paid out at end of January 2005 and the disposal of fixed assets was completed by the end of March 2005.

Net interest and other income increased by $156,000, to $190,000 for the three months ended March 31, 2005, from $34,000 for the three months ended March 31, 2004. The increase was a result of the higher interest rates and the sale of our former French subsidiary in 2004 at a net loss.

Restricted Stock

Liquidity and Capital Resources

We have experienced significant operating losses since inception. As of March 31, 2005 we had an accumulated deficit of $189.7 million. We have financed our operations since inception primarily through equity financings. In February 2004 we completed a private placement of approximately 3.0 million shares of common stock at $8.50 per share. Our net proceeds from the private placement were approximately $23.9 million, after deducting offering costs and commissions. The proceeds are being used to fund operations to help us reach profitability. Once we reach profitability, we expect to finance our operation through cash received from sales of our product. In the future, depending upon a variety of factors, we will likely need to raise additional funds through bank facilities, debt or equity offerings or other sources of capital.

As of March 31, 2005, we had cash, cash equivalents, restricted cash and short-term investments of $24.3 million, compared with $32.3 million at December 31, 2004. The decrease of $8.0 million is primarily due to $7.8 million of cash used in operating activities and $0.3 million used for capital expenditures, partially offset by $0.1 million from the issuance of common stock.

Operating Activities

Net cash used in operating activities was $7.8 million in the three months ended March 31, 2005, primarily as a result of our net loss of $6.4 million adjusted for non-cash related items of $0.5 million relating to depreciation and amortization and stock compensation expense. Other major items that contributed to net cash used in operating activities were related to an increase in inventories of $0.9 million, an increase in other current assets of $0.5 million and a decrease in accounts payable of $0.9 million, offset by an increase in accrued compensation of $0.3 million. We expect cash usage in operating activities to decrease sequentially from quarter to quarter as we expect moderate revenue growth on a quarterly basis.

The changes in accounts receivable were minimal because we did not experience a material fluctuation in revenues and collections activities. As of March 31, 2005, our worldwide days sales outstanding was 53 days, which was unchanged from December 31, 2004. We have credit policies that help us to monitor our collection activities and reduce our credit loss exposure. We continue to improve and modify those policies as our business evolves. Our goal is to consistently improve our days sales outstanding. We may not be able to maintain our current ratio or we may experience less than satisfactory performance in collection due to factors outside of our control such as changes in economic climates.

The $0.9 million increase in inventories was due to a build up in work in process and finished goods inventory levels to support forecasted sales. We expect inventory levels to increase further in the second quarter of 2005.

Net cash used in operating activities for the three months ended March 31, 2004 was $7.3 million, primarily as a result of our net loss of $7.1 million, adjusted for non-cash related items of $1.3 million relating to depreciation and amortization, stock compensation expenses, provision for bad debt allowance and inventories. Other major items that contributed to net cash used in operating activities were related to an increase in other current assets of $0.7 million primarily from prepaid insurance premiums and pay down of accounts payable and other liabilities of $0.9 million, offset by changes in other assets such as accounts receivable, inventories and other non-current assets of $0.1 million.

Investing Activities

Net cash provided by investing activities for the three months ended March 31, 2005 was $7.4 million, from sales of short-term investments of $13.4 million, partially offset by purchases of investments of $5.7 million and capital expenditures of $0.3 million. Net cash used in investing activities for the three months ended March 31, 2004 was $16.1 million from the purchase of investments of $23.9 million and capital expenditures of $0.1 million, partially offset by sales of investments of $7.9 million.

Financing Activities

Net cash provided by financing activities for the three months ended March 31, 2005 was $0.1 million from the exercise of stock options. Net cash provided by financing activities was $24.7 million for the three months ended March 31, 2004, primarily from the issuance of our common stock in a private placement completed in February 2004. Our net proceeds from the issuance of approximately 3.0 million shares of our common stock at $8.50 per share in the private placement were approximately $23.9 million, after deducting offering costs and commissions totaling $1.6 million. We also received $0.8 million from the exercises of stock options in the first quarter of 2004.

We expect to have negative cash flows from operations into at least 2006 and we estimate that our existing capital resources will be sufficient to meet our cash requirements for at least the next 12 months. The successful achievement of our business objectives may require additional financing and therefore, we may in the future seek to raise additional funds through bank facilities, debt or equity offerings or other sources of capital. Any additional equity financing may be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants. Additional funding may not be available when needed or on terms acceptable to us. If we are unable to obtain additional capital, we may be required to delay, reduce the scope of or eliminate our sales and marketing activities. Our future liquidity and capital requirements will depend upon many factors, including, among others:

• Resources devoted to establish sales, marketing and distribution capabilities;

• The rate of product adoption by doctors and patients; and

• The insurance payor community’s acceptance of and reimbursement for the Essure procedure.

Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued (“SFAS”) No. 123 (R), “Share-Based Payments” (revised 2004). The provisions of SFAS 123(R) will require us to measure all stock-based compensation awards using a fair value method and record such expense in the consolidated financial statements, including grants of employee stock options. In addition, the adoption of SFAS 123(R) will require additional accounting related to the income tax effects and additional disclosure regarding the cash flow effects resulting from share-based payment arrangements. SFAS 123(R) is effective for all public companies for annual periods beginning after June 15, 2005. We will adopt SFAS 123 (R) effective January 1, 2006. We have not yet determined whether the adoption of FAS 123(R) will result in amounts that are similar to the current pro forma disclosures under SFAS 123. We are evaluating the requirements for FAS 123(R) and expect the adoption to have a significant adverse impact on our statement of operations and net loss per share.

Risk Factors

In addition to the other information in this Form 10-Q, the following factors should be considered carefully in evaluating Conceptus and our business. This Form 10-Q contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth below and elsewhere in this Form 10-Q..

We have a limited history of operation with Essure and have incurred significant operating losses since inception. We expect to incur significant operating losses for the foreseeable future and we may never achieve or maintain profitability.

We have a limited history of operation with Essure and have incurred significant operating losses since our inception in 1992, including operating losses of $6.6 million for the three months ended March 31, 2005, $26.6 million in fiscal 2004, $40.2 million in fiscal 2003, and $33.1 million in fiscal 2002. We expect to continue to incur significant operating expenses and net losses as we continue sales and marketing efforts in the United States. Our net losses will continue until sufficient revenues can be generated to offset these expenses. We may not be able to generate these revenues, and we may never achieve profitability. Our failure to achieve and sustain profitability would negatively impact the market price of our common stock.

We are presently a one-product company and if our product fails to gain market acceptance, our business will suffer.

We are attempting to introduce a novel product into the contraception market, which is dominated by procedures that are well established among physicians and patients and are routinely taught to new physicians. As a result, we believe that recommendations and endorsements by physicians will be essential for market acceptance of our product. We do not know whether physicians and patients will accept our product or whether we will be able to obtain their recommendations or endorsements in sufficient amounts to be profitable. We believe that physicians will not use a product unless they determine, based on clinical data and other factors, that it is an attractive alternative to other means of contraception and that it offers clinical utility in a cost-effective manner. Physicians are traditionally slow to adopt new products and treatment practices, partly because of perceived liability risks. We are dependent on Essure, which is currently our only commercial product. If Essure does not achieve significant market acceptance among physicians, patients and healthcare payors, even if reimbursement levels are sufficient and necessary United States and international regulatory approvals are maintained, we may never achieve significant revenues or profitability.

Our future liquidity and capital requirements are uncertain.

As we commercialize Essure on a wide-scale basis, we may require additional financing and therefore may in the future seek to raise additional funds through bank facilities, debt or equity offerings or other sources of capital. Any additional equity financing may be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants. Additional funding may not be available when needed or on terms acceptable to us. If we are unable to obtain additional capital, we may be required to delay, reduce the scope of or eliminate our selling and marketing activities. We expect to have negative cash flows from operations into at least calendar 2006. Our future liquidity and capital requirements will depend upon many factors, including, among others:

• the rate of product adoption by doctors and patients;

• obtaining government and third-party reimbursement for Essure;

• the resources devoted to increasing manufacturing capacity to meet commercial demands;

• our ability to reduce our cost of sales;

• the resources devoted to developing and conducting sales and marketing and distribution programs; and

• the progress and cost of product development programs.

If the effectiveness and safety of our product are not supported by long-term data, we may not achieve market acceptance and we could be subject to liability.

The Pivotal trial of Essure was designed to support a PMA application and to have five years of post-market follow-up. In addition, patients in the Phase II study will be followed to five years. The long-term results of using Essure will not be available for several years. If long-term studies or clinical experience indicate that Essure is less effective or less safe than our current data suggest, we may not achieve or sustain market acceptance and/or we could be subject to significant liability.

Our Co-Promotion Agreement with GYNECARE may not be successful

On October 30, 2003, we announced the signing of an exclusive U.S. co-promotion agreement with GYNECARE for marketing Essure in the United States in combination with the GYNECARE THERMACHOICE Uterine Balloon Therapy endometrial ablation system. With the FDA’s approval of marketing and labeling claims regarding compatibility of the Essure procedure and the THERMACHOICE device in July 2004, marketing has commenced. However, the success of the joint marketing campaign will depend upon the effectiveness of our GYNECARE sales team training programs, market demand for Essure in conjunction with the THERMACHOICE treatment, the efforts and commitment of GYNECARE to this new program and the results of the required 50 patient post-approval clinical study. This agreement includes certain performance clauses that if not met, could lead to the termination of the agreement by Conceptus in July 2005.

We have limited sales and marketing experience and minimal distribution capabilities, and if we are unable to develop our sales and marketing capabilities or be successful in our co-marketing agreement with GYNECARE, we may be unsuccessful in commercializing Essure.

In order to market, sell and distribute Essure, we will need to maintain and continue to develop a sales force and marketing group with relevant experience and to develop the relationship with GYNECARE for co-marketing the Essure device to the endometrial ablation market. Developing a marketing and sales force is expensive and time consuming and can impact the effectiveness of our product launch. If we fail to establish adequate marketing and sales capabilities, we may be unable to commercialize Essure successfully. Furthermore, certain factors in our relationship with GYNECARE are outside of our control, such as the number of sales persons, their compensation and the number of products they are selling, which could adversely impact the revenues and market development we expect from this co-marketing agreement. This agreement includes certain performance clauses that if not met, could lead to the termination of the agreement by Conceptus in July 2005.

Our direct-to-consumer advertising campaign may not be successful

In August 2004, we launched a six-month advertising campaign in the Chicago, Illinois metropolitan area involving radio, direct mail, and print media (magazine). Such advertising programs aimed at increasing consumer awareness for our product are expensive and may have limited success, if any. Such campaigns require consumers to make contact with an Essure physician, often involving a referral from their primary care physician and then to be provided information regarding birth control options by the physician, be pre-authorized for insurance reimbursement and then be scheduled for the procedure. Many of these steps are not within our control, and the program may not result in revenue generation commensurate with its costs.

We depend on our contract manufacturer to supply our commercial product requirements and we may experience disruption in supply if they are not in compliance with FDA and other health authority regulations.

In April 2004, we received FDA approval to begin manufacturing the Essure product at Accellent, formerly named Venusa, our third-party subcontractor located in Mexico. We transitioned almost all of our internal manufacturing operations to Accellent by the end of 2004 to manufacture the components and assemble our product. If Accellent does not comply with FDA and other health authority regulations or encounters manufacturing difficulties, this could negatively impact sales of Essure.

Government or third party reimbursement for Essure may not be available or may be inadequate, which would limit our future product revenues and delay or prevent our profitability.

Market acceptance of Essure in the United States and in international markets will depend in part upon the availability of reimbursement within prevailing healthcare payment systems. Reimbursement systems in international markets vary significantly by country and sometimes by region, and reimbursement approvals must be obtained on a country-by-country basis. Many international markets have government-managed health care systems that determine reimbursement for new devices and procedures. In most markets, there are private insurance systems as well as government-managed systems. Regardless of the type of reimbursement system, we believe that physician advocacy of our product will be required to obtain reimbursement. Availability and extent of continued reimbursement will depend, at least in part, on the clinical and cost effectiveness of our product. We do not know whether reimbursement for our product will continue to be available in the United States or in international markets under either government or private reimbursement systems, or whether physicians will support and advocate reimbursement for use of our product for all indications intended by us. We may be unable to obtain or maintain reimbursement in any country within a particular time frame, for a particular amount, or at all, which would limit our future product revenues and delay or prevent our profitability.

We may not maintain regulatory approvals for Essure, our only product, which would delay or prevent us from generating product revenues, and would harm our business and force us to curtail or cease operations.

Numerous government authorities, both in the United States and internationally, regulate the manufacture and sale of medical devices, including Essure. In the United States, the principal regulatory authorities are the FDA and corresponding state agencies, such as the California Department of Health Services. The process of obtaining and maintaining required regulatory clearances is lengthy, expensive and uncertain.

We have received FDA approval to market Essure in the United States. If we lose that approval or fail to comply with existing or future regulatory requirements, it would delay or prevent us from generating further product revenues.

Sales of medical devices outside of the United States are subject to international regulatory requirements that vary widely from country to country. The time required to obtain clearance required by foreign countries may be longer or shorter than that required for FDA clearance, and requirements for licensing may differ significantly from FDA requirements. Many countries in which we currently market or intend to market Essure either do not currently regulate medical devices or have minimal registration requirements; however, these countries may develop more extensive regulations in the future, which could delay or prevent us from marketing Essure in these countries.

The FDA and certain foreign regulatory authorities impose numerous requirements with which medical device manufacturers must comply in order to maintain regulatory approvals. FDA enforcement policy strictly prohibits the promotion of approved medical devices for uses other than those for which the device is specifically approved by the FDA. We will be required to adhere to applicable FDA regulations, such as the Quality System Regulation, and similar regulations in other countries, which include testing, control and documentation requirements. Ongoing compliance with the Quality System Regulation and other applicable regulatory requirements will be monitored through periodic inspections by federal and state agencies, including the FDA and the California Department of Health Services, and by comparable agencies in other countries. If we fail to comply with applicable regulatory requirements, we may be subject to, among other things, warning letters, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, refusal of the government to grant pre-market clearance or pre-market approval for devices, withdrawal of approvals and criminal prosecution, any of which could negatively impact our business.

Our intellectual property rights may not provide meaningful commercial protection for our product, which could enable third parties to use our technology, or very similar technology, and could impair our ability to compete in the market.

We rely on patent, copyright, trade secret and trademark laws to limit the ability of others to compete with us using the same or similar technology in the United States and other countries. However, as described below, these laws afford only limited protection and may not adequately protect our rights to the extent necessary to sustain any

competitive advantage we may have. The laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the United States, and many companies have encountered significant problems in protecting their proprietary rights abroad. These problems can be caused by the absence of rules and methods for defending intellectual property rights.

We will be able to protect our technology from unauthorized use by third parties only to the extent that they are covered by valid and enforceable patents or are effectively maintained as trade secrets. The patent positions of companies developing medical devices, including our patent position, generally are uncertain and involve complex legal and factual questions concerning the enforceability of such patents against alleged infringement. Recent judicial decisions have established new case law and a reinterpretation of previous patent case law, and consequently we cannot assure you that historical legal standards surrounding the questions of infringement and validity will be applied in future cases. In addition, legislation may be pending in Congress that, if enacted in its present form, may limit the ability of medical device manufacturers in the future to obtain patents on surgical and medical procedures that are not performed by, or as a part of, devices or compositions that are themselves patentable. Our ability to protect our proprietary methods and procedures may be compromised by the enactment of this legislation or any other limitation or reduction in the patentability of medical and surgical methods and procedures. Changes in either the patent laws or in interpretations of patent laws in the United States and other countries may therefore diminish the value of our intellectual property.

We own, or control through licenses, a variety of issued patents and pending patent applications. However, the patents on which we rely may be challenged and invalidated, and our patent applications may not result in issued patents. Moreover, our patents and patent applications may not be sufficiently broad to prevent others from practicing our technologies or from developing competing products. We also face the risk that others may independently develop similar or alternative technologies or design around our patented technologies.

We have taken security measures to protect our proprietary information, especially proprietary information that is not covered by patents or patent applications. These measures, however, may not provide adequate protection of our trade secrets or other proprietary information. We seek to protect our proprietary information by entering into confidentiality agreements with employees, collaborators and consultants. Nevertheless, employees, collaborators or consultants could still disclose our proprietary information and we may not be able to protect our trade secrets in a meaningful way. If we lose any employees we may not be able to prevent the unauthorized disclosure or use of our technical knowledge or other trade secrets by those former employees despite the existence of a nondisclosure and confidentiality agreement and other contractual restrictions designed/intended to protect our proprietary technology. In addition, others may independently develop substantially equivalent proprietary information or techniques or otherwise gain access to our trade secrets.

Our ability to compete effectively will depend substantially on our ability to develop and maintain proprietary aspects of our technology. Our issued patents, any future patents that may be issued as a result of our United States or foreign patent applications, or the patents under which we have license rights may not offer any degree of protection against competitive products. Any patents that may be issued or licensed to us or any of our patent applications could be challenged, invalidated or circumvented in the future.

If we cannot operate our business without infringing third-party intellectual property rights, our prospects will suffer.

Our success will depend in part on our ability to operate without infringing or misappropriating the proprietary rights of others. We may be exposed to future litigation by third parties based on claims that our product infringes the intellectual property rights of others. There are numerous issued patents in the medical device industry and, as described in the next risk factor, the validity and breadth of medical device patents involve complex legal and factual questions for which important legal principles remain unresolved. Our competitors may assert that our product and the methods we employ may be covered by United States or foreign patents held by them. In addition, because patent applications can take many years to issue, there may be currently pending patent applications of which we are unaware that may later result in issued patents that our product may infringe. There could also be existing patents of which we are unaware that our product may inadvertently infringe. If we lose a patent infringement lawsuit, we could be prevented from selling our product unless we can obtain a license to use technology or ideas covered by that patent or are able to redesign the product to avoid infringement. A license may not be available to us on terms acceptable to us, or at all, and we may not be able to redesign our product to avoid

any infringement. If we are not successful in obtaining a license or redesigning our product, we may be unable to sell our product and our business would suffer.

We have been, and may in the future, be a party to patent litigation, which could be expensive and divert our management’s attention.

The medical device industry has been characterized by extensive litigation regarding patents and other intellectual property rights, and companies in the industry have used intellectual property litigation to gain a competitive advantage. We may become a party to patent infringement claims and litigation or interference proceedings declared by the United States Patent and Trademark Office (PTO), to determine the priority of inventions. The defense and prosecution of these matters are both costly and time consuming. We may need to commence proceedings against others to enforce our patents, to protect our trade secrets or know-how or to determine the enforceability, scope and validity of the proprietary rights of others. These proceedings would result in substantial expense to us and significant diversion of effort by our technical and management personnel.

A third party, Ovion, Inc., brought to our attention a patent and certain claims from a pending patent application owned by it. Ovion indicated it believes that the claims of its patent and application cover Essure and its use. On October 23, 2003, we entered into a settlement agreement with Ovion pursuant to which we received a sole, worldwide license to Ovion’s patent rights relative to the Essure system, and Ovion may not grant any additional such licenses to other parties. The settlement agreement provided for the payment of a royalty to Ovion that will be equal to 3.25% of the cumulative net sales of Essure in excess of $75.0 million for a period of no longer than ten years. In addition, the settlement agreement provided for a cash payment of $2.0 million in the fourth quarter of 2003 as a prepaid royalty, and a license fee of $2.0 million payable in our common stock in equal installments in the first and second quarters of 2004. Ovion was not granted any rights to our intellectual property pursuant to the settlement agreement. The settlement agreement was approved by the U.S. District Court for the Northern District of California on November 6, 2003.

Although we have reached a settlement agreement with Ovion, we still believe that some or all of Ovion’s claims should be included within our own patents and we have requested that the PTO declare an interference. An interference is a proceeding within the PTO to determine which party was the first to invent, and which party is thereby entitled to ownership of, the claims. We believe that we filed our patent applications for Essure before Ovion filed the application that issued as its patent, and that we are entitled to any patentable claims now appearing in their patent that cover our product. We do not know whether the PTO will declare an interference, whether we invented our product prior to Ovion’s date of invention, or whether we will prevail in an interference proceeding if it is declared by the PTO. If the PTO declares an interference in our favor and we are found to have priority of invention, we may avoid having to pay Ovion future royalties on the sales of our product.

An adverse determination in new litigation or interference proceedings to which we are or may become a party could subject us to significant liabilities to third parties or require us to seek licenses from third parties. Although patent and intellectual property disputes in the medical device area have often been settled through licensing or similar arrangements, costs associated with such arrangements may be substantial and could include ongoing royalties. We may be unable to obtain necessary licenses on satisfactory terms, if at all. Adverse determinations in a judicial or administrative proceeding or failure to obtain necessary licenses could prevent us from manufacturing and selling Essure.

One of the patents included in our license from Target Therapeutics, a division of Boston Scientific Corporation, has been the subject of reexamination proceedings in the PTO and an infringement lawsuit by Target Therapeutics. We are not a party to this lawsuit. The patent is directed to variable stiffness catheters for use with guidewires, as might be used in our future products. Although the PTO reaffirmed the patent with amended claims and the lawsuit was settled, the patent could be challenged or invalidated in the future. If this patent is invalidated, our ability to prevent others from using this proprietary technology would be compromised.

If we fail to manage any expansion, our business could be impaired.

We may in the future acquire one or more technologies, products or companies that complement our business. We may not be able to effectively integrate these into our business and any such acquisition could bring

additional risks, exposures and challenges to our company. If we fail to manage any acquisition, our business could be impaired.

Our third-party manufacturer and we will depend upon third party and single source suppliers for raw materials and finished goods and we do not have forward contracts with many of these suppliers.

We and our third party manufacturer purchase both raw materials used in our product and finished goods from various suppliers, and we rely on a single source for one component of our product, the polyester fiber. We do not have formal supply contracts with several key vendors and, accordingly, these firms may not continue to supply us or our third party manufacturer with raw materials or finished goods in sufficient quantities, or at all. Delays associated with any future raw materials or finished goods shortages could impair our sales of Essure, particularly as our third-party manufacturer scales up its manufacturing activities in support of United States and international commercial sales of Essure.

Health care reform may limit our return on our product.

The levels of revenue and profitability of medical device companies may be affected by the efforts of government and third party payors to contain or reduce the costs of health care through various means. In the United States, there have been, and we expect that there will continue to be, a number of federal, state and private proposals to control health care costs. These proposals may contain measures intended to control public and private spending on health care as well as to provide universal public access to the health care system. If enacted, these proposals may result in a substantial restructuring of the health care delivery system. Significant changes in the United States health care system are likely to have a substantial impact over time on the manner in which we conduct our business and could have a material adverse effect on our business, financial condition and results of operations.

We may be exposed to product liability claims, and we have only limited insurance coverage.

The manufacture and sale of medical products involve an inherent risk of exposure to product liability claims and product recalls. We currently maintain product liability insurance with coverage limits of $10.0 million per occurrence and an annual aggregate maximum of $10.0 million, which we believe is comparable to that maintained by other companies of similar size serving similar markets. However, we cannot assure you that product liability claims in connection with clinical trials or commercial sales of Essure will not exceed such insurance coverage limits or that such insurance will continue to be available on commercially reasonable terms, or at all. Insurance is expensive and in the future may not be available on acceptable terms, if at all. A successful product liability claim or series of claims brought against us in excess of our insurance coverage, or a recall of our product, could cause our stock price to fall.

We may not be able to attract and retain additional key management, sales and marketing and technical personnel or we may lose existing key management, sales and marketing or technical personnel, which may delay our development and marketing efforts.

We depend on a number of key management, sales and marketing and technical personnel. The loss of the services of one or more key employees could delay the achievement of our development and marketing objectives. Our success will also depend on our ability to attract and retain additional highly qualified management, sales and marketing and technical personnel to meet our growth goals. We face intense competition for qualified personnel, many of whom are often subject to competing employment offers, and we do not know whether we will be able to attract and retain such personnel.

We face intense competition, and if we are unable to compete effectively, demand for Essure may be reduced.

The medical device industry is highly competitive and is characterized by rapid and significant technological change. The length of time required for product development and regulatory approval plays an important role in a company’s competitive position. As we commercialize Essure, we expect to compete with:

• other methods of permanent contraception, in particular tubal ligation;

• other methods of non-permanent contraception, including devices such as intrauterine devices, or IUDs, vaginal rings, condoms and prescription drugs such as the birth control pill, injectable and implantable contraceptives and patches; and

• other companies that may develop permanent contraception devices that are similar to or otherwise compete with Essure.

We are aware of a company that is in the clinical stages of development for non-incisional permanent contraception devices, and other companies may develop products that could compete with Essure. Competitive factors may render Essure obsolete or noncompetitive or reduce demand for Essure.

Our future quarterly results may fluctuate.

Our future revenues and results of operations may fluctuate significantly from quarter to quarter and will depend upon, among other factors:

• the rate at which new physicians are trained;

• actions relating to reimbursement matters;

• the rate at which we establish United States and international distributors or marketing partners and the degree of their success;

• the extent to which Essure gains market acceptance;

• the timing and size of distributor purchases; and

• introduction of competitive products.

Changes in stock option accounting rules may adversely impact our reported operating results prepared in accordance with generally accepted accounting principles, our stock price and our competitiveness in the employee marketplace.

Technology companies like ours have a history of using broad based employee stock option programs to hire, incentivize and retain our workforce in a competitive marketplace. Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) allowed companies the choice of either using a fair value method of accounting for options, which would result in expense recognition for all options granted, or using an intrinsic value method, as prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), with a pro forma disclosure of the impact on net income (loss) of using the fair value option expense recognition method. We had elected to apply APB 25 and accordingly we generally do not recognize any expense with respect to employee stock options as long as such options are granted at exercise prices equal to the fair value of our common stock on the date of grant.

In December 2004, the FASB issued, SFAS 123(R) “Share-Based Payments”. We will adopt this statement on January 1, 2006 which is the first annual reporting period after June 15, 2005. This statement will have a significant impact on our consolidated statement of operations as we will be required to expense the fair value of our stock options rather than disclosing the impact on our consolidated result of operations within our footnotes in accordance with the disclosure provisions of SFAS 123. This will result in lower reported earnings per share, which could negatively impact our future stock price. In addition, this could impact our ability to utilize broad based employee stock plans to reward employees and could result in a competitive disadvantage to us in the employee marketplace.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The following discusses our exposure to market risk related to changes in interest rates and foreign currency exchange rates. These exposures may change over time as business practices evolve and could have a material adverse impact on our financial results.

Interest Rate Risk: We have been exposed to interest rate risk as it applies to interest earned on holdings of short-term marketable investments. Interest rates that may affect these items in the future will depend on market conditions and may differ from the rates we have experienced in the past. A 10% change in interest rates would not

be material to our results of operations. We reduce the sensitivity of our results of operations to these risks by maintaining an investment portfolio, which is primarily comprised of highly rated, short-term investments. We do not hold or issue derivative, commodity instruments or other financial instruments for trading purposes.

Foreign Currency Exchange Risk: Our expenses, except for those related to Australia, were denominated in United States dollars. Our revenues, 1% and 4% of which were in foreign currencies in the three months ended March 31, 2005 and 2004, respectively, were immaterial in relation to our overall financial position. As a result, we have relatively little exposure for currency exchange risks and foreign exchange losses have been minimal to date. We do not currently enter into forward exchange contracts to hedge exposure denominated in foreign currencies or any other derivative financial instruments for trading or speculative purposes. In the future, if we feel our foreign currency exposure has increased, we may consider entering into hedging transactions to help mitigate that risk. As of March 31, 2005, a fluctuation in exchange rates of 10% in the foreign currencies to which we are exposed would not have a material impact on our results of operations or financial condition.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures:

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and in reaching a reasonable level of assurance, management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As of March 31, 2005, the end of our most recent fiscal quarter, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control Over Financial Reporting:

There has been no change in the company’s internal controls over financial reporting during the company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the company’s internal controls over financial reporting.

Inherent Limitations of Internal Controls

Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

From time to time, we are involved in legal proceedings arising in the ordinary course of business. We believe there is no litigation pending that could have, individually or in the aggregate, a material adverse effect on its financial position, result of operations or cash flows.

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

ISSUER PURCHASES OF EQUITY SECURITIES

Period	Total Number of Shares Purchased (1)	Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Program	Maximum Number of Shares That May Yet Be Purchased Under this Program
January 1, 2005 through January 31, 2005	—	—		—	—

February 1, 2005 through February 28, 2005	—	—		—	—

March 1, 2005 through March 31, 2005	2,000	$	0.003	—	—

TOTAL	2,000

(1) We purchased 2,000 shares of restricted stock from one former employee in accordance with the terms of the Restricted Stock Purchase Agreements relating to such shares.

Item 3. Defaults upon Senior Securities

None.

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

None.

Item 5. Other Information

None.

Item 6. Exhibits

(a) Exhibits.

10.1		Fifth Amended and Restated 2001 Equity Plan, Incorporated by reference to Exhibit 10.1 of the Registrant’s Report on Form 8-K filed on January 11, 2005.

31.1		Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

	By: /s/ Gregory E. Lichtwardt
	Gregory E. Lichtwardt
	Executive Vice President, Treasurer and
	Chief Financial Officer

Part I.	Financial Information

Item 1.	Condensed Consolidated Financial Statements (unaudited)

	a) Condensed Consolidated Balance Sheets as of March 31, 2005 and December 31, 2004

	b) Condensed Consolidated Statements of Operations for the three month periods ended March 31, 2005 and 2004

	c) Condensed Consolidated Statements of Cash Flows for the three month periods ended March 31, 2005 and 2004

	d) Notes to Condensed Consolidated Financial Statements

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk

Item 4.	Controls and Procedures

Part II.	Other Information

Item 1.	Legal Proceedings

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

Item 3.	Defaults upon Senior Securities

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

Item 5.	Other Information

Item 6.	Exhibits

Signature

Certifications