IMPAC MEDICAL SYSTEMS INC - 10-Q Quarterly Report

(Former name, former address and former fiscal year, if changed since last report)

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

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

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. ¨

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995.

The statements contained in this Form 10-Q that are not purely historical are forward looking statements within the meaning of Section 21E of the Securities and Exchange Act of 1934, including statements regarding the Company’s expectations, beliefs, hopes, intentions or strategies regarding the future. Forward looking statements include statements regarding the Company’s business strategy, timing of, and plans for, the introduction of new products and enhancements, future sales, market growth and direction, competition, market share, revenue growth, operating margins and profitability. All forward looking statements included in this document are based upon information available to the Company as of the date hereof, and the Company assumes no obligation to update any such forward looking statement. Actual results could differ materially from the Company’s current expectations. Factors that could cause or contribute to such differences include the Company’s ability to expand outside the radiation oncology market or expand into international markets, our inability to recognize revenue from multiple element software contracts where certain elements have been delivered, installed and accepted but other elements remain undelivered, lost sales or lower sales prices due to competitive pressures, the ability to integrate its products successfully with related products and systems in the medical services industry, reliance on distributors and manufacturers of oncology equipment to market its products, changes in Medicare reimbursement policies, the integration and performance of acquired businesses, and other factors and risks discussed in the 10-K/A and other reports filed by the Company from time to time with the Securities and Exchange Commission.

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

The accompanying unaudited condensed consolidated financial statements of IMPAC Medical Systems, Inc. and its subsidiaries (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and six month periods ended March 31, 2004 are not necessarily indicative of the results that may be expected for the year ending September 30, 2004, or for any future period. The balance sheet at September 30, 2003 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. These financial statements and notes should be read with the financial statements and notes thereto for the year ended September 30, 2003 included in the Company’s Form 10-K/A for the fiscal year ended September 30, 2003.

On November 20, 2002, the Company completed an initial public offering in which it sold 1,875,000 shares of common stock at $15.00 per share for net cash proceeds of approximately $24,300,000, net of underwriting discounts, commissions and other offering costs. Upon the closing of the offering, all of the Company’s outstanding shares of redeemable convertible preferred stock automatically converted into 1,238,390 shares of common stock. In addition to the shares sold by the Company, an additional 312,500 shares were sold by selling stockholders on the date of the offering and 328,125 shares were sold by selling stockholders in the exercise of the underwriters’ over-allotment option during December 2002. The Company did not receive any proceeds from the sale of shares by the selling stockholders or the exercise of the over-allotment.

On May 12, 2003, the Company completed a secondary offering in which it sold 200,000 shares of common stock at $19.00 per share for net cash proceeds of approximately $3,200,000, net of underwriting discounts, commissions and other offering costs. In addition to the shares sold by the Company, 2,178,223 shares were sold by selling stockholders on the date of the offering and 356,733 shares were sold by selling stockholders in the exercise of the underwriters’ over-allotment option during May 2003. The Company did not receive any proceeds from the sale of shares by the selling stockholders or from the exercise of the over-allotment option.

Inventories are stated at the lower of cost (determined on a first-in, first-out basis) or market. As of March 31, 2004 and September 30, 2003, inventories are comprised entirely of finished goods.

Upon the closing of the Company’s initial public offering, all outstanding shares of redeemable convertible preferred stock automatically converted into shares of common stock. Prior to the conversion, the carrying value of the redeemable convertible preferred stock was increased by periodic accretions using the effective interest method, so that the carrying amount would equal the redemption value at the redemption date. These increases were effected through charges against retained earnings and were carried out through the initial public offering closing date. Because the redeemable convertible preferred stock automatically converted into common stock upon the closing of the initial public offering, the non-cash accretion charges are no longer required and will not be applied in future quarters.

The Company’s revenue is derived primarily from two sources: (i) software license revenue from sales to distributors and end users and (ii) maintenance and services revenue from providing software support, education and consulting services to end users. The Company typically requires deposits upon the receipt of a signed purchase and license agreement, which are classified as customer deposit liabilities on the Company’s consolidated balance sheet.

The Company accounts for sales of software and maintenance revenue under the provisions of Statement of Position 97-2, (“SOP 97-2”), “Software Revenue Recognition,” as amended. SOP 97-2 requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on vendor-specific objective evidence (“VSOE”) of the fair value of the delivered and/or undelivered elements. For hardware transactions where no software is involved, the Company applies the provisions of Staff Accounting Bulletin 101 “Revenue Recognition.”

The Company recognizes revenue from the sale of software licenses when persuasive evidence of an arrangement exists, the product has been accepted, the fee is fixed or determinable, and collection of the resulting receivable is probable. Acceptance generally occurs after the product has been installed, training has occurred and the product is in clinical use at the customer site. For distributor related transactions, acceptance occurs with delivery of software registration keys to the distributor’s order fulfillment department.

The fee for multiple-element arrangements is allocated to each element of the arrangement, such as maintenance and support services, based on the relative fair values of the elements. The Company determines the fair value of each element in multi-element arrangements based on vendor-specific objective evidence for each element which is based on the price charged when the same element is sold separately. If evidence of fair value of all undelivered elements

exists but evidence does not exist for one or more delivered elements, then revenue is recognized using the residual method. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue.

The first year of maintenance and support, which includes updates and support, for the Company’s software products is included in the purchase price. Upon revenue recognition, the Company defers 12% of the list price, which is the renewal rate, and recognizes that portion over the remaining term of the included maintenance and support period. Fair value of services, such as training or consulting, are based upon separate sales by the Company of these services to other customers. Payments received for maintenance and services are deferred and recognized as revenue ratably over the contract term. Training and consulting services are billed based on hourly rates, and are generally recognized as revenue as these services are performed. Amounts deferred for installed and accepted software products under multiple element arrangements where VSOE of the fair value for all undelivered elements does not exist, maintenance services and term software license agreements comprise the main components of deferred revenue.

For direct software sales licensed on a term basis, the initial term lasts from three to five years with annual renewals after the initial term. The customer pays a deposit typically equal to the initial annual fee upon signing the license agreement, and the Company invoices the customer for subsequent annual fees 60 days before the anniversary date of the signed agreement. The Company recognizes revenue for the annual fees under these term license agreements ratably over the applicable twelve-month period. The annual fee includes maintenance and support.

The Company recognizes revenue from third-party products and related configuration and installation services sold with its licensed software upon acceptance by the customer. The Company recognizes revenue from third-party products sold separately from its licensed software upon delivery.

In December 2003, the Company added a pathology information management system to its suite of product offerings with the acquisition of certain assets of Tamtron Corporation from IMPATH Inc. (see Note 6). Pathology information management systems involve significant implementation and customization efforts essential to the functionality of the related products. Accordingly, the Company recognizes the license and professional consulting services generated through the sale of pathology management information systems using the percentage-of-completion method using labor hours incurred as prescribed by SOP No. 81-1, “Accounting for Performance of Construction-Type and Certain Product-Type Contracts.” The progress toward completion is measured based on labor hours incurred as compared to total estimated hours to complete. The Company accounts for a change in estimate in the period the change was identified. Provisions for estimated contract losses are recognized in the period in which the loss becomes probable and can be reasonably estimated.

The Company has also entered into an application service provider agreement whereby the Company provides all software, equipment and support during the term of the agreement. Revenues are recognized ratably over the term of the agreement, generally 60 months. Under the terms of this agreement, the customers must pay for the final two months of the term up front. These deposits are classified as long-term customer deposit liabilities on the Company’s consolidated balance sheet.

The Company uses the intrinsic value method of APB Opinion No. 25 (“APB No. 25”), “Accounting for Stock Issued to Employees,” in accounting for its employee stock options, and presents disclosure of pro forma information required under SFAS No. 123, as amended by SFAS No. 148. No compensation expense is included in the net loss attributable to common stockholders as reported during the three and six months ended March 31, 2004 and 2003.

Had compensation costs been determined based upon the fair value at the grant date, consistent with the methodology prescribed under SFAS No. 123, the Company’s total stock-based compensation cost, pro forma net income (loss) available for common stockholders and pro forma net income (loss) per common share, basic and diluted, would have been as follows (in thousands, except per share data):

The determination of fair value of all options granted after the Company’s initial public offering include an expected volatility factor in addition to the risk free interest rate, expected term and expected dividends.

Comprehensive income (loss) generally represents all changes in stockholders’ equity except those resulting from investments or contributions by stockholders. The Company’s unrealized gains and losses on available-for-sale securities and cumulative translation adjustments represent the components of comprehensive income (loss) that were excluded from the net income available for common stockholders. Total comprehensive income (loss) for the six months ended March 31, 2004 and 2003 is presented in the following table (in thousands):

Basic net income (loss) per common share is computed by dividing net income (loss) available for common stockholders by the weighted-average number of vested common shares outstanding for the period. Diluted net income (loss) per common share is computed giving effect to all potential dilutive common stock, including options and redeemable convertible preferred stock.

A reconciliation of the numerator and denominator used in the basic and diluted net loss per share follows (in thousands).

The following outstanding options and redeemable convertible preferred stock were excluded from the computation of diluted net income (loss) per share as their effect is antidilutive:

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FIN 46, “Consolidation of Variable Interest Entities”, an Interpretation of ARB 51, which subsequently has been revised by FIN 46-R. The primary objectives of FIN 46-R are to provide guidance on the identification of entities for which control is achieved through means other than through voting rights (variable interest entities or VIEs) and how to determine when and which business enterprise should consolidate the VIE (the primary beneficiary). This new model for consolidation applies to an entity in which either (1) the equity investors (if any) do not have a controlling financial interest or (2) the equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial support from other parties. In addition, FIN 46-R requires that both the primary beneficiary and all other enterprises with a significant variable interest in a VIE make additional disclosures. FIN 46-R is effective for VIEs created after January 31, 2003 and is effective for all VIEs created before February 1, 2003 that are Special Purpose Entities (SPEs) in the first reporting period ending after December 15, 2003 and for all other VIEs created before February 1, 2003 in the first reporting period ending after March 15, 2004. The Company believes there are no entities qualifying as VIEs and the adoption of FIN 46-R to date has not had any effect on the Company’s financial position, cash flows or results of operations.

Position No. 97-2 regarding software and non-software deliverables in a multiple element arrangement, giving consideration to whether the deliverables are essential to the functionality of one another and whether the whole arrangement falls within SOP 97-2 as a result. EITF Issue No. 03-05 is effective for interim periods beginning after August 13, 2003. The adoption of EITF Issue No. 03-05 did not have a material impact on the Company’s financial position or results of operations.

In addition to facility leases listed in our Form 10-K/A filed on April 16, 2004, the Company acquired certain assets and assumed certain liabilities of Tamtron Corporation and Medical Registry Services, Inc. on December 23, 2003 (see Note 6). In connection with this acquisition, the Company assumed lease agreements for facilities in San Jose, California and Hackensack, New Jersey from that date forward. The lease for the San Jose, California location expired in March 2004 and was not renewed. The facility lease for the Hackensack, New Jersey location expires in July 2005. As of March 31, 2004, total minimum future payments under the Hackensack, New Jersey lease, payable in monthly installments, amounted to approximately $119,000.

In March 2004, the Company entered into a new facility lease agreement in San Jose, California which expires in March 2007. As of March 31, 2004, total minimum future payments under this lease, payable in monthly installments, amounted to approximately $504,000.

Prior to the effectiveness of the Company’s registration statement for its initial public offering, an officer of the Company sent an email to 15 friends whom he had designated as potential purchasers of common stock in a directed share program in connection with the initial public offering. The email was not accompanied by a preliminary prospectus and may have constituted a prospectus that does not meet the requirements of the Securities Act of 1933. If the email did constitute a violation of the Securities Act of 1933, the recipients of the letter who purchased common stock in the Company’s initial public offering could have the right, for a period of one year from the date of their purchase of common stock, to obtain recovery of the consideration paid in connection with their purchase of common stock. For one year following the offering, the Company classified a total of 6,500 shares issued with rescission rights outside of stockholders’ equity, as the redemption features were not within the control of the Company. Any possible rescission rights would have lapsed in November 2003, and the 6,500 shares were reclassified to stockholders’ equity.

On December 23, 2003, the Company completed the acquisition of certain assets and certain liabilities of Tamtron Corporation (“Tamtron”) and Medical Registry Services, Inc. (“MRS”), the PowerPath^{^®} pathology information management and cancer registry information system businesses of IMPATH Inc. for total cash consideration of $22.0 million and approximately $494,000 of acquisition costs. The acquisitions were made pursuant to an asset purchase agreement, dated November 24, 2003, by and among Tamtron, MRS and the Company. The Company intends to continue to operate each of the acquired businesses.

The acquisition of assets and liabilities of Tamtron and MRS was accounted for in accordance with SFAS No. 141 “Business Combinations” using the purchase method of accounting and, accordingly, the results of operations of Tamtron and MRS were included in the Company’s consolidated financial statements subsequent to December 23, 2003. The purchase price was allocated to the net tangible and identifiable intangible assets acquired and the liabilities assumed based on their estimated fair values at the date of acquisition as determined by management. The excess of the purchase price over the fair value of the net identifiable assets was allocated to goodwill. The purchase price was allocated as follows (in thousands):

The Company is amortizing developed/core technology, the customer base and tradename on a straight line basis over two to five years, five to seven years and two to six years, respectively. In accordance with SFAS No. 142, no amortization has been recorded on the goodwill. As a result of these acquisitions, the Company expects to recognize amortization expense of $1.0 million during the remainder of fiscal year 2004. The Company expects to recognize amortization expense of $2.0 million, $1.6 million, $1.4 million, $1.4 million and $638,000 during fiscal years 2005, 2006, 2007, 2008 and thereafter, respectively.

The fair value of the identifiable assets, including the portion of the purchase price attributed to the developed/core technology, acquired in-process research and development, the customer base and the tradename was determined by management. The income approach was used to value developed/core technology, acquired in-process research and development, the customer base and the tradename, which includes an analysis of the completion costs, cash flows, other required assets and risk associated with achieving such cash flows. Gross margins were estimated to be stable and operating expense ratios were estimated to slightly improve over the years. The present value of the cash flows for MRS was calculated with a discount rate of 15% for the developed/core technology, customer base and tradename, and 20% for the in-process research and development. The present value of the cash flows for Tamtron was calculated with a discount rate of 15% for the developed/core technology and customer base, 17.5% for the tradename and 20% for the in-process research and development.

The in-process research and development projects relate primarily to the development of additional modules to the pathology information system and additional features for the registry system and are expected to be completed over the next twelve months. The purchased in-process technology was not considered to have reached technological feasibility and it has no alternative future use. Accordingly, it was recorded as a component of operating expense. The revenues, expenses, cash flows and other assumptions underlying the estimated fair value of the acquired in-process research and development involve significant risks and uncertainties. The risks and uncertainties associated with completing the acquired in-process projects include retaining key personnel

and being able to successfully and profitably produce, market and sell related products. The Company does not know of any developments which would lead it to significantly change its original estimate of the expected timing and commercial viability of these projects.

Goodwill of approximately $14.1 million represented the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired. The Company believes that its existing registry product offering along with the assets of MRS positions it as a leader in the market for data aggregation of cancer care information. The Company also believes that the addition of assets from Tamtron in the area of pathology information systems creates a more relevant and comprehensive product offering to its customers. The combination of both acquisitions allows the Company to better achieve its goal to provide a total solution that manages the complexity of cancer care throughout the spectrum of detection, diagnosis, treatment and follow-up.

The following pro forma financial information is based on the respective historical financial statements of the Company, Tamtron and MRS. The pro forma financial information reflects the consolidated results of operations as if the acquisitions of Tamtron and MRS occurred at the beginning of each of the periods presented and includes the amortization of the identifiable intangible assets. The pro form data excludes non-recurring charges, such as in-process research and development of approximately $557,000 in the quarter ended December 31, 2003. The pro forma financial data presented is not necessarily indicative of the Company’s results of operations that might have occurred had the transaction been completed at the beginning of the periods presented, and do not purport to represent what the Company’s consolidated results of operations might be for any future period (in thousands, except per share data).

The following discussion should be read in conjunction with our consolidated financial statements and the related notes appearing in our Form 10K/A for the fiscal year ended September 30, 2003. Our discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties, such as our plans, objectives, expectations and intentions. Actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including those set forth elsewhere in this Form 10-Q.

The Management’s Discussion and Analysis of Financial Condition and Results of Operations presented below reflects the effects of the restatement of our condensed consolidated balance sheet as of March 31, 2003 and the condensed consolidated statement of operations for the three and six months ended March 31, 2003 and statement of cash flows for the six months ended March 31, 2003.

We provide information technology systems for cancer care. Our systems provide electronic medical record, imaging, decision support, scheduling and billing applications in an integrated platform to manage the complexities of cancer care, from detection and diagnosis through treatment and follow-up. We were founded in 1990, and our growth has been primarily organic, supplemented by several product and small company acquisitions.

Although our revenues in the first and second quarter of fiscal 2004 have increased over the comparable fiscal 2003 periods, the bookings in our core oncology point-of-care business, which constitutes the majority of our non-recurring revenue, have unexpectedly flattened over the last several months. We initially noted a softening of backlog in the first quarter of fiscal 2004, which, at the time, was within historical norms. However, bookings have remained soft in calendar 2004. We believe several factors are contributing to this softness.

First, on the radiation oncology front, all three linear accelerator manufacturers have introduced “next generation” devices which have new operator front-ends and require new integration strategies. This has created uncertainty in the marketplace as customers are not fully aware of the connectivity options and the device manufacturers have used it as a means to confuse the marketplace and bundle their proprietary solutions. Second, we are also facing increasing pressure from competitors who have bundled deals where the software component is being offered at significant discounts as we have seen price shifting from the software to the hardware components putting us at a pricing disadvantage. Third, the second quarter of fiscal 2004 also witnessed a consolidation of oncology software players with the two independent medical oncology IT players being acquired by radiation oncology companies. Fourth, Medicare reimbursement policies also continue to put a damper on oncology IT spending. Decreased reimbursements in the radiation oncology segment and anticipated reductions in the medical oncology segment have led to delays in purchasing as facilities re-examine their budgets and return on investment expectations. Fifth, over the last several months our accounting restatement had a minor effect on bookings as some of our competitors used the event to sell against us. Finally, if our new installation backlog continues to contract, we will have less installation scheduling flexibility, which will expose our revenue stream to quarterly fluctuations if customers are not willing to take installation due to, for example, construction or equipment delays.

We sell our products directly throughout the world and primarily in North America, Europe and the Pacific Rim countries. In addition, we use non-exclusive distributors to augment our direct sales efforts. Sales through our primary distributor, Siemens Medical Systems, Inc., represented 12.2% and 9.9% of our total net sales in the three and six months ended March 31, 2004, respectively, and 7.3% and 8.7% for the same periods in fiscal 2003, respectively. The increase in distributor sales as a percentage of net sales is primarily attributable to a higher growth rate in distributor sales relative to non-distributor sales. We have signed agreements with other distributors, which have not yet generated sales. Revenues from the sale of our products and services outside the United States accounted for 7.4% and 4.9% of our net sales in the three and six months ended March 31, 2004, respectively, and 5.5% and 5.8% of our net sales for the same periods in fiscal 2003, respectively. The fiscal year to date decline in international sales as a percentage of net sales is primarily attributable to a higher growth rate in our domestic sales.

We license point-of-care and registry software products. Our point-of-care products are comprised of modules that process administrative, clinical, imaging and therapy delivery information. Our registry products aggregate data on patient outcomes for regulatory and corporate reporting purposes. Currently, a majority of our point-of-care software is licensed on a perpetual basis, and a majority of our registry sales is licensed on a term basis.

Our focus with regard to software licensing and maintenance and support service is to provide flexibility in the structure and pricing of our product offerings to meet the unique functional and financial needs of our customers. For those customers who license on a perpetual basis, we promote annual maintenance and support service agreements as an incremental investment designed to preserve the value of the customer’s initial investment. For those customers who license on a term basis, annual maintenance and support contributes greatly to the value of the annual license, and the two cannot be segregated from each other. For those customers using our application service provider option, independent of the licensing method, these annual fees allow the customer to outsource, in a cost effective manner, support and connectivity functions that are normally handled by internal resources.

The decision to implement, replace, expand or substantially modify an information system is a significant commitment for healthcare organizations. In addition, our systems typically require significant capital expenditures by the customer. Consequently, we experience long sales and implementation cycles. The sales cycle for our systems ranges from six to twenty-four months or more from initial contact to contract execution. Our implementation cycle generally ranges from three to nine months from contract execution to completion of implementation. In addition to the core system, approximately one-third of our customers purchase additional product modules along with the core system that they intend to implement over a period of time greater than the typical implementation cycle of three to nine months.

We have experienced significant variations in revenues and operating results from quarter to quarter. Our quarterly operating results may continue to fluctuate due to a number of factors, including: the timing, size and complexity of our product sales and implementations; our inability to recognize revenue from multiple element software contracts where certain elements have been delivered, installed and accepted but other elements remain undelivered; construction delays at client centers which impact our ability to install products; the timing of installation of third party medical devices, including accelerators, simulation machines and imaging devices, at client sites, which must be installed before we can implement our systems; overall demand for healthcare information technology; and other factors discussed in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors” section of our Annual Report on Form 10-K/A for the year ended September 30, 2003.

We record orders for products licensed on a perpetual basis upon the receipt of a signed purchase and license agreement, purchase order, and a substantial deposit. We record orders for products licensed on a term basis upon receipt of a signed purchase and license agreement, purchase order and a deposit typically equal to the first year’s fees. All contract deposits are held as a liability as outlined in the terms and conditions set forth in the purchase and license agreement. Maintenance and support is recorded as deferred revenue upon the invoice date and held as a current liability on the balance sheet. Under the terms of the original purchase and license agreement, maintenance and support automatically renews on an annual basis unless the customer provides a written cancellation. We recognize revenue from these sales ratably over the underlying maintenance period.

For direct software sales licensed on a perpetual basis, we include one year of maintenance and support as part of the purchase price. Standard annual fees for maintenance and support after the first year equal 12% of the then current list price unless the customer negotiates other terms or service levels.

We recognize revenue once software products outlined in the related purchase and license agreement have been installed, accepted and in clinical use at the customer site. When a customer accepts only a subset of the products outlined in a multiple element purchase and license agreement and we have not established vendor specific objective evidence, or VSOE, of the fair value of the undelivered elements, we invoice the customer for the accepted products and record the transaction as deferred software license revenue. We recognize the deferred revenue when all elements in a multiple element arrangement are accepted, VSOE of the fair value is established on the remaining undelivered elements, or the undelivered elements for which VSOE of the fair value does not exist have been canceled, whichever occurs first.

The first year of maintenance and support for our software products is included in the purchase price. Upon revenue recognition, we defer 12% of the list price, which is the renewal rate, and recognize that portion over the remaining term of the included maintenance and support period. For example, if revenue recognition occurs four months subsequent to product acceptance, we would recognize one third of the 12% maintenance and support deferral as revenue and recognize the remaining two thirds of the deferral over the following eight months. In situations where the first phase of software products are installed

greater than one year prior to our ability to recognize the related revenue, it is not be necessary to defer 12% of the list price and recognize that portion over the included maintenance and support period as the first year maintenance and support obligation is no longer applicable. In these cases, 12% of the license purchase price is classified as maintenance and services revenue at the time of revenue recognition.

For direct software sales licensed on a term basis, the initial term lasts from three to five years with annual renewals after the initial term. The customer pays a deposit typically equal to the initial annual fee upon signing the license agreement, and we invoice the customer for subsequent annual fees 60 days before the anniversary date of the signed agreement. We recognize revenue for the annual fees under these term license agreements ratably over the applicable twelve-month period. The purchase price includes annual maintenance and support.

We recognize revenue from third-party products and related configuration and installation services sold with our licensed software upon acceptance by the customer. We recognize revenue from third-party products sold separately from our licensed software upon delivery. Third-party products represented 2.1% and 3.3% of our total net sales in the three and six months ended March 31, 2004, respectively, and 5.4% and 4.9% for the same period in fiscal 2003, respectively. The decrease in third-party sales as a percentage of net sales is attributable to a lower growth rate in our third-party product sales.

We recognize distributor related revenues upon the receipt of a completed purchase order and the related customer information needed to generate software registration keys, which allow us to distribute the software to the end user and satisfy our regulatory information tracking requirements. We provide maintenance and support to our distributor. The cost of the first year’s support is included in the fee. Renewal support is purchased for 5% of the transfer price for software licenses sold to their customers. We defer the distributor’s first year post-contract support, based on the renewal rate, and recognize that portion of the revenue ratably over the support period. We invoice maintenance and support annually at the beginning of each fiscal year and recognize revenue ratably over the applicable twelve-month period.

In December 2003, we added a pathology information management system to our suite of product offerings with the acquisition of certain assets of Tamtron Corporation from IMPATH Inc. (see Note 6 to the condensed consolidated financial statements). Pathology information management systems involve significant implementation and customization efforts essential to the functionality of the related products. Accordingly, we recognize the license and professional consulting services generated through the sale of pathology management information systems using the percentage-of-completion method using labor hours incurred as prescribed by SOP No. 81-1, “Accounting for Performance of Construction-Type and Certain Product-Type Contracts.” The progress toward completion is measured based on labor hours incurred as compared to total estimated hours to complete. We account for a change in estimate in the period the change was identified. Provisions for estimated contract losses are recognized in the period in which the loss becomes probable and can be reasonably estimated.

A large part of our company cost structure is driven by the number of employees and all related benefit and facility costs. As a result, a significant amount of strategic and fiscal planning is focused on this area, so we can develop internal resources at a controlled and sustainable rate. Since revenue recognition happens subsequent to all implementation and training activities, we incur the costs of labor, travel and some third-party product expenses in advance.

System installations require several phases of implementation in the process of accepting product delivery and have led to our development of a highly specialized client service organization. All new orders require multiple site visits from our personnel to properly install, configure and train customer personnel. In transactions where we are required to defer the recognition of software license revenue, the associated incremental direct travel expenses are recorded as a prepaid expense until the associated revenue is recognized. Several point-of-care products are used with various third-party hardware and software products that are also sold and configured during the implementation process. After the initial implementation process, our application support staff provides phone support and any applicable system updates. A substantial percentage of engineering costs are allocated to client services due to continuing engineering efforts related to the support and enhancement of our products. Historically, cost of sales has increased at approximately the same rate as net sales. However, as newly developed products and acquired product lines are released to the customers, additional investments in client service staff could cause gross margins to fluctuate.

Research and development expenses include costs associated with the design, development and testing of our products. These costs consist primarily of:

We currently expense all research and development costs as incurred. Our research and development efforts are periodically subject to significant non-recurring costs that can cause fluctuations in our quarterly research and development expense trends. We expect that research and development expenses will increase in absolute dollars for the foreseeable future as we continue to invest in product development.

We have recently expanded our sales force, made significant investments in marketing communications and increased trade show activities to enhance market awareness of our products. We expect that sales and marketing expenses will increase in absolute dollars for the foreseeable future as we continue to expand our sales and marketing capabilities. In transactions where we are required to defer the recognition of software license revenue, the associated incremental direct commission expense is recorded as a prepaid expense until the associated revenue is recognized.

A significant portion of facility, infrastructure and maintenance costs are allocated as overhead to other functions based on distribution of headcount. We expect that our general and administrative expenses will increase as a public company.

Our property and equipment is recorded at our cost minus accumulated depreciation and amortization. We depreciate the costs of our tangible capital assets on a straight-line basis over the estimated economic life of the asset, which is generally three to seven years. Acquisition related intangible assets have historically been amortized based upon the estimated economic life, which is generally two to six years. Leasehold improvements and equipment purchased through a capital lease are amortized over the life of the related asset or the lease term, if shorter. If we sell or retire an asset, the cost and accumulated depreciation is removed from the balance sheet and the appropriate gain or loss is recorded. We expense repair and maintenance costs as incurred.

From September 27, 2002 until our initial public offering, the holders of a majority of our then outstanding redeemable convertible preferred stock could have required us to redeem the preferred shares by paying in cash an amount equal to the greater of $3.23 per share or the fair market value plus all declared or accumulated but unpaid dividends within thirty days. These shares automatically converted to common stock upon the closing of our initial public offering in November 2002. We accreted charges that reflected the increase in market value of the redeemable convertible preferred stock as an adjustment to retained earnings and, as a result, increased the amount of net loss attributable to common stockholders. After the initial public offering, no further accretion is required. The redemption value of the redeemable convertible preferred stock was $16.8 million at the time of the initial public offering. This amount was reallocated on our balance sheet from redeemable convertible preferred stock to common stock and additional paid-in capital, less the stated par value.

The following table sets forth certain operating data as a percentage of net sales for the periods indicated:

Net Sales. Net sales increased 21.6% to $15.4 million in the three months ended March 31, 2004 from $12.7 million for the same period in fiscal 2003 including $2.0 million related to the acquisition of certain assets and certain liabilities of Tamtron Corporation (“Tamtron”) and Medical Registry Services, Inc. (“MRS”), the PowerPath^® pathology information management and cancer registry information system businesses of IMPATH Inc.

Net software sales increased 9.5% to $8.6 million in the three months ended March 31, 2004 from $7.8 million for the same period in fiscal 2003. New systems sales in oncology accounted for $238,000 of the $741,000 increase, sales of registry systems from the acquired product line accounted for $814,000, sales of pathology lab systems from the acquired product line accounted for $501,000, sales of imaging systems accounted for $379,000, offset by a net decrease in sales of new products to existing customers of $1.2 million. We deferred a net amount of $1.8 million in software license revenue in the three months ended March 31, 2004, installations of new systems in oncology accounted for $1.5 million, installations of new products to existing customers accounted for $148,000 and installations of imaging systems accounted for the remaining amount of the deferral. We deferred $2.6 million of software license revenue for the same period in fiscal 2003.

Maintenance and services sales also increased 41.1% to $6.9 million for the three months ended March 31, 2004 from $4.9 million for the same period in fiscal 2003. Maintenance and support contracts contributed $2.1 million of the $2.0 million increase offset by a decrease in training and installation of $80,000. The acquired pathology line of business contributed $624,000 of the total increase in maintenance and services. Our continued high customer retention on maintenance and support contracts, the general price increase, deferral of installed and accepted software license revenue, and expansion of our service offerings all contributed to the growth of maintenance and services as a percentage of net sales.

Cost of Sales. Total cost of sales increased 47.7% to $6.0 million for the three months ended March 31, 2004 from $4.0 million for the same period in fiscal 2003. Our gross margin decreased to 61.4% for the three months ended March 31, 2004 from 68.2% for the same period in fiscal 2003.

Cost of sales relating to net software sales increased 46.0% to $3.4 million for the three months ended March 31, 2004 from $2.4 million for the same period in fiscal 2003. Our gross margin associated with net software sales decreased to 59.7% for the three months ended March 31, 2004 compared to 69.8% for the same period in fiscal 2003. The increase in expenses was related to $1.1 million in employee costs, $256,000 in travel costs, $109,000 in implementation costs and $24,000 in telephone costs offset by a reduction of $355,000 in supplies and materials. During the three months ended March 31, 2004, we deferred $93,000 in direct incremental travel expenses associated with software installation and training trips compared to $174,000 during the same period in fiscal 2003. We expect to recognize the deferred travel expenses once the associated product revenues are recognized. The decline in gross margins associated with net software sales relates to delayed implementation of new oncology systems and increased employee expenses associated with the two product line acquisitions in December 2003. We believe the margins related to the acquired businesses should improve once we have depleted the acquired deferred revenue backlog.

Cost of sales relating to maintenance and services increased 50.1% to $2.5 million for the three months ended March 31, 2004 from $1.7 million for the same period in fiscal 2003. Our gross margin associated with maintenance and services decreased to 63.5% for the three months ended March 31, 2004 from 65.6% for the same period in fiscal 2003. The increase in expenses of $838,000 was related to $432,000 in continuing engineering costs, $427,000 in employee related expenses, $11,000 in travel expenses offset by reductions of $17,000 in supplies and materials and $16,000 in telephone expense. Expenses associated with the support personnel from the acquired product lines for the three months ended March 31, 2004 contributed to the decline in our gross margin associated with maintenance and services.

Research and Development. Research and development expenses increased 27.6% to $3.0 million for the three months ended March 31, 2004 from $2.4 million for the same period in fiscal 2003. As a percentage of total net sales, research and development expenses increased to 19.5% for the three months ended March 31, 2004 from 18.6% for the same period in fiscal 2003. Additional engineering headcount and the associated personnel expenses accounted for $667,000, travel expenses accounted for $15,000 offset by reductions of $26,000 of supplies and materials and $5,000 in telephone expense. The increase as a percentage of total net sales in the three months ended March 31, 2004 was primarily due to increased engineering headcount associated with the acquired product lines in December 2003.

Sales and Marketing. Sales and marketing expenses increased 16.2% to $3.9 million for the three months ended March 31, 2004 from $3.3 million for the same period in fiscal 2003. As a percentage of total net sales, sales and marketing expenses decreased to 25.1% for the three months ended March 31, 2004 from 26.2% for the same period in fiscal 2003. The increase in expenses in absolute dollars related to $577,000 in employee related expenses, $56,000 in advertising expenses, $48,000 in travel expenses, 39,000 in outside services, $28,000 in supplies and materials and $13,000 in sponsorships offset by a reduction in commissions of $233,000. The decrease as a percentage of total net sales in the three months ended March 31, 2003 was due to increased net sales relative to sales and marketing expenses. During the three months ended March 31, 2004, we deferred $171,000 in direct incremental commission expenses compared to $93,000 during the same period in fiscal 2003. We expect to recognize the deferred commission expenses once the associated product revenues are recognized.

General and Administrative. General and administrative expenses increased 30.2% to $1.9 million for the three months ended March 31, 2004 from $1.4 million for the same period in fiscal 2003. As a percentage of total net sales, general and administrative expenses increased to 12.0% for the three months ended March 31, 2004 from 11.3% for the same period in fiscal 2003. The increase in absolute dollars was primarily due to increases in accounting and legal fees of $314,000 primarily related to our restatement, maintenance expense of $44,000, regulatory fees of $30,000, business insurance premiums of $27,000, travel expense of $22,000 and contributions of $20,000. The percentage of total net sales in the three months ended March 31, 2004 was influenced by additional expenses related to the restatement of our financial statements.

Amortization of Intangible Assets. Amortization expenses increased 464.1% to $581,000 for the three months ended March 31, 2004 from $103,000 for the same period in fiscal 2003. Our acquisition of substantially all of the assets of Tamtron and MRS in December 2003 increased amortization expense as it relates to developed/core technology, customer base and trade name.

Operating Income. Operating income decreased 88.8% to $161,000 for the three months ended March 31, 2004 from $1.4 million for the same period in fiscal 2003. Operating income decreased significantly due to delayed implementations of new oncology systems, higher amortization of intangible assets related to the December 2003 asset purchases and additional fees associated with the restatement of our financial statements.

Interest and Other Income, Net. Interest and other income, net decreased 26.8% to $101,000 for the three months ended March 31, 2004 from $138,000 for the same period in fiscal 2003. The decrease was primarily related to our lower cash balance subsequent to the asset purchases in December 2003.

Income Taxes. Our effective tax rate increased slightly to 35.0% during the three months ended March 31, 2004 from 34.9% during the same period in fiscal 2003.

Net Sales. Net sales increased 25.0% to $29.8 million in the six months ended March 31, 2004 from $23.9 million for the same period in fiscal 2003 including $2.2 million related to the acquisition of certain assets and certain liabilities of Tamtron and MRS.

Net software related sales increased 16.3% to $16.9 million in the six months ended March 31, 2004 from $14.5 million for the same period in fiscal 2003. Registry sales from the acquired product line accounted for $918,000 of the $2.4 million increase, new system sales in oncology accounted for $738,000, sales of pathology from the acquired product line and lab systems accounted for $508,000, sales of imaging systems accounted for $445,000 offset by a decrease in imaging and urology sales of $238,000.

Maintenance and services also increased 38.6% to $12.9 million for the six months ended March 31, 2004 from $9.3 million for the same period in fiscal 2003. Maintenance and support contracts contributed $3.7 million of the $3.6 million increase offset by a decrease in installation and training of $93,000. Our continued high customer retention on maintenance and support contracts, the general price increase, deferral of installed and accepted software license revenue, and expansion of our service offerings all contributed to the growth of maintenance and services as a percentage of net sales.

Cost of Sales. Total cost of sales increased 43.5% to $11.1 million for the six months ended March 31, 2004 from $7.7 million for the same period in fiscal 2003. Our gross margin decreased to 62.8% for the six months ended March 31, 2004 from 67.5% for the same period in fiscal 2003.

Cost of sales relating to net software sales increased 46.4% to $6.4 million for the six months ended March 31, 2004 from $4.4 million for the same period in fiscal 2003. Our gross margin associated with net software sales decreased to 62.2% for the six months ended March 31, 2004 from 70.0% for the same period in fiscal 2003. The increase in expenses related to $1.7 million in employee costs, $296,000 in travel expenses, $165,000 in implementation costs, $15,000 in telephone expenses offset by a reduction of $129,000 in supplies and materials. During the six months ended March 31, 2004, we deferred $209,000 in direct incremental travel expenses associated with software installation and training trips compared to $221,000 during the same period in fiscal 2003. We expect to recognize the deferred travel expenses once the associated product revenues are recognized. The decline in gross margins associated with net software sales relates to delays implementations of new oncology systems and increased employee expenses associated with the two product line acquisitions in December 2003. We believe the margins related to the acquired businesses should improve once we have recognized the acquired deferred revenue balance.

Cost of sales relating to maintenance and services increased 39.7% to $4.7 million for the six months ended March 31, 2004 from $3.4 million for the same period in fiscal 2003. Our gross margin associated with maintenance and services decreased slightly to 63.6% for the six months ended March 31, 2004 from 63.9% for the same period in fiscal 2003. The increase in expenses was associated with $744,000 in continuing engineering costs, $661,000 in employee related expenses offset by reductions of $26,000 in supplies and materials, $25,000 in telephone expense and $15,000 in travel expenses. Expenses associated with the support personnel from the acquired product lines for the six months ended March 31, 2004 contributed to the slight decline in our gross margin associated with maintenance and services.

Research and Development. Research and development expenses increased 21.7% to $5.4 million for the six months ended March 31, 2004 from $4.5 million for the same period in fiscal 2003. As a percentage of total net sales, research and development expenses decreased to 18.2% for the six months ended March 31, 2004 from 18.7% for the same period in fiscal 2003. Additional engineering headcount and the associated personnel expenses accounted for $1.0 million and travel expenses accounted for $22,000 offset by a reduction of $38,000 in supplies and materials, $23,000 in telephone expense and $5,000 in outside services. The decrease as a percentage of total net sales in the six months ended March 31, 2004 was due to increased net sales relative to research and development expenses.

Sales and Marketing. Sales and marketing expenses increased 21.3% to $7.9 million for the six months ended March 31, 2004 from $6.5 million for the same period in fiscal 2003. As a percentage of total net sales, sales and marketing expenses decreased to 26.3% for the six months ended March 31, 2004 from 27.2% for the same period in fiscal 2003. The increase in expenses related to $1.2 million in employee related expenses, $162,000 in travel expenses, $110,000 in advertising expenses, $101,000 in outside services, $66,000 in sponsorships, $45,000 in supplies and materials and $28,000 in trade show expenses offset by a reduction in commission expense of $332,000. The decrease as a percentage of total net sales in the six months ended March 31, 2004 was due to increased net sales relative to sales and marketing expenses and the cyclical nature of trade show spending. During the six months ended March 31, 2004, we deferred $222,000 in direct incremental commission expenses compared to $105,000 during the same period in fiscal 2003. We expect to recognize the deferred commission expenses when the associated product revenues are recognized.

General and Administrative. General and administrative expenses increased 21.9% to $3.1 million for the six months ended March 31, 2004 from $2.5 million for the same period in fiscal 2003. As a percentage of total net sales, general and administrative expenses decreased to 10.4% for the six months ended March 31, 2004 from 10.6% for the same period in fiscal 2003. The increase in absolute dollars was primarily due to increases in accounting and legal fees of $432,000, maintenance fees of $92,000, regulatory fees of $34,000, contributions of $20,000 and travel expenses of $10,000 offset by reductions in various operational expenses of $36,000. The increase as a percentage of total net sales in the six months ended March 31, 2004 was influenced by additional expenses related to the restatement of our financial statements.

In-process Research and Development. We recorded a write-off of in-process research and development in the amount of $557,000 in the six months ended March 31, 2004 due to an analysis allocating the purchase price paid for certain intellectual property in that period. Both product lines that were acquired were in the process of bringing certain new products and functionality to their existing product offerings at the time of acquisition. In conjunction with the management of those businesses, we estimated that the products were incomplete and believed there were sufficient technological risks associated with these products to qualify the in-process research and development $557,000 write-off. We did not have an in-process research and development write-off for the same period in 2003.

Amortization of Intangible Assets. Amortization expenses increased 242.0% to $701,000 for the six months ended March 31, 2004 from $205,000 for the same period in fiscal 2003. Our acquisition of substantially all of the assets of Tamtron, Inc. and Medical Registry Services, Inc. in December 2003 increased amortization expense as it relates to developed/core technology, customer base and trade name.

Operating Income. Operating income decreased 55.8% to $1.1 million for the six months ended March 31, 2004 from $2.4 million for the same period in fiscal 2003. Operating income decreased significantly due to delays in implementations of new oncology systems, an in-process research and development write-off, higher amortization of intangible assets related to the December 2003 asset purchases and additional fees associated with the restatement of our financial statements.

Interest and Other Income, Net. Interest and other income, net increased 14.4% to $246,000 for the six months ended March 31, 2004 from $215,000 for the same period in fiscal 2003. The increase was primarily related to additional cash balances being invested from our public offering proceeds offset by lower cash balances subsequent to our product line acquisitions in December 2003.

Income Taxes. Our effective tax rate was increased slightly to 35.0% during the six months ended March 31, 2004 from 34.9% during the same period in fiscal 2003.

Accretion of Redeemable Convertible Preferred Stock. Historically, each reporting period, the carrying value of the redeemable convertible preferred stock has been increased by periodic accretions, using the effective interest method, so that the carrying amount would equal the redemption value at the redemption date. These increases were effected through charges against retained earnings. Several factors have influenced our determination of the value of the redeemable convertible preferred stock. These factors included plans for the initial public offering, the performance of our business, changes in our business model and significant product introductions, current market conditions and the performance of the stock price of our comparable companies. During the six months ended March 31, 2003, we recorded accretion charges of $2.2 million, all of which was incurred during the first quarter in the time period leading up to the initial public offering. There were no accretion charges recorded for the six months ending March 31, 2004. Upon the closing of our initial public offering in November 2002, all shares of our redeemable convertible preferred stock automatically converted into an equal number of shares of common stock. Therefore, we have not incurred, nor will we incur, accretion charges related to the Series A redeemable convertible preferred stock after our initial public offering.

Our backlog is comprised of customer deposits, deferred software license revenue, other deferred revenue and unearned revenue. Customer deposits represent required deposits paid by our customers when they place orders. These deposits are held as a liability until revenue recognition. Deferred software license revenue represents the revenues on installed, accepted and invoiced products that we cannot yet recognize because the products installed were only a subset of the products outlined in a multiple element arrangement for which we do not have VSOE of the fair value on all of the undelivered elements. The amounts classified as deferred software license revenue will be recognized as revenue once we establish VSOE of the fair value on the remaining undelivered elements, the remaining elements for which VSOE of the fair value does not exist have been installed and accepted or the remaining elements for which VSOE of the fair value does not exist have been canceled, whichever occurs first. Other deferred revenue represents maintenance and support services and term licenses which are generally recognized ratably over the support period and license term, respectively. Unearned revenue represents the value of products ordered but not installed or accepted in excess of the contract deposit. Orders are recognized only once we have received a signed purchase and license agreement, an authorized purchase order and a deposit check. Therefore, amounts in our sales pipeline that have not met all three order recognition criteria are not included in our backlog.

The components of backlog as of March 31, 2004 and 2003 and December 31, 2003 are as follows (amounts in thousands):

Total backlog increased 50.3% to $80.7 million at March 31, 2004 from $53.3 million at March 31, 2003. In addition, total backlog increased 15.9%, or $11.1 million, from $69.6 million at December 31, 2003. During the three months ended March 31, 2004, bookings in our core oncology point-of-care business, have unexpectedly flattened. We initially noted a softening of backlog in the three months ended December 31, 2003; however, at that time the amount was within historical norms and we expected our typical second quarter upswing. Bookings have remained soft however in the three months ended March 31, 2004. Of the total $80.7 million of backlog at March 31, 2004, we expect to recognize approximately $75.2 million of our backlog during the twelve months following March 31, 2004 with the remaining portion to be completed in subsequent periods. We cannot assure you that contracts included in backlog will generate the specified revenues or that these revenues will be fully recognized within the specified time periods.

Deferred revenue increased $13.0 million to $36.4 million for the twelve months ended March 31, 2004 from $23.4 million at March 31, 2003. Of the $13.0 million increase, deferred software license revenue and the related deferred maintenance and support contributed $4.9 million. This increase was comprised of $3.3 million of new installations in oncology and $2.4 million in imaging systems offset by a decrease of $743,000 in new products to existing customers. The remaining $8.0 million increase relates to other deferred revenue of $3.9 million in post contract maintenance and support for oncology products, $1.9 million in registry term licenses, $1.2 million in post contract maintenance and support for pathology products and $1.0 million of pathology license revenue.

We experience a seasonal pattern in our revenues, with our first quarter typically having the lowest revenues followed by increasing revenue growth in the subsequent quarters of our fiscal year. We believe the seasonality of our revenue is influenced by the year end of many of our customers’ budgetary cycles. As much of the labor and indirect expense associated with software systems for which revenue has been deferred are not matched with the subsequent revenue recognition, net income does not display a clear and predictable seasonal pattern.

In addition, the implementation of a significant contract previously included in backlog, or a contract intended to be installed in a phased manner over a longer than average time period, could generate a large increase in revenue and net income for any given quarter or fiscal year, which may prove unusual when compared to changes in revenue and net income in other periods. Furthermore, we typically experience long sales cycles for new customers, which may extend over several quarters before a sale is consummated and a customer implementation occurs. As a result, we believe that quarterly results of operations will continue to fluctuate and that quarterly results may not be indicative of future periods. The timing of revenues is influenced by a number of factors, including the timing of individual orders, customer implementations and seasonal customer buying patterns.

We have financed our operations since inception primarily through cash from operating activities, a $4.0 million private placement of equity in 1996, net proceeds of $24.4 million from our initial public offering of common stock in November 2002 and net proceeds of $3.2 million from our secondary public offering of common stock in May 2003. Cash, cash equivalents and available-for-sale securities were $45.2 million at March 31, 2004.

During the six months ended March 31, 2004, net cash provided by operating activities was $62,000 compared to $1.1 million for the same period in fiscal 2003. In the six months ended March 31, 2004, cash provided by operations was primarily attributable to net income after adjustment for the non-cash charges relating to depreciation and amortization, an increase in deferred revenue, offset by increases in accounts receivable, prepaid expenses and other current assets and a decrease in accrued liabilities and accounts payable. In the six months ended March 31, 2003, cash provided by operations was primarily attributable to increases in sales leading to a higher net income after adjustment for the non-cash charges relating to depreciation and amortization, an increase in customer deposits and increases in income taxes payable and deferred revenue, offset by an increase in accounts receivable due to higher sales and a decrease in accrued liabilities. As referenced previously in the backlog section, bookings in our core oncology point-of-care business, have unexpectedly flattened. The subsequent impact of orders may effect the historical trend of operating cash in subsequent quarters.

In determining average days’ sales outstanding and accounts receivable turnover, we use our gross annual invoicing and gross accounts receivable balances in each calculation as we believe this provides a more conservative and relevant measurement basis due to the significance of our deferred revenue. Our accounts receivable turnover decreased to 3.5 for the six months ended March 31, 2004 from 4.5 for the same period in fiscal 2003. Our days’ sales outstanding at March 31, 2004 increased to 103 from 79 at March 31, 2003. We believe that the acquired accounts receivable balances from Tamtron and MRS have impacted the calculation of accounts receivable turnover and days sales outstanding ratios. In addition, during the three months ended March 31, 2004, the collections personnel devoted the majority of their time to assisting with the restatement and were unable to complete as many collection calls. We are currently recruiting additional dedicated collections resources, and we continue our efforts to improve collections by formalizing escalation procedures and improving internal communications. Revenue is only recognized when all of the criteria for revenue recognition have been met which is upon acceptance and invoicing of the final balance of the fee unless the invoice has payment terms extending longer than 60 days. Any invoice that has payment terms longer than 60 days is considered to have extended payment terms and is not recognized as a receivable or revenue until it is due and payable.

Net cash used in investing activities was $21.5 million for the six months ended March 31, 2004 and $1.3 million for the same period in fiscal 2003. During the six months ended March 31, 2004, cash used in investing activities primarily related to the acquisition of certain assets of Tamtron and MRS for $22.0 million and approximately $494,000 in acquisition costs and the purchase of $1.1 million of capital equipment to support two office moves during the period, offset by $2.1 million in net proceeds from sales and maturities of available-for-sale securities.. During the six months ended March 31, 2003, cash used in investing activities primarily related to the purchase of $1.1 million in capital assets and $181,000 in net purchases of available-for-sale securities.

Net cash provided by financing activities was $1.0 million for the six months ended March 31, 2004, compared to $25.0 million for the same period in fiscal 2003. Cash provided by financing activities during the six months ended March 31, 2004 can be attributed to $1.2 million received from the issuance of common stock, offset by capital lease principal payments of $194,000. Cash provided by financing activities during the six months ended March 31, 2003 can be attributed primarily to net proceeds of $24.4 million received in our initial public offering during November 2002.

The following table describes our commitments to settle contractual obligations in cash not recorded on the balance sheet as of March 31, 2004 (in thousands). The telecommunications contracts with AT&T include wireless, frame-relay, voice/data and internet transport services.

We expect to increase capital expenditures consistent with our anticipated growth in infrastructure and personnel. We also may increase our capital expenditures as we expand our product lines or invest in new markets. We believe that the net proceeds from the common stock sold in the initial public offering, together with available funds and cash generated from operations will be sufficient to meet our operating requirements, assuming no change in the operations of our business, for at least the next 18 months.

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FIN 46, “Consolidation of Variable Interest Entities”, an Interpretation of ARB 51, which subsequently has been revised by FIN 46-R. The primary objectives of FIN 46-R are to provide guidance on the identification of entities for which control is achieved through means other than through voting rights (variable interest entities or VIEs) and how to determine when and which business enterprise should consolidate the VIE (the primary beneficiary). This new model for consolidation applies to an entity in which either (1) the equity investors (if any) do not have a controlling financial interest or (2) the equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial support from other parties. In addition, FIN 46-R requires that both the primary beneficiary and all other enterprises with a significant variable interest in a VIE make additional disclosures. FIN 46-R is effective for VIEs created after January 31, 2003 and is effective for all VIEs created before February 1, 2003 that are Special Purpose Entities (SPEs) in the first reporting period ending after December 15, 2003 and for all other VIEs created before February 1, 2003 in the first reporting period ending after March 15, 2004. We believe there are no entities qualifying as VIES and the adoption of FIN 46-R to date has not had any effect on our financial position, cash flows or results of operations.

In May 2003, the EITF reached a consensus on EITF Issue No. 03-05, “Applicability of AICPA Statement of Position 97-2, Software Revenue Recognition, to Non-Software Deliverables in Arrangements Containing More-Than-Incidental Software”. EITF No. 03-05 addresses the applicability of Statement of Position No. 97-2 regarding software and non-software deliverables in a multiple element arrangement, giving consideration to whether the deliverables are essential to the functionality of one another. EITF Issue No. 03-05 is effective for interim periods beginning after August 13, 2003. The adoption of EITF Issue No. 03-05 did not have a material impact on our financial position or results of operations.

This Form 10-Q contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of factors both in and out of our control, including the risks faced by us described below and elsewhere in this Form 10-Q and in our Form 10-K/A for the fiscal year ended September 30, 2003.

You should carefully consider the risks described below. In addition, the risks described below are not the only ones facing us. We have only described the risks we consider to be the most material. However, there may be additional risks that are viewed by us as not material or are not presently known to us.

If any of the events described below were to occur, our business, prospects, financial condition and/or results of operations could be materially adversely affected. When we say below that something could or will have a material adverse effect on us, we mean that it could or will have one or more of these effects. In any such case, the price of our common stock could decline, and you could lose all or part of your investment in our company.

Our operating results may fluctuate significantly and may cause our stock price to decline.

We have experienced significant variations in revenues and operating results from quarter to quarter. Our quarterly operating results may continue to fluctuate due to a number of factors, including:

Because a significant percentage of our expenses will be relatively fixed, changes in the timing of sales and implementations could cause significant variations in operating results from quarter to quarter. We believe that period to period comparisons of our historical results of operations are not necessarily meaningful. You should not rely on these comparisons as indicators of our future performance.

Due to the length of our sales cycle, we are required to spend substantial time and expense before we are able to recognize revenue.

The sales cycle for our systems ranges from six to twenty four months or more from initial contact to contract execution, and we may require an additional three to nine months to complete implementation. During this period, we will expend substantial time, effort and financial resources preparing contract proposals, negotiating the contract and implementing our systems. As a result, we may not realize any revenues from some customers after expending considerable resources. Even if we do realize revenues from a project, delays in implementation may keep us from recognizing these revenues during the same period in which sales and implementation expenses were incurred. This could cause our operating results to fluctuate from quarter to quarter.

The majority of our sales has been into the radiation oncology market. If we are unable to expand outside the radiation oncology market or expand into international markets, our ability to grow will be limited.

Sales of our products into the radiation oncology market in the United States, including maintenance and services, represented approximately 73.4% of our net sales in the fiscal year ended September 30, 2003. Many of the largest radiation oncology facilities and practices in the United States have previously purchased our systems. In addition, in 2004, we have experienced softness in bookings in our core oncology point-of-care business. To sustain our growth, we must expand our radiation oncology sales outside the United States and increase our sales outside of the radiation oncology market. We have expanded our product offerings domestically to address medical oncology, hospital and central registry data aggregation and reporting, and recently, laboratory information systems, urology and pathology. However, we may not be successful selling our products in international radiation oncology markets, or marketing our products in new markets.

If we are unable to integrate our products successfully with existing information systems and oncology treatment devices, or we are restricted from access to new device interfaces, customers may choose not to use our products and services.

For healthcare facilities to fully benefit from our products, our systems must integrate with the customer’s existing information systems and medical devices. This may require substantial cooperation, investment and coordination on the part of our customers. There is little uniformity in the systems and devices currently used by our customers, which complicates the integration process. If these systems are not successfully integrated, our customers could choose not to use, or to reduce their use of, our systems, which would harm our business.

Our ability to design systems that integrate applications, devices and information systems has been a key to our success in the radiation oncology market. Our competitors include manufacturers of radiation oncology equipment. The three major linear accelerator manufacturers are expected to introduce “next generation” devices in 2004, which will have new operator front-ends and require new integration strategies. We have been in the process of developing our next generation of connectivity options and expect them to be ready when these new devices begin to ship. If these manufacturers were to deny us access to new device interfaces, we would lose one of our key competitive advantages and our sales would be adversely impacted. In addition, we don’t know whether our new products will be accepted in the marketplace or whether they will generate revenues and margins comparable to our current products.

We operate in an intensely competitive market that includes companies that have greater financial, technical and marketing resources than we do, and companies who bundle their software with hardware sales at little or no additional cost, which makes it harder for us to sell our systems.

We operate in a market that is intensely competitive. Our principal oncology competitor is Varian Medical Systems, Inc. We also face competition from providers of enterprise level healthcare information systems, practice management systems, general decision support and database systems and other segment-specific software applications. In addition, although we have cooperative strategic arrangements with Siemens Medical Systems, Inc. and other companies for the sale of some of our products, these companies also compete with us on the sale of some of our products. A number of existing and potential competitors are more established than we are and have greater name recognition and financial, technical and marketing resources than we do.

Our most significant competitors also manufacture radiation oncology devices and other equipment used by healthcare providers who may be our potential customers. These particular competitors pose a competitive risk for us because they market their software with their hardware products as a bundled solution at little or no additional cost, which could enhance their ability to meet a potential customer’s needs. In recent quarters, this bundling practice has been intensified, placing us at a pricing disadvantage. As a result, to make a sale, we must convince

potential customers that our products are sufficiently superior to the software offered by the medical device manufacturer to justify the additional costs of purchasing our products. In addition, one of our most significant competitors recently acquired an oncology software company, which may make it a more effective competitor. We also expect that competition will continue to increase, particularly if enterprise level healthcare software providers, such as Cerner Corporation and Eclipsys Corporation, choose to focus on the oncology market. As a result of increased competition, we may need to reduce the price of our products and services, and we may experience reduced gross margins or loss of market share, any one of which could significantly reduce our future revenues and operating results.

A decline in spending for healthcare information technology and services may result in less demand for our products and services, which could adversely affect our financial results.

The purchase of our products and services involves a significant financial commitment by our customers. The cost of our systems typically ranges from $75,000 to more than $500,000. At the same time, the healthcare industry faces significant financial pressures that could adversely affect overall spending on healthcare information technology and services. For example, the Balanced Budget Act of 1997 significantly reduced Medicare reimbursements to hospitals, leaving them less money to invest in infrastructure. To date in 2004. we estimate that reimbursements in the radiation oncology segment have decreased by approximately 10%, and reimbursement in the medical oncology segment is expected to decrease in 2005. Moreover, a general economic decline or further reductions in Medicare reimbursements to hospitals could cause hospitals to reduce or eliminate information technology-related spending. If spending for healthcare information technology and services declines or increases slower than we anticipate, demand for our products and services could decline, adversely affecting the prices we may charge.

Changing customer requirements could decrease the demand for our products, which could harm our business and adversely affect our revenues.

The market for our products and services is characterized by rapidly changing technologies, evolving industry standards and new product introductions and enhancements that may render existing products obsolete or less competitive. For example, the three major linear accelerator manufacturers are expected to introduce “next generation” devices in 2004, which will have new operator front-ends and require new integration strategies. As a result, our position in the healthcare information technology market could erode rapidly due to unforeseen changes in the features, functions or pricing of competing products. Our future success will depend in part on our ability to enhance our existing products and services and to develop and introduce new products and services to meet changing customer requirements. We have been in the process of developing our next generation of connectivity options and expect them to be ready when these new devices begin to ship this summer. We don’t know; however, whether our new products will be accepted in the marketplace or whether they will generate revenues and margins comparable to our current products.

The process of developing products and services such as those we offer is complex and in the future is expected to become increasingly more complex and expensive as new technologies and new methods of treating cancer are introduced. If we are unable to enhance our existing products or develop new products to meet changing customer requirements, including the introduction of new cancer treatment methods with which our products are not currently compatible, demand for our products could suffer.

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

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

In March 2004, the FASB issued a proposed Statement, “Share-Based Payment, an amendment of FASB Statements No. 123 and 95”, which generally would require share-based payments to employees be accounted for using a fair-value-based method and recognized as expenses in our statements of operations. The effective date the proposed standard is recommending is for fiscal years beginning after December 15, 2004. Should this proposed statement be finalized, it will have a significant impact on our consolidated statement of operations as we will be required to expense the fair value of our stock options rather than disclosing the impact on our consolidated result of operations within our footnotes. This will result in lower reported earnings per share which could negatively impact our future stock price. In addition, should the proposal be finalized, this could impact our ability to utilize broad based employee stock plans to reward employees and could result in a competitive disadvantage to us in the employee marketplace.

We depend on our relationships with distributors and oncology equipment manufacturers to market our products, and if these relationships are discontinued, or we are unable to develop new relationships, our revenues could decline.

To successfully market and sell our products both in the United States and in foreign markets, we have developed relationships with distributors and leading oncology equipment manufacturers, including Siemens Medical Systems, Inc. Sales to Siemens represented 8.2% of our net sales in fiscal 2003, 13.0% in fiscal 2002 and 13.3% in fiscal 2001. We rely on these collaborative relationships to augment our direct sales efforts and maintain market access to potential customers, particularly in Europe and Asia, and our business strategy includes entering into additional third-party relationships in the future. Some of these manufacturers and distributors also produce or distribute products that directly compete with our core products.

We may not be able to maintain or develop these relationships with distributors and oncology equipment manufacturers, and these relationships may not continue to be successful. If any of these relationships is terminated, not renewed or otherwise unsuccessful, or if we are unable to develop additional relationships, our sales could decline, and our ability to continue to grow our business could be adversely affected. This is particularly the case for our international sales, where we rely on our distributors’ expertise regarding foreign regulatory matters and their access to actual and potential customers. In many cases, these parties have extensive relationships with our existing and potential customers and influence the decisions of these customers. In addition, if these relationships fail, we will have to devote additional resources to market our products than we would otherwise, and our efforts may not be as effective as those of the distributors and manufacturers with whom we have relationships. We are currently investing, and plan to continue to invest, significant resources to develop these relationships. Our operating results could be adversely affected if these efforts with distributors and manufacturers do not generate revenues necessary to offset these investments.

Recent changes to Medicare reimbursement policies could negatively affect oncologists, which could adversely affect their IT spending decisions and our growth prospects.

Sales of our IT systems to medical oncologists, who treat cancer through the infusion of chemotherapy agents, represent a small but growing portion of our current revenue and an opportunity for future growth. The Centers for Medicare and Medicaid Services (CMS), which regulates payment rates for drugs and services reimbursed under Medicare Part B, including chemotherapy drugs and services, has indicated that it may eliminate the drug administration charge for chemotherapy in 2005. While there is not necessarily a direct correlation between provider revenue and IT spending, a significant decease in the Part B reimbursement could negatively influence an oncologist’s willingness to invest in new systems. If these Medicare reforms result in reduced IT spending by oncologists, our growth opportunities could be adversely impacted.

We are subject to extensive federal, state and international regulations, which could cause us to incur significant costs.

Four of our medical device products, including two device connectivity products and two imaging products, are subject to extensive regulation by the U.S. Food and Drug Administration, or FDA, under the Federal

Food, Drug and Cosmetic Act, or FDC Act, and by the Food and Drug Branch of the California Department of Health Services, or FDB, which is the California state agency that oversees compliance with FDA regulations. The FDA’s regulations govern product design and development, product testing, product labeling, product storage, premarket clearance or approval, advertising and promotion, and sales and distribution. Unanticipated changes in existing regulatory requirements or adoption of new requirements could hurt our business, financial condition and results of operations.

Numerous regulatory requirements apply to our medical device products, including the FDA’s Quality System Regulations, which require that our manufacturing operations follow design, testing, process control, documentation and other quality assurance procedures during the manufacturing process. We are also subject to FDA regulations regarding labeling, adverse event reporting, and the FDA’s prohibition against promoting products for unapproved or “off-label” uses.

We face the risk that a future inspection by the FDA or FDB could find that we are not in full regulatory compliance. Our failure to comply with any applicable FDA regulation could lead to warning letters, non-approvals, suspensions of existing approvals, civil penalties and criminal fines, product seizures and recalls, operating restrictions, injunctions and criminal prosecution. If we fail to take adequate corrective action in response to any FDA observation of noncompliance, we could face enforcement actions, including a shutdown of our manufacturing operations and a recall of our products, which would cause our product sales, operating results and business reputation to suffer.

To market and sell our products in countries outside the United States, we must obtain and maintain regulatory approvals and comply with the regulations of those countries. These regulations and the time required for regulatory review vary from country to country. Obtaining and maintaining foreign regulatory approvals is expensive and time consuming. We plan to apply for regulatory approvals in particular countries, but we may not receive the approvals in a timely way or at all in any foreign country in which we plan to market our products, and if we fail to receive such approvals, our ability to generate revenue will be harmed.

Our products could be subject to recalls even after receiving FDA approval or clearance. A recall would harm our reputation and adversely affect our operating results.

The FDA, FDB and similar governmental authorities in other countries in which we market and sell our products have the authority to require the recall of our products in the event of material deficiencies or defects in design or manufacture. A government mandated recall, or a voluntary recall by us, could occur as a result of component failures, manufacturing errors or design defects, including defects in labeling. A recall could divert management’s attention, cause us to incur significant expenses, harm our reputation with customers and negatively affect our future sales.

Regulation of additional products of ours not currently subject to regulation as medical devices by the FDA could increase our costs, delay the introduction of new products and adversely affect our revenue growth.

The FDA has increasingly regulated computer products and computer-assisted products as medical devices under the FDC Act. If the FDA chooses to regulate any more of our products as medical devices, we would likely be required to take the following actions:

We may not be able to convince the FDA to grant approval to a request for market clearance. If any of our products fails to comply with FDA requirements, we could face FDA refusal to grant pre-market clearance or approval of products, withdrawal of existing FDA clearances and approvals, fines, injunctions or civil penalties, recalls or product corrections, production suspensions and criminal prosecution. FDA regulation of additional products could increase our operating costs, delay or prevent the marketing of new or existing products and adversely affect our revenue growth.

New and potential federal regulations relating to patient confidentiality could require us to redesign our products.

State, federal and foreign laws regulate the privacy and security of individually identifiable health information. Although compliance with these laws and regulations is presently the principal responsibility of the hospital, physician or other healthcare provider, we must ensure that our products and business operations support these requirements by providing adequate privacy and security protection to associated patient health information. Regulations governing electronic health data transmission, privacy and security are evolving rapidly and are often unclear and difficult to apply.

Of particular importance is the Health Insurance Portability and Accountability Act of 1996, or HIPAA. Under HIPAA, the Secretary of Health and Human Services, or HHS, has adopted national data interchange standards for some types of electronic transactions and the data elements used in those transactions; adopted security standards to protect the confidentiality, integrity and availability of patient health information; and adopted privacy standards to prevent inappropriate access, use and disclosure of patient health information. In December 2000, HHS published the final privacy regulations, which took effect in April 2003. These regulations restrict the use and disclosure of individually identifiable health information without the prior informed consent of the patient. In February 2003, HHS published the final security regulations, which will take effect in April 2005. These regulations mandate that healthcare facilities implement operational, physical and technical security measures to reasonably prevent accidental, negligent or intentional inappropriate access or disclosure of patient health information. We have made changes to our products and business operations to support these regulatory requirements. We feel that our currently available products and operations fully support our customers’ requirements to comply with the above regulations. However, HHS enforcement efforts may find that our operations and product offerings are insufficient to support our customers’ regulatory requirements. A customer’s failure to meet any applicable HIPAA regulation could lead to fines, injunctions or criminal prosecution of the customer, which would cause our product sales and business reputation to suffer. Initial enforcement efforts and regulatory changes could also force us to redesign our products or further change our operations. We may incur significant product development costs to modify or redesign our products to address evolving data security and privacy requirements.

We cannot predict the potential impact of any rules that have not yet been proposed or any forthcoming changes to the newly enacted rules. In addition, other foreign, federal and/or state privacy and security legislation may be enacted at any time.

If our products fail to provide accurate and timely information to our customers in their treatment of patients, our customers may be able to assert claims against us that could result in substantial costs to us, harm our reputation in the industry and cause demand for our products to decline.

We provide products that assist clinical decision-making and relate to patient medical histories and treatment plans. If these products fail to provide accurate and timely information, customers may be able to assert liability claims against us. Any potential liability claims, regardless of their outcome, could result in substantial costs to us, divert management’s attention from operations and decrease market acceptance of our products. We attempt to limit by contract our liability for damages arising from negligence, errors or mistakes. Despite this precaution, the limitations of liability set forth in our contracts may not be enforceable or may not otherwise protect us from liability for damages. We maintain general liability insurance coverage, including coverage for errors or omissions. However, this coverage may not continue to be available on acceptable terms or may not be available in sufficient amounts to cover one or more large claims against us. In addition, the insurer might refuse coverage as to any future claim.

Highly complex software products such as ours often contain undetected errors or failures when first introduced or as updates and new versions are released. It is particularly challenging for us to test our products

because it is difficult to simulate the wide variety of computing environments in which our customers may deploy them. Despite extensive testing, from time to time we have discovered defects or errors in our products. Defects, errors or difficulties could cause delays in product introductions and shipments, result in increased costs and diversion of development resources, require design modifications or decrease market acceptance or customer satisfaction with our products. In addition, despite testing by us and by current and potential customers, errors may be found after commencement of commercial shipments, which may result in loss of or delay in market acceptance of our products.

We recently completed a major acquisition in December 2003. If we undertake additional acquisitions, they may be disruptive to our business and could have an adverse effect on our future operations and cause the market price of our common stock to decline.

An element of our business strategy has been expansion through acquisitions. Since 1997, we have completed seven acquisitions of businesses or product lines, including the acquisition of certain assets and certain liabilities of Tamtron Corporation and Medical Registry Services, Inc., the pathology information management and cancer registry information system businesses of IMPATH Inc., for total cash consideration, including acquisition costs, of $22.5 million. As a result of these acquisitions, we face the following risks:

If we pursue any future acquisitions, we will also face additional risks, including the following:

Interruptions in our power supply or telecommunications capabilities or the occurrence of an earthquake or other natural disaster could disrupt our operations and cause us to lose revenues or incur additional expenses.

Our primary facilities are located in California near known earthquake fault zones and are vulnerable to significant damage from earthquakes. We are also vulnerable to damage from other types of disasters, including tornadoes, fires, floods, power loss, communications failures and similar events. If any disaster were to occur, our ability to operate our business at our facilities could be seriously impaired or destroyed. The insurance we maintain may not be adequate to cover our losses resulting from disasters or other business interruptions.

We currently do not have backup generators to be used as alternative sources of power in the event of a loss of power to our facilities. During any power outage, we would be temporarily unable to continue operations at our facilities. This would have adverse consequences for our customers who depend on us for system support and outsourcing services. Any such interruption in operations at our facilities could damage our reputation and harm our ability to obtain and retain customers, which could result in lost revenue and increased operating costs.

We have customers for whom we store and maintain critical patient and administrative data on computer servers in our application service provider, or ASP, data center. Those customers access this data remotely through telecommunications lines. If our back-up power generators fail during any power outage or if our telecommunications lines are severed or impaired for any reason, those customers would be unable to access their critical data causing an interruption in their operations. In such event our remote access customers and their patients could seek to hold us responsible for any losses. We may also potentially lose those customers and our reputation could be harmed.

If we fail to attract, motivate and retain highly qualified technical, marketing, sales and management personnel, our ability to operate our business could be impaired.

Our success depends, in significant part, upon the continued services of our key technical, marketing, sales and management personnel and on our ability to continue to attract, motivate and retain highly qualified employees. Competition for these employees is intense. In addition, the process of recruiting personnel with the combination of skills and attributes required to operate our business can be difficult, time-consuming and expensive. The success of our business depends to a considerable degree on our senior management team. The loss of any member of that team, particularly Joseph Jachinowski, James Hoey or David Auerbach, our founders, could hurt our business.

We depend on licenses from third parties for rights to the technology used in several of our products. If we are unable to continue these relationships and maintain our rights to this technology, our business could suffer.

We depend upon licenses for some of the technology used in our products from a number of third-party vendors, including Pervasive Software Inc., Medicomp Systems, Inc., First DataBank, Inc., Crystal Decisions, Inc. and SoftVelocity, Inc. If we were unable to continue using the technology made available to us under these licenses on commercially reasonable terms or at all, we may have to discontinue, delay or reduce product shipments until we obtain equivalent replacement technology, which could hurt our business. In addition, if our vendors choose to discontinue support of the licensed technology in the future, we may not be able to modify or adapt our own products.

If we fail to protect our intellectual property, our business could be harmed.

We are dependent upon our proprietary information and technology. Our means of protecting our proprietary rights may not be adequate to prevent misappropriation. The laws of some foreign countries may not protect our proprietary rights as fully as do the laws of the United States. Also, despite the steps we have taken to protect our proprietary rights, it may be possible for unauthorized third parties to copy aspects of our products, reverse engineer our products or otherwise obtain and use information that we regard as proprietary. In some limited instances, customers can access source-code versions of our software, subject to contractual limitations on the permitted use of the source code. Although our license agreements with these customers attempt to prevent misuse of the source code, the possession of our source code by third parties increases the ease and likelihood of potential misappropriation of such software. Furthermore, others could independently develop technologies similar or superior to our technology or design around our proprietary rights. In addition, infringement or invalidity claims or claims for indemnification resulting from infringement claims could be asserted or prosecuted against us. Regardless of the validity of any claims, defending against these claims could result in significant costs and diversion of our resources. The assertion of infringement claims could also result in injunctions preventing us from distributing products. If any claims or actions are asserted against us, we might be required to obtain a license to the disputed intellectual property rights, which might not be available on reasonable terms or at all.

Our international sales, marketing and service activities expose us to uncertainties that could limit our growth and adversely affect our operating results.

In addition to our domestic operations, we currently conduct sales, marketing and service activities in other countries in North America, Europe and the Pacific Rim. Our international operations pose risks that include:

If we are unable to meet and overcome these challenges, our international operations may not be successful, which would limit the growth of our business.

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

We have been exposed to interest rate risk as it applies to our limited use of debt instruments and interest earned on holdings of long and short-term marketable securities. Interest rates that may affect these items in the future will depend on market conditions and may differ from the rates we have experienced in the past. A 10% change in interest rates would not be material to our results of operations. We reduce the sensitivity of our results of operations to these risks by maintaining an investment portfolio, which is primarily comprised of highly rated, short-term investments. We do not hold or issue derivative, derivative commodity instruments or other financial instruments for trading purposes.

We have operated mainly in the United States and greater than 99% of our sales were made in U.S. dollars in each of the six months ended March 31, 2004 and 2003. Accordingly, we have not had any material exposure to foreign currency rate fluctuations. Currently, all of our international distributors denominate all transactions in U.S. dollars. However, as we sell to customers in the United Kingdom and Europe through our recently formed UK subsidiary a majority of those sales may be denominated in euros or pounds sterling. The functional currency of our new UK subsidiary is pounds sterling. Thus, exchange rate fluctuations between the euro and pounds sterling will be recognized in the statements of operations as these foreign denominated sales are remeasured by our UK subsidiary. As exchange rate fluctuations occur between pounds sterling and the U.S. dollar, these fluctuations will be recorded as cumulative translation adjustments within stockholders’ equity as a component of accumulated other comprehensive income (loss) as our UK subsidiary is translated into U.S. dollars for consolidation purposes.

In April 2004, our management determined to restate our consolidated financial statements as of and for the years ended September 30, 2003, 2002 and 2001, to shift some previously recognized revenues to later quarters or to defer recorded revenues and recognize them in periods subsequent to September 30, 2003. During the restatement, our independent auditors, PricewaterhouseCoopers LLP, advised management and the Audit Committee that it noted certain matters regarding software revenue recognition practices during the periods under review that it considered to be material weaknesses.

Joseph Jachinowski, our Chief Executive Officer, and Kendra Borrego, our Chief Financial Officer, conducted an evaluation of the effectiveness of IMPAC’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) as of March 31, 2004. Based on this evaluation, they concluded that, as of the end of the period covered by this report, there were still certain deficiencies in our disclosure controls and procedures.

As part of our disclosure controls and procedures over the selection and application of accounting principles, in particular software revenue recognition under SOP 97-2, our accounting officers independently reviewed SOP 97-2 together with other accounting literature, consulted with our independent auditing firm regarding revenue recognition and accounting developments, attended continuing education courses for the accounting profession and reviewed various accounting journals and other literature with respect to the existence of new accounting pronouncements and their application to IMPAC.

These controls and procedures were found to be deficient in identifying the accounting issues which were the subject of the restatement. Specifically, the controls and procedures did not result in (i) our proper understanding of the application of SOP 97-2 for multiple element contracts, (ii) the identification of an improper usage of a retroactive acceptance clause resulting in revenue being recognized in the incorrect period and (iii) the deferral of 12% of the current list price of the software rather than 12% of the net purchase price.

In response to the matters identified, we have taken steps to strengthen control processes and procedures to identify, rectify and prevent the recurrence of the circumstances that resulted in our determination to restate prior period financial statements. We intend to correct the identified weaknesses in our disclosure controls and procedures that led to the restatement by taking the following steps, among others:

We believe changes to our system of internal controls and our disclosure controls and procedures will be adequate to provide reasonable assurance that the objectives of these control systems will be met. However, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake.

Our registration statement (Registration No. 333-89724) under the Securities Act of 1933, as amended, for our initial public offering became effective on November 19, 2002. A total of 2,515,625 shares of common stock were registered, and we sold 1,875,000 shares of our common stock to an underwriting syndicate. Thomas Weisel Partners LLC, SG Cowen Securities Corporation and U.S. Bancorp Piper Jaffray Inc. were the managing underwriters of the offering. An additional 640,625 shares of common stock were sold on behalf of selling stockholders as part of the same offering. All shares were sold to the public at a price of $15.00 per share. In connection with the offering, we paid approximately $2.0 million in underwriting discounts and commissions to the underwriters. Offering proceeds, net of aggregate costs to us of approximately $1.8 million, were approximately $24.4 million. As discussed in Note 6 to the condensed consolidated financial statements, we acquired certain assets and assumed certain liabilities of Tamtron Corporation and Medical Registry Services, Inc. from IMPATH Inc. We used approximately $22.5 million of the funds received in our public offerings to finance this acquisition.

We intend to use the remaining net proceeds of the offering for working capital and to expand our business generally.

The Company held its annual meeting of stockholders on February 17, 2004. At the annual meeting, the following matters were voted upon:

1. Election of Directors: Election of the following directors to serve for a term ending upon the 2007 annual meeting of stockholders or when their successors are elected and qualified:

Joseph K. Jachinowski and Gregory M. Avis continue to serve the Company for a term ending upon the 2005 annual meeting of stockholders or when their successors are elected and qualified, and David A. Auerbach, Dr. Robert J. Becker and Gregory T. Schiffman continue to serve the Company for a term ending upon the 2006 annual meeting of stockholders or when their successors are elected and qualified.

2. Amendment to 2002 Stock Plan: Approval of an amendment and restatement of the IMPAC Medical Systems, Inc. 2002 Stock Plan to allow for grants of stock appreciation rights and stock units.

The following reports on Form 8-K were filed during the three month period ended March 31, 2004:

The following report on Form 8-K was furnished during the three month period ended March 31, 2004:

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

IMPAC MEDICAL SYSTEMS, INC.

Registrant

Dated: May 14, 2004

/s/ JOSEPH K. JACHINOWSKI

Joseph K. Jachinowski

Chairman of the Board, President and

Chief Executive Officer

/s/ KENDRA A. BORREGO

Kendra A. Borrego

Chief Financial Officer


		Page

PART I. FINANCIAL INFORMATION

Item 1.	Condensed Consolidated Financial Statements (unaudited)	1

	Condensed Consolidated Balance Sheets as of March 31, 2004 and September 30, 2003	1

	Condensed Consolidated Statements of Operations for the Three and Six Months Ended March 31, 2004 and 2003	2

	Condensed Consolidated Statements of Cash Flows for the Six Months Ended March 31, 2004 and 2003	3

	Notes to Condensed Consolidated Financial Statements	4

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	9

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	25

Item 4.	Controls and Procedures	25

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	26

Item 2.	Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities	26

Item 3.	Defaults Upon Senior Securities	26

Item 4.	Submission of Matter to a Vote of Securities Holders	26

Item 5.	Other Information	26

Item 6.	Exhibits and Reports on Form 8-K	26

Signatures		28


	March 31, 2004		September 30, 2003
(In thousands)
Assets
Current assets:
Cash and cash equivalents	$	37,560	$	57,979
Available-for-sale securities		3,905		7,052
Accounts receivable, net		19,612		12,100
Unbilled accounts receivable		905		—
Inventories		68		66
Deferred income taxes, net		6,966		6,334
Income tax refund receivable		—		339
Prepaid expenses and other current assets		5,809		4,667

Total current assets		74,825		88,537
Available-for-sale securities		3,762		2,719
Property and equipment, net		4,423		3,573
Deferred income taxes		1,116		1,137
Goodwill		14,759		654
Other intangible assets, net		8,855		918
Other assets		477		459

Total assets	$	108,217	$	97,997

Liabilities, Common Stock Subject to Rescission Rights and Stockholders’ Equity
Current liabilities:
Customer deposits	$	11,243	$	10,900
Accounts payable		756		864
Accrued liabilities		3,355		4,758
Income taxes payable		2,485		2,353
Deferred revenue		36,343		27,079
Capital lease obligations		1		74

Total current liabilities		54,183		46,028
Customer deposits		266		232
Capital lease obligations, non-current		—		41

Total liabilities		54,449		46,301

Common stock subject to rescission rights		—		98

Stockholders’ equity:
Preferred stock		—		—
Common stock		10		10
Additional paid-in capital		49,083		47,792
Accumulated other comprehensive income (loss)		7		(16	)
Retained earnings		4,668		3,812

Total stockholders’ equity		53,768		51,598

Total liabilities, common stock subject to rescission rights and stockholders’ equity	$	108,217	$	97,997


	Three Months Ended March 31,						Six Months Ended March 31,
	2004			2003			2004			2003
(In thousands, except per share data)
Sales:
Software license and other, net	$	8,559		$	7,818		$	16,897		$	14,525
Maintenance and services		6,873			4,872			12,926			9,325

Total net sales		15,432			12,690			29,823			23,850

Cost of sales:
Software license and other, net		3,449			2,363			6,379			4,357
Maintenance and services		2,512			1,674			4,715			3,375

Total cost of sales		5,961			4,037			11,094			7,732

Gross profit		9,471			8,653			18,729			16,118

Operating expenses:
Research and development		3,009			2,358			5,440			4,470
Sales and marketing		3,861			3,324			7,869			6,485
General and administrative		1,859			1,428			3,094			2,539
Amortization of intangible assets		581			103			701			205
Write-off of purchased in-process research and development		—			—			557			—

Total operating expenses		9,310			7,213			17,661			13,699

Operating income		161			1,440			1,068			2,419
Interest expense		(1	)		(5	)		(4	)		(11	)
Interest and other income		102			143			250			226

Income before provision for income taxes		262			1,578			1,314			2,634
Provision for income taxes		(92	)		(551	)		(460	)		(920	)

Net income		170			1,027			854			1,714
Accretion of redeemable convertible preferred stock		—			—			—			(2,229	)

Net income (loss) available for common stockholders	$	170		$	1,027		$	854		$	(515	)

Net income (loss) per common share:
Basic	$	0.02		$	0.11		$	0.09		$	(0.06	)

Diluted	$	0.02		$	0.10		$	0.08		$	(0.06	)

Weighted-average shares used in computing net income (loss) per common share:
Basic		9,863			9,340			9,810			8,394

Diluted		10,315			9,913			10,277			8,394


	Six Months Ended March 31,
	2004			2003
(In thousands)
Cash flows from operating activities:
Net income	$	854		$	1,714
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization of property and equipment		939			811
Amortization of intangible assets		701			205
Write-off of purchased in-process research and development		557			—
Provision for doubtful accounts		66			64
Deferred income taxes		(631	)		—
Loss on disposal of property and equipment		—			101
Changes in assets and liabilities, net of effects of acquisitions:
Accounts receivable		(5,921	)		(4,550	)
Unbilled accounts receivable		58			—
Inventories		(2	)		21
Prepaid expenses and other current assets		(1,127	)		24
Other assets		19			(190	)
Customer deposits		377			(244	)

Accounts payable		(471	)		106
Accrued liabilities		(1,406	)		(55	)
Income tax payable/refund receivable		471			(2,217	)
Deferred revenue		5,578			5,357

Net cash provided by operating activities		62			1,147

Cash flows from investing activities:
Acquisition of property and equipment		(1,112	)		(1,149	)
Proceeds from disposal of property and equipment		—			51
Payments for the acquisition of Tamtron and MRS product lines		(22,494	)		—
Purchases of available-for-sale securities		(23,587	)		(16,634	)
Proceeds from sales of available-for-sale securities		14,044			16,387
Proceeds from maturities of available-for-sale securities		11,635			66

Net cash used in investing activities		(21,514	)		(1,279	)

Cash flows from financing activities:
Principal payments on capital leases		(194	)		(31	)
Proceeds from the issuance of common stock, net		1,194			24,986

Net cash provided by financing activities		1,000			24,955

Effect of exchange rates on cash		33			(28	)
Net increase (decrease) in cash and cash equivalents		(20,419	)		24,795
Cash and cash equivalents at beginning of period		57,979			23,432

Cash and cash equivalents at end of period	$	37,560		$	48,227


	Three Months Ended March 31,						Six Months Ended March 31,
	2004			2003			2004			2003
Net income (loss) available for common stockholders as reported	$	170		$	1,027		$	854		$	(515	)
Less stock-based compensation cost under a fair value method		(534	)		(165	)		(807	)		(330	)

Pro forma net income (loss) available for common stockholders	$	(364	)	$	862		$	47		$	(845	)

Net income (loss) per common share, basic
As reported	$	0.02		$	0.11		$	0.09		$	(0.06	)

Pro forma	$	(0.04	)	$	0.09		$	0.00		$	(0.10	)

Net income (loss) per common share, diluted
As reported	$	0.02		$	0.11		$	0.08		$	(0.06	)

Pro forma	$	(0.04	)	$	0.09		$	0.00		$	(0.10	)

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	Three Months Ended March 31,				Six Months Ended March 31,
	2004		2003		2004		2003
Numerator:
Net income	$	170	$	1,027	$	854	$	1,714
Accretion of redeemable convertible preferred stock		—		—		—		(2,229	)

Net income (loss) available for common stockholders	$	170	$	1,027	$	854	$	(515	)

Denominator:
Weighted average shares used in computing basic net income (loss) per common share		9,863		9,340		9,810		8,394
Dilutive effect of options to purchase shares		452		573		467		—

Weighted average shares used in computing diluted net income (loss) per common share		10,315		9,913		10,277		8,394


Tangible assets	$	2,986
Deferred revenue		(3,692	)
Other assumed liabilities		(101	)
Developed/core technology		5,138
Customer base		3,032
Tradename		469
In-process research and development		557
Goodwill		14,105

	$	22,494


	Three Months Ended March 31		Six Months Ended March 31,
	2003		2004		2003
Net sales	$	16,240	$	32,639	$	29,846
Net income available for common stockholders	$	1,378	$	1,490	$	(444	)
Net income per common share,
Basic	$	0.15	$	0.15	$	(0.05	)
Diluted	$	0.14	$	0.14	$	(0.05	)
Weighted-average shares used in computing net income per common share:
Basic		9,340		9,810		8,394
Diluted		9,913		10,277		8,394


	March 31,				December 31,
	2004		2003		2003
Customer deposits	$	11,509	$	9,677	$	10,911
Deferred software license revenue		16,257		11,535		14,482
Other deferred revenue		20,086		11,849		18,212
Unearned revenue		32,859		20,288		26,027

Total backlog	$	80,711	$	53,349	$	69,632


	Operating Leases		Telecommunications Contracts		Total Future Obligations
Remainder of Fiscal 2004	$	1,587	$	760	$	2,347
Fiscal 2005		3,034		1,299		4,333
Fiscal 2006		2,701		1,200		3,901
Fiscal 2007		1,102		930		2,032

Total	$	8,424	$	4,189	$	12,613


Nominee	Total Votes For	Total Votes Withheld
James P. Hoey	8,048,869	944,927
Dr. Christopher M. Rose	8,620,487	373,309


For	Against	Abstain	No Vote
6,184,299	2,278,492	725	530,280



		10.7		2002 Stock Plan, as amended and restated on November 18, 2003.

		31.1		Certification of Principal Executive Officer Pursuant to Section 302.

		31.2		Certification of Principal Financial Officer Pursuant to Section 302.

		32.1		Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350.

		32.2		Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350.