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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2004

OR

For the transition period from              to             

Commission file number 000-30959

RITA MEDICAL SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

967 N. Shoreline Blvd.

Mountain View, CA 94043

(Address of principal executive offices, including zip code)

650-314-3400

(Registrant’s telephone number, including area code)

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 Act).    Yes  x    No  ¨

As of October 29, 2004, there were 36,787,586 shares of the registrant’s Common Stock outstanding.

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INDEX

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PART 1. FINANCIAL INFORMATION

Item 1. Financial Statements

RITA MEDICAL SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, unaudited)

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

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RITA MEDICAL SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data, unaudited)

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

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RITA MEDICAL SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands, unaudited)

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

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RITA MEDICAL SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by RITA Medical Systems, Inc. (the “Company”) in accordance with accounting principles generally accepted in the United States of America for interim financial information. These principles are consistent in all material respects with those applied in the Company’s financial statements contained in the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2003 and pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X promulgated by the Securities and Exchange Commission. However, interim financial statements do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments (all of which are of a normal recurring nature, including the elimination of intercompany accounts) necessary to present fairly the financial position, results of operations and cash flows of the Company for the periods indicated. Interim results of operations are not necessarily indicative of the results to be expected for the full year or any other interim periods. These unaudited condensed consolidated financial statements should be read in conjunction with the financial statements and footnotes thereto for the year ended December 31, 2003 contained in the Company’s annual report on Form 10-K.

2. Business Combination

On July 29, 2004, the Company merged with Horizon Medical Products, Inc. (“Horizon”) in a transaction accounted for under the purchase method of accounting. The combined companies will continue to operate under the name RITA Medical Systems, Inc. The merger was pursued and completed because the management groups and stockholders of each company believe the combined entity will achieve higher sales and profitability than either or both of the pre-merger companies on a stand-alone basis. These factors contributed to a purchase price in excess of the fair value of Horizon’s net tangible and intangible assets acquired and, as a result, the Company has recorded goodwill in connection with this transaction.

Each Horizon common stockholder received 0.4212 of a share of the Company’s common stock for each share of Horizon common stock held. The Company thereby issued approximately 18.7 million shares of its common stock to acquire all issued and outstanding shares of Horizon common stock, and further assumed all outstanding Horizon options and warrants that, upon exercise, will result in the issuance of approximately 3.9 million shares of the Company’s common stock. The fair value of shares issued by the Company was approximately $91.6 million based on a price per share of $4.896, the Company’s average closing price the day the proposed merger was announced (May 13, 2004), the two business days preceding the announcement and the two business days following the announcement. The fair value of options and warrants, all of which were fully vested when assumed by the Company was determined to be approximately $15.4 million using the Black-Scholes valuation model. Costs incurred to effect the merger included as a component of purchase price were $2.3 million. The total purchase price was approximately $109.3 million. The fair value of assets acquired, net of liabilities assumed, was approximately $18.0 million, resulting in goodwill of $91.3 million.

The allocation of purchase price is as follows (in thousands):

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The merger was completed on July 29, 2004 and none of Horizon’s results of operations prior to that date are included in the Company’s condensed consolidated statements of operations for the three or nine month periods ended September 30, 2004. However, the Company has prepared pro forma financial information showing sales and net loss for the combined entity for the three and nine month periods ended September 30, 2004 and September 30, 2003, respectively, as if the merger occurred as of the beginning of the periods presented. This unaudited pro forma financial information is not intended to represent or be indicative of the consolidated results of operations of the Company that would have been reported had the acquisition been completed as of the dates presented and should not be taken as representative of the future consolidated results of operations or financial condition of the Company (in thousands, except per share amounts):

Restructuring costs of $1,089,000, consisting entirely of severance related to the termination of employees to eliminate certain duplicative activities, were incurred in the third quarter of 2004 (see Note 10, “Restructuring”).

3. Liquidity

As of September 30, 2004, the Company’s total assets were $145.6 million, total tangible assets were $23.0 million, total liabilities were $26.7 million, working capital was $3.8 million and cash and cash equivalents totaled $3.1 million. Current and anticipated demand for the Company’s products as well as procurement and production affect the need for capital. Also, the Company’s merger with Horizon requires significant cash payments over the last three months of 2004 and further requires service of debt, which totaled approximately $18.1 million as of September 30, 2004. Approximately $8.3 million of this debt is current, with $6.5 million coming due in July of 2005. To make our debt payments, we need to sell additional equity or debt securities, obtain an additional credit facility or renegotiate the terms of our debt. There can be no assurance that additional financing will be available to us or, if available, that such financing will be available on terms favorable to the Company and our stockholders, or that we can successfully renegotiate our debt terms. Failure to make timely debt payments may require us to curtail operations, perhaps to a significant extent. In addition, future equity financings could result in dilution to stockholders, and future debt financings could result in certain financial and operational restrictions.

4. Net loss per share

Basic earnings per share figures are calculated based on the weighted-average number of common shares outstanding during the period less the weighted-average number of any common shares subject to repurchase by the Company. Diluted earnings per share further includes the dilutive effect of potentially dilutive securities consisting of stock options and warrants provided that the inclusion of such securities is not antidilutive; the Company has reported net losses and therefore has excluded such potentially dilutive securities from its calculation of diluted earnings per share.

The reconciliation of total weighted average outstanding common shares to shares used in determining net loss per share is as follows (in thousands):

The following numbers of shares represented by options and warrants (prior to application of the treasury stock method) were excluded from the computation of diluted net loss per share as their effect was antidilutive (in thousands):

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5. Accounting for stock-based compensation

During the year ended December 31, 2002, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure.” The Company accounts for stock-based employee compensation arrangements in accordance with provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and Financial Accounting Standards Board Interpretations (“FIN”) No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.”

Under APB Opinion No. 25, compensation expense is based on the difference, if any, on the date of the grant between the fair value of the Company’s stock and the exercise price. SFAS No. 123 defines a “fair value” based method of accounting for an employee stock option or similar equity instruments.

The following table illustrates the effect on net loss and net loss per common share for the three and nine month periods ended September 30, 2004 and 2003, respectively, if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation granted under all of the stock option plans and the Employee Stock Purchase Plan (in thousands, except per share amounts):

The determination of stock-based employee compensation, as relating to stock option plans, under the fair value based method used the following weighted average assumptions:

The corresponding assumptions for the Employee Stock Purchase Plan were as follows:

6. Inventories

The components of the Company’s inventories at September 30, 2004 and December 31, 2003, respectively, were as follows (in thousands):

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7. Intangible assets and related amortization

The Company’s intangible assets and related accumulated amortization at September 30, 2004 and December 31, 2003, respectively, were as follows (in thousands):

The amortization periods of our intangible assets as of September 30, 2004 are as follows:

Aggregate amortization expense for the nine months ended September 30, 2004, and estimated amortization expense for the three months ended December 31, 2004 and each of the five years ended December 31, 2005 through 2009 is as follows (in thousands):

The Company has adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” and Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Under these standards, the potential impairment of the Company’s goodwill will be reviewed at least annually, or more often if changes in business conditions so dictate. No impairment of goodwill has been determined to exist as of September 30, 2004.

8. Debt

The Company has short-term notes payable relating to its insurance coverage. These short-term notes total approximately $1,080,000 as of September 30, 2004.

Also, as part of the merger of RITA and Horizon, the Company assumed the following debts:

Senior Subordinated Convertible Notes (the “Senior Notes”) were originally issued by Horizon in March 2002, in the amount of $15,033,000. As of September 30, 2004, $14,763,000 was due under the Senior Notes, of which $6,501,000 will come due in July 2005, with the balance coming due in July 2008. The Senior Notes bear interest, payable quarterly, at 6.0% per annum. The interest rate on the Senior Notes will increase to 8.0% on January 29, 2005 and to 14% on July 29, 2005. The Company may prepay the Senior Notes without a penalty prior to their respective maturity dates.

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A Junior Promissory Note (the “Junior Note”) payable to a major financial institution was originally executed by Horizon in April 2002, in the amount of $2.0 million. As of September 30,2004, $1,595,000 was due under the Junior Note. The Junior Note bears interest at a rate of 6% per annum, is payable monthly and matures in March 2007. The monthly principal payment is $22,500 until maturity at which time a balloon payment of $920,000 is due.

A Note Payable for the Stepic business purchase (the “Stepic Note”) was executed by Horizon in 1998. As of September 30, 2004, $643,000 was due under the Stepic Note. The Stepic Note bears interest at 8% and calls for monthly interest and principal payments of approximately $38,000. The Stepic Note is scheduled to be fully repaid in March 2006.

Future maturities of debt outstanding as of September 30, 2004 are as follows (in thousands):

9. Deferred maintenance revenue and other deferred revenue

Revenue for maintenance contracts is recognized on a pro-rata basis over the period of the applicable maintenance contract, ranging from 12 to 36 months. Costs are recognized as incurred. The Company had no deferred maintenance revenue during the three and nine month periods ended September 30, 2003. Changes in the Company’s deferred maintenance revenue during the three and nine months ended September 30, 2004 were as follows (in thousands):

Additionally, during the third quarter of 2004 the Company recorded $648,000 in deferred revenue relating to a shipment to a distributor that was determined not to meet the standard for revenue recognition as defined in the SEC’s Staff Accounting Bulletin No. 104, “Revenue Recognition.”

10. Restructuring

In the third quarter of 2004, in connection with the merger of RITA and Horizon, the Company recorded a restructuring charge of $1,089,000 related to the termination of employees to eliminate certain duplicative activities. These charges were accounted for in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” As of September 30, 2004, $245,000 of the severance amounts had been paid and $844,000 has been accrued. The Company expects to pay approximately $370,000 of the remaining severance amounts by the end of the year and the remaining balance during 2005. Additional severance provisions related to further restructuring activities are possible in the fourth quarter of 2004 and 2005.

11. Segment information

As a result of the merger with Horizon, the Company expanded its customer base and portfolio of products, which resulted in two groups of medical oncology products: radiofrequency ablation (RFA) systems, which consist largely of the original RITA products and vascular access systems, which consist largely of the former Horizon products.

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Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the Company’s chief executive officer in deciding how to allocate resources and in assessing performance. The Company’s chief executive officer reviews financial information on a consolidated basis, accompanied by disaggregated information about sales by groups of similar products for purposes of making operating decisions and assessing financial performance. For purposes of allocating resources, the Company evaluates the performance of its product groups based only on sales. The Company does not assess the performance of its product groups on measures of income or expenses. Accordingly, the Company operates as one operating segment. Below are the Company’s sales by geographic region (in thousands):

As mentioned above, the Company has two groups of medical oncology products. Sales for these two groups are as follows (in thousands):

12. Comprehensive income (loss)

Comprehensive income (loss) generally represents all changes in stockholders’ equity except those resulting from investments or contributions by stockholders. The Company’s unrealized gains and losses on available-for-sale securities represent the only components of comprehensive loss that are excluded from the Company’s net loss. These components are not significant individually, or in the aggregate, and therefore, no separate statement of comprehensive loss has been presented.

13. Recent accounting pronouncements

The Financial Accounting Standard Board (“FASB”) issued an exposure draft entitled “Share-Based Payment, an Amendment of FASB Statements Nos. 123 and 95.” This exposure draft would require stock-based compensation to employees to be recognized as a cost in the financial statements and that such cost be measured according to the fair value of the stock options. In the absence of an observable market price for the stock awards, the fair value of the stock options would be based upon a valuation methodology that takes into consideration various factors, including the exercise price of the option, the expected term of the option, the current price of the underlying shares, the expected volatility of the underlying share price, the expected dividends on the underlying shares and the risk-free interest rate. The proposed requirements in the exposure draft would be effective for the first fiscal year beginning after June 15, 2005. The FASB intends to issue a final statement in late 2004. We will continue to monitor communications on this subject from the FASB in order to determine the impact on our financial statements.

At its March 2004 meeting, the Emerging Issue Task Force (“EITF”) reached a consensus recognition and measurement guidance previously discussed under EITF 03-01. The consensus clarifies the meaning of other-than-temporary impairment and its application to investments classified as either available-for-sale or held-to-maturity under FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and investments accounted for under the cost method or the equity method. The recognition and measurement guidance for which the consensus was reached in the March 2004 meeting is to be applied to other-than-temporary impairment evaluations in reporting periods beginning after June 15, 2004. The Company does not expect the adoption of the disclosure requirements of EITF 03-01 to have a material impact on its financial position, cash flows or results of operations.

14. Commitments and contingencies

In the course of our merger with Horizon, we have incurred commitments for operating leases related to facility rental. Future minimum payments under operating leases are as follows (in thousands):

The Company is, and may in the future be, involved in litigation relating to claims arising from the ordinary course of business. Management is not currently aware of any matters that will have a material adverse effect on the financial position, results of operations or cash flows of the Company.

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

This Management’s Discussion and Analysis of Financial Condition and Results of Operations and other parts of this quarterly report on Form 10-Q contain forward-looking statements that involve risks and uncertainties. Words such as “anticipates”, “expects”, “intends”, “plans”, “believes”, “seeks”, “estimates”, “should”, and similar expressions identify such forward-looking statements. These statements are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from those expressed or forecasted. Factors that might cause such a difference include, but are not limited to, those discussed in the section entitled “Factors That May Affect Future Results” and those appearing elsewhere in this quarterly report on Form 10-Q, in our joint proxy statement / prospectus, dated June 25, 2004, for the meeting of our stockholders on July 29, 2004 and in our annual report on Form 10-K for the fiscal year ended December 31, 2003. Additionally, factors that might cause actual results to be different from forecasted results may be found in the “Factors That May Affect Future Results” section of Horizon Medical Products’ annual report on Form 10-K for their fiscal year ended December 31, 2003 and in their quarterly report on Form 10-Q for their first fiscal quarter ended March 31, 2004. Readers are cautioned not to place undue reliance on these forward-looking statements that reflect management’s analysis only as of the date hereof. We assume no obligation to update these forward-looking statements to reflect actual results or changes in factors or assumptions affecting such forward-looking statements.

Overview

We develop, manufacture and market innovative products for cancer patients, including radiofrequency ablation systems for treating cancerous tumors as well as percutaneous vascular and spinal access systems. In 2001, we commercially launched our StarBurst XLi family of disposable devices and significantly expanded our direct domestic sales organization and our international distribution network. In 2002, the XLi family of disposable devices gained wide acceptance with our customers in the United States. In 2003, we introduced our next generation in infusion technology, the Xli-Enhanced (“Xlie”) disposable device. The Xlie device builds upon our established infusion expertise, making the ablation process easier and more efficient.

On July 29, 2004, we completed a merger with Horizon Medical Products, Inc. (“Horizon”). Horizon operated as a specialty medical device company focused on manufacturing and marketing vascular products, particularly oncology product lines including implantable vascular ports, tunneled catheters and stem cell transplant catheters used in cancer treatment protocols. Each Horizon common stockholder received 0.4212 of a share of the Company’s common stock for each share of Horizon common stock held. The Company thereby issued approximately 18.7 million shares of its common stock to acquire all issued and outstanding shares of Horizon common stock, and further assumed all outstanding Horizon options and warrants that, upon exercise, will result in the issuance of approximately 3.9 million shares of the Company’s common stock. The fair value of shares issued by the Company was approximately $91.6 million based on a price per share of $4.896, the Company’s average closing price the day the proposed merger was announced (May 13, 2004), the two business days preceding the announcement and the two business days following the announcement. The fair value of options and warrants, all of which were fully vested when assumed by the Company was determined to be approximately $15.4 million using the Black-Scholes valuation model. Costs incurred to effect the merger and to be included as a component of purchase price were $2.3 million. The total purchase price was approximately $109.3 million. The fair value of assets acquired, net of liabilities assumed, was approximately $18.0 million, resulting in goodwill of $91.3 million. We believe the merger will lead to higher sales and greater profitability due to a larger, more effective sales group, consolidation of manufacturing resulting in lower product costs, and reduced administrative expenses.

Management relies on certain statistical measurements to assess trends in sales growth and the effectiveness of our selling strategies. The following table, derived from our Consolidated Statements of Operations and other unaudited data for the three and nine months ended September 30, 2004 and 2003, and for the years ended December 31, 2003, 2002 and 2001, sets forth some of these measurements:

Consolidation of Horizon’s results did not begin until the closing date of the merger, July 29, 2004. Therefore, the percentages shown for historical periods must be used with caution, as they may not be indicative of future results. In particular, the percentage of sales attributable to vascular access products is expected to be higher in future periods.

Prior to completion of the Horizon merger, our products were sold in the United States exclusively through our direct sales force and internationally through distribution partners. Horizon, in contrast, made use of domestic distribution partners in selected

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areas of the United States. Since completion of the merger, we have begun to distribute our radiofrequency ablation products through some of these domestic distribution partners. However, direct sales will remain the Company’s predominant mode of domestic distribution for the foreseeable future.

Our sales in the United States are more profitable than our sales in international markets because direct selling, which avoids distributor discounts, permits higher average selling prices for our products. Accordingly, we have made significant investments in our domestic sales force in an effort to increase sales growth in the United States, and have, to date, introduced our premium-priced Starburst Xli and Xlie families of disposable needles only in this region. These actions have resulted in a growing percentage of sales derived from the domestic market. The merger with Horizon should permit wider and even more efficient coverage of the domestic market, further strengthening this trend. In contrast, our international markets in Europe and Japan have relatively more restrictive reimbursement conditions than those in the United States, which combined with our distributor discounts, limit our average selling prices in these markets. Further, some of our distributors in Europe and Japan have been reducing their inventory levels. These factors have resulted in slow growth or even declining volume in some of our international markets. Going forward, we note that the reduction in international inventories experienced in preceding periods seems to have diminished. We expect 2004 sales growth in the United States to continue to outpace international growth because we believe the principle impact of the Horizon merger will be upon the domestic market and because introduction of premium products to our international distributors will have a relatively small impact on growth due to pricing limitations. However, we also note reimbursement approval for our radiofrequency procedure in Japan, effective April 1, 2004, and the receipt of modest orders from our Japanese distributor during the third quarter of 2004. We believe that Japan will once again be an important source of international revenue beginning in 2005.

Prior to completion of the Horizon merger, essentially all of our sales came from the sale of our disposable devices and radiofrequency generators used in the treatment of cancerous liver tumors and the percentage of our sales derived from disposable products was growing relative to that of hardware products. Going forward, we expect that more than 90% of our sales will be derived from our disposable products that have higher gross margins than our hardware products. Further, the merger with Horizon expanded our product offering, which should result in additional sales for the company, primarily from the sale of implantable vascular ports used in cancer treatment protocols. During the third quarter of 2004, integration of the two sales groups required training that adversely impacted sales growth and may continue to limit sales growth over the balance of 2004. However, we believe that in 2005 the broader product line and larger sales group resulting from the merger will enable us to increase the efficiency of our selling effort.

Our manufacturing costs consist of raw materials, including generators and ancillary hardware components produced for us by third-party suppliers, labor to produce our disposable devices and to inspect incoming, in-process and finished goods, sterilization performed by an outside service provider and general overhead expenses. Our manufacturing costs are volume-dependent, and our unit costs should decrease as our production volumes increase. The ongoing integration of our manufacturing operations in our Manchester, Georgia location should result in lower costs in the future from the use of less expensive labor and economies of scale. We also believe we have the opportunity to reduce the cost of our vendor-supplied hardware products through higher order volumes or product redesign. Besides manufacturing costs, our cost of goods sold for 2003 and the nine months ended September 30, 2004 reflects amortization of capitalized license fees associated with the April 2003 settlement of our patent litigation dispute with Boston Scientific Corporation. We expect these amortization charges to continue through 2015. Further, our cost of goods sold also includes provisions to our reserve for obsolete inventory. Technology in our marketplace has evolved rapidly and we have, from time to time, recognized relatively high expenses related to obsolete inventory as our product line has changed. We may experience similar product changes and related obsolete inventory provisions in the future, although we generally expect only modest impacts from such provisions.

Our gross margins reflect our selling prices, our domestic / international mix percentages, our product mix percentages, our production volumes, the costs we pay for vendor manufactured product and our provisions for obsolete inventory. Our gross margin for the three months ended September 30, 2004 was 65%, compared to a gross margin of 68% for the three months ended September 30, 2003. Historically, the gross margin rate for our vascular access products has been lower than that of our radiofrequency ablation products. For this reason, we expect that future company gross margins will, on average, be reduced by inclusion of these products in our results.

In addition to the selling statistics discussed above, management relies on certain measurements to assess the effectiveness of our operations. The following tables sets forth some of these measurements, derived from our Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2004 and 2003, our Consolidated Statements of Operations for the years ended December 31, 2003, 2002 and 2001, our Unaudited Condensed Consolidated Balance Sheets as of March 31and September 30, 2004, and our Consolidated Balance Sheets as of December 31, 2003, 2002 and 2001:

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If we are to become profitable, we must continue to manage our operating expenses. Our operating expenses consist of product development costs, clinical trial expenses, patent litigation expenses, sales and marketing expenses related to our selling efforts in the United States and Europe, and administrative expenses, including the costs associated with our status as a public company, professional service expenses and our provisions for uncollectible accounts. Changes in these expenses are determined by the breadth of our new product development portfolio, the number of headcount we maintain in our selling and administrative functions, the scope of our marketing efforts, the costs we incur in defense of our patents and intellectual property rights and the extent to which credit issues and economic conditions constrain our ability to collect our receivables.

Research spending for the three months ended September 30, 2004 was $0.9 million, or 5% lower than in the prior year period, and little growth is expected over the balance of 2004. Research spending in 2005 is expected to increase modestly, driven by programs aimed at technical innovation of our radiofrequency ablation products. We expect that the merger with Horizon will have only minimal impact on growth in research and development expenses.

Selling, general and administrative expense for the three months ended September 30, 2004 was $2.0 million higher than in the three months ended September 30, 2003, due to the consolidation of Horizon results and expenses incurred in the integration of the two companies. Also, the merger resulted in recognition of intangible assets, amortization of which will result in charges to selling, general and administrative expense of approximately $180,000 per month for the foreseeable future. However, headcount reductions, particularly in the domestic sales groups, were effected during the third quarter of 2004, and will continue during the fourth quarter of 2004. These headcount reductions should result in expense levels for the combined company that are lower than the sum of expenses for the two companies prior to the merger. However, the severance associated with headcount reductions resulted in a $1.1 million restructuring expense, exclusive of selling, general and administrative expenses, for the three months ended September 30, 2004. Additional severance provisions related to further restructuring activities are possible in the fourth quarter of 2004 and 2005.

In addition to management of our operating expenses, we must continue to conserve our cash and raise additional cash. Our combined total of cash, cash equivalents and marketable securities was $4.1 million as of September 30, 2004, down from $9.5 million as of December 31, 2003. Our net cash used in operating activities for the nine months ended September 30, 2004 was $5.5 million. We have approximately $18.1 million in short term and long term debt as of September 30, 2004, with $6.5 million coming due in July 2005. We must continue to strictly manage our use of cash and will need to raise additional cash through borrowing or sale of equity securities or renegotiate the repayment terms of our debt, in order to support operations and to satisfy our debt obligations over the next twelve months.

We incurred a net loss of $3.3 million for the three months ended September 30, 2004 compared to $2.5 million for the three months ended September 30, 2003. Due to integration costs, the costs associated with research and development programs and our sales and marketing efforts, we expect to incur net losses throughout 2004. Profitability depends on, among other things, our success in expanding product usage in our current markets and in developing new markets, as well as the successful integration of Horizon’s operations. To the extent current or new markets do not materialize in accordance with our expectations, our sales could be lower than expected and we may be unable to achieve or sustain profitability.

Critical Accounting Policies and Estimates

Our critical accounting policies and estimates were discussed in our annual report on Form 10-K for the fiscal year ended December 31, 2003. All of the policies and estimates discussed at that time remain unchanged. However, because the merger with Horizon resulted in goodwill of $91.3 million as of September 30, 2004, management has determined that the Company’s accounting policy regarding goodwill should also be considered a critical accounting policy.

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Goodwill and other intangible assets

We account for our goodwill under Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets.” The SFAS No. 142 goodwill impairment model is a two-step process. First, it requires a comparison of the book value of net assets to the fair value of the reporting units that have goodwill assigned to them. If the fair value is determined to be less than book value, a second step is performed to compute the amount of the impairment. Recoverability of the asset is measure by comparison of the asset’s carrying amount to future net undiscounted cash flows the asset is expected to generate. If such asset is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds the projected discounted future net cash flows arising from the asset. We test goodwill for impairment during the third quarter of every fiscal year, and when an event occurs or circumstances change such that it is reasonably possible that an impairment may exist.

Results of Operations

The following table sets forth the percentage of net revenue represented by certain items in our Condensed Consolidated Statements of Operations for the quarter ended September 30, 2004 and the four preceding fiscal quarters: