Back to GetFilings.com

Table of Contents

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarter ended

June 30, 2004

Commission File No.

No. 1-9767

IRIS INTERNATIONAL, INC.

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s Telephone Number: (818) 709-1244

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

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

The registrant had 15,807,606 shares of common stock outstanding as of July 27, 2004.

Table of Contents

IRIS INTERNATIONAL, INC.

INDEX TO FORM 10-Q

1

Table of Contents

PART I

FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

IRIS INTERNATIONAL, INC.

CONSOLIDATED BALANCE SHEETS

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

2

Table of Contents

IRIS INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

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

3

Table of Contents

IRIS INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

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

4

Table of Contents

IRIS INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

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

5

Table of Contents

IRIS INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited)

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

6

Table of Contents

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Company History

IRIS International, Inc., (collectively “IRIS” or the “Company”) was incorporated in California in 1979 and reincorporated during 1987 in Delaware under the name of International Remote Imaging Systems, Inc. The Company changed its name to IRIS International, Inc. in December 2003. The Company designs, develops, manufactures and markets in vitro diagnostic (“IVD”) equipment, including IVD imaging systems based on patented and proprietary automated intelligent microscopy (“AIM”) technology, as well as special purpose centrifuges and other small instruments for automating microscopic procedures performed in clinical laboratories.

2. Summary of Significant Accounting Policies

Basis of Presentation of Unaudited Interim Financial Statements:

In the opinion of management, the accompanying unaudited consolidated financial statements contain all normal recurring adjustments necessary to present fairly the financial position of the Company as of June 30, 2004 and the results of its operations for the three and six-month periods then ended. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company’s latest annual report on Form 10-K. Interim results are not necessarily indicative of results for a full year.

Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The significant estimates in the preparation of the consolidated financial statements relate to the assessment of the carrying value of accounts receivables, inventories, purchased intangibles, estimated provisions for warranty costs and deferred tax assets. Actual results could differ materially from those estimates.

Principles of Consolidation

The consolidated financial statements include the accounts of IRIS International, Inc. and its wholly owned subsidiaries. All inter-company accounts and transactions have been eliminated in the consolidated financial statements.

Cash Equivalents and Short-Term Investments

Short-term investments principally include certificates of deposit with maturities greater than three months and less than one year. For purposes of the statement of cash flows, IRIS considers all highly liquid debt instruments purchased with a remaining maturity of three months or less when purchased to be cash equivalents. IRIS places its cash and investments with high credit quality financial institutions. At times, these deposits may be in excess of the federally insured limit.

Accounts Receivable

IRIS sells predominantly to entities in the healthcare industry. IRIS grants uncollateralized credit to its customers, primarily hospitals, clinical and research laboratories, and distributors. IRIS performs ongoing credit evaluations of its customers before granting uncollateralized credit. The Company does not have any single customer, which accounts for 10% or more of its consolidated revenues or 10% or more of its accounts receivable at the balance sheet date.

Accounts receivable are customer obligations due under normal trade terms. We sell our products to distributors and customers in the health care industry. We perform credit evaluations of our customers’ financial condition and although we generally do not require collateral, letters of credit may be required from our customers in certain circumstances.

7

Table of Contents

Senior management reviews accounts receivable on a monthly basis to determine if any receivables will potentially be uncollectible. We include any accounts receivable balances that are determined to be uncollectible, along with a general reserve, in our overall allowance for doubtful accounts. After all attempts to collect a receivable have failed, the receivable is written off against the allowance. Based on the information available to us, we believe our allowance for doubtful accounts as of June 30, 2004 is adequate.

Inventories

Inventories are carried at the lower of cost or market on a first in, first out basis. Provision for potentially obsolete or slow-moving inventory is made based on management’s analysis of inventory levels and future sales forecasts. The Company classifies inventories that are not expected to be utilized or sold within the next twelve months as long-term in the accompanying consolidated balance sheet.

Investment available for sale

Management classifies the investment in the common shares of Applied Imaging Corporation (NASDAQ: AICX) that were received as consideration for the previous sale of a wholly owned subsidiary, as available for sale. Investments in available for sale securities are reported at fair value with unrealized holding gains and losses, net of tax, reported as a separate component of shareholders’ equity until realized, or until management believes a permanent decline in value has occurred. Realized gains and losses are included in earnings. There was a realized loss of $7,070 in the six months ended June 30, 2004.

Property and Equipment and Depreciation

Property and equipment are recorded at cost, less accumulated depreciation and amortization. Depreciation is generally computed using the straight-line method over three to five years, the estimated useful lives of the assets. Leasehold improvements are amortized over the lesser of their useful life or the remaining term of the lease.

Goodwill

Goodwill is recorded at cost. The realizability of the goodwill is evaluated at least annually, or as events or circumstances indicate a possible inability to recover the carrying amount. Such evaluation is based on various analyses, including cash flow and profitability projections. The analysis necessarily involves significant management judgment to evaluate the capacity of an acquired business to perform within projections. At December 31, 2003, the Company evaluated its goodwill and determined that fair value had not decreased below carrying value and no adjustment to impair goodwill was necessary in accordance with SFAS No. 142.

Software Development Costs

The Company capitalizes certain software development costs for new products and product enhancements once all planning, designing, coding and testing activities necessary to establish that the product can be produced to meet its design specifications are completed, and concludes capitalization when the product is ready for general release. Research and development costs relating to software development are expensed as incurred. Amortization of capitalized software development costs is provided on a product-by-product basis at the greater of the amount computed using (a) the ratio of current revenues for a product to the total of current and anticipated future revenues or (b) the straight-line method over the remaining estimated economic life of the product up to five years. The Company capitalized $30,549 and $279,517 of software development costs during the six months ended June 30, 2004 and 2003.

Long-Lived Assets

The Company identifies and records an impairment loss for long-lived assets whenever events or changes in circumstances result in the carrying amount of the assets exceeding the sum of the expected future undiscounted cash flows associated with such assets. The measurement of the impairment losses recognized is based on the difference between the fair values and the carrying amounts of the assets.

