As previously reported in our quarterly report on Form 10Q for the quarter ended June 30, 2002, on July 17, 2002, Fisher Scientific Company L.L.C. ("Fisher") filed a lawsuit against Cepheid in the United States District Court. The parties entered into a settlement agreement with respect to the dispute in the fourth quarter of 2002, pursuant to which the parties dismissed all claims against each other.

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

No matters were submitted to a vote of security holders in the last quarter of 2002.

Our common stock has been traded on the Nasdaq National Market since our initial public offering on June 21, 2000 under the symbol CPHD. Prior to such time, there was no public market for our common stock. Through March 18, 2002, the high and low sale prices for our common stock, as reported on the Nasdaq National Market, were as follows:

On March 18, 2003 the last reported sale price of our common stock on the Nasdaq National Market was $4.64 per share. On March 18, 2003, there were approximately 296 holders of record of our common stock.

We have never declared or paid any cash dividends on our capital stock. We currently intend to retain future earnings, if any, for development of our business and, therefore, do not anticipate that we will declare or pay cash dividends on our capital stock in the foreseeable future.

ITEM 6. SELECTED FINANCIAL DATA

The following tables contain selected consolidated financial data that were derived from our consolidated financial statements. The selected consolidated financial data set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," the consolidated financial statements and the related notes included elsewhere in this annual report on Form 10-K and in our prior annual and quarterly reports, and other information we have filed with the SEC. The historical results are not necessarily indicative of results to be expected for any future period. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."

The pro forma net loss per share and shares used in computing pro forma net loss per share are calculated as if all of our convertible preferred stock was converted into shares of common stock on the date of their issuance. See Note 12 of Notes to Consolidated Financial Statements for information concerning the deemed dividend upon issuance of convertible preferred stock in the first quarter of 2000.

                                                                       Year Ended December 31,
                                                       -----------------------------------------------------
                                                         2002       2001       2000       1999       1998
                                                       ---------  ---------  ---------  ---------  ---------
                                                                 (in thousands, except per share data)
Consolidated Statements of Operations Data:
Revenues:
   Product sales..................................... $  12,413  $   8,669  $   4,397  $     159  $      --
   License and royalty revenue.......................       200        124         --         --         --
   Grant and government sponsored
   research revenue..................................     1,838      2,554      2,249      2,249      2,870
   Research and development
   contract revenue..................................       203          7        416      1,187        707
                                                       ---------  ---------  ---------  ---------  ---------
Total revenues.......................................    14,654     11,354      7,062      3,595      3,577
                                                       ---------  ---------  ---------  ---------  ---------

Operating costs and expenses:
  Cost of product sales..............................     8,766      6,330      3,851         97         --
  Research and development (including
    charges for stock-based compensation
    of $351, $1,246 and $3,706 in 2002,
    2001 and 2000, respectively).....................    16,889     15,003     15,055     10,261      5,990
  Selling, general and administrative
    (including charges for stock-based
    compensation of $189, $543 and $1,152
    in 2002, 2001 and 2000, respectively)............     8,572      6,727      4,675      1,298      1,178
  Restructuring expenses.............................       245         --         --         --         --
                                                       ---------  ---------  ---------  ---------  ---------
Total costs and operating expenses                       34,472     28,060     23,581     11,656      7,168
                                                       ---------  ---------  ---------  ---------  ---------
Loss from operations.................................   (19,818)   (16,706)   (16,519)    (8,061)    (3,591)
Net interest income..................................        77      1,195      1,700        142        280
                                                       ---------  ---------  ---------  ---------  ---------
Net loss.............................................   (19,741)   (15,511)   (14,819)    (7,919)    (3,311)
Deemed dividend to Series C preferred
  shareholders.......................................        --         --    (19,114)        --         --
                                                       ---------  ---------  ---------  ---------  ---------
Net loss applicable to common shareholders........... $ (19,741) $ (15,511) $ (33,933) $  (7,919) $  (3,311)
                                                       =========  =========  =========  =========  =========

Basic and diluted net loss per common share.......... $   (0.70) $   (0.60) $   (2.14) $   (1.90) $   (1.37)
                                                       =========  =========  =========  ========== =========

Shares used in computing basic and diluted
  net loss per common share..........................    28,203     25,939     15,859      4,164      2,414


                                                                          December 31,
                                                       ------------------------------------------  ---------
                                                         2002       2001       2000       1999       1998
                                                       ---------  ---------  ---------  ---------  ---------
                                                                     (in thousands)
Consolidated Balance Sheet Data:
Cash and cash equivalents and short term investments. $  14,505  $  24,680  $  39,698  $   1,493      8,676
Restricted cash......................................     2,296        661         --         --        300
Working capital......................................    16,962     27,442     41,259        732      8,347
Total assets.........................................    30,191     34,492     47,353      4,886     11,042
Long-term debt, net of current portion...............     1,629      1,167      1,504      1,205        531
Accumulated deficit..................................   (62,576)   (42,835)   (27,324)   (12,505)    (4,586)
Total shareholders' equity...........................    20,758     29,478     42,647      1,557      9,175

Set forth is unaudited consolidated financial data for 2002 and 2001.

                                                            Quarter Ended
                                              ------------------------------------------
                                              03/31/02   06/30/02   09/30/02   12/31/02
                                              ---------  ---------  ---------  ---------
                                                   (in thousands, except per share data)
        Year Ended December 31, 2002
                (unaudited)
Total revenues.............................. $   2,367  $   3,205  $   4,429  $   4,652

Operating costs and expenses:
  Costs of product sales....................     1,609      2,135      2,928      2,094
  Research and development..................     4,001      4,563      4,547      3,778
  Selling, general and administrative.......     1,775      2,065      2,471      2,261
  Restructuring expenses....................        --         --        262        (17)
                                              ---------  ---------  ---------  ---------
Total costs and operating expenses..........     7,385      8,763     10,208      8,116
                                              ---------  ---------  ---------  ---------
Loss from operations........................    (5,018)    (5,558)    (5,779)    (3,464)
Net interest income.........................        48         24         17        (11)
                                              ---------  ---------  ---------  ---------
Net loss.................................... $  (4,970) $  (5,534) $  (5,762) $  (3,475)
                                              =========  =========  =========  =========

Basic and diluted net loss per common share. $   (0.19) $   (0.21) $   (0.20) $   (0.11)
                                              =========  =========  =========  =========
Shares used in computing basic and diluted
  net loss per share........................    26,346     26,380     29,302     30,784


                                                            Quarter Ended
                                              ------------------------------------------
                                              03/31/01   06/30/01   09/30/01   12/31/01
                                              ---------  ---------  ---------  ---------
                                                   (in thousands, except per share data)
        Year Ended December 31, 2001
                (unaudited)
Total revenues.............................. $   3,348  $   2,042  $   2,791  $   3,173

Operating costs and expenses:
  Costs of product sales....................     1,940      1,303      1,394      1,693
  Research and development..................     3,701      3,607      3,783      3,912
  Selling, general and administrative.......     1,405      1,592      1,869      1,861
                                              ---------  ---------  ---------  ---------
Total costs and operating expenses..........     7,046      6,502      7,046      7,466
                                              ---------  ---------  ---------  ---------
Loss from operations........................    (3,698)    (4,460)    (4,255)    (4,293)
Net interest income.........................       513        352        229        101
                                              ---------  ---------  ---------  ---------
Net loss....................................    (3,185)    (4,108)    (4,026)    (4,192)
                                              =========  =========  =========  =========

Basic and diluted net loss per common share. $   (0.12) $   (0.16) $   (0.15) $   (0.16)
                                              =========  =========  =========  =========
Shares used in computing basic and diluted
  net loss per common share.................    25,680     25,846     26,054     26,173

We develop, manufacture and market fully integrated systems that enable sophisticated genetic and DNA analysis of patients and organisms by automating complex manual laboratory procedures. Based on state-of-the-art microfluidic and microelectronic technologies, our easy-to-use systems analyze complex biological samples in disposable cartridges designed to perform rapidly and automatically all of the steps associated with sophisticated molecular biological procedures. We are focusing our efforts on those applications where rapid genetic and DNA testing is particularly important, such as the infectious disease, biothreat and cancer testing markets. In particular, we have designed our systems to be capable of use in genetic management of disease, performing a broad range of genetic tests that include identifying infectious organisms, evaluating at-risk populations for the early detection of disease such as cancer, determining the stage of the disease and assessing what might be the most effective therapy. We also have designed our systems to detect food, air and water contaminants rapidly through genetic identification of disease causing agents. We are collaborating with strategic partners to co-develop assays, or biological tests, and to provide marketing and sales support across a broad range of markets.

We commenced commercial sales of our first product, the Smart Cycler®, in May 2000. The Smart Cycler is a DNA amplification and detection system initially directed at the life sciences research market. We began shipping the Smart Cycler II, which features various enhancements to the Smart Cycler, in November 2002. We believe our Smart Cycler products allow users to analyze biological samples faster and more efficiently than any other product currently available.

Our GeneXpert® system, currently in the final stages of development, integrates automated sample preparation with our Smart Cycler amplification and detection technology. We expect to launch the GeneXpert system in unregulated markets in the second half of 2003. Following clinical trials and FDA approval, we anticipate commercial launch of the GeneXpert system to the clinical genetic assessment market in early 2005. We believe that the GeneXpert system is the only genetic analysis system that integrates automated sample preparation with genetic analysis, while also offering customers a complete testing system comprised of both instrumentation and disposable cartridges containing all necessary reagents for a particular test.

We consider certain accounting policies related to revenue recognition, the inventory reserve, and warranty accrual to be critical policies. Inherent in our determination of when to recognize revenue, and in our calculation of our inventory reserve and warranty accrual, are a number of estimates, assumptions and judgments. These estimates, assumptions, and judgments include deciding whether the elements required to recognize revenue from a particular arrangement are present and estimating the amount of inventory obsolescence and warranty costs associated with shipped products.

Inventory Reserve and Warranty Accrual. We maintain reserves for inventory obsolescence and warranty costs that we believe are reasonable and that are based on our historical experience and current expectations for future performance of operations. The inventory reserve is established utilizing management's estimate of the potential future obsolescence of inventory. A substantial decrease in demand for our product could lead to excess inventories and could require us to increase our reserve for inventory obsolescence.

Our warranty accrual is established utilizing management's estimate for the future costs of providing customers with a calibration as well as the cost of repairing any instrument failures during the one-year warranty period. A significant change in failure rates of our Smart Cycler system could lead to increased warranty costs and could require us to increase our warranty reserve. If such adverse conditions were to occur, we cannot readily predict what effect on our financial condition or results of operations would result, as any such effect would depend on both future results of operations and the magnitude and timing of the adverse conditions.

Results of Operations

We derive our revenue principally from sales of the Smart Cycler and associated disposable reaction tubes and, to a lesser extent, from contractual payments for services rendered in research and development arrangements. Total revenues increased 29% to $14.7 million for the year ended December 31, 2002 from $11.4 million for the year ended December 31, 2001. The increase in total revenues for the year ended December 31, 2002 as compared to prior year was due to an overall increase in product sales, offset by a decline in contract revenues. Total product sales increased 43% to $12.4 million for the year ended December 31, 2002 from $8.7 million for the prior year. The growth in product sales for the year ended December 31, 2002 as compared to the prior year resulted from an increase of 35% in instrument sales, particularly of the Smart Cycler system, initial prototype sales of our GeneXpert system, and an increase of more than 190% in reagent and disposable sales, particularly our disposable Smart Cycler reaction tubes. The increase in product sales was due to the growth of sales through our international distribution network and direct sales force in the United States, and growing market acceptance of the Smart Cycler system. For the year ended December 31, 2002, product sales through distributors represented 54% of our total product sales (including instruments, reagents, and disposables). We had no direct customers that represented more than 10% of product sales for either of the years ended December 31, 2002 or December 31, 2001.

Grant and government sponsored research revenue decreased 28% to $1.8 million for the year ended December 31, 2002 from $2.6 million for the year ended December 31, 2002. The decrease resulted from a decline in the number of active government contracts worked on during the year ended December 31, 2002 as compared to the prior year. Research and development contract revenue increased $196,000 to $203,000 for the year ended December 31, 2002. This increase resulted from work performed in conjunction with our participation in the pilot program to develop a biothreat detection system for the USPS. We believe both grant and government sponsored research revenue and research and development contract revenue could decline in upcoming fiscal year as we continue to increase our product marketing efforts and shift our business away from research and development.

Cost of product sales

Cost of product sales consists of raw materials, direct labor, manufacturing overhead, facility and warranty costs. Cost of product sales increased 39% to $8.8 million for the year ended December 31, 2002 from $6.3 million for the year ended December 31, 2001. The increase in absolute dollars of cost of product sales for the year ended December 31, 2002 as compared to the prior year was driven by the corresponding increase in product sales. Our product gross margin percentage for the year ended December 31, 2002 was 29% as compared to 27% for the prior year period. The increase in product gross margin for the year ended December 31, 2002 as compared to the prior year period was due to increased economies of scale due to increased production volume and an increase in the average selling price of our Smart Cycler system resulting from more direct sales offset by increased warranty costs. The increase in warranty costs is primarily due to approximately $0.4 million in warranty costs recognized in the third quarter of 2002 to enhance the reliability of the Smart Cycler system.

Research and development expenses

Selling, general and administrative expenses

Selling, general and administrative expenses consist of salaries, amortization of deferred stock compensation, severance costs, accounting and other professional fees, facility costs, and human resource expenses. Selling, general and administrative expenses increased 27% to $8.6 million for the year ended December 31, 2002 from $6.7 million for the year ended December 31, 2001. The increase for the year ended December 31, 2002 as compared to the prior year period was due to a $1.1 million increase in salaries and personnel-related expenses, primarily comprised of salaries for increased sales, marketing and executive headcount, $0.2 million in severance costs, a $0.3 million increase in sales commissions due to increased product sales, a $0.2 million increase in travel and lodging costs primarily due to our expanded direct sales force, and a $0.4 million increase in legal costs, partially offset by a $0.3 million decrease in our amortization of non-cash deferred stock compensation. We expect that our selling, general and administrative expenses will increase slightly in 2003 compared to the 2002 level as we realign or, where necessary, add to, our existing resources in order to continue to execute our business strategy, particularly with respect to our efforts to increase European sales through our new entity European subsidiary, Cepheid SA.

Interest income, net

Net interest income decreased to $77,000 in 2002 from $1.2 million in 2001. The $1.1 million decrease was primarily due to a decrease in our cash and cash equivalents balance as well as lower interest rates resulting in lower interest income. Interest expense also increased due to increased borrowings on our lease line of credit during the year end December 31, 2002.

We incurred restructuring expenses of $245,000 related to the restructuring plan that we completed during the quarter ended September 30, 2002. The restructuring charge was primarily composed of severance costs for terminated employees and to small degree of professional fees and the write-off of impaired assets. In connection with the plan, our headcount was reduced by approximately 15%. The purpose of the restructuring plan was to realign our workforce to reflect our shift in emphasis from research and development to manufacturing and marketing of our instruments and reagent systems. As a result of the restructuring plan, we expect that we will realize a near-term reduction in our annual operating expenses of approximately $3.5 million which is comprised of salaries and consulting fees. However, we will be redeploying approximately $2.5 million of those savings in 2003 as we expand our commercialization activities. There are no remaining cash payments to be made under this restructuring plan at December 31, 2002.

Income taxes

We incurred net operating losses in 2002 and 2001, and consequently we did not pay any federal, state or foreign income taxes. As of December 31, 2002 and 2001, we had deferred tax assets of approximately $24.3 million and $16.3 million, respectively. The net deferred tax asset has been fully offset by a valuation allowance, as the future realization of the tax benefit is not currently likely. The net valuation allowance increased by $8.0 million during the year ended December 31, 2002. Deferred tax assets relate to net operating loss carryforwards, research credit carryforwards and capitalized research and development costs. As of December 31, 2002, we had federal net operating loss carry forwards of approximately $52.0 million. We also had federal research and development tax credit carry forwards of approximately $1.1 million.

Our federal net operating loss and credit carryforwards, if not offset against future taxable income, will expire from 2011 through 2022. Under the provisions of the Internal Revenue Code of 1986, substantial changes in ownership may limit the amount of net operating loss carryforwards that could be utilized annually in the future to offset taxable income.

Total revenues increased 61% to $11.4 million for the year ended December 31, 2001 from $7.1 million for the year ended December 31, 2000. Revenues in 2001 and 2000 include $8.7 and $4.4 million, respectively from the sale of Smart Cycler instruments and reaction tubes. A limited number of Smart Cycler prototypes were sold in 1999 and associated revenue was recognized in and through April 2000. We launched the Smart Cycler in the United States through our distributors Fisher Scientific in May 2000, in the Far East through Takara in the fourth quarter of 2000, in Europe through Eurogentec in the fourth quarter of 2000, and in Malaysia and Singapore though BioSynTech Sdn Bhd in the second quarter of 2001.

From launch through the end of December 2001, we had sold more than 570 Smart Cycler systems and over 1.5 million reaction tubes. Over three quarters of the sales during those years were through distributors and the majority of sales were through Fisher. Fisher's business is focused primarily on the research market. Most of its sales have been to academic laboratories, but a portion has been to biotech and pharmaceutical companies. Our own direct sales efforts are focused on the government, including domestic preparedness and public health labs, plus potential collaborators and industrial customers, primarily food- related. Our largest customer category is academics/universities, which represented about 50% of sales in 2001. The next two largest categories are government and biotechnology/ pharmaceutical companies. They represented approximately 37% and 13%, respectively of sales in 2001.

During the year, the Company's addition of a direct sales force helped to improve direct sales specifically in the food testing and biothreat markets. Additionally, the terrorist attacks of September 11 increased focus on the potential of bioterrorist attacks. Increased funds have been allocated to various government agencies for military and homeland defense. The Company experienced an increased demand for its Smart Cycler family of products in the third and fourth quarter of 2001. We believe that increase was due both to the addition of our direct sales force and the impact of the September 11 terrorist attacks.

Grant and government sponsored research revenue increased 18% to $2.6 million for the year ended December 31, 2001 from $2.2 million for the year ended December 31, 2000. The increase is primarily due to an increased level of activity on the contracts as they were completed during the year ended December 31, 2002. Research and development contract revenue decreased by 98% to $7,000 from $0.4 million in 2000. The Company switched its focus from grant and government sponsored research to the expansion of its Smart Cycler sales efforts and the development of its GeneXpert product. During 2001, we focused on the completion of our existing government research and development contracts. As a result, essentially no new grant and government sponsored research or research and development contracts were executed in 2001.

Cost of product sales

Cost of product sales increased 66% to $6.3 million for the year ended December 31, 2001 from $3.8 million for the year ended December 31, 2000. The increase was due to the 98% increase in product sales, partially offset by increased economies of scale due to higher unit volumes.

Research and development expenses

Research and development expenses decreased 0.1% to $15.0 million for the year ended December 31, 2001 from $15.1 million for the year ended December 31, 2000. This decrease included a decrease of $2.5 million in non-cash charges related to the amortization of deferred stock-based compensation. The $2.4 million increase in research and development expenses is comprised of a $2.3 million increase in salaries and personnel related costs, partially offset by a $0.5 million increase in facility and related costs offset by a $0.2 million decrease in outside consulting and $0.2 million increase in expensed furniture and equipment. Development activities switched to GeneXpert in 2001 from Smart Cycler in 2000

Selling, general and administrative expenses

Selling, general and administrative expenses increased 43% to $6.7 million for the year ended December 31, 2001 from $4.7 million for the year ended December 31, 2000. This $2.0 million increase is attributable to a $1.1 million increase in salaries and related personnel costs, a $0.6 million increase in facilities and related costs, a $0.4 million increase in corporate legal and other professional fees, a $0.1 million increase in insurance costs, a $0.2 million increase in investor and public relations, and a $0.2 million increase in temporary help and consulting partially offset by a $0.6 million decrease in non-cash charges related to the amortization of deferred stock-based compensation. During 2001, the Company added small direct sales force focused on distributor support as well as direct sales in the food testing and biothreat markets. Additionally, the Company increased its advertising and promotional activities for its Smart Cycler product line. These activities resulted in a substantial year over year increase in selling, general, and administrative expenses.

Interest income, net

Net interest income decreased to $1.2 million in 2001 from $1.7 million in 2000. The $0.5 million decrease was due primarily to decreased interest income resulting from a decrease in our cash and cash equivalents during 2001 as well as a decrease in interest rates and resulting investment yield during 2001 as compared to 2000.

Income taxes

We incurred net operating losses in 2001 and 2000, and consequently we did not pay any federal, state or foreign income taxes. As of December 31, 2001, we had federal net operating loss carryforwards of approximately $34.0 million. We also had federal research and development tax credit carryforwards of approximately $0.9 million. The net operating loss and credit carryforwards will expire at various dates beginning in 2011 through 2021, if not utilized. Utilization of the net operating losses and credits may be substantially limited due to the change in ownership provisions of the Internal Revenue Code of 1986 and similar state provisions. The annual limitation may result in the expiration of net operating losses and credits before utilization.

As of December 31, 2001 and 2000, we had deferred tax assets of approximately $16.3 million and $9.2 million, respectively. The net deferred tax asset has been fully offset by a valuation allowance. The net valuation allowance increased by $7.1 million during the year ended December 31, 2000. Deferred tax assets relate to net operating loss carryforwards, research credit carryforwards and capitalized research and development costs.

Liquidity and Capital Resources

Through December 31, 2002, we had received net proceeds of $76.0 million from sales of common and convertible preferred stock, including net proceeds of $9.5 million from the sale of 4,000,000 shares of common stock in August 2002 under a shelf registration statement, net of issuance costs of $1.1 million. In addition, in March 2003, we completed another offering of common stock under the shelf registration statement for net proceeds of approximately $4.7 million.

Through December 31, 2002, we had financed equipment, land, and building purchases and leasehold improvements totaling approximately $6.7 million. As of December 31, 2002, we had $3.1 million in equipment financing obligations. These equipment obligations are secured by the financed equipment, bear interest at a weighted-average interest rate of 8.21% and are due in monthly installments through September 2005. Under the terms of our current equipment financing agreement, a balloon payment is due at the end of each individual lease term for an item of equipment. In June 2002, our existing equipment line of credit was amended to allow us to borrow an additional $4.0 million, of which we drew down $1.4 million in the second quarter of 2002 and $0.7 million in the third quarter of 2002. In connection with this amendment, we entered into a negative covenant pledge agreement pursuant to which we were required to complete a cumulative $20.0 million financing by September 30, 2002 or all funding under the equipment line of credit would cease and we would be required to provide a cash deposit or irrevocable letter of credit equivalent to 100% of all soft costs financed. Soft costs primarily represent leasehold improvements and custom manufacturing equipment. We did not complete the required level of cumulative e financing prior to September 30, 2002 and, as a result, we provided a letter of credit in the amount of $1.1 million to the creditor in October 2002 and will not be able to draw down additional funding.

In December 2002, we purchased land and a building for approximately $0.4 million for our newly formed French subsidiary. We financed the purchase with a ten-year mortgage loan, which bears interest at 4.75% per year and is fully secured by the land and building. Additionally, the loan is guaranteed by a standby letter of credit in the amount of $0.5 million. The collateral for this standby letter of credit is classified as a component of restricted cash at December 31, 2002.

Net cash provided by investing activities was $2.1 million for the year ended 2002, and net cash used in investing activities was $11.1 million and $1.7 million for the years ended December 31, 2001 and 2000, respectively. Net cash provided by investing activities for the year ended December 31, 2002 consisted of $8.8 million from the maturity of marketable securities, offset by $5.0 million in capital expenditures and $1.6 million in restricted cash. Net cash used in investing activities for the year ended December 31, 2001 consisted of $1.7 million in capital expenditures, $8.8 million for the purchase of marketable securities, offset by $0.7 million in restricted cash. Net cash used in investing activities for the year ended December 31, 2000 consisted of $1.7 million in capital expenditures.

Net cash provided by financing activities consisted primarily of proceeds from sales of common stock and proceeds from loan arrangements partially offset by principal payments under the loan arrangements. We received $11.7 million, $0.4 million, and $51.7 million in cash from financing activities for the years ended December 31, 2002, 2001 and 2000, respectively. The $11.7 million in 2002 included proceeds of $10.5 million from sales of common stock, including $9.5 million from our August 2002 common stock offering, and $2.6 million in proceeds from equipment and mortgage loans, offset by repayments of $1.3 million on our equipment and mortgage loans. The $51.7 million in 2000 included proceeds of $51.0 million, net of issuance costs, from sales of common stock and convertible preferred stock and proceeds from equipment loans of $1.2 million, offset by repayments of equipment loans of $0.5 million.

Our contractual obligations for the next five years, and thereafter, are currently as follows (in thousands):

                                   LESS
                                  THAN 1        1-3         4-5       AFTER 5
CONTRACTUAL OBLIGATIONS(1)         YEAR        YEARS       YEARS       YEARS        TOTAL
- ------------------------------  ----------  -----------  ----------  ----------  ------------
Equipment and mortgage loans.. $    1,681  $     1,889  $      100  $      196  $      3,866
Operating leases..............      1,352        4,304       3,089       5,372        14,117
Research funding..............        117           49          --          --           166
Minimum royalty payments......        260          844         620       3,031         4,755
                                ----------  -----------  ----------  ----------  ------------
  Total contractual cash
     obligations.............. $    3,410  $     7,086  $    3,809  $    8,599  $     22,904
                                ==========  ===========  ==========  ==========  ============

We expect to have negative cash flow from operations through at least the end of 2003. We expect our cash use to average approximately $1.5 million per month for 2003. For the year ended December 31, 2002, total cash used was $8.5 million or $18.0 million after subtracting out the $9.5 million in net proceeds received from our August 2002 common stock offering. After the proceeds of approximately $4.7 million from our March 2003 common stock offering, we anticipate that our existing capital resources will enable us to maintain currently planned operations through the end of 2003. This expectation is based on our current operating plan and may change as a result of many factors, including our future capital requirements, which depend on a number of factors outside our control. For example, our future capital requirements will depend on, among other things, market acceptance of our products, the resources we devote to developing and supporting our products, continued progress of our research and development of potential products, the need to acquire licenses to new technology or to use our technology in new markets, and the availability of other financing. Consequently, we may need additional funding sooner than anticipated. We currently have no credit facility or committed sources of capital. To the extent operating and capital are insufficient to meet future requirements, we will have to raise additional funds. These funds may not be available on favorable terms, if at all. If adequate funds are not available on attractive terms, we may be required to curtail operations significantly or to obtain funds by entering into financing, supply or collaboration agreements on unattractive terms.

To the extent our capital resources are insufficient to meet future capital requirements, we will need to raise additional capital or incur indebtedness to fund our operations. In December 2001, we filed a shelf registration statement for the issuance of up to $35.0 million in debt and/or equity securities. As of December 31, 2002, we had approximately $24.4 million still available under this registration statement. After our common stock offering completed in March 2003, we have approximately $19.4 million still available under this registration statement. There can be no assurance that additional debt or equity financing will be available on acceptable terms, if at all. If adequate funds are not available, we may be required to delay, reduce the scope of, or eliminate our research and development programs, reduce our commercialization efforts or obtain funds through arrangements with collaborative partners or others that may require us to relinquish rights to technologies or products that we might otherwise seek to develop or commercialize. Although we have no current plans, agreements or commitments providing for any acquisition, we may, if the opportunity arises, use net proceeds from an offering of equity or debt securities to acquire or invest in products, technologies or companies.

The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in may have market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in short term commercial paper and money market funds. Due to the short-term nature of the investments, we believe we have no material exposure to interest rate risk arising from our investments. Therefore we have not included quantitative tabular disclosure in this Form 10K.

We do not enter into financial investments for speculation or trading purposes and are not a party to financial or commodity derivatives. We have operated primarily in the United States and all sales to date have been made in U.S. Dollars. Accordingly, we have not made any material exposure to foreign currency rate fluctuations.

The Board of Directors and Shareholders
Cepheid

We have audited the accompanying consolidated balance sheets of Cepheid as of December 31, 2002 and 2001, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2002. Our audits also included the financial statement schedule listed in the index at Item 15(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Cepheid at December 31, 2002 and 2001 and the consolidated results of its operations and its 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. Also in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

/s/ ERNST & YOUNG LLP          

Palo Alto, California
January 30, 2003, except for
Note 16, as to which the date is
March 4, 2003

CEPHEID

CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)

                                                                              December 31,
                                                                         ----------------------
                                                                            2002        2001
                                                                         ----------  ----------
                                ASSETS
Current assets:
  Cash and cash equivalents............................................ $   14,505  $   15,905
  Short term investments...............................................         --       8,775
  Restricted cash......................................................      2,296         661
  Accounts receivable..................................................      3,044       2,020
  Inventory............................................................      3,850       3,568
  Prepaid expenses and other current assets............................        352         338
                                                                         ----------  ----------
Total current assets...................................................     24,047      31,267
Property and equipment, net............................................      6,144       3,175
Other assets...........................................................         --          50
                                                                         ----------  ----------
Total assets........................................................... $   30,191  $   34,492
                                                                         ==========  ==========

                 LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Accounts payable..................................................... $    2,367  $      587
  Accrued compensation.................................................      1,171         778
  Accrued other liabilities............................................      2,092       1,399
  Current portion of equipment financing...............................      1,423       1,029
  Current portion of bank loan payable.................................         32          --
  Current portion of deferred rent.....................................         --          32
                                                                         ----------  ----------
Total current liabilities..............................................      7,085       3,825

Equipment financing, less current portion..............................      1,629       1,167
Bank loan payable, less current portion................................        364          --
Deferred rent, less current portion....................................        355          22
Commitments
Shareholders' equity:
  Common stock, no par value;
    100,000,000 shares authorized, 30,985,716 and 26,646,338 shares
    issued and outstanding at December 31, 2002 and 2001, respectively.     75,928      65,459
  Additional paid-in capital...........................................      7,505       7,694
  Deferred stock based compensation....................................       (103)       (833)
  Accumulated foreign exchange translation adjustment..................          4          --
  Accumulated other comprehensive loss.................................         --          (7)
  Accumulated deficit..................................................    (62,576)    (42,835)
                                                                         ----------  ----------
Total shareholders' equity.............................................     20,758      29,478
                                                                         ----------  ----------
Total liabilities and shareholders' equity............................. $   30,191  $   34,492
                                                                         ==========  ==========

See accompanying notes.

CEPHEID

CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)

                                                  Years Ended December 31,
                                              -------------------------------
                                                2002       2001       2000
                                              ---------  ---------  ---------
Revenues:
  Instrument sales.......................... $  11,075  $   8,208  $   4,336
  Reagent and disposable sales..............     1,338        461         61
                                              ---------  ---------  ---------
     Total Product Sales....................    12,413      8,669      4,397
  License and royalty revenue...............       200        124         --
  Grant and government sponsored
    research revenue........................     1,838      2,554      2,249
  Research and development contract revenue.       203          7        416
                                              ---------  ---------  ---------
     Total revenues.........................    14,654     11,354      7,062
                                              ---------  ---------  ---------
Operating costs and expenses:
  Cost of product sales.....................     8,766      6,330      3,851
  Research and development (including
    charges for stock-based compensation
    of $351, $1,246 and $3,706 in 2002,
    2001 and 2000, respectively)............    16,889     15,003     15,055
  Selling, general and administrative
    (including charges for stock-based
    compensation of $189, $543 and $1,152
    in 2002, 2001 and 2000, respectively)...     8,572      6,727      4,675
  Restructuring expenses....................       245         --         --
                                              ---------  ---------  ---------
     Total costs and operating expenses.....    34,472     28,060     23,581
                                              ---------  ---------  ---------
Loss from operations........................   (19,818)   (16,706)   (16,519)
Interest income.............................       313      1,450      1,887
Interest expense............................      (236)      (255)      (187)
                                              ---------  ---------  ---------
Net loss....................................   (19,741)   (15,511)   (14,819)

Deemed dividend to Series C preferred
  shareholders..............................        --         --    (19,114)
                                              ---------  ---------  ---------
Net loss applicable to common shareholders.. $ (19,741) $ (15,511) $ (33,933)
                                              =========  =========  =========

Basic and diluted net loss
  per common share.......................... $   (0.70) $   (0.60) $   (2.14)
                                              =========  =========  =========
Shares used in computing basic and
  diluted net loss per common share.........    28,203     25,939     15,859

See accompanying notes.

CEPHEID

CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(in thousands, except share data)

                                                                                                                       Notes    Deferred   Accumulated Accumulated
                                                                     Convertible                                     Receivable  Stock-      Other       foreign
                                                                   Preferred Stock      Common Stock      Additional   from       Based     Compre-     exchange                     Total
                                                                 ------------------- -------------------   Paid-in    Share-     Compen-    hensive    translation  Accumulated   Shareholders'
                                                                  Shares     Amount   Shares     Amount    Capital    holders    sation       Loss     adjustment     Deficit       Equity
                                                                 ---------  -------- ---------  --------  ---------  ---------  ---------  ----------  -----------  -----------   -----------
Balance at December 31, 1999....................................    6,947  $ 13,566     6,871  $    351  $     766  $     (69) $    (552) $       --  $        --  $   (12,505) $      1,557
Issuance of shares of common stock at $0.12 -- $6.00
  per share for cash under employee and consultant plans and
  to other investors at various dates, net of repurchases.......       --        --       406       549         --         --         --          --           --           --           549
Payment on note receivable from related party...................       --        --        --        --         --         34         --          --           --           --            34
Issuance of Series C convertible preferred stock to
  investors at $3.00 per share in January 2000
  for cash, net of issuance costs of $26........................    6,380    19,114        --        --         --         --         --          --           --           --        19,114
Issuance of common stock for initial public offering at
  $6.00 per share less issuance costs of $3,495.................       --        --     5,750    31,005         --         --         --          --           --           --        31,005
Conversion of convertible preferred stock to common stock.......  (13,327)  (32,680)   13,327    32,680         --         --         --          --           --           --            --
Deferred stock-based compensation...............................       --        --        --        --      6,265         --     (6,265)         --           --           --            --
Amortization of deferred stock-based compensation...............       --        --        --        --         --         --      3,579          --           --           --         3,579
Issuance of options to consultants
  to purchase common stock for services rendered................       --        --        --        --      1,279         --         --          --           --           --         1,279
Issuance of shares of common stock at $5.10 to employees
  for cash under employee stock purchase plan...................       --        --        70       359         --         --         --          --           --           --           359
Comprehensive loss:
  Net loss......................................................       --        --        --        --         --         --         --          --           --      (14,819)      (14,819)
  Net unrealized loss on available-for-sale securities..........       --        --        --        --         --         --         --         (10)          --           --           (10)
                                                                                                                                                                                  -----------
        Total comprehensive loss................................       --        --        --        --         --         --         --          --           --           --       (14,829)
                                                                 ---------  -------- ---------  --------  ---------  ---------  ---------  ----------  -----------  -----------   -----------
Balance at December 31, 2000....................................       --        --    26,424    64,944      8,310        (35)    (3,238)        (10)          --      (27,324)       42,647
Payment on note receivable from related party...................       --        --        --        --         --         35         --          --           --           --            35
Adjustment to deferred stock based compensation
  for terminated employees......................................       --        --        --        --       (625)        --        625          --           --           --            --
Issuance of shares of common stock for
  cash at $.05   - $4.125  per share under employee
  and director option plans at various dates....................       --        --        41        48         --         --         --          --           --           --            48
Repurchase of common shares for cash at
  $0.12 - $1.50  per share originally issued under
  employee option plans at various dates........................       --        --       (60)      (49)        --         --         --          --           --           --           (49)
Repurchase of common shares for cash at $.005 per share
  originally issued to founders of the Company at various dates.       --        --      (109)       (1)        --         --         --          --           --           --            (1)
Exercise of warrants in exchange
  for issuance of common shares.................................       --        --       147        --         --         --         --          --           --           --            --
Amortization of deferred stock-based compensation...............       --        --        --        --         --         --      1,780          --           --           --         1,780
Amortization of deferred stock based compensation
  related to options issued to consultants to purchase
  common stock for services rendered............................       --        --        --        --          9         --         --          --           --           --             9
Issuance of shares of common stock at $2.56 to employees
  for cash under employee stock purchase plan...................       --        --       203       517         --         --         --          --           --           --           517
Comprehensive loss:
  Net loss......................................................       --        --        --        --         --         --         --          --           --      (15,511)      (15,511)
  Net unrealized gain on available-for-sale securities..........       --        --        --        --         --         --         --           3           --           --             3
                                                                                                                                                                                  -----------
        Total comprehensive loss................................       --        --        --        --         --         --         --          --           --           --       (15,508)
                                                                 ---------  -------- ---------  --------  ---------  ---------  ---------  ----------  -----------  -----------   -----------
Balance at December 31, 2001....................................       --        --    26,646    65,459      7,694         --       (833)         (7)          --      (42,835)       29,478
Issuance of common shares under secondary stock offering........       --        --     4,000     9,505         --         --         --          --           --           --         9,505
Foreign currency adjustment.....................................       --        --        --        --         --         --         --          --            4           --             4
Adjustment to deferred stock based compensation
  for terminated employees......................................       --        --        --        --       (201)        --        201          --           --           --            --
Issuance of shares of common stock for
  cash at $.12  - $4.13  per share under employee
  and director option plans at various dates....................       --        --       151       369         --         --         --          --           --           --           369
Repurchase of common shares for cash at
  $.35 - $1.50  per share originally issued under
  employee option plans at various dates........................       --        --        (7)      (10)        --         --         --          --           --           --           (10)
Exercise of warrants in exchange for issuance of common shares..       --        --         8        --         --         --         --          --           --           --            --
Amortization of deferred stock-based compensation...............       --        --        --        --         --         --        529          --           --           --           529
Amortization of deferred stock based compensation
  related to options issued to consultants to purchase
  common stock for services rendered............................       --        --        --        --         12         --         --          --           --           --            12
Issuance of shares of common stock at $3.21 to employees
  for cash under employee stock purchase plan...................       --        --       188       605         --         --         --          --           --           --           605
Comprehensive loss:
  Net loss......................................................       --        --        --        --         --         --         --          --           --      (19,741)      (19,741)
  Net unrealized gain on available-for-sale securities..........       --        --        --        --         --         --         --           7           --           --             7
                                                                                                                                                                                  -----------
        Total comprehensive loss................................       --        --        --        --         --         --         --          --           --           --       (19,734)
                                                                 ---------  -------- ---------  --------  ---------  ---------  ---------  ----------  -----------  -----------   -----------
Balance at December 31, 2002....................................       --  $     --    30,986  $ 75,928  $   7,505  $      --  $    (103) $       --  $         4  $   (62,576) $     20,758
                                                                 =========  ======== =========  ========  =========  =========  =========  ==========  ===========  ===========   ===========

See accompanying notes.

CEPHEID

CONSOLIDATED STATEMENT OF CASH FLOWS
(amounts in thousands)

                                                                              Year Ended December 31,
                                                                         -------------------------------
                                                                           2002       2001       2000
                                                                         ---------  ---------  ---------
OPERATING ACTIVITIES:
Net loss............................................................... $ (19,741) $ (15,511) $ (14,819)
Adjustments to reconcile net loss to net cash used in
 operating activities:
 Depreciation and amortization.........................................     2,025      1,397        880
 Amortization of deferred stock-based compensation.....................       540      1,780      3,579
 Stock-based compensation related to consulting services rendered......        12          9      1,279
 Deferred rent.........................................................       301        (22)       (12)
 Changes in operating assets and liabilities:
   Accounts receivable.................................................    (1,024)       387     (1,841)
   Inventory...........................................................      (282)    (1,796)    (1,486)
   Prepaid expenses and other assets...................................        36        196       (121)
   Accounts payable and other current liabilities......................     2,473        252        534
   Accrued compensation................................................       393        268        164
                                                                         ---------  ---------  ---------
Net cash used in operating activities..................................   (15,267)   (13,040)   (11,843)
                                                                         ---------  ---------  ---------
INVESTING ACTIVITIES:
Capital expenditures...................................................    (4,994)    (1,682)    (1,694)
Proceeds from maturities of marketable securities......................                   --         --
Purchase of marketable securities......................................     8,775     (8,775)        --
Restricted cash........................................................    (1,635)      (661)        --
                                                                         ---------  ---------  ---------
Net cash (used in) provided by investing activities....................     2,146    (11,118)    (1,694)
                                                                         ---------  ---------  ---------
FINANCING ACTIVITIES:
Net proceeds from the sales of preferred shares........................        --         --     19,114
Net proceeds from the sales of common shares...........................    10,469        517     31,913
Repayment on note receivable from shareholder..........................        --         35         34
Proceeds from loan arrangements........................................     2,563        816      1,178
Principle payments under loan arrangements.............................    (1,311)    (1,003)      (497)
                                                                         ---------  ---------  ---------
Net cash provided by financing activities..............................    11,721        365     51,742
                                                                         ---------  ---------  ---------
Net increase (decrease) in cash and cash equivalents...................    (1,400)   (23,793)    38,205
Cash and cash equivalents at beginning of year.........................    15,905     39,698      1,493
                                                                         ---------  ---------  ---------
Cash and cash equivalents at end of year............................... $  14,505  $  15,905  $  39,698
                                                                         =========  =========  =========

See accompanying notes.

Organization and Business

Principles of Consolidation

The consolidated financial statements of Cepheid include the accounts of the Company and it's wholly owned subsidiary. All significant intercompany balances and transactions have been eliminated.

Use of Estimates

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

Revenue Recognition

The Company recognizes revenue from product sales when goods are shipped, there is persuasive evidence that an arrangement exists, delivery has occurred, the price is fixed and determinable and collectibility is reasonably assured. No rights of return exist for the Company's products except in the case of damaged goods.

Contract revenues related to research and development agreements and government grants are recognized as the related services are performed based on the performance requirements of the relevant contract. Non- refundable contract fees for which no further performance obligations exist, with no continuing involvement required on the part of the Company, are recognized on the earlier of the date the payments are received or when collection is assured. Under research and development agreements, the Company is required to perform specific research and development activities and is reimbursed based on the costs associated with each specific contract over the term of the agreement. Milestone related revenues are recognized upon the achievement of the specified milestone when the related milestone was at risk at the inception of the arrangement and milestone related obligations are fulfilled. Deferred revenue is recorded when funds are received in advance of services to be performed.

Significant Concentrations

The Company distributes its products through its direct sales force and through third-party distributors. For the years ended ended December 31, 2002 and 2001, product sales through distributors represented 54% and 74%, respectively, of total product sales (consisting of sales of instruments, reagents and disposables). The Company's three distributors in the United States, the Far East and Europe each accounted for 40%, 11%, and 3%, respectively, of total product sales for the year ended December 31, 2002, and 39%, 25%, and 10%, respectively, of total product sales for the year ended December 31, 2001.

Financial instruments that potentially subject the company to concentrations of credit risk primarily consist of cash equivalents and marketable securities.

Financial Instruments

The carrying amounts of financial instruments including cash and cash equivalents, short-term investments, accounts receivable, accounts payable, and short-term debt approximated fair value as of December 31, 2002 and 2001, because of the relatively short maturity of these instruments.

Warranty Accrual

The Company warrants its products from defect for a period of 12 months from the date of sale for material and labor costs to repair the product. Accordingly, a provision for the estimated cost of the warranty is recorded at the time revenue is recognized. Our warranty accrual is established utilizing management's estimate for future costs of providing customers with a calibration as well as the cost of repairing any instrument failures during the one-year warranty period. As of December 31, 2002 and 2001, the accrued warranty liability was $0.6 million and $0.3 million, respectively. The activity in the warranty accrual for the year ended December 31, 2002 consisted of the following (in thousands):

Balance at December 31, 2001................ $     302

Costs incurred and charged against reserve..      (280)

2002 provisions for warranty................       242

2002 provision for specific warranty repair.       370
                                              ---------

Balance at December 31, 2002................ $     634
                                              =========

Research and Development

Research and development expenses consist of costs incurred for company-sponsored and collaborative research and development activities. These costs include direct and research-related overhead expenses. Research and development expenses under collaborative agreements and government grants approximate the revenue recognized under such agreements. The Company expenses research and development costs as such costs are incurred.

Cash and cash equivalents consist of cash on deposit with banks, money market instruments, commercial paper and debt securities with original maturities of 90 days or less. At December 31, 2002 and 2001, the Company had $14.5 million and $15.9 million, respectively, in cash and cash equivalents.

Short-term investments consist of commercial paper with original maturities of greater than 90 days and less than one year. At December 31, 2002, the Company had no such short-term investments and $8.8 million of short-term investments at December 31, 2001. We classify our marketable securities as available-for-sale and record our investments at fair market value in accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Available- for-sale securities are carried at amounts that approximate fair market value based on quoted market prices with unrealized gains and losses recorded as a separate component of the shareholders' equity. Such unrealized gains and losses were not significant at December 31, 2002 and 2001. The cost of securities sold is based on the specific identification method.

Restricted cash consists of a certificate of deposits and bank term deposits all with maturities of greater than 90 days. At December 31, 2002 and 2001, the Company had $2.3 million and $0.7 million of restricted cash, respectively. The $2.3 million in restricted cash at December 31, 2002 is made up of $1.1 million which is collateral for a standby letter of credit issued in connection with an equipment lease obligation, $0.5 million which is collateral for a standby letter of credit issued in connection with a mortgage obligation, and $0.7 million which is collateral for a standby letter of credit issued in connection with a facility lease. The $0.7 million in restricted cash balance at December 31, 2001 is collateral for a standby letter of credit issued in connection with a facility lease obligation.

Inventory

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

The Company maintains a reserve for inventory obsolescence. This reserve is established utilizing management's estimate of the potential future obsolescence of inventory. At December 31, 2002 and 2001, the reserve for inventory obsolescence was $0.4 million and $0.5 million, respectively.

Property and Equipment

Property and equipment are stated at cost. Depreciation is calculated using the straight-line method, and the cost is amortized over the estimated useful lives of the assets, which range from three to five years. Leasehold improvements are amortized using the straight-line method over the estimated useful lives of the assets or the term of the lease, whichever is shorter.

Software Costs

In March 1998, the ACIPA issued Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1"). SOP 98-1 requires that the entities capitalize certain costs related to internal use software once certain criteria have been met. The Company adopted the provisions of SOP 98-1 on January 1, 1999. From inception through December 31, 2002, the Company has capitalized approximately $0.6 million relating to the purchase and installation of enterprise resource planning, accounting, cadcam and documentation systems for internal use. The assets are depreciated using the straight-line method over a useful life, which is expected to be five years.

Impairment of Long-Lived Assets

We adopted FAS 144, "Accounting for the Impairment or Disposal of Long- Lived Assets", on January 1, 2002. FAS supercedes FAS 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of". The primary objectives of FAS 144 are to develop one accounting model based on the framework established in FAS 121 for long-lived assets to be disposed of by sale, and to address significant implementation issues. Our adoption of FAS 144 did not have a material impact on our financial position or results of operations.

Stock-Based Compensation

Pro forma net loss and net loss per share information has been determined as if the Company had accounted for its employee stock options granted under the fair value method of SFAS 123. The fair value of these options was estimated at the date of grant using the Black-Scholes option pricing model, with the following weighted-average assumptions: risk-free interest rates of 4%, 5.0% and 6.0% for grants in fiscal 2002, 2001 and 2000, respectively; a weighted-average expected life of five years; and a dividend yield of zero. The weighted-average fair value of options granted during 2002, 2001, and 2000 was $3.54, $4.06 and $4.22, respectively. The expected volatility of the Company's common stock used in the pricing model was 1.4 for 2002.

For purposes of disclosures pursuant to FAS 123 as amended by FAS 148, the estimated fair value of options is amortized to expense over the options' vesting period. The following table illustrates the effect on net loss per share if we had applied the fair value recognition provision of FAS123 to stock based employee compensation (in thousands, except per share data):

                                                       Years Ended December 31,
                                                   -------------------------------
                                                     2002       2001       2000
                                                   ---------  ---------  ---------

Net loss as reported............................. $ (19,741) $ (15,511) $ (33,933)

Deduct: Total stock-based employee compensation
determined under the fair value method for all
awards, net of tax related effects...............    (3,338)    (1,045)      (138)

Add: Amortization of deferred stock compensation.       540      1,780      3,579
                                                   ---------  ---------  ---------
Pro forma net loss............................... $ (22,539) $ (14,776) $ (30,492)
                                                   =========  =========  =========
Basic and diluted net loss per share:

As reported...................................... $   (0.70) $   (0.60) $   (2.14)
Pro forma........................................ $    0.80  $    0.57  $    1.92

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

Comprehensive (Income) Loss

Comprehensive loss includes net loss as well as other comprehensive loss. The Company's other comprehensive loss consists of unrealized gains and losses on available-for-sale securities. Total comprehensive loss and the components of accumulated other comprehensive loss are presented in the accompanying Consolidated Statements of Stockholders' Equity. Total accumulated other comprehensive income is displayed as a separate component of stockholders' equity in the accompanying Consolidated Balance Sheets.

Segment Reporting

Effective in January 1998, the Company adopted Statement of Financial Accounting Standards No. 131, "Disclosure about Segments of an Enterprise and Related Information" ("SFAS 131"). SFAS 131 establishes annual and interim reporting standards for an enterprise's operating segments and related disclosures about its products, services, geographic areas, and major customers. The Company has determined that it operates in only one segment and accordingly, the adoption of SFAS 131 had no impact on the financial statements.

Net Loss Per Common Share

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

The computation of pro forma basic and diluted net loss per share includes shares issuable upon the conversion of outstanding shares of convertible preferred stock (using the as-if converted method) from the original date of issuance.

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

                                                  Years Ended December 31,
                                              -------------------------------
                                                2002       2001       2000
                                              ---------  ---------  ---------
Net loss applicable to common shareholders.. $ (19,741) $ (15,511) $ (33,933)
                                              =========  =========  =========
Basic and diluted:
  Weighted-average shares of
    common stock outstanding................    28,400     26,450     17,310
  Less: weighted-average
    shares subject to repurchase............      (197)      (511)    (1,451)
                                              ---------- ---------------------
  Shares used in computing basic
    and diluted net loss per share..........    28,203     25,939     15,859
                                              ========== ========== ==========

Basic and diluted net loss per common share. $   (0.70) $   (0.60) $   (2.14)
                                              ========== ========== ==========
Pro forma basic and diluted:
  Shares used above.........................                          15,859
  Pro forma adjustment to reflect
    weighted-average effect of assumed
    conversion of preferred stock...........                           5,897
                                                                    ----------
  Shares used in computing pro forma
    basic and diluted net loss per share....                          21,756
                                                                    ==========
Pro forma basic and diluted net loss
    per share...............................                       $   (1.56)
                                                                    ==========

During all periods presented, the Company had securities outstanding which could potentially dilute basic earnings per common share in the future, but were excluded from the computation of diluted net loss per common share, as their effect would have been antidilutive. These outstanding securities consist of the following :

                                                  Years Ended December 31,
                                              ----------------------------------
                                                 2002        2001        2000
                                              ----------  ----------  ----------
Outstanding options.........................  3,307,876   2,238,899     802,815
Warrants....................................     13,013      41,549     274,797
                                              ----------  ----------  ----------
         Total..............................  3,320,889   2,280,448   1,077,612
                                              ==========  ==========  ==========
Weighted average exercise price of options.. $     4.19  $     4.12  $     5.85
                                              ==========  ==========  ==========

Weighted average exercise price of warrants. $     2.58  $     2.58  $     2.58
                                              ==========  ==========  ==========

Recently Issued Accounting Standards

In June 2003, the Financial Accounting Standards Board (FASB) issued FAS 146, "Accounting for Costs Associated with Exit or Disposal Activities, " which addresses accounting for restructuring, discontinued operation, plant closing, or other exit or disposal activity. FAS 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. FAS 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The Company had a restructuring during the year-end ended December 31, 2002. The company early adopted as permitted and accounted for this restructuring accordingly. See Note 15 for related discussion.

In November 2002, the FASB issued Interpretation No. 45 (or FIN 45), "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantee's of Indebtedness of Others." FIN 45 elaborates on the existing disclosure requirements for most guarantees, including residual value guarantees issued in conjunction with operating lease arrangements. It also clarifies that at the time a company issues a guarantee, the company must recognize an initial liability for the fair value of the obligation it assumes under that guarantee and must disclose that information in its interim and annual financial statements. The initial recognition and measurement provisions apply on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. Our adoption of FIN 45 did not have a material impact on our results of operations and financial position.

In January 2003, the FASB issued Interpretation No. 46 or (FIN 46), "Consolidation of Variable Interest Entities." FIN 46 requires a variable interest to be consolidated by a company if that company is subject to a majority of of the risk of loss from the variable interest entity's activities or entitled to a receive a majority of the entity's residual returns or both. A variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have a equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. A variable interest entity often holds financial assets, including loans or receivables, real estate or other property. A variable interest entity may be essentially passive or it may engage in research and development or other activities on behalf of another company. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply to all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The Company does not believe that the adoption of this standard will have a material impact on its financial position or results of operations.

In December 2002, the FASB issued Statement No. 148, "Accounting for Stock-Based Compensation- Transition and Disclosure." FAS 148 amends FAS 123 "Accounting for Stock-Based Compensation" to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation. In addition, FAS 148 amends the disclosure requirements of FAS 123 to require more 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 additional disclosure requirements of FAS 148 are effective for fiscal years ended after December 15, 2002. We have elected to continue to follow the intrinsic value method of accounting as prescribed by Accounting Principles Board Opinion No. 25 (or APB 25), "Accounting for Stock Issued to Employees," to account for employee stock options.

In November 2002, the Financial Accounting Standards Board issued Emerging Issues Task Force (referred to as EITF) Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables." EITF Issue No. 00- 21 addresses certain aspects of the accounting by a company for arrangements under which it will perform multiple revenue-generating activities. EITF Issue No. No. 0021 addresses when and how an arrangement involving multiple deliverables should be divided into separate units of accounting. EITF Issue No. 00-21 provides guidance with respect to the effect of certain customers rights due to company nonperformance on the recognition of revenue allocated to delivered units of accounting. EITF Issue No. 00-21 addresses the impact on the measurement and/or allocation of arrangement consideration of customer cancellation provisions and consideration that varies as a result of future actions of the customer or the company. Finally, EITF Issue No. 00-21 provides guidance with respect to the recognition of the cost of certain deliverables that are excluded from the revenue accounting for an arrangement. The provisions of EITF Issue No. 00-21 will apply to revenue arrangement entered into in fiscal periods beginning after June 15, 2003, Cepheid is currently evaluating the effect that the adoption of EITF Issue No. 00-21 will have its Consolidated Financial Statements.

The Company has a worldwide exclusive license with Lawrence Livermore National Laboratory ("LLNL") to use or sublicense certain patent rights and to make, have made, import, and use certain licensed products relating to the patent rights for the use of rapid thermal cycling technology with real time optical detection for nucleic acid amplification. In consideration for this technology, the Company paid LLNL an issue fee of $0.2 million in 1997, which was included in research and development expense in that year. Upon commercialization of any product containing the licensed technology, including the Smart Cycler system, the Company is required to pay royalties to LLNL based on net sales. In April 2000, the Company entered into a non-exclusive license agreement with Applied Biosystems (formerly PE Biosystems) for the use of a thermal cycling technology in specific fields. The license requires the Company to pay royalties on a percentage of product sales. The Company had accrued royalties totaling $0.3 million and $0.3 million relating to the LLNL and Applied Biosytem agreements as of December 31, 2002 and 2001, respectively.

In April 2000, the Company entered into a $1.8 million "best-efforts" contract with Soldier Biological Chemical Command (" SBC- COM"), formerly the Edgewood Research, Development and Engineering Center ("ERDEC"), a department of the U.S. government to develop and build a completely automated and portable biological agent detection system that would provide for real time analysis of potentially contaminated samples collected from the environment such as air. The agreement provided for research and development funding to the Company. $0.3 million (17% of total Grant and government sponsored research revenue), $0.7 million (27% of total Grant and government sponsored research revenue) and $0.8 million (37% of total Grant and government sponsored research revenue) was recognized for the years ended December 31, 2002, 2001, and 2000, respectively.

U.S. Department of the Army

In November 1997, the Company entered into an agreement with the U.S. Army to conduct research and development services relating to the design and development of a specified device. The agreement was modified in May and August of 1998 and modified again in May and December of 2000. The agreement provided for research and development cost-plus-fixed-fee funding and is performed on a "best-efforts" basis. The aggregate funding for the agreement, including all modifications, totaled $1.9 million. In May 2002, an additional $3.4 million in funding was added to this contract and the performance period was extended to April 2004. Revenue recognized under this arrangement was $1.5 million (83% of total grant and government-sponsored research revenue), $0.4 million (17% of total grant and government-sponsored research revenue), and $0.2 million (10% of total grant and government sponsored research revenue) for the years ended December 31, 2002, 2001 and 2000, respectively.

Grant from the Defense Advanced Research Projects Agency

In May 1998, the Company received a three-year grant of approximately $4.1 million from the Defense Advanced Research Projects Agency ("DARPA") to perform research and development on the design and development of a specific device. Over the three year period, approximately $1.0 million of this amount directly funded work being performed by the United States Military Institute for Infectious Disease ("USAMRIID"), a subcontractor to the Company under the grant. The associated revenue and expense related to these subcontractors appear in the Company's statement of operations. During 2001, the grant was extended to December 31, 2001 with no additional funding granted. The three-year grant is subject to annual funding approval. For the first, second and third years of the program, $1.1 million, $1.6 million, and $1.4 million, respectively, was awarded. Such amounts exclude funding for the USAMRIID subcontract. Costs associated with the research and development activities under this grant for the years ended December 31, 2001, 2000 approximate the revenue recognized of $1.3 million (51% of total grant and government-sponsored research revenue) and $1.0 million (44% of total grant and government-sponsored research revenue). There was no such revenue recognized for the year ended December 31, 2002.

                                                           December 31,
                                                      ----------------------
                                                         2002        2001
                                                      -----------  ---------
Raw materials....................................... $     2,361  $   1,877
Work in process.....................................         988      1,387
Finished goods......................................         501        304
                                                      -----------  ---------
                                                     $     3,850  $   3,568
                                                      ===========  =========

                                                           December 31,
                                                      ----------------------
                                                         2002        2001
                                                      -----------  ---------

Land................................................ $        16  $      --
Buildings...........................................         346         --
Scientific equipment................................       5,764      3,277
Office furniture, computers and equipment...........       2,921      2,218
Leasehold improvements..............................       1,210        694
                                                      -----------  ---------
                                                          10,257      6,189
Less accumulated depreciation and amortization......      (4,113)    (3,014)
                                                      -----------  ---------
                                                     $     6,144  $   3,175
                                                      ===========  =========

                   Year Ending December 31,
- --------------------------------------------------------------
    2003...................................................... $     1,681
    2004......................................................       1,248
    2005......................................................         591
    2006......................................................          50
    2007......................................................          50
    Thereafter................................................         246
                                                                -----------
         Total minimum payments...............................       3,866
    Amount representing interest..............................        (418)
                                                                -----------
    Present value of future payments..........................       3,448
    Current portion of equipment and mortgage financing.......      (1,455)
                                                                -----------
    Non-current portion of equipment and mortgage financing... $     1,993
                                                                ===========

                   Year Ending December 31,
- --------------------------------------------------------------
    2003...................................................... $     1,352
    2004......................................................       1,393
    2005......................................................       1,435
    2006......................................................       1,478
    2007......................................................       1,522
    Thereafter................................................       6,939
                                                                -----------
         Total minimum payments............................... $    14,119
                                                                ===========

                                                                         Issuance
                                                                           Price
                                                                            per
                                                              Shares       Share
                                                            -----------  ---------

Series A..................................................   2,530,000  $    1.25
Series B..................................................   3,666,658       2.25
Series C..................................................     750,000       3.00
                                                            -----------
Balance, December 31, 1999................................   6,946,658       3.00
Series C..................................................   6,379,978
                                                            -----------
                                                            13,326,636
                                                            ===========

                                                Shares
                                               Available                   Weighted
                                                  for        Number        Average
                                                Future         of          Exercise
                                                 Grant       Shares         Price
                                              -----------  -----------  --------------
Balance, December 31, 1999..................     699,240      289,360  $         0.39
  Authorized................................   1,000,000           --              --
  Granted below fair value..................  (1,065,050)   1,065,050  $         5.02
  Exercised.................................          --     (500,415) $         1.16
  Forfeited.................................      51,180      (51,180) $         3.65
                                              -----------  -----------
Balance, December 31, 2000..................     685,370      802,815  $         5.85
  Authorized................................   2,667,732           --              --
  Granted below fair value..................  (1,600,360)   1,600,360  $         3.23
  Exercised.................................          --      (41,676) $         1.15
  Forfeited.................................     122,600     (122,600) $         4.74
                                              -----------  -----------
Balance, December 31, 2001..................   1,875,342    2,238,899  $         4.12
  Authorized................................     799,390           --              --
  Granted...................................  (1,563,175)   1,563,175  $         3.98
  Exercised.................................          --     (150,722) $         2.45
  Forfeited.................................     343,476     (343,476) $         3.64
                                              -----------  -----------
Balance, December 31, 2002..................   1,455,033    3,307,876  $         4.19
                                              ===========  ===========

                                                Options Outstanding
                                                 and Exercisable
                                              ------------------------
                                                                           Weighted
                                                                           Average
                                                            Weighted     Contractual
                                                Number       Average         Life
                                                  of        Exercise      Remaining
               Exercise Price                   Shares        Price       (in years)
- --------------------------------------------  -----------  -----------  --------------
$0.12 to $0.50..............................      17,415  $      0.21            5.02
 $1.50 to $2.20 ............................     176,001         1.67            7.57
 $2.32......................................     634,024         2.32            8.73
 $2.82 to $3.58.............................     281,765         3.14            8.77
 $3.61......................................     750,000         3.61            9.28
 $3.69 to $5.58.............................     882,767         4.36            8.18
 $6.00 to $8.50.............................     484,554         7.16            7.71
 $14.38.....................................      81,350        14.38            7.56
                                              -----------  -----------  --------------
                                               3,307,876         4.19            8.45
                                              ===========  ===========  ==============

                                                   December 31,
                                              ------------------------
                                                 2002         2001
                                              -----------  -----------
Stock Options:
  Options outstanding.......................   3,307,876    2,238,899
  Reserved for future grants................   1,455,033    2,023,502
Employee Stock Purchase Plan................     137,230      125,750
Warrants outstanding........................      13,013       41,549
                                              -----------  -----------
                                               4,913,152    4,429,700
                                              ===========  ===========

                                                       December 31,
                                                  --------------------
                                                    2002       2001
                                                  ---------  ---------
Net operating loss carry forwards............... $  18,500  $  12,000
Capitalized research and development costs......     1,890      1,600
Research and other credit carry forwards........     2,330      1,600
Reserves........................................       450        400
Other -- Net....................................     1,160        700
                                                  ---------  ---------
Total deferred tax assets.......................    24,330     16,300
Valuation allowance for deferred tax assets.....   (24,330)   (16,300)
                                                  ---------  ---------
Net deferred tax assets......................... $      --  $      --
                                                  =========  =========

                                      Balance   Additions
                                        at      Charged to             Balance
                                     Beginning  Costs and              at End
Description                           of Year   Expenses   Deductions  of Year
- -----------------------------------  ---------  ---------  ---------  ---------
Allowance for doubtful accounts:
 Year ended December 31, 2000...... $      --  $      --  $      --  $      --
 Year ended December 31, 2001......        --         48         --         48
 Year ended December 31, 2002......        48         --         --         48

Inventory reserve:
 Year ended December 31, 2000...... $     138  $     444  $     145  $     437
 Year ended December 31, 2001......       437        274        162        549
 Year ended December 31, 2002......       549        237        343        443