8

Table of Contents

Stock-Based Compensation

The Company has adopted the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123 defines a fair value based method of accounting for an employee stock option. Fair value of the stock option is determined considering factors such as the exercise price, the expected life of the option, the current price of the underlying stock and its volatility, expected dividends on the stock, and the risk-free interest rate for the expected term of the option. Under the fair value based method, compensation cost is measured at the grant date based on the fair value of the award and is recognized over the service period. Pro forma disclosures for entities that elect to continue to measure compensation cost under the intrinsic method provided by Accounting Principles Board Opinion No. 25 must include the effects of all awards granted. The Company accounts for stock-based awards to non-employees in accordance with SFAS No. 123 and EITF 96-18. An expense is recognized for common stock, warrants or options issued or repriced, for services rendered by non-employees based on the estimated fair value of the security exchanged.

IRIS has adopted the disclosure only provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock Based Compensation”, as amended by Statement No. 148. If compensation expense for the stock options had been determined using “fair value” at the grant date for awards during 2004 and 2003, consistent with the provisions of Statement of Financial Accounting Standards No. 123, the Company’s net income (loss) and income (loss) per share would have been reduced to the pro forma amounts indicated below:

The pro forma calculations above are for informational purposes only. Future calculations of the pro forma effects of stock options may vary significantly due to changes in the assumptions described above as well as future grants, and for forfeitures of stock options.

Revenue Recognition

Revenues are derived from the sale of IVD instruments, sales of consumable supplies and services for its IVD systems as well as sales of small laboratory devices and related supplies. Revenue is recognized once all of the following conditions have been met: a) an authorized purchase order has been received in writing with a fixed and determinable sales price, b) customer credit worthiness has been established, and c) delivery of the product based on shipping terms. The majority of domestic IVD instrument sales generally require installation and training to be performed.

Revenue is recorded in accordance with the provisions of Emerging Issues Task Force (EITF) Statement No. 00-21 “Revenue Arrangements with Multiple Deliverables” and Staff Accounting Bulletin (SAB) No. 104 “Revenue Recognition in Financial Statements” which generally requires revenue earned on product sales involving multiple-elements to be allocated to each element based on the relative fair values of those elements. Multiple elements of the Company’s domestic product sales include IVD instruments and training. Training elements are valued based on hourly rates, which the Company charges for these services when sold apart from hardware sales. Accordingly, IRIS allocates revenue to each element in a multiple- element arrangement based on the element’s respective fair value, with the fair value determined by the price charged when that element is sold and specifically defined in a quotation or contract.

9

Table of Contents

IRIS recognizes revenues from the sale of instruments, consumables and small laboratory devices when title and risk of loss passes to the customers and revenues from service contracts are recognized ratably over the term of the service period, which typically ranges from twelve to sixty months. Payments for service contracts are generally received in advance. Deferred revenue represents the revenues to be recognized over the remaining term of the service contracts.

Warranties

IRIS records the estimated cost of warranty expense at the time of product delivery.

Research and Development Expenditures

Except for certain capitalized software development costs described above (see Software Development Costs), research and development expenditures are charged to operations as incurred. Net research and development expense includes total research and development costs incurred, including costs incurred under research and development grants and contracts, less costs reimbursed under research and development grants and contracts.

Income Taxes

IRIS accounts for income taxes in accordance with SFAS No. 109 “Accounting for Income Taxes,” which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the differences between the financial statement and the tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense represents the tax payable for the period and the change during the period in deferred tax assets and liabilities.

Marketing Costs

All costs related to marketing and advertising are expensed at the time the advertising takes place.

Fair Value of Financial Instruments

The amount recorded for financial instruments in the Company’s consolidated financial statements approximates fair value as defined in SFAS No. 107, “Disclosures about Fair Value of Financial Instruments”. The fair value of short-term borrowings and notes payable described in Note 4 approximate their carrying value due to the variable nature of the interest rates in these instruments.

Earnings Per Share

Basic earnings per share are computed by dividing net income or loss by the weighted average number of common shares outstanding. Diluted earnings per share is computed by dividing net income by the weighted average number of common shares and common stock equivalents outstanding, calculated on the treasury stock method for options and warrants. Common stock equivalents for the six months ended June 30, 2004 included 892,516 from stock options and 715,336 from warrants. Common stock equivalents for the previous year’s period have been excluded from the computation because their effect is antidilutive.

Segment Reporting

The Company determines and discloses its segments in accordance with SFAS No. 131; “Disclosures about Segments of an Enterprise and Related Information,” which uses a “management” approach for determining business segments. The management approach designates the internal organization that is used by management for making operating decisions and assessing performance as the source of the Company’s reportable segments. SFAS No. 131 also requires disclosures about products and services, geographic areas, and major customers. See Note 9 — “Segment and Geographic Information”.

10

Table of Contents

Certain Risks and Uncertainties

Dependence on Instrument Sales: The Company derives most of its revenues from the sale of the urinalysis analyzers, and related supplies and services. Relatively modest declines in unit sales or gross margins could have a material adverse effect on the Company’s revenues and profits.

Reliance on Single Source Suppliers: Certain key components of our instruments are manufactured according to our specifications or are available only from single suppliers.

3. Inventories

Inventories consist of the following:

4. Short-Term Borrowings and Notes Payable

In April 2004, we used a portion of the proceeds received from a private placement of our stock to retire all outstanding indebtedness to the Bank and the Subordinated Note Holder. See Note 6.

In May 2004, we signed a new credit facility with a major bank. The credit facility consists of a $6.5 million revolving line of credit for working capital and a $10.0 million line of credit for acquisitions and product opportunities. Borrowings under the revolving line of credit are limited to a percentage of eligible receivables and inventory. The entire credit facility has variable interest rates, which will change from time to time based on changes to either the LIBOR rate or the lender’s prime rate. As of June 30, 2004, there were no borrowings under the new credit facility. The Company is subject to certain financial covenants under the credit facility with the bank and as of June 30, 2004, we were in compliance with such covenants.

5. Income Taxes

The income tax provision for the six-month period ended June 30, 2004 was $645,254 as compared to a benefit of $492,596 for the comparable period last year. The income tax provision differs from the federal statutory rate due primarily to state income taxes and permanent differences between income reported for financial statement and income tax purposes.

Realization of deferred tax assets associated with net operating losses (“NOL”) and tax credit carry forward is dependent upon our being able to generate sufficient taxable income prior to their expiration. Management believes it is more likely than not that the deferred tax assets will be realized through future taxable income or alternative tax strategies. However, the net deferred tax assets could be reduced in the near term if management’s estimates of taxable income during the carryforward period are not realized or are significantly reduced or alternative tax strategies are not available. We will continue to review its estimates of taxable income and will make adjustments to the valuation allowance, when necessary.

Also, should the Company undergo an ownership change as defined in Section 382 of the Internal Revenue Code, NOLs generated prior to the ownership change would be subject to an annual limitation. If this occurs, a valuation allowance may be necessary.

11

Table of Contents

6. Capital Stock

Private Placement of Stock

On April 16, 2004, we signed an agreement with an investment bank for the private placement of 2,130,000 shares of the Company’s common stock at a price of $5.85 per share (a 10% discount to market). In addition, each of the investors received a 5-year warrant to purchase 3 additional shares of common stock for each 20 shares of common stock purchased in the offering. The agreement requires us to file a registration statement within 30 days of closing and to have the registration statement declared effective within 90 days of closing. In May 2004, we filed a registration statement, which was declared effective on May 21, 2004. We realized net proceeds (after deducting offering expense of $1.0 million) of approximately $11.5 million. We used approximately $5.5 million of the net proceeds to retire all the Company’s outstanding indebtedness to the Bank and the Subordinated Note Holder.

Stock and Stock Option Issuances

During the six months ended June 30, 2004, we (i) issued 830,378 shares of common stock from the exercise of options, (ii) issued options to purchase 145,000 shares of common stock and (iii) cancelled forfeited options to purchase 34,217 shares of common stock. At June 30, 2004, options to purchase 2,193,935 shares of common stock were issued and still outstanding. Outstanding options will expire at various dates through the end of 2012. The exercise price for such options ranges from $0.69 to $6.40 per share. At June 30, 2004, there were 426,526 shares of common stock available for the granting of future options under the Company’s stock option plans.

Warrants

At June 30, 2004, the following warrants to purchase common stock were outstanding and exercisable:

On July 14, 2004, the warrant for 853,040 shares was fully exercised by the holder and we received $1,620,776 in proceeds, and are required to register such shares on Form S-3 with the Securities & Exchange Commission that we expect to file shortly.

7. Contingencies

Litigation

From time to time, the Company is party to certain litigation arising in the normal course of business. Management believes that the resolution of such matters will not have a material adverse effect on our financial position, results of operations or cash flows.

Guarantees

In November 2002, FASB issued FIN No. 45 “Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others — an interpretation of FASB Statements No. 5, 57 and 107 and rescission of FIN 34.” The following is a summary of the Company’s agreements that we have determined are within the scope of FIN 45.

We enter into indemnification provisions under (i) agreements with other companies in its ordinary course of business, typically with business partners, contractors, and customers, landlords and (ii) agreements with investors. Under such provisions the Company generally indemnifies and holds harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of the Company’s activities or, in some cases, as a result of the indemnified party’s activities under the agreement. Indemnification provisions often include indemnifications relating to representations made by the Company with regard to intellectual property rights. Such indemnification provisions generally survive termination of the underlying agreement. In addition, in some cases,

12

Table of Contents

we agree to reimburse employees for certain expenses and to provide salary continuation. The maximum potential amount of future payments we could be required to make under these indemnification provisions is unlimited. To date, the Company has not incurred any material costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, we have no recorded liabilities for these agreements as of June 30, 2004.

8. Royalty Income

A competitor previously developed several urine sediment analyzers under license agreements using our prior technology. We received royalties under the license of $318,726 and $218,956 for the six months ended June 30, 2004 and 2003.

9. Segment and Geographic Information

Our continuing operations are organized on the basis of products and related services and under SFAS No. 131 operate in two segments: (1) IVD instruments and (2) small laboratory devices and related supplies.

The IVD instrument segment designs, develops, manufactures, markets and distributes IVD systems based on patented and proprietary AIM technology for automating microscopic procedures for urinalysis. The segment also provides ongoing sales of supplies and services necessary for the operation of installed urinalysis workstations. In the United States, these products are sold through a direct sales force. Internationally, products are sold through distributors.

The small laboratory devices segment designs, develops, manufactures and markets a variety of benchtop centrifuges, small instruments and supplies. These products are used primarily for manual specimen preparation and dedicated applications in coagulation, cytology, hematology and urinalysis. These products are sold worldwide through distributors.

The tables below present information about reported segments:

13

Table of Contents

The Company ships products from two locations in the United States. Substantially all long-lived assets were located in the United States and totaled $6,459,512 at June 30, 2004. Sales to international customers amounted to approximately $3.5 million and $700,000 during the six months ended June 30, 2004 and 2003.

14

Table of Contents

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

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements, which reflect our current views about future events and financial results. We have made these statements in reliance on the safe harbor created by the Private Securities Litigation Reform Act of 1995. Forward-looking statements include our views on future financial results, financing sources, product development, capital requirements, market growth and the like, and are generally identified by phrases such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans” and similar words. Forward-looking statements are merely predictions and therefore inherently subject to uncertainties and other factors which could cause the actual results to differ materially from the forward-looking statement. These uncertainties and other factors include, among other things:

Sets forth below are other significant uncertainties and factors affecting forward-looking statements. The readers should understand that uncertainties and other factors identified in this Quarterly Report are not a comprehensive list of all the uncertainties and other factors that may affect forward-looking statements. We do not undertake any obligation to update or revise any forward-looking statements or the list of uncertainties and other factors that could affect those statements.

Overview

IRIS International, Inc., a Delaware corporation was formed in 1979. Our company currently consists of three operating units. Our largest unit, Iris Diagnostics Division, designs, manufactures and markets in vitro diagnostics (IVD) systems, consumables and supplies for urinalysis analyzers. Our StatSpin subsidiary markets small centrifuges and other processing equipment and accessories for rapid specimen processing. Our (ADIR) subsidiary assists in the advancement of proprietary imaging technology while conducting government-sponsored research and contract development in imaging and pattern recognition.

In August 2003, we launched the iQ200 IVD urine analyzer. During 2003, we incurred significant expenses relating to the launch of the iQ200, manufacturing learning curve, international expansion and training relating to new product introduction. In addition, we experienced a significant senior management restructuring during 2003 resulting in approximately $1.2 million in costs arising from severance agreements, of which $400,000 occurred during the first quarter of 2003 and the remainder during the fourth quarter of 2003.

We currently generate revenues primarily from two segments: IVD instruments (which includes instruments, consumables supplies and service) and small laboratory device instruments and supplies. We released the iQ200, in the third quarter of 2003. Although we continue to support our legacy models, we expect sales of consumables for such products to diminish gradually as the legacy models are expected to be replaced by the iQ200 and future upgrades.

Our IVD business, Iris Diagnostics, is in a transitional period due to the introduction of its new iQ200 platform product. During this transitional period recurring revenues are impacted by a number of factors; i) a four and a half month time lag between instrument shipment and consumable generation, ii) a delay in service contract and parts revenue due to a 15-month warranty period and iii) lower gross margins due to an increase in sales through international distributors vs. direct customer sales domestically. Management expects revenues and earnings to improve in future periods as the installed base begins to generate recurring revenue to more than offset these transitional effects.

15

Table of Contents

A substantial portion (approximately 80%) of our revenues are derived from our IVD Segment of which consumables supplies and services contribute higher gross margins than revenues from instruments. Consumables include products such as chemical reagents and urine test strips. Service revenues are derived primarily from annual service contracts purchased by our domestic customers. Once our analyzers and systems are installed, we generate recurring revenue from sales of consumables and service (including parts), which should continue to expand as the installed base of related instruments expands. Sales of small laboratory devices and supplies, sold by StatSpin, primarily consist of centrifuge systems and a new DNA workstation and related supplies. Sales of StatSpin’s products are made worldwide through distributors.

We continue to make significant investments in research and development for new products and enhancements to existing products. We internally fund our research and development programs, however through our ADIR subsidiary; we receive grants from the National Institute of Science and Technology and to a lesser extent, contracts from third parties.

The following table summarizes product technology expenditures for the periods indicated:

Critical Accounting Policies

Our critical accounting policies upon which our financial position and results of operations depend are those related to revenue recognition, inventory valuation, and income tax assets and liabilities. We summarize our most critical accounting policies below.

Revenue recognition – Revenues are derived from the sale of IVD instruments, sales of consumable supplies and services for IVD systems as well as sales of small laboratory devices and related supplies. Revenue is recognized once all of the following conditions have been met: a) an authorized purchase order has been received in writing with a fixed and determinable sales price, b) customer credit worthiness has been established, and c) delivery of the product based on shipping terms. The majority of domestic IVD instrument sales generally require installation and training to be performed.

Revenue is recorded in accordance with the provisions of EITF Statement No. 00-21 “Revenue Arrangements with Multiple Deliverables” and SAB No. 104 “Revenue Recognition in Financial Statements” which generally requires revenue earned on product sales involving multiple-elements to be allocated to each element based on the relative fair values of those elements. Multiple-elements of the Company’s domestic product sales include IVD instruments and training. Training elements are valued based on hourly rates, which the Company charges for these services when sold apart from hardware sales.

Accordingly, we allocate revenue to each element in a multiple-element arrangement based on the element’s respective fair value, with the fair value determined by the price charged when that element is sold and specifically defined in a quotation or contract.

We recognize revenues from service contracts ratably over the term of the service period, which typically ranges from twelve to sixty months. Payments for service contracts are generally received in advance. Deferred revenue represents the revenues to be recognized over the remaining term of the service contracts.

16

Table of Contents

Inventory valuation – We value inventories at the lower of cost or market value on a first-in, first-out basis. Provision for potentially obsolete or slow-moving inventory is made based on management’s analysis of inventory levels and future sales forecasts. We recognize that although we have introduced a new urine analyzer in the iQ200, an installed base of the legacy products still exist. We maintain a base supply of service parts for these products, a portion of which is classified as long-term on our balance sheet. Management will periodically review the carrying value of such parts to ensure that they continue to have net realizable value.

Capitalized Software – We capitalize software development costs in connection with our development of our urine analyzers. We account for such software development in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 86, “Accounting for the Cost of Capitalized Software to Be Sold, Leased or Otherwise Marketed.” We capitalize software development costs once technological feasibility is established and such costs are determined to be recoverable against future revenues.

Capitalized software development costs are expensed to cost of sales over periods up to five years. When, in management’s estimate, future revenues will not be sufficient to recover previously capitalized software development costs, we will expense such items as additional software development amortization in the period the impairment is identified. Such adjustments are normally attributable to changes in market conditions or product quality considerations.

Income taxes – we account for income taxes in accordance with SFAS No. 109 “Accounting for Income Taxes,” which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the differences between the financial statement and the tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense represents the tax payable for the period and the change during the period in deferred tax assets and liabilities.

Results of Operations

Comparison of quarter ended June 30, 2004 to quarter ended June 30, 2003

Sales of IVD instruments are made both domestically and internationally. Our own sales staff makes domestic sales directly to the customer, whereas international sales are made through independent distributors. International sales represented 17% of consolidated net revenues during the three months ended June 30, 2004 compared to 4% during the three months ended June 30, 2003. With the launch of our new iQ200 analyzer, we have increased our focus on the international marketplace, with the ultimate goal of balancing our urinalysis business between domestic and international markets. Since our international sales are made through independent distributors, our gross profit margin, on such sales, is lower than domestic sales of the same products.

Net revenues for the quarter ended June 30, 2004 increased by $3.8 million to $10.3 million or 58% over the same period in the prior year. Revenues from the IVD urinalysis segment totaled $8.4 million or 81% of consolidated revenue in the current year, up from $5.1 million or 78% of consolidated revenue in the prior year and included sales of IVD instruments which increased to $3.5 million from $821,000, an increase of 328% over the second quarter of 2003. The increase is primarily due to sales of the iQ200, which first became available in the third quarter of 2003. Sales of the iQ200 and the iQ200 systems accounted for over $3.3 million of the instrument sales in the current period. Sales of IVD system consumables and services increased in the quarter to $4.7 million from $4.2 million during the prior year quarter, an increase of $542,000, primarily due to the larger installed base of IVD instruments. Segment revenues also include royalty and license fees, which increased to $133,000 from $89,000 in the comparable period from the prior year. Revenues from the small laboratory devices segment increased to $2.0 million from $1.4 million, an increase of $513,000 or 36%. This increase is primarily due to increased sales of centrifuges, and the new ThermoBrite^® DNA workstation.

Consolidated cost of goods sold increased as a percentage of consolidated net revenues to 54% in the second quarter of 2004 compared to 47% in the second quarter of 2003, which resulted in consolidated net margins of 46% for the current quarter as compared to 53% in the second quarter of 2003.

17

Table of Contents

IVD Instruments’ cost of goods sold as a percentage of related sales amounted to 74% in the current quarter as compared to 83% for the same period in the prior year, which resulted in net margins of 26% and 17%. In the prior year costs were impacted by lower volume of instrument sales. In the current year quarter, revenues were impacted by higher sales through distributors internationally, which generate lower gross margins. In addition we incurred approximately $300,000 in additional costs from engineering and retrofit charges for product improvements and approximately $200,000 in reserves for potential product returns and upgrades. The impact of these charges reduced gross margins by 15% during the current quarter.

IVD Consumables and Services’ cost of goods sold, as a percentage of related sales was 42% for the current quarter as compared to 39% in the same period last year, which resulted in net margins of 58% and 61%. This increase is primarily due to discounts given to international distributors and an increasing proportion of service activity covered by initial warranties on the new iQ200.

Small Laboratory Instruments’ cost of goods sold as a percentage of sales amounted to 51% for the current quarter, the same as the second quarter of last year, which resulted in net margins of 49% in both periods.

Marketing and selling expenses, as a percentage of net revenues were 17% in the quarter ended June 30, 2004, down from 19% in the same period last year. Marketing and selling expenses totaled $1.7 million, compared to $1.2 million for the comparable prior year period, an increase of $520,000. The increase is due primarily to increased commissions due to higher revenues ($163,000) additional sales and technical support personnel costs ($153,000), and additional travel costs ($28,000) all associated with the increased sales activity following the launch of the iQ200. In addition, the current quarter includes $152,000 of costs related to our international sales and support infrastructure, which had not yet been established in the prior year quarter.

General and administrative expenses decreased $50,000 to $1.2 million from $1.3 million in the comparable period in the prior year. General and administrative expenses for the period as a percentage of net revenue were 12% as compared to 19% in the same period in the prior year.

Research and development expenses decreased to $1.0 million for the current quarter from $1.3 million in the second quarter of last year. The decrease is due primarily to a reduction in the expenditures related to the iQ200, which was released in the third quarter of 2003. We expect to continue to invest in research and development during 2004 at a slightly reduced rate as compared to 2003, with our primary focus being on enhancements to our existing products.

Interest expense increased to $145,000 in the quarter ended June 30, 2004 from $92,000 in the comparable quarter of the prior year, primarily due to the write off, in the current quarter, of $120,000 of deferred debt financing charges relating to the repayment of all our outstanding debt with a portion of the proceeds from the private placement.

The income tax provision for the quarter ended June 30, 2004 amounted to $292,000, as compared to a benefit of $167,000 for the quarter ended June 30, 2003. The change is a function of the taxable income or loss. The tax provision is a non-cash item, since the Company has significant deferred tax assets resulting from tax net loss carryforwards.

Comparison of six months ended June 30, 2004 to six months ended June 30, 2003

Sales of IVD instruments are made both domestically and internationally. Our own sales staff makes domestic sales directly to the customer, whereas international sales are made through independent distributors. International sales represented 18% of consolidated net revenues during the six months ended June 30, 2004 compared to 6% during the six months ended June 30, 2003.

Net revenues for the six months ended June 30, 2004 increased by $7.0 million to $19.7 million or 56% over the same period in the prior year. Revenues from the IVD urinalysis segment totaled $15.8 million or 80% of consolidated revenue in the current year, up from $10.0 million or 78% of consolidated revenue in the prior year quarter and included sales of IVD instruments, which increased to $6.1 million from $1.4 million an increase of 331% over the first six months of 2003. The increase is primarily due to sales of the iQ200, which first became available in the third quarter of 2003. Sales of the iQ200 Automated Urine Microscopy Analyzers and the iQ200 Automated Urinalysis Systems accounted for over $5.3 million of the instrument sales in the current period. In spite of a reduction in service revenue due to the disproportional increase in the number of iQ200’s under warranty, sales of IVD system consumables and services increased in the period to $9.4 million from $8.3 million during the prior year period, an increase of $1.1 million, primarily due to the larger installed base of IVD instruments. Segment revenues also include royalty and license fees, which increased to $319,000 from

18

Table of Contents

$219,000 in the comparable period from the prior year. Revenues from the small laboratory devices segment increased to $3.9 million from $2.7 million, an increase of $1.2 million or 44%. This increase is primarily due to increased sales of centrifuges and the new ThermoBrite^® DNA denaturation and hybridization station.

Consolidated cost of goods sold as a percentage of net revenues increased to 52% in the first six months of 2004 compared to 47% in the first six months of 2003.

IVD Instruments’ cost of goods sold as a percentage of related sales amounted to 73% in the six-month period as compared to 106% during the same period in the prior year. A much lower volume of instrument sales impacted the prior year period. In the current year period, cost as a percentage of revenues resulted from higher revenues through distributors internationally, which generate lower gross margins. In addition we incurred, approximately $300,000 in additional costs stemming from engineering and retrofit charges for product improvements and approximately $200,000 in reserves for potential product returns and upgrades. The impact of these charges reduced our gross margins by 8% during the six-month period.

IVD Consumables and Services’ cost of goods sold for as a percentage of related sales was 40% for the current year six-month period as compared to 37% in the same period last year. This increase is primarily due to higher international sales through distributors and an increasing proportion of service activity covered by initial warranties on the new iQ200.

Small Laboratory Instruments’ cost of goods for as a percentage of sales totaled 51% for the current period, as compared to 52% in the first six months of last year.

Marketing and selling expenses, as a percentage of net revenues were 16% in the six months ended June 30, 2004, down from 17% in the same period last year. Marketing and selling expenses totaled $3.2 million, compared to $2.2 million for the comparable prior year period, an increase of $1.0 million. The increase is due primarily to increased commissions due to higher revenues ($250,000) additional sales and technical support personnel costs ($318,000), additional travel costs ($91,000) and all associated with the increased sales activity following the launch of the iQ200. In addition, the current period includes $282,000 of costs related to our international sales and support infrastructure, which had not yet been established in the prior year period.

General and administrative expenses decreased $635,000 to $2.4 million from $3.0 million in the comparable period in the prior year. The decrease includes non-recurring costs of $400,000 incurred in the prior year period associated with a management restructuring and a reduction of board related expenses of $76,000 in the current year period. General and administrative expenses for the period as a percentage of net revenue were 12% as compared to 24% in the same period in the prior year.

Research and development expenses decreased to $2.0 million for the six months ended June 30, 2004 from $2.5 million in the same period last year. The decrease is due primarily to a reduction in the expenditures related to the iQ200, released in the third quarter of 2003. We expect to continue to invest in research and development during 2004 at a slightly reduced rate as compared to 2003, with our primary focus being on enhancements to our existing products.

Interest expense increased to $235,000 in the six months ended June 30, 2004 from $187,000 in the comparable period of the prior year primarily due to the write off of $121,000 of deferred financing charges when we repaid our outstanding debt in April.

The income tax provision for the six months ended June 30, 2004 amounted to $645,000, as compared to a benefit of $493,000 for the six months ended June 30, 2003. The change is a function of the taxable income or loss. This tax provision is a non-cash item, since the Company has significant deferred tax assets, resulting from the use of tax loss carryforwards.

19

Table of Contents

Contractual Obligations and Contingent Liabilities and Commitments

The following table aggregates the Company’s expected contractual obligations and commitments subsequent to June 30, 2004:

Liquidity and Capital Resources

Our primary source of liquidity is cash flow generated from operations, which depends heavily on sales of our IVD urinalysis systems and subsequent sales of consumables and service for these systems as well as the sale of small laboratory devices and supplies. Cash and cash equivalents amounted to $10.3 million at June 30, 2004, up from $2.4 million at December 31, 2003.

Cash provided by operations for the six months ended June 30, 2004, amounted to $411,000 as compared to cash used in operations of $883,000 in the prior year, a $1.3 million improvement. The primary reason for the improvement is we had pretax income of $1.6 million during the current year period compared to a pretax loss of $1.2 million during the same period of the prior year, a $2.8 million improvement which was offset by an increase in receivables of $1.0 million plus a $676,000 reduction in accounts payable and accrued expenses during the current year.

Cash used in investing activities totaled $329,000 during the first six months of 2004 as compared to $861,000 used in the same period of the prior year. The decrease is due to the reduction in expenditures for property and equipment and capitalized software development from prior year level partially offset by $197,000 realized from the sale of short-term investments.

Net cash provided by financing activities amounted to $7.7 million during the first six months of 2004 as compared to $698,000 during the same period of the prior year. During the current year we raised $11.5 million from the private placement of Company stock and an additional $1.3 million from the exercise of stock options and the sale of stock to employees through our Employee Stock Purchase Plan partially offset by repayment of outstanding debt.

On April 22, 2004, we completed the private placement of 2,130,000 shares of the Company’s common stock at $5.85 per share. Each investor received a 5-year warrant to purchase 3 additional shares of common stock at $7.80 per share for each 20 shares of common stock purchased in the offering. In May 2004, we filed a registration statement, which was declared effective on May 21, 2004. We realized net proceeds (after deducting offering expenses of $1.0 million) of approximately $11.5 million. We used approximately $5.5 million of the net proceeds to retire our outstanding indebtedness to the Bank and the Subordinated Note Holder.

In May 2004, we signed a new credit facility with our bank, consisting of a $10.0 million line of credit for acquisitions and product opportunities and a $6.5 million revolving line of credit for working capital. As of June 30, 2004, there were no borrowings under the new credit facility. The Company is subject to certain financial covenants under the credit facility the bank and as of June 30, 2004 was in compliance with such covenants.

Inflation

We do not foresee any material impact on our operations from inflation.

20

Table of Contents

Healthcare Reform Policies

In recent years, an increasing number of legislative proposals have been introduced or proposed in Congress and in some state legislatures that would effect major changes in the healthcare system, nationally, at the state level or both. Future legislation, regulation or payment policies of Medicare, Medicaid, private health insurance plans, health maintenance organizations and other third-party payors could adversely affect the demand for our current or future products and our ability to sell our products on a profitable basis. Moreover, healthcare legislation is an area of extensive and dynamic change, and we cannot predict future legislative changes in the healthcare field or their impact on our business.

RISK FACTORS

Risks Related to Our Business

Our success depends largely on the acceptance of our new iQ200 operating platform.

Our current strategy assumes that our iQ200 operating platform will be adopted by a large number of end-users. We have invested and continue to invest, a substantial amount of our resources in promotion and marketing of the iQ200 operating platform in order to increase its market penetration, expand its sales into new geographic areas and enhance and expand its system features. A failure of our iQ200 operating platform to achieve and maintain a significant market presence, or the failure to successfully implement our promotion and marketing strategy, will have a material adverse effect on our financial condition and results of operations.

Any failure to successfully introduce our future products and systems into the market could adversely affect our business.

The commercial success of our future products and systems depends upon their acceptance by the medical community. Our future product plans include capital-intensive laboratory instruments. We believe that these products can significantly reduce labor costs, improve precision and offer other distinctive benefits to the medical research community. However, there is often market resistance to products that require significant capital expenditures or which eliminate jobs through automation. We have no assurance that the market will accept our future products and systems, or that sales of our future products and systems will grow at the rates expected by our management.

If we fail to meet changing demands of technology, we may not continue to be able to compete successfully with our competitors.

The market for our products and systems is characterized by rapid technological advances, changes in customer requirements, and frequent new product introductions and enhancements. Our future success depends upon our ability to introduce new products that keep pace with technological developments, enhance current product lines and respond to evolving customer requirements. Our failure to meet these demands could result in a loss of our market share and competitiveness and could harm our revenues and results of operations.

Any failure or inability to protect our technology and confidential information could adversely affect our business.

Patents. Our commercial success depends in part on our ability to protect and maintain our Automated Intelligent Microscopy (or AIM) and other proprietary technology. We have received patents with respect to portions of the technologies of AIM. However, ownership of technology patents may not insulate us from potentially damaging competition. Patent litigation relating to clinical laboratory instrumentation patents (like the ones we own) often involves complex legal and factual questions. Therefore, we can make no assurance that claims under patents currently held by us, or our pending or future patent applications, will be sufficiently broad to adequately protect what we believe to be our proprietary rights. Additionally, one or more of our patents could be circumvented by a competitor. We believe that our proprietary rights do not infringe upon the proprietary rights of third parties. However, third parties may assert infringement claims against us in the future. If we are unsuccessful in our defense against any infringement claim our patents, or patents in which we have licensed rights, may be held invalid and unenforceable.

21

Table of Contents

Trade Secrets. We have trade secrets, unpatented technology and proprietary knowledge related to the sale, promotion, operation, development and manufacturing of our products. We generally enter into confidentiality agreements with our employees and consultants. However, we cannot guarantee that our trade secrets, unpatented technology or proprietary knowledge will not become known or be independently developed by competitors. If any of this proprietary information becomes known to third parties, we may have no practical recourse against these parties.

Copyrights. We claim copyrights in our software and the ways in which it assembles and displays images. We also claim trademark rights in the United States and other foreign countries. However, we can make no assurance that we will be able to obtain enforceable copyright and trademark protection, nor that this protection will provide us a significant commercial advantage.

Potential Litigation Expenses. Offensive or defensive litigation regarding patent and other intellectual property rights could be time-consuming and expensive. Additionally, litigation could demand significant attention from our technical and management personnel. Any change in our ability to protect and maintain our proprietary rights could materially and adversely affect our financial condition and results of operations.

Our products could infringe on the intellectual property rights of others.

Given the complete factual and legal issues associated with intellectual property rights, there can be no assurance that our current and future products do not or will not infringe the intellectual property rights of others. A determination that such infringement exists or even a claim that it exists could involve us in costly litigation and have an adverse effect on our business and financial condition.

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

The healthcare industry in recent years has been characterized by consolidation. Large hospital chains and groups of affiliated hospitals prefer to negotiate comprehensive supply contracts for all of their supply needs at once. Large suppliers can often equip an entire laboratory and offer hospital chains and groups one-stop shopping for laboratory instruments, supplies and service. Larger suppliers also typically offer annual rebates to their customers based on the customer’s total volume of business with the supplier. The convenience and rebates offered by these large suppliers are administrative and financial incentives that we do not offer our customers. Our plans for further market penetration in the urinalysis market will depend in part on our ability to overcome these and any new barriers resulting from continued consolidation in the healthcare industry. The failure to overcome such barriers could have a material adverse effect on our financial condition or results of operation.

Since we operate in the medical technology industry, our products are subject to government regulation that could impair our operations.

Most of our products are subject to stringent government regulation in the United States and other countries. These regulatory processes can be lengthy, expensive and uncertain. Additionally, securing necessary clearances or approvals may require the submission of extensive official data and other supporting information. Our failure to comply with applicable requirements could result in fines, recall or seizure of products, total or partial suspension of production, withdrawal of existing product approvals or clearances, refusal to approve or clear new applications or notices, or criminal prosecution. If any of these events were to occur, they could harm our business. Changes in existing federal, state or foreign laws or regulations, or in the interpretation or enforcement of these laws, could also materially and adversely affect our business.

Changes in government regulation of the healthcare industry could adversely affect our business.

Federal and state legislative proposals are periodically introduced or proposed that would affect major changes in the healthcare system, nationally, at the state level or both. Future legislation, regulation or payment policies of Medicare, Medicaid, private health insurance plans, health maintenance organizations and other third-party payors could adversely affect the demand for our current or future products and our ability to sell our products on a profitable basis. Moreover, healthcare legislation is an area of extensive and dynamic change, and we cannot predict future legislative changes in the healthcare field or their impact on our industry or our business. Any impairment in our ability to market our products could have a material adverse effect on our financial condition and results of operation.

22

Table of Contents

We may need additional capital in the future. If additional capital is not available, we may have to curtail or cease operations.

We have limited capital and will require substantial capital resources to execute our business strategy. Also, there can be no assurance that all or even a significant portion of the capital sought can be raised. Any additional equity financings may be dilutive to our existing stockholders and may involve the issuance of securities that have rights, preferences or privileges senior to those of our current stockholders. A debt financing, if available, may involve restrictive covenants on our business that could limit our operational and financial flexibility, and the amount of debt incurred could make us more vulnerable to economic downturns or operational difficulties and limit our ability to compete. Furthermore, financing may not be available when needed and, if available, may not be on terms acceptable to us.

We have a history of significant operating losses and we may incur losses in the future.

We have incurred significant losses since our inception and, as of December 31, 2003, we had accumulated a deficit of approximately $25.0 million. We may not achieve profitability in the future and further losses may arise. Our ability to achieve profitable operations in the future will depend on our ability to sell our products at sufficient volumes and with sufficient margins to be profitable. If we are unable to do so, we will not be profitable and our financial condition and results of operation will suffer.

We may not be able to realize the deferred tax asset relating to our tax net operating loss carry forward.

As of June 30, 2004, IRIS has deferred tax assets in excess of $8.0 million resulting from the differences between the financial statement and the tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. There is no assurance that we will be able to generate taxable income in the years that the differences reverse.

Our success depends largely on sales of laboratory instruments and related sales of consumables and service contracts.

Historically, we derived most of our revenues from the sale of urinalysis workstations. Relatively modest declines in unit sales or gross margins for this product line could diminish our revenues and profits. In addition, because our installed instruments utilize a large volume of consumables and produce service revenue, any decline in our installed base will diminish our revenues and profits even further.

We rely on independent and some single-source suppliers for key components of our instruments. Any delay or disruption in the supply of components may prevent us from selling our products and negatively impact our operations.

Certain of our components are obtained from outside vendors, the loss or breakdown of our relationships with these outside vendors could subject us to substantial delays in the delivery of our products to our customers. Furthermore certain key components of our instruments are manufactured by only one supplier. For example, ARKRAY is the single source supplier for our new line of urine chemistry analyzers and related consumable products and spare parts. Roche Diagnostics is the sole source for our proprietary CHEMSTRIP/IRIStrip urine test strips and related urine test strip readers, both used in the Model 500 and 939 UDx urinalysis workstations. Because these suppliers are the only vendors with which we have a relationship for a particular component, we may be unable to sell products if one of these suppliers becomes unwilling or unable to deliver components meeting our specifications. Our inability to sell products to meet delivery schedules could have a material adverse effect on our reputation in the industry as well as our financial condition and results of operation.

One of our single-source suppliers has terminated its agreement with us.

Roche Diagnostics has exercised its right, to terminate the agreements relating to the supply of test strips and related urine test strip readers. Roche will continue to supply test strips and replacement readers to our installed base of workstations for six years after termination of these contracts or 2009. The failure to successfully and timely complete the phase out of their strips and readers with the introduction of our new iQ200 analyzers would have a material adverse affect on our instrument sales and the revenue growth for system supplies and service.

23

Table of Contents

We face intense competition and our failure to compete effectively, particularly against larger, more established companies will cause our business to suffer.

The healthcare industry is highly competitive. We compete in this industry based primarily on product performance, service and price. Many of our competitors have substantially greater financial, technical and human resources than we do, and may also have substantially greater experience in developing products, obtaining regulatory approvals and manufacturing and marketing and distribution. As a result, they may be better able to compete for market share, even in areas in which our products may be superior. Further, our competitive position could be harmed by the establishment of patent protection by our competitors or other companies. The existing competitors or other companies may succeed in developing technologies and products that are more effective or affordable than those being developed by us or that would render our technology and products less competitive or obsolete. If we are unable to effectively compete in our market, our financial condition and results of operation will materially suffer.

Our success depends on our ability to attract, retain and motivate management and other skilled employees.

Our success depends in significant part upon the continued services of key management and skilled personnel. Competition for qualified personnel is intense and there are a limited number of people with knowledge of, and experience in, our industry. We do not have employment agreements with most of our key employees nor maintain life insurance polices on them. The loss of key personnel, especially without advance notice, or our inability to hire or retain qualified personnel, could have a material adverse effect on our instrument sales and our ability to maintain our technological edge. We cannot guarantee that we will continue to retain our key management and skilled personnel, or that we will be able to attract, assimilate and retain other highly qualified personnel in the future.

Defective products may subject us to liability.

Our products are used to gather information for medical decisions and diagnosis. Accordingly, a defect in the design or manufacture of our products, or a failure of our products to perform for the use that we specify, could have a material adverse effect on our reputation in the industry and subject us to claims of liability arising from inaccurate or allegedly inaccurate test results. Misuse of our products by a technician that results in inaccurate or allegedly inaccurate test results could similarly subject us to claims of liability. We currently maintain product liability insurance coverage for up to $1.0 million per incident and up to an aggregate of $2.0 million per year. We also currently maintain a product liability umbrella policy for coverage of claims aggregating to $10.0 million. Although management believes this liability coverage is sufficient protection against future claims, there can be no assurance of the sufficiency of these policies. Any substantial underinsured loss would have a material adverse effect on our financial condition and results of operation. Furthermore, any impairment of our reputation could have a material adverse effect on our sales, revenues and prospects for future business. We have not received any indication that our insurance carrier will not renew our product liability insurance at or near current premiums; however, we cannot guarantee that this will continue to be the case. In addition, any failure to comply with Federal Drug Administration regulations governing manufacturing practices could hamper our ability to defend against product liability lawsuits.

Business interruptions could adversely affect our business.

Products for Iris Diagnostics and StatSpin are manufactured in a single facility for each division and are vulnerable to interruption in the event of war, terrorism, fire, earthquake, power loss, floods, telecommunications failure and other events beyond our control. If our facilities were significantly damaged or destroyed by any cause, we would experience delays in locating a new facility and equipment and qualifying the new facility with the FDA. Our results would suffer. In addition, we may not carry adequate business interruption insurance to compensate us for losses that may occur and any losses or damages incurred by us could be substantial.

24

Table of Contents

If we are unable to manage our growth, our results could suffer.

We have been experiencing significant growth in the scope of our operations. This growth has placed significant demands on our management as well as operational resources. In order to achieve our business objectives, we anticipate that we will need to continue to grow. If this growth occurs, it will continue to place additional significant demands on our management and our operational resources, and will require that we continue to develop and improve our operational, financial and other internal controls both in the U.S. and internationally. In particular, our growth rate has increased, if it continues, will increase the challenges in implementing appropriate control systems, expanding our sales and marketing infrastructure capabilities, providing adequate training and supervision to maintain high quality standards, and preserving our cultural values. The main challenge associated with our growth has been cash flow management. Our inability to scale our business appropriately or otherwise adopt to growth, could cause our business, financial condition and results of operations to suffer.

Our quarterly sales and operating results may fluctuate in future periods, and if we fail to meet expectations the price of our common stock may decline.

Our quarterly sales and operating results have fluctuated significantly in the past and are likely to do so in the future due to a number of factors, many of which are not within our control. If our quarterly sales or operating results fall below the expectations of investors or securities analysts, the price of our common stock could decline substantially. Factors that might cause quarterly fluctuations in our sales and operating results include the following:

The amount of expenses we incur depends, in part, on our expectations regarding future sales. In particular, we expect to continue incurring substantial expenses relating to the marketing and promotion of our products. Since many of our costs are fixed in the short term, if we have a shortfall in sales, we may be unable to reduce expenses quickly enough to avoid losses. If this occurs, we will not be profitable. Accordingly, you should not rely on quarter-to-quarter comparisons of our operating results as an indication of our future performance.

We depend on independent distributors to sell our products in international markets.

We sell our products in international markets through independent distributors. These distributors may not command the necessary resources to effectively market and sell our products. If a distributor fails to meet annual sales goals, it may be difficult and costly to locate an acceptable substitute distributor. If a change in our distributors becomes necessary, we may experience increased costs, as well as substantial disruption and a resulting loss of sales.

25

Table of Contents

Our sales in international markets are subject to a variety of laws and political and economic risks that may adversely impact our sales and results of operations in certain regions.

Our ability to capitalize on growth in new international markets and to maintain the current level of operations in our existing international markets is subject to risks associated with international sales operations. These include: