UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 24, 2005

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

For the transition period from ___ to ___

Commission File Number: 000-20198

CHOLESTECH CORPORATION

(Exact name of registrant as specified in its charter)

California (State or other jurisdiction of incorporation or organization)		94-3065493 (I.R.S. Employer Identification No.)

3347 Investment Boulevard, Hayward, CA 94545
(Address of principal executive offices) (Zip Code)

(510) 732-7200
(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 þ No o

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

As of June 24, 2005, 14,688,602 shares of the registrant’s common stock were outstanding.

 

 

CHOLESTECH CORPORATION
INDEX

				Page
PART I		FINANCIAL INFORMATION
ITEM 1.		CONDENSED FINANCIAL STATEMENTS (unaudited)
		Condensed Balance Sheets as of June 24, 2005 and March 25, 2005			3
		Condensed Statements of Operations for the thirteen weeks ended June 24, 2005 and June 25, 2004			4
		Condensed Statements of Cash Flows for the thirteen weeks ended June 24, 2005 and June 25, 2004			5
		Notes to Condensed Financial Statements			6
ITEM 2.		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS			11
ITEM 3.		QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK			30
ITEM 4.		CONTROLS AND PROCEDURES			30
PART II		OTHER INFORMATION
ITEM 1.		LEGAL PROCEEDINGS			31
ITEM 6.		EXHIBITS			32
		SIGNATURES			33
EXHIBIT 10.61
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32

PART I — FINANCIAL INFORMATION

ITEM 1. CONDENSED FINANCIAL STATEMENTS

CHOLESTECH CORPORATION

		June 24, 2005				March 25, 2005(1)
		(unaudited)
Assets
Current assets:
Cash and cash equivalents		$	5,331			$	4,304
Marketable securities			20,389				19,574
Accounts receivable, net			4,128				4,651
Inventories, net			8,718				8,356
Prepaid expenses and other assets			1,562				1,889
Deferred tax assets			809				2,333
Total current assets			40,937				41,107
Property and equipment, net			8,367				8,176
Long-term marketable securities			8,961				9,590
Long-term deferred tax assets			15,800				15,248
Total assets		$	74,065			$	74,121
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable and accrued expenses		$	3,258			$	4,259
Accrued payroll and benefits			1,979				2,984
Other liabilities			252				286
Total current liabilities			5,489				7,529
Contingencies (note 6)
Shareholders’ equity:
Common stock, no par value; 25,000,000 shares authorized; 14,688,602 and 14,614,914 shares issued and outstanding at June 24, 2005 and March 25, 2005, respectively			92,056				91,681
Accumulated other comprehensive income			(50	)			(116	)
Deferred compensation			(290	)			(241	)
Accumulated deficit			(23,140	)			(24,732	)
Total shareholders’ equity			68,576				66,592
Total liabilities and shareholders’ equity		$	74,065			$	74,121

See Notes to Condensed Financial Statements

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

		Thirteen Weeks Ended
		June 24,				June 25,
		2005				2004
Revenue		$	15,065			$	9,553
Cost of revenue			5,472				4,004
Gross profit			9,593				5,549
Operating expenses:
Sales and marketing			3,312				2,784
Research and development			1,067				902
General and administrative			2,755				2,443
Total operating expenses			7,134				6,129
Income (loss) from operations			2,459				(580	)
Interest and other income, net			133				15
Income (loss) before provision for income taxes			2,592				(565	)
Provision (benefit) for income taxes			1,000				(220	)
Net income (loss)			1,592			$	(345	)
Net income (loss) per share:
Basic		$	0.11			$	(0.02	)
Diluted		$	0.11			$	(0.02	)
Shares used to compute income per share:
Basic			14,618				14,163
Diluted			14,913				14,163

See Notes to Condensed Financial Statements

CONDENSED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

		Thirteen Weeks Ended
		June 24,				June 25,
		2005				2004
Cash flows from operating activities:
Net income (loss)		$	1,592			$	(345	)
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			686				749
Stock-based compensation			25				—
Change in allowance for losses on accounts receivable			(44	)			(37	)
Change in inventory reserve			(115	)			(599	)
Deferred tax asset			972				(170	)
Changes in assets and liabilities:
Accounts receivable			567				2,791
Inventories			(247	)			(880	)
Notes receivable			—				50
Prepaid expenses and other assets			327				558
Accounts payable and accrued expenses			(1,001	)			110
Accrued payroll and benefits			(1,005	)			127
Other liabilities			(34	)			(41	)
Net cash provided by operating activities			1,723				2,313
Cash flows from investing activities:
Sales and maturities of marketable securities			6,710				5,087
Purchases of marketable securities			(6,830	)			(6,810	)
Purchases of property and equipment			(877	)			(965	)
Net cash used in investing activities			(997	)			(2,688	)
Cash flows from financing activities:
Issuance of common stock			301				649
Net cash provided by financing activities			301				649
Net increase in cash and cash equivalents			1,027				274
Cash and cash equivalents at beginning of period			4,304				2,502
Cash and cash equivalents at end of period		$	5,331			$	2,776

See Notes to Condensed Financial Statements

NOTES TO CONDENSED FINANCIAL STATEMENTS

1.

Interim Results

     The interim unaudited financial information of Cholestech Corporation (the “Company”) is prepared in conformity with accounting principles generally accepted in the United States of America. The financial information included herein has been prepared by management, without audit by an independent registered public accounting firm, and should be read in conjunction with the audited consolidated financial statements contained in the Annual Report on Form 10-K for the fiscal year ended March 25, 2005. The information furnished includes all adjustments and accruals consisting only of normal recurring accrual adjustments that are, in the opinion of management, necessary for a fair presentation of results for the interim periods. Certain information or footnote disclosure normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America has been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission.

     The interim results are not necessarily indicative of the results of operations for the full fiscal year ending March 31, 2006.

2.

Balance Sheet Data

     The components of inventories are as follows (in thousands), net:

		June 24, 2005				March 25, 2005
Raw materials		$	2,524			$	2,277
Work-in-process			2,116				2,395
Finished goods			4,078				3,684
		$	8,718			$	8,356

3.

Reclassifications

     Certain financial statement items have been reclassified to conform to the current period’s presentation. These reclassifications had no impact on previously reported results of operations.

4.

Net Income (Loss) Per Share

     Basic earnings per share is computed by dividing net income (loss) (numerator) by the weighted average number of common shares outstanding (denominator) during the period. Diluted earnings per share gives effect to all potential common stock outstanding during a period, if dilutive. The following table reconciles the numerator (net income or loss) and denominator (number of shares) used in the basic and diluted per share computations:

		Thirteen Weeks Ended
		June 24,				June 25,
(in thousands, except per share data)		2005				2004
Net income (loss)		$	1,592			$	(345	)
Shares
Basic			14,618				14,163
Effect of dilutive securities			295				—
Diluted			14,913				14,163
Per share net income (loss)
Basic		$	0.11			$	(0.02	)
Effect of dilutive securities			0.00				0.00
Diluted		$	0.11			$	(0.02	)

     As of June 24, 2005, options to purchase 704,163 shares of common stock were considered anti-dilutive because the respective exercise prices were greater than the average fair market value of the common stock. As of June 25, 2004, options to purchase 2,255,488 shares of common stock were considered anti-dilutive because the respective exercise prices were greater than the average fair market value of the common stock.

5.

Stock-Based Compensation

     The Company accounts for its stock-based compensation plans in accordance with SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”) as amended by SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure (“SFAS 148”). As permitted under SFAS 148, the Company uses the intrinsic value-based method of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), to account for its employee stock-based compensation plans. Under APB 25, compensation expense is based on the difference, if any, on the date of grant between the fair value of the Company’s common shares and the exercise price of the option. Compensation costs for stock options, if any, are realized ratably over the vesting period. During the thirteen week period ended June 24, 2005, deferred compensation charged to operations related to restricted stock was $25,000.

     The Company provides additional proforma disclosures required by SFAS 123 as amended by SFAS 148. Had the compensation cost for the Company’s stock option and stock purchase plans been determined based on the fair market value of the options at the grant dates, as prescribed in SFAS 123, the Company’s net income (loss) and net income (loss) per share would have been as follows:

		Thirteen Weeks Ended
		June 24,				June 25,
(in thousands, except per share data)		2005				2004
Net income (loss) as reported		$	1,592			$	(345	)
Add: Stock-based employee compensation expense included in reported net income, net of tax			15				—
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of tax			683				842
Pro forma net income (loss)		$	924			$	(1,187	)
Net income (loss) per share:
Basic
As reported		$	0.11			$	(0.02	)
Pro forma		$	0.06			$	(0.08	)
Diluted
As reported		$	0.11			$	(0.02	)
Pro forma		$	0.06			$	(0.08	)

     The pro forma information presented above for the thirteen weeks ended June 25, 2004 has been revised from the information previously presented in the Company’s Form 10-Q for the period ended June 25, 2004. Such pro forma disclosure may not be representative of future compensation costs because options vest over several years and additional grants are anticipated to be made each year.

     The fair value of each stock option is estimated on the date of the grant using the Black-Scholes valuation model, with the following weighted-average assumptions used for grants during the applicable periods:

		Thirteen Weeks Ended
		June 24,				June 25,
		2005				2004
Risk free interest rate			3.73	%			1.42	%
Expected life		4.5 Years				7 Years
Expected volatility			65.0	%			76.3	%
Dividend yield			0.0	%			0.0	%

     Under APB 25, compensation expense for grants to employees is based on the difference, if any, on the date of the grant, between the fair market value of the Company’s stock and the option exercise price. SFAS 123 defines a “fair value” based method of accounting for an employee stock option or similar equity investment. The pro forma disclosure of the difference between compensation expense included in net loss and the related cost measured by the fair value method is presented above.

6.

Contingencies

     On August 2, 2002, N.V. Euromedix (“Euromedix”) filed suit against the Company in the Commercial Court in Leuven, Belgium (No. F5700-02), seeking damages for the wrongful termination of an implied distribution agreement with the Company for Europe and parts of the Middle East. On November 7, 2002, the court dismissed the suit. On December 31, 2002, Euromedix filed suit against the Company in the Commercial Court in Leuven, Belgium (No. B/02/00044), seeking damages in the amount of approximately €3.5 million for the wrongful termination of an implied distribution agreement with the Company for Europe and parts of the Middle East. At the introductory hearing on April 1, 2003, the case was sent to the general docket and there have been no further developments. The Company believes this claim is without merit and intends to continue to defend the claim vigorously.

     On March 14, 2003, the Company initiated trademark infringement proceedings against Euromedix before the President of the Commercial Court in Leuven, Belgium (No. BRK/03/00017), seeking in principle an order (i) to prohibit Euromedix from selling, stocking, importing, exporting or promoting in the European Economic Area (EEA) products that violate the Company’s trademarks, under a penalty of €10,000 for each LDX Analyzer sold, a penalty of €1,000 for each cassette sold contrary to the prohibition and a €25,000 penalty for each publicity of advertisement for such products; (ii) to prohibit Euromedix from using certain slogans and phrases, in combination with products associated with certain of the Company’s trademarks, in trade documents or other announcements, under a penalty of €25,000 for each document used contrary to this prohibition; and (iii) to order the destruction of the inventory of products held by Euromedix that violate the Company’s trademarks, which have been imported into the EEA without the Company’s permission.

     A hearing was held on April 29, 2003 regarding certain procedural issues. In a judgment rendered on May 27, 2003, the Judge of Seizures of the Court of First Instance referred the complaint to the Constitutional Court before rendering a final decision. The Judge of Seizures asked the Constitutional Court to render an opinion regarding certain constitutional issues related to the trademark infringement arguments the Company raised at the hearing. On March 24, 2004, the Constitutional Court issued its judgment which supported the Company’s claims. A hearing was scheduled for November 9, 2004 by the Judge of Seizures of the Court of First Instance to hear additional submissions. On December 21, 2004, the Judge of Seizures of the Court of First Instance decided against Euromedix’s opposition to certain procedural issues.

     After the decisions of the Judge of Seizures of the Court of First Instance, the Company filed requests for a procedural calendar in the three trademark infringement proceedings against Euromedix of which two are pending before the President of the Commercial Court of Leuven and one before the Commercial Court of Leuven. Both parties have exchanged submissions. All three cases have been pleaded at a hearing on June 21, 2005 and have been taken into deliberation. A judgment has not yet been rendered.

     Euromedix has filed a request for a procedural calendar in the case pending before the Commercial Court of Leuven regarding the termination of the business relationship on July 11, 2002. The Company has filed submissions and will file additional submissions by August 18, 2005. The case is set for pleadings at a hearing on November 8, 2005.

     On March 26, 2004, a putative class action lawsuit captioned Northshore Dermatology Center, S.C. v. Cholestech Corporation, and Does 1-10, Case No. 04CH05342, was filed in the Circuit Court of Cook County, Illinois. The Company was served with the complaint and summons on March 31, 2004. The complaint alleged that the Company violated the federal Telephone Consumer Protection Act and various Illinois state laws by sending unsolicited advertisements via facsimile transmission to residents of Illinois. The complaint sought class certification and statutory damages of $500 to $1,500 each on behalf of a class that would include all residents of Illinois who received an unsolicited facsimile advertisement from the Company. On January 18, 2005 the parties entered into an agreement to settle all claims on behalf of a nationwide class. Under the terms of the settlement, the Company paid $625,000 in cash to settle all claims, $600,000 of which was funded by insurance. The Company also agreed to pay up to $50,000 for providing notice to the class and for processing claims. The Court gave final approval to the settlement on July 11, 2005, and a final accounting is scheduled for November 2005.

     The Company is also subject to various additional legal claims and assessments in the ordinary course of business, none of which are expected by management to result in a material adverse effect on the financial statements.

7.

Comprehensive Income (Loss)

     The Company’s total comprehensive income (loss) was as follows (in thousands):

		Thirteen Weeks Ended
		June 24,				June 25,
		2005				2004
Net income (loss)		$	1,592			$	(345	)
Change in unrealized gain on investments, net			(66	)			(139	)
Change in future currency contracts			—				9
Total comprehensive income (loss)		$	1,526			$	(475	)

8.

Income Taxes

     For the thirteen weeks ended June 24, 2005, the Company recorded a provision for income taxes of $1 million for an effective tax rate of 39%. For the thirteen weeks ended June 25, 2004, the Company recorded a benefit for income taxes of $220,000, primarily resulting from the increase in the value of the net operating loss arising from the loss in the period.

     The realizability of the deferred tax assets is primarily dependent on the ability of the Company to generate income in the future. Subsequent changes in the Company’s estimate of future profitability could require the Company to change its estimate of the realizability of its deferred tax assets and record a valuation allowance. Such a change in estimate would result in a material deferred tax expense in the period of change.

9.

Warranties

     The Company records an accrual for estimated warranty costs when revenue is recognized. Warranty covers repair costs of the LDX Analyzer and replacement costs of defective single-use test cassettes. The warranty period for the LDX Analyzer is one year and for single use test cassettes is the shelf-life of the product. The warranty cost of the GDX Analyzer and test cartridges are the responsibility of the vendor. The Company has processes in place to estimate accruals for warranty exposure. The processes include estimated LDX Analyzer failure rates and repair costs, known design changes, and estimated replacement rates for single use test cassettes. Although the Company believes it has the ability to reasonably estimate warranty expenses, unforeseeable changes in factors impacting the estimate for warranty could occur and such changes could cause a material change in the Company’s warranty accrual estimate. Such a change would be recorded in the period in which the change was identified. Changes in the Company’s product warranty liability during the thirteen weeks ended June 24, 2005 and June 25, 2004, respectively, were as follows (in thousands):

		Thirteen Weeks Ended
		June 24,				June 25,
		2005				2004
Balance at the beginning of the year		$	286			$	314
Accruals and charges for warranty for the period			79				188
Cost of repairs and replacements			(114	)			(229	)
Balance		$	251			$	273

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     Certain statements in this Quarterly Report on Form 10-Q are “forward-looking statements” within the meaning of federal securities laws. These statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by the forward-looking statements. These risks and other factors include those listed under “Factors Affecting Future Operating Results” and elsewhere in this Quarterly Report on Form 10-Q. In some cases, you can identify forward-looking statements by terminology such as “may”, “will”, “should”, “expect”, “plan”, “anticipate”, “believe”, “estimate”, “predict”, “potential”, “continue” or the negative of these terms or other comparable terminology. Forward-looking statements include, but are not limited to, the following statements: recent significant developments that may have an impact on our company; anticipated future sales and marketing, research and development and general and administrative expenditures; anticipated income from cash and marketable securities and expected capital expenditures. In evaluating these statements, you should specifically consider various factors, including the risks outlined under “Factors Affecting Future Operating Results”. These factors may cause our actual results to differ materially from any forward-looking statement.

     Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of these forward-looking statements. We are under no duty to update any of the forward-looking statements after the date of this Quarterly Report on Form 10-Q to conform our prior statements to actual results.

     The following discussion and analysis of our financial condition and results of operations should be read together with our condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q.

Overview

     We are a leading provider of diagnostic tools and information for immediate risk assessment and therapeutic monitoring of heart disease and diabetes. We currently manufacture the LDX^® System (the “LDX System”), which includes the LDX Analyzer and a variety of single-use test cassettes and market the LDX System in the United States, Canada, Europe, Asia, Australia and Latin America. The LDX System, which is waived under the Clinical Laboratory Improvement Amendments (“CLIA”), allows healthcare providers to perform individual tests or combinations of tests with a single drop of blood from a fingerstick within five minutes. Our current products measure and monitor blood cholesterol, related lipids, glucose and liver function, and are used to test patients at risk of or suffering from heart disease, diabetes and liver disease. The LDX System can also provide the Framingham Risk Assessment from the patient’s results as measured on the lipid profile cassette. In the first thirteen weeks of fiscal year 2006, revenue from sales of the LDX Analyzer and single use test cassettes represented over 97% of our revenue.

     Our corporate headquarters is located in Hayward, California. All of our manufacturing, research, regulatory and administrative activities are conducted at this location. We sell our products through a worldwide network of over 85 distributors. We have 23 regional sales managers who coordinate and work with our distribution partners to identify and promote sales of our products. We also employ 18 field technical service representatives who are responsible for field customer service and customer retention initiatives within our existing installed base of products.

     We have experienced recent significant developments that may have an impact on our company, including the following:

	•		In June 2005, we announced that we had been granted a patent by the U.S. Patent Office (6,881,581) and the European Patent Office (EP 1,329,724) for a new method of measuring HDL in human blood. We believe that this patent provides a very different approach than those of other existing patents describing the measurement of HDL and that this patent also permits the development of the Cholestech LDX Lipid Profile/Alanine Amino-transferase (“Lipid/ALT”) cassette by preventing the interference of the HDL chemistry with the ALT assay on the same cassette.
	•		In June 2005, we announced that the Cholestech LDX® System has been certified by the Cholesterol Reference Method Laboratory Network (“CRMLN”). This certification validates that the system consistently meets the gold standard for accuracy and reproducibility developed by the Centers for Disease Control and Prevention (“CDC”) for the measurement of total cholesterol and HDL cholesterol consistent with National Cholesterol Education Program (“NCEP”) analytical goals.

Results of Operations

     The following table sets forth our results of operations (in thousands) expressed as a percentage of total revenue. Our historical operating results are not necessarily indicative of the results for any future period.

		Thirteen Weeks Ended
		June 24, 2005								June 25, 2004
																		Amount of				Percent
						% of								% of				Increase				Increase
		Amount				sales				Amount				sales				(Decrease)				(Decrease)
Revenue		$	15,065				100	%		$	9,553				100	%		$	5,512				58	%
Cost of revenue			5,472				36				4,004				42				1,468				37
Gross profit			9,593				64				5,549				58				4,044				73
Operating expenses
Sales and marketing			3,312				22				2,784				29				528				19
Research and development			1,067				7				902				9				165				18
General and administrative			2,755				18				2,443				26				312				13
Total operating expenses			7,134				47				6,129				64				1,005				16
Income (loss) from operations			2,459				16				(580	)			(6	)			3,039				524
Interest and other income			133				1				15				—				118				787
Provision (benefit) for income taxes			1,000				7				(220	)			(2	)			1,220				555
Net income (loss)		$	1,592				11	%		$	(345	)			(4	)%		$	1,937				561	%

Thirteen weeks ended June 24, 2005 and June 25, 2004

     Revenue. For the thirteen weeks ended June 24, 2005, revenue increased $5.5 million, or 58%, to $15.1 million from $9.6 million for the thirteen weeks ended June 25, 2004. Revenue in the prior year was significantly impacted by the Company’s decision to eliminate quarter-end discounts on large volume purchases by its distribution partners. Sales of single use test cassettes increased $5.2 million, or 68%, from $7.7 million for the thirteen weeks ended June 25, 2004 to $12.9 million for the thirteen weeks ended June 24, 2005. Revenue from sales of our LDX analyzer decreased $41,000, or 7%, to $577,000 for the thirteen weeks ended June 24, 2005 from $618,000 for the thirteen weeks ended June 25, 2004. Revenue from sales of our GDX analyzer and related products remained fairly consistent at $422,000 for the thirteen weeks ended June 24, 2005 compared to $475,000 for the thirteen weeks ended June 25, 2004.

     For the thirteen weeks ended June 24, 2005, domestic revenue increased $5.3 million, or 69%, to $13.0 million from $7.7 million for the thirteen weeks ended June 25, 2004. Most of the domestic increase related to revenue from single use test cassettes, which increased 77% or $4.9 million from the prior year period. Domestic LDX revenue increased $151,000, or 51%, to $448,000 for the thirteen weeks ended June 24, 2005 from $297,000 for the thirteen weeks ended June 25, 2004. Domestic revenue for our GDX Analyzer and related single use test cartridges decreased $27,000, or 7%, to $361,000 for the thirteen weeks ended June 24, 2005 from $388,000 for the thirteen weeks ended June 25, 2004.

     International revenue increased $166,000, or 9%, to $2.0 million for the thirteen weeks ended June 24, 2005 from $1.9 million for the thirteen weeks ended June 25, 2004. The revenue increase resulted from the sale of single use test cassettes which increased $328,000, or 25%, to $1.6 million for the thirteen weeks ended June 24, 2005 compared to $1.3 million for the thirteen weeks ended June 25, 2004. This was offset by a $191,000 decrease in international LDX revenue during the same period. Additionally, international revenue for our GDX and related single use test cartridges decreased $27,000, or 30%, to $62,000 for the thirteen weeks ended June 24, 2005 from $89,000 for the thirteen weeks ended June 25, 2004.

     Cost of Revenue. Cost of revenue includes direct labor, direct material, overhead and royalties. Cost of revenue increased $1.5 million, or 37%, to $5.5 million for the thirteen weeks ended June 24, 2005 from $4.0 million for the thirteen weeks ended June 25, 2004. Most of the increase related to increased unit volume of products sold. Gross margins were 64% and 58% for the thirteen weeks ended June 24, 200 and June 25, 2004, respectively. The improvement in gross margin was driven by an increase in the average selling price of products in the LDX analyzer business and increase in test cassette volume. During the thirteen weeks ended June 24, 2005, 86% of revenue was derived from cassette sales compared to 80% for the thirteen weeks ended June 25, 2004.

     Sales and Marketing Expenses. Sales and marketing expenses include salaries, commissions, bonuses, travel and expenses for outside services related to marketing programs. Sales and marketing expenses increased $528,000, or 19%, to $3.3 million for the thirteen weeks ended June 24, 2005 from $2.8 million for the thirteen weeks ended June 25, 2004. The increase was mainly attributable to increased headcount, higher commissions and trade show participation. As a percent of total revenue, sales and marketing expenses decreased to 22% for the thirteen weeks ended June 24, 2005 from 29% for the thirteen weeks ended June 25, 2004. Over the balance of the fiscal year, we expect sales and marketing expenses to remain consistent with first quarter levels as a percentage of total revenue.

     Research and Development Expenses. Research and development expenses include salaries, bonuses, expenses for professional consulting services, supplies and depreciation of capital equipment. Research and development expenses increased $165,000, or 18%, to $1.1 million for the thirteen weeks ended June 24, 2005 from $902,000 for the thirteen weeks ended June 25, 2004. The increase was mainly attributable to an increase in headcount relating to the development of new products. As a percent of total revenue, research and development expenses decreased to 7% for the thirteen weeks ended June 24, 2005 from 9% for the thirteen weeks ended June 25, 2004. Over the balance of the fiscal year, we expect research and development expenses to further increase as a percentage of total revenue as we prepare new products for the marketplace.

     General and Administrative Expenses. General and administrative expenses include compensation, benefits and expenses for outside professional services, including information services, legal and accounting. General and administrative expenses increased $312,000, or 13%, to $2.7 million for the thirteen weeks ended June 24, 2005 from $2.4 million for the thirteen weeks ended June 25, 2004. The increase was mainly attributable to an increase in headcount and higher fees for outside professional services and consulting, including legal and accounting, due to costs of compliance activities related to the Sarbanes-Oxley Act of 2002. These increases were partially offset by lower insurance premiums and decreased recruiting fees. As a percent of total revenue, general and administrative expenses decreased to 18% for the thirteen weeks ended June 24, 2005 from 26% for the thirteen weeks ended June 25, 2004. Over the balance of the fiscal year, we expect general and administrative expenses to remain consistent with first quarter levels.

     Interest and Other Income, Net. Interest and other income, net, reflects income from the investment of cash balances and marketable securities, less the fees charged by financial institutions. Interest income, net of expenses, increased $118,000, or 787%, to $133,000 for the thirteen weeks ended June 24, 2005 from $15,000 for the thirteen weeks ended June 25, 2004. The increase was primarily attributable an increase in cash and marketable securities and interest rates from the prior year.

     Income Taxes. For the thirteen weeks ended June 24, 2005, we recognized a provision for income taxes of $1 million, compared to an income tax benefit of $220,000 for the thirteen weeks ended June 25, 2004. The provision was related to the pretax income of $2.6 million.

Liquidity and Capital Resources

     Cash flow information for the thirteen weeks ended June 24, 2005 and June 25, 2004 was as follows (in thousands):

		June 24,				June 25,
		2005				2004
Cash, cash equivalents, marketable securities and long-term investments		$	34,681			$	25,460
Net cash provided by operating activities			1,723				2,313
Net cash used in investing activities			(997	)			(2,688	)
Net cash provided by financing activities			301				649
Net increase in cash and cash equivalents		$	1,027			$	274

     We have financed our operations primarily through the sale of equity securities, including employee stock option exercises, and net cash provided by operations. From our inception to June 24, 2005, we have raised $87.6 million in net proceeds from equity financings. In addition to these amounts, we have available a $4.0 million revolving bank line of credit agreement which was renewed in September 2004 and will expire in September 2006. While the agreement is in effect, we are required to deposit assets with a collective value, as defined in the line of credit agreement, equivalent to no less than 100% of the outstanding principal balance. Amounts outstanding under the line of credit bear interest at either our choice of 0.5% below the bank’s prime rate or 1.75% above the LIBOR rate, depending on the payment schedule. There are currently no amounts outstanding under this line of credit and as a result, there were no limitations on our deposited assets.

     Cash Provided by Operating Activities. The net cash provided by operations of $1.7 million for the thirteen weeks ended June 24, 2005 was primarily attributable to net income of $1.6 million and $1.5 million of non-cash adjustments including depreciation. A $1.4 million increase in working capital, other than cash, resulted from decreases in accounts payable and accrued liabilities, accrued payroll and benefits, and other liabilities. Accounts receivable and prepaid and other current assets also decreased $894,000 which was offset by a $247,000 increase in inventories.

     The net cash provided by operations of $2.3 million for the thirteen weeks ended June 25, 2004 was primarily attributable to decreased working capital other than cash. Reductions to accounts receivable, prepaid expenses and notes receivable combined with increased trade payables and accrued payroll provided $3.6 million of cash. This was offset by a net loss, non-cash adjustments and increased inventory which resulted in a $1.3 million use of cash. The reduction in accounts receivable related primarily to the decline in revenue during the fiscal quarter.

     Cash Provided by (Used in) Investing Activities. Investing activities resulted in the net use of $1.0 million of cash during the thirteen weeks ended June 24, 2005. Spending on additional manufacturing equipment, facilities improvements and software accounted for $877,000 of capital improvements, as well as a $120,000 purchase of marketable securities during the period. Over the remainder of the current fiscal year, we intend to spend approximately $3.7 million on additional capital expenditures for production equipment and other long lived assets.

     Investing activities resulted in the net use of $2.7 million of cash during the thirteen weeks ending June 25, 2004. Spending on additional manufacturing equipment and software accounted for $965,000 of capital improvements and we made a $1.7 million purchase of marketable securities during the period.

     Cash Provided by Financing Activities. Cash provided by financing activities for both the thirteen weeks ended June 24, 2005 and June 25, 2004 related to the issuance of common stock pursuant to the employee stock incentive plans. We raised $301,000 and $695,000 from the incentive programs for the thirteen weeks ended June 24, 2005 and June 25, 2004, respectively.

Critical Accounting Policies

     Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenue and expenses and disclosures at the date of the financial statements. On an ongoing basis, we evaluate our estimates, including those related to accounts receivable, inventories and income taxes. We use authoritative pronouncements, historical experience and other assumptions as the basis for making estimates. Actual results could differ from these estimates.

     We have made no changes to our critical accounting policies from those described in our most recent Annual Report on Form 10-K. For a description of critical accounting policies, please refer to the Annual Report on Form 10-K for the fiscal year ended March 25, 2005.

Recent Accounting Pronouncements

     We reviewed the current accounting literature and determined there are no recent pronouncements that will have a material impact on our financial statements.

Factors Affecting Future Operating Results

     Our revenue and operating results have varied significantly from quarter to quarter in the past and may continue to fluctuate in the future. As of June 24, 2005, we had an accumulated deficit of $23.1 million. We recorded a net profit of $4.9 million for fiscal year 2003, a net profit of $8.7 million for fiscal year 2004, and a net profit of $4.1 million for fiscal year 2005. The following are some of the factors that could cause our revenue, operating results and margins to fluctuate significantly from quarter to quarter:

	•		the timing and level of market acceptance of the LDX System and the GDX System;
	•		manufacturing problems, efficiencies, capacity constraints or delays;
	•		the timing of the introduction, availability and market acceptance of new tests and products;
	•		changes in demand for our products based on changes in third-party reimbursement policies, changes in government regulation and other factors;
	•		product pricing and discounts;
	•		the timing and level of expenditures associated with research and development activities;
	•		the timing, establishment and maintenance of strategic distribution arrangements and the success of the activities conducted under such arrangements;
	•		the timing of significant orders from, and shipments to, customers;
	•		competition from diagnostic companies with greater financial capital and resources;
	•		costs and timing associated with business development activities, including potential licensing of technologies or intellectual property rights;
	•		additions or departures of our key personnel;
	•		promotional program spending by both domestic and European pharmaceutical companies;
	•		variations in the mix of products sold; and
	•		litigation or the threat of litigation.

     These and other factors are difficult to predict and could have a material adverse effect on our business, financial condition and operating results. Fluctuations in quarterly demand for our products may cause our manufacturing operations to fluctuate in volume, increase uncertainty in operational planning and/or affect cash flows from operations. We commit to many of our expenses in advance, based on our expectations of future business needs. These costs are largely fixed in the short-term. As a result, when business levels do not meet expectations, our fixed costs will not be recovered and we will experience losses. This situation is likely to result in the future because of the variability and unpredictability of our revenue. This also means that our results will likely not meet the expectations of public market security analysts or investors at one time or another, which may result in the market price of our common stock declining.

     Our success depends in part on our ability to develop and maintain the proprietary aspects of our technology and operate without infringing the proprietary rights of others. We have ten United States patents, one German patent and have filed patent applications relating to our technology internationally under the Patent Cooperation Treaty and individual foreign patent applications. The risks of relying on the proprietary nature of our technology include:

	•		our pending patent applications may not result in the issuance of any patents, or, if issued, such patents may not offer protection against competitors with similar technology;
	•		our patents may be challenged, invalidated or circumvented in the future, and the rights created under our patents may not provide a competitive advantage;
	•		competitors, many of whom have substantially greater resources than us and have made substantial investments in competing technologies, may seek to apply for and obtain patents covering technologies that are more effective than ours. This could render our technologies or products obsolete or uncompetitive or could prevent, limit or interfere with our ability to make, use or sell our products either in the United States or in international markets;
	•		the medical products industry has been characterized by extensive litigation regarding patents and other intellectual property rights; and
	•		an adverse determination in litigation or interference proceedings to which we may become a party could subject us to significant liabilities to third parties or require us to seek licenses from third parties, which may not be available on commercially reasonable terms or at all.

     We may in the future become subject to patent infringement claims and litigation or interference proceedings conducted in the United States Patent and Trademark Office to determine the priority of inventions. Litigation may also be necessary to enforce any patents issued to us, to protect our trade secrets or know-how or to determine the enforceability, scope and validity of the proprietary rights of others. The defense and prosecution of intellectual property suits, patent interference proceedings and related legal and administrative proceedings are both costly and time consuming and will likely result in substantially diverting the attention of technical and management personnel from our business operations. We may also be subject to significant damages or equitable remedies regarding the development and sale of our products and operation of our business.

     For example, in fiscal year 2004, we entered into a settlement agreement and license agreement with Roche, which settled all existing patent litigation between the parties on a worldwide basis. As a part of the settlement, we pay Roche an ongoing royalty and Roche granted an irrevocable, non-exclusive, worldwide license to us for its patents related to HDL cholesterol. In addition, the parties also agreed upon a mechanism for the resolution of future patent infringement disputes. We believe that any such dispute resolution will confirm that our HDL cholesterol test cassette, currently under development, does not infringe Roche’s patents. If however, upon the resolution of any such dispute, it is ultimately determined that our new HDL cholesterol test cassette is covered by Roche’s patents, we will pay Roche the same ongoing royalty.

     We rely on trade secrets, technical know-how and continuing invention to develop and maintain our competitive position. Others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets or disclose such technology. We may also be unable to adequately protect our trade secrets, or be capable of protecting our rights to our trade secrets.

     Our current products incorporate technologies that are the subject of patents issued to, and patent applications filed by, others. We have obtained licenses for certain of these technologies. We may in the future be required to negotiate to obtain licenses for new products. Some of our current licenses are subject to rights of termination and may be terminated. Our licensors may not abide by their contractual obligations and, as a result, may limit the benefits we currently derive from their licenses. We may be unable to renegotiate or obtain licenses for technology patented by others on commercially reasonable terms, or at all. We also may be unable to develop alternative approaches if we are unable to obtain licenses. Our future licenses may also not be adequate for the operation of our business. Failure to obtain, maintain or enforce necessary licenses on commercially reasonable terms or to identify and implement alternative approaches could prevent us from introducing our products and severely harm our business.

     The market price of our common stock has in the past been, and in the future is likely to be, highly volatile. For example, between June 25, 2004 and June 24, 2005, the price of our common stock, as reported on the NASDAQ National Market System, has ranged from a low of $6.39 to a high of $13.20. These fluctuations could result in substantial losses for investors. Our stock price may fluctuate for a number of reasons including:

	•		quarterly variations in our operating results;
	•		litigation or threat of litigation;
	•		developments in or disputes regarding patent or other proprietary rights;
	•		announcements of technological or competitive developments by us and our competitors;
	•		regulatory developments regarding us or our competitors;
	•		changes in the current structure of the healthcare financing and payment systems;
	•		our failure to achieve, or changes in, financial estimates by securities analysts and comments or opinions about us by securities analysts or major shareholders;
	•		stock market price and volume fluctuations, which have particularly affected the market prices for medical products and high technology companies and which are often been unrelated to the operating performance of such companies; and
	•		general economic, political and market conditions.

     With the advent of the internet, new avenues have been created for the dissemination of information. We do not have control over the information that is distributed and discussed on electronic bulletin boards and investment chat rooms. The motives of the people or organizations that distribute such information may not be in our best interest or in the interest of our shareholders. This, in addition to other forms of investment information, including newsletters and research publications, could result in a significant decline in the market price of our common stock.

     In addition, stock markets have from time to time experienced extreme price and volume fluctuations. The market prices for diagnostic product companies have been affected by these market

fluctuations and such effects have often been unrelated to the operating performance of such companies. These broad market fluctuations may cause a decline in the market price of our common stock.

     Securities class action litigation is often brought against a company after a period of volatility in the market price of its stock. This type of litigation has been brought against us in the past and could be brought against us in the future, which could result in substantial expense and damage awards and divert management’s attention from running our business.

     In the United States, healthcare providers that purchase products such as the LDX System and the GDX System generally rely on their patients’ healthcare insurers, including private health insurance plans, federal Medicare, state Medicaid and managed care organizations, to reimburse all or part of the cost of the procedure in which the product is being used. We will be unable to successfully market our products if their purchase and use is not subject to reimbursement from government health authorities, private health insurers and other third-party payors. If this reimbursement is not available or is limited, healthcare providers will be much less likely to use our products, our sales will be greatly reduced and our business may fail.

     There are current conditions in the healthcare industry that increase the possibility that third-party payors may reduce or eliminate reimbursement for tests using our products in certain settings. These conditions include:

	•		third-party payors are increasingly scrutinizing and challenging the prices charged for both existing and new medical products and services;
	•		healthcare providers are moving toward a system in which employers are requiring participants to bear a greater burden of the cost of their healthcare benefits which could result in fewer elective procedures, such as the use of our products for diagnostic screening;
	•		general uncertainty regarding what changes will be made in the reimbursement methods used by third-party payors and how that will affect the use of products such as ours, which may deter healthcare providers from adopting the use of our products; and
	•		an overall escalating cost of medical products and services has led to and will continue to lead to increased pressures on the healthcare industry, both domestic and international, to reduce the cost of products and services, including products offered by us.

     Market acceptance of our products in international markets is also dependent, in part, on the availability of reimbursement or funding, as the case may be, within prevailing healthcare systems. Reimbursement, funding and healthcare payment systems in international markets vary significantly by country and include both government sponsored healthcare and private insurance. Third-party reimbursement and coverage may not be available or adequate in either the United States or international markets, and current reimbursement or funding amounts may be decreased in the future. Also, future legislation, regulation or reimbursement policies of third-party payors may adversely affect demand for our products or our ability to sell our products on a profitable basis. Any of these events could materially harm our business.

     We believe that the healthcare industry in the United States is likely to undergo fundamental changes due to current political, economic and regulatory influences. We anticipate that Congress, state legislatures and the private sector will continue to review and assess alternative healthcare delivery and payment systems. Potential alternatives include mandated basic healthcare benefits, controls on healthcare spending through limitations on the growth of private health insurance premiums and Medicare and Medicaid spending, the creation of large insurance purchasing groups, price controls and other fundamental changes to the healthcare delivery system. We expect legislative debate to continue in the future and for market forces to demand reduced costs. We cannot predict what impact the adoption of any federal or state healthcare reform measures, future private sector reform or market forces may have on our business. Any changes in the healthcare system could potentially have extremely negative effects on our business.

     To increase revenue and achieve sustained profitability, we will have to successfully maintain our existing distribution relationships and develop new distribution relationships. We depend on our distributors to assist us in promoting market acceptance of the LDX System and the GDX System. However, we may be unable to enter into and maintain new arrangements on a timely basis, or at all. Even if we do enter into additional distributor relationships, those distributors may not devote the resources necessary to provide effective sales and marketing support to our products. In addition, our distributors sell products offered by our competitors. If our competitors offer our distributors more favorable terms or have more products available to meet their needs or utilize the leverage of broader product lines sold through the distributor, those distributors may de-emphasize or decline to carry our products. In addition, our distributors’ order decision-making process is complex and involves several factors, including end-user demand, warehouse allocation and marketing resources, which can make it difficult to accurately predict total sales for the quarter until late in the quarter. In order to keep our products included in distributors’ marketing programs, in the past we have provided promotional goods or made short-term pricing concessions. The discontinuation of promotional goods or pricing concessions could have a negative effect on our business. Our distributors could also modify their business practices, such as payment terms, inventory levels or order patterns. If we are unable to maintain successful relationships with distributors or expand our distribution channels or we experience unexpected changes in payment terms, inventory levels or other practices by our distributors, our business will suffer.

     Our product sales are primarily made through our network of over 85 domestic and international distributors. As a result, our financial results, quarterly product sales, trends and comparisons are affected by fluctuations in the buying patterns of end-user customers and our distributors, and by the changes in inventory levels of our products held by these distributors. We have only limited visibility over the inventory levels of our products held by our domestic and international distributors. While we attempt to assist our distributors in maintaining targeted stocking level of our products, we may not consistently be accurate or successful. This process involves the exercise of judgment and use of assumptions as to future uncertainties including end-user customer demand, and the reaction of our distributors to our new quarterly pricing policy. Consequently, actual results could differ from our

estimates. Inventory levels of our products held by our distributors may exceed or fall below the levels we consider desirable on a going-forward basis, which may harm our financial results due to unexpected buying patterns of our distributors or our ability to efficiently manage or invest in internal resources, such as manufacturing and shipping capacity, to meet the actual demand for our products.

     The market for diagnostic products in which we operate is intensely competitive. Our business is based on the sale of diagnostic products that physicians and other healthcare providers can administer in their own facilities without sending samples to laboratories. Thus, our competition consists primarily of clinical reference laboratories and hospital-based laboratories that use automated testing systems, as well as manufacturers of other rapid diagnostic tests. To achieve and maintain market acceptance for the LDX System and the GDX System, we must demonstrate that the LDX System and the GDX System are cost effective and time saving alternatives to other rapid diagnostic tests as well as to clinical and hospital laboratories. Even if we can demonstrate that our products are more cost effective and save time, physicians and other healthcare providers may resist changing their established source of such tests. The LDX System and the GDX System may be unable to compete with these other testing services and analyzers. In addition, companies with a significant presence in the market for clinical diagnostics, such as Abbott Laboratories, Bayer Diagnostics, Beckman Coulter, Inc. and Roche Diagnostics (a subsidiary of Roche Holdings, Ltd.) have developed or are developing analyzers designed for point of care testing. These competitors have substantially greater financial, technical, research and other resources and larger, more established marketing, sales, distribution and service organizations than us. These competitors also offer broader product lines than us, have greater name recognition than us and offer discounts as a competitive tactic. In addition, several smaller companies are currently making or developing products that compete or will compete with ours. We may not have the financial resources, technical expertise or marketing, distribution or support capabilities to compete successfully in the future. Even if we do have such resources and capabilities, we may not employ them successfully.

     Our LDX System, including the LDX Analyzer and single use test cassettes, currently accounts for substantially all of the revenue of our business. If this revenue does not grow, our overall business will be severely harmed. In addition, we have limited experience marketing and distributing the GDX System, and it is uncertain whether this product will achieve broad market acceptance in our target markets and generate significant revenue in the future. For us to increase revenue, sustain profitability and maintain positive cash flows from operations, the LDX System and the GDX System must continue to and begin to gain market acceptance among healthcare providers, particularly physician office laboratories. We have made only limited sales of the LDX System to physician office laboratories to date relative to the size of the available market. Factors that could prevent broad market acceptance of the LDX System and the GDX System include:

	•		low levels of awareness of the availability of our technology in both the physician and other customer groups;
	•		the availability and pricing of other testing alternatives;
	•		a decrease in the amount of reimbursement for performing tests on the LDX System and the GDX System;
	•		many managed care organizations have contracts with laboratories, which require participating or employed physicians to send patient specimens to contracted laboratories; and

•

physicians are under growing pressure by Medicare and other third-party payors to limit their testing to “medically necessary” tests.

     If our LDX System does not achieve broader market acceptance and our GDX System does not achieve favorable market acceptance, our business will not grow. Even if we are successful in continuing to place our LDX Analyzer at physician office laboratories and other near-patient testing sites and marketing our GDX System, there can be no assurance that placement of these products will result in sustained demand for our single use test cassettes and single use test cartridges.

     In addition, we must leverage our installed base of systems in order to increase the sales of our single use test cassettes and single use test cartridges. If we are unable to increase the usage of cassettes on our current installed base, we will have to identify new customers and induce them to purchase an analyzer, which requires more time and effort and has a significantly larger purchase price than the single use test cassettes.

     As a result of these many hurdles to achieving broad market acceptance for the LDX System and the GDX System, demand may not be sufficient to sustain revenue and profits from operations. Because the LDX System currently contributes the vast majority of our revenue, and we expect the GDX System to contribute a portion of our revenue in the future, we could be required to cease operations if the LDX System and the GDX System do not achieve and maintain a significant level of market acceptance.

     We believe our business will not grow significantly if we do not develop, acquire or form alliances for new tests and products to use in conjunction with the LDX System and the GDX System. If we do not develop market and introduce new tests and products to the market, our business will not grow significantly and will be harmed. Developing new tests involves many significant problems and risks, including:

	•		research and development is a very expensive process;
	•		research and development takes a very long time to result in a marketable product;
	•		significant costs (including diversion of resources) may be incurred in development before knowing if the development will result in a test that is commercially viable;
	•		a new test will not be successful unless it is effectively marketed to its target market;
	•		the manufacturing process for a new test must be reliable, cost efficient and high volume and must be developed and implemented in a timely manner to produce the test for sale;
	•		new tests must meet a significant market need to be successful; and
	•		new tests must obtain proper regulatory approvals to be marketed.

     We could experience difficulties that delay or prevent the successful development, introduction and marketing of new tests and products. For example, regulatory clearance or approval of any new tests or products may not be granted on a timely basis, or at all. We have experienced difficulties obtaining regulatory approval for tests in the past. Because the evaluation of applications by the FDA for CLIA waived status is not based on precisely defined, objectively measurable criteria, we cannot predict the likelihood of obtaining CLIA waived status for future products. In addition, our business strategy includes entering into agreements with clinical and commercial collaborators and other third parties for the development, clinical evaluation and marketing of existing products and products under

development. These agreements may be subject to rights of termination and may be terminated without our consent. The parties to these agreements also may not abide by their contractual obligations to us and may discontinue or sell their current lines of business. Research performed under a collaboration for which we receive or provide funding may not lead to the development of products in the timeframe expected, or at all. If these agreements are terminated earlier than expected, or if third parties do not perform their obligations to us properly and on a timely basis, we may not be able to successfully develop new products as planned, or at all.

     We manufacture all of the single use test cassettes that are used with the LDX Analyzer. The manufacture of single use test cassettes is a highly complex and precise process that is sensitive to a wide variety of factors. Significant additional resources, implementation of additional manufacturing equipment or changes in our manufacturing processes have been, and may continue to be, required for the scaling-up of each new product prior to commercialization or in order to meet increasing customer demand once commercialization begins, and this work may not be completed successfully or efficiently. In the past, we have experienced lower than expected manufacturing yields that have adversely affected gross margins and delayed product shipments. If we do not maintain acceptable manufacturing yields of test cassettes or experience product shipment delays, our business, financial condition and operating results could be materially adversely affected. We may reject or be unable to sell a substantial percentage of test cassettes because of:

	•		raw materials variations or impurities;
	•		human error;
	•		manufacturing process variances and impurities; and
	•		decreased manufacturing equipment performance.

     Our LDX manufacturing equipment and cassette manufacturing lines would be costly and time consuming to repair or replace if their operation were interrupted. The interruption of our manufacturing operations or the loss of associates dedicated to the manufacturing facility could severely harm our business. The risks involving our manufacturing lines include:

	•		as our production levels have increased, we could be required to use our machinery more hours per day and the down time resulting from equipment failure could increased;
	•		the custom nature of much of our manufacturing equipment increases the time required to remedy equipment failures and replace equipment;
	•		we have a limited number of associates dedicated to the operation and maintenance of our manufacturing equipment, the loss of whom could impact our ability to effectively operate and service such equipment;
	•		we manufacture all of our cassettes at our Hayward, California manufacturing facility, so manufacturing operations are at risk to interruption from earthquake, fire, power outages or other events affecting this one location; and
	•		our newest manufacturing line is operating at production capability. Our failure to maintain production levels and operate this line at production capability for an extended period would impact our ability to increase our manufacturing capacity.

     We believe we will be required to reduce manufacturing costs for new and existing test cassettes to achieve sustained profitability. We currently manufacture the majority of our dry chemistry cassettes on a single production line. A second manufacturing line is currently used for overflow production and for research and development purposes. The complexity and custom nature of our manufacturing process increases the amount of time and money required to add an additional manufacturing line. In addition, we may need to implement additional cassette manufacturing cost reduction programs. Failure to maintain full production levels for our newest manufacturing line could prevent us from satisfying customer orders in a timely manner, which could lead to customer dissatisfaction and loss of business and a failure to reduce manufacturing costs for dry chemistry tests, which could prevent us from achieving sustained profitability.

     Historically, a significant portion of our total revenue has been generated outside of the United States. International revenue as a percentage of our total revenue was approximately 14% in fiscal year 2005 and 14% in fiscal year 2004. We anticipate that international revenue will continue to represent a significant portion of our total revenue in the future. Our revenue is generally denominated in United States dollars; however, a strengthening of the dollar could make our products less competitive in foreign markets and, as a result, our future revenue from international operations may be unpredictable. We make foreign currency denominated purchases related to our GDX System in the United Kingdom. This exposes us to risks associated with currency exchange fluctuations. To minimize this risk, we have undertaken certain foreign currency hedging transactions; however, weakening of the dollar could make the cost of the GDX System less competitive in the domestic market, resulting in less predictable domestic revenue.

In addition to foreign currency risks, our international sales and operations may also be subject to the following risks:

	•		our dependency on pharmaceutical companies’ promotional programs as a primary source of international revenue;
	•		unexpected changes in regulatory requirements;
	•		the impact of recessions in economies outside the United States;
	•		changes in a specific country’s or region’s political or economic conditions, particularly in emerging nations;
	•		less effective protection of intellectual property rights in some countries;
	•		changes in tariffs and other trade protection measures;
	•		difficulties in managing international operations; and
	•		potential insolvency of international distributors and difficulty in collecting accounts receivable and longer collection periods.

     If we are unable to minimize the foregoing risks, they may harm our current and future international sales and, consequently, our business.

     We currently depend on single source vendors to provide certain subassemblies, components and raw materials used in the manufacture of our products. We also depend on a third-party manufacturer for the GDX System. Any supply interruption in a single sourced material or product could restrict our ability to manufacture and distribute products until a new source of supply is identified and qualified. We may not be successful in qualifying additional sources of supply on a timely basis, or at all. Failure to obtain a usable alternative source or product could prevent us from manufacturing and distributing our products, resulting in inability to fill orders, customer dissatisfaction and loss of business. This would likely severely harm our business. In addition, an uncorrected impurity or supplier’s variation in material, either unknown to us or incompatible with our manufacturing process, could interfere with our ability to manufacture and distribute products. Because we are a small customer of many of our suppliers and we purchase their subassemblies, components and materials with purchase orders instead of long-term commitments, our suppliers may not devote adequate resources to supplying our needs. Any interruption or reduction in the future supply of any materials currently obtained from single or limited sources could severely harm our business.

     Sales to a limited number of customers have accounted for a significant portion of our revenue in each fiscal period. We expect that sales to a limited number of customers will continue to account for a substantial portion of our total revenue in future periods. Our top ten customers comprised approximately 67% of our revenue in fiscal year 2005. In fiscal year 2005, Physicians Sales and Service accounted for approximately 24% of our total revenue, Henry Schein Inc. accounted for approximately 9% and McKesson Medical Surgical accounted for approximately 7% of our total revenue. In fiscal year 2004, Physicians Sales and Service accounted for approximately 23% of our total revenue, Henry Schein Inc. accounted for approximately 9% and McKesson Medical Surgical accounted for approximately 8% of our total revenue. We have experienced periods in which sales to some of our major customers, as a percentage of total revenue, have fluctuated due to delays or failures to place expected orders. We do not have long-term agreements with any of our customers, who generally purchase our products pursuant to cancelable short-term purchase orders. If we were to lose a major customer or if orders by or shipments to a major customer were to otherwise decrease or be delayed, our operating results would be harmed.

     The Sarbanes-Oxley Act of 2002 along with other recent and proposed rules from the Securities and Exchange Commission and NASDAQ require changes in our corporate governance, public disclosure and compliance practices. Many of these new requirements will increase our legal and financial compliance costs, and make some corporate actions more difficult, such as proposing new or amendments to stock option plans, which now require shareholder approval. These developments could make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These developments also could make it more difficult for us to attract and retain qualified executive officers and qualified members of our board of directors, particularly to serve on our audit committee.

     The manufacture and sale of our diagnostic products, including the LDX System and the GDX System, is subject to extensive regulation by numerous governmental authorities, principally the FDA and corresponding state and foreign regulatory agencies. We are unable to commence marketing or commercial sales in the United States of any of the new tests we develop until we receive the required clearances and approvals. The process of obtaining required regulatory clearances and approvals is lengthy, expensive and uncertain. As a result, our new tests under development, even if successfully developed, may never obtain such clearance or approval. Additionally, certain material changes to products that have already been cleared or approved are subject to further review and clearance or approval. Medical devices are subject to continual review, and later discovery of previously unknown problems with a cleared product may result in restrictions on the product’s marketing or withdrawal of the product from the market. If we lose previously obtained clearances, or fail to comply with existing or future regulatory requirements, we may be unable to market the affected products, which would depress our revenue and severely harm our business.

     In addition, any future amendment or addition to regulations impacting our products could prevent us from marketing the LDX System and the GDX System. Regulatory changes could hurt our business by increasing burdens on our products or by reducing or eliminating certain competitive advantages of the LDX System’s and the GDX System’s waived status. Food and Drug Administration clearance or approval of products such as ours can be obtained by either of two processes:

	•		the 510(k) clearance process, which generally takes from four to 12 months but may take longer; and
	•		the pre-market approval process, which is a longer and more costly process than a 510(k) clearance process, involves the submission of extensive supporting data and clinical information and generally takes one to three years but may take significantly longer.

     If our future products are required to obtain a pre-market approval, this would significantly delay our ability to market those tests and significantly increase the costs of development.

     The use of our products and those of our competitors is also affected by federal and state regulations, which provide for regulation of laboratory testing, as well as by the laws and regulations of foreign countries. The scope of these regulations includes quality control, proficiency testing, personnel standards and inspections. In the United States, clinical laboratory testing is regulated under the Clinical Laboratory Improvement Act of 1976.

     The LDX Analyzer, our total cholesterol, high density lipoproteins, triglycerides and glucose tests in any combination, our ALT test cassette, the GDX Analyzer and A1C test cartridges have been classified as waived from the application of many of the requirements under the CLIA. We believe this waived classification is critical for our products to be successful in their domestic markets. Any failure of our new tests to obtain waived status under the CLIA will severely limit our ability to commercialize such tests. Loss of waived status for existing diagnostic products or failure to obtain waived status for new products could limit our revenue from sales of such products, which would severely harm our business.

     Our manufacturing processes and, in certain instances, those of our contract manufacturers, are subject to stringent federal, state and local regulations governing the use, generation, manufacture,

storage, handling and disposal of certain materials and wastes. Failure to comply with present or future regulations could result in many things, including warning letters, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, refusal of the government to grant pre-market clearance or pre-market approval for devices, withdrawal of approvals and criminal prosecution. Any of these developments could harm our business. We and our contract manufacturers are also subject to federal, state and foreign regulations regarding the manufacture of healthcare products and diagnostic devices, including:

	•		Quality System Regulations, which requires manufacturers to be in compliance with Food and Drug Administration regulations;
	•		ISO9001/EN46001 requirements, which is an industry standard for maintaining and assuring conformance to quality standards; and
	•		other foreign regulations and state and local health, safety and environmental regulations, which include testing, control and documentation requirements.

     Changes in existing regulations or adoption of new governmental regulations or policies could prevent or delay regulatory approval of our products or require us to incur significant costs to comply with manufacturing and environmental regulations, which could harm our business.

     We continue to evaluate strategic opportunities available to us and we may pursue product, technology or business acquisitions. These acquisitions could be very costly, could result in dilution to existing investors and could result in integration problems that harm our business as a whole. Any acquisition could result in expending significant amounts of cash, issuing potentially dilutive equity securities or incurring debt or unknown liabilities associated with the acquired business. In addition, our acquisitions may not be successful in achieving our desired strategic objectives, which could materially harm our operating results and business. Acquisitions may also result in difficulties in assimilating the operations, technologies, products, services and personnel of the acquired company or business or in achieving the cost savings or other financial benefits we anticipated. These difficulties could result in additional expenses, diversion of management attention and an inability to respond quickly to market issues. Any of these results could harm us financially.

     If we are successful in achieving and maintaining market acceptance for the LDX System and the GDX System, we will be required to expand our operations, particularly in the areas of sales, marketing and manufacturing. As we expand our operations, this expansion will likely result in new and increased responsibilities for management personnel and place significant strain on our management, operating and financial systems and resources. To accommodate any such growth and compete effectively, we will be required to implement and improve our information systems, procedures and controls, and to expand, train, motivate and manage our work force. Our personnel, systems, procedures and controls may not be adequate to support our future operations. Any failure to implement and improve operational, financial and management systems or to manage our work force as required by future growth, if any, could harm our business and prevent us from improving our financial condition as a result of increased sales.

     Our success depends in significant part on the continued service of certain key scientific, technical, regulatory and managerial personnel. Our success will also require us to continue to identify, attract, hire and retain additional highly qualified personnel in those areas. Competition for qualified personnel in our industry is very competitive due to the limited number of people available with the necessary technical skills and understanding of our industry. We may be unable to retain our key personnel or attract or retain other necessary highly qualified personnel in the future, which would harm the development of our business.

     Sale and use of our products and the past performance of testing services by our formerly wholly owned subsidiary could lead to the filing of a product liability or professional liability claim. If any of these claims are brought, we may have to expend significant resources defending against them. If we are found liable for any of these claims, we may have to pay damages that could severely hurt our financial position. Loss of these claims could also hurt our reputation, resulting in our losing business and market share. The medical testing industry has historically been litigious, and we face financial exposure to these liability claims if use of our products results in personal injury or improper diagnosis. We also face the possibility that defects in the design or manufacture of our products might necessitate a product recall.

     We currently maintain product liability insurance and professional liability insurance for claims relating to the past performance of testing services, but there can be no assurance that the coverage limits of our insurance policies will be adequate. Insurance is expensive and difficult to obtain, and we may be unable to maintain product liability insurance in the future on acceptable terms or in sufficient amounts to protect us against losses due to product liability. Inability to maintain insurance at an acceptable cost or to otherwise protect against potential product liability could prevent or inhibit the continued commercialization of our products. In addition, a product liability or professional liability claim in excess of relevant insurance coverage or a product recall could severely harm our financial condition.

     We intend to expend substantial funds for capital expenditures and working capital related to research and development, expansion of sales and marketing activities and other working capital and general corporate purposes. Although we believe our cash, cash equivalents, marketable securities, cash flow anticipated to be generated by future operations and available bank borrowings under an existing line of credit will be sufficient to meet our operating requirements for the foreseeable future, we may still require additional financing. For example, we may be required to expend greater than anticipated funds if unforeseen difficulties arise in expanding manufacturing capacity for existing cassettes or in the course of completing required additional development, obtaining necessary regulatory approvals, obtaining waived status under CLIA or introducing or scaling up manufacturing for new tests.

     If we need additional capital in the future, we may seek to raise additional funds through public or private financing, collaborative relationships or other arrangements. Any additional equity financing may be dilutive to our existing shareholders or have rights, preferences and privileges senior to those of our existing shareholders. If we raise additional capital through borrowings, the terms of such

borrowings may impose limitations on how our management may operate the business in the future. Collaborative arrangements, if necessary to raise additional funds, may require us to relinquish our rights to technologies, products or marketing territories. Our failure to raise capital on acceptable terms when needed could prevent us from developing our products and our business.

     Our board of directors has the authority to issue up to 5,000,000 shares of preferred stock and to determine the rights, preferences, privileges and restrictions of such shares without any further vote or action by our shareholders. To date, our board of directors has designated 25,000 shares as Series A participating preferred stock in connection with our “poison pill” anti-takeover plan. The issuance of preferred stock under certain circumstances could have the effect of delaying or preventing an acquisition of our company or otherwise adversely affecting the rights of the holders of our stock. The “poison pill” may have the effect of rendering more difficult or discouraging an acquisition of our company which is deemed undesirable by our board of directors. The “poison pill” may cause substantial dilution to a person or group attempting to acquire us on terms or in a manner not approved by our board of directors, except pursuant to an offer conditioned on the negation, purchase or redemption of the rights issued under the “poison pill.”

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

For quantitative and qualitative disclosures about market risk affecting us, see Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” of our Annual Report on Form 10-K for the fiscal year ended March 25, 2005, which is incorporated herein by reference. Our exposure to market risk has not changed materially since March 25, 2005.

ITEM 4. CONTROLS AND PROCEDURES

     Evaluation of Disclosure Controls and Procedures. Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Exchange Act of 1934, as amended) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective as of June 24, 2005 to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

     Changes in Internal Control Over Financial Reporting. There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

     On August 2, 2002, N.V. Euromedix (“Euromedix”) filed suit against the Company in the Commercial Court in Leuven, Belgium (No. F5700-02), seeking damages for the wrongful termination of an implied distribution agreement with the Company for Europe and parts of the Middle East. On November 7, 2002, the court dismissed the suit. On December 31, 2002, Euromedix filed suit against the Company in the Commercial Court in Leuven, Belgium (No. B/02/00044), seeking damages in the amount of approximately €3.5 million for the wrongful termination of an implied distribution agreement with the Company for Europe and parts of the Middle East. At the introductory hearing on April 1, 2003, the case was sent to the general docket and there have been no further developments. The Company believes this claim is without merit and intends to continue to defend the claim vigorously.

     On March 14, 2003, the Company initiated trademark infringement proceedings against Euromedix before the President of the Commercial Court in Leuven, Belgium (No. BRK/03/00017), seeking in principle an order (i) to prohibit Euromedix from selling, stocking, importing, exporting or promoting in the European Economic Area (EEA) products that violate the Company’s trademarks, under a penalty of €10,000 for each LDX Analyzer sold, a penalty of €1,000 for each cassette sold contrary to the prohibition and a €25,000 penalty for each publicity of advertisement for such products; (ii) to prohibit Euromedix from using certain slogans and phrases, in combination with products associated with certain of the Company’s trademarks, in trade documents or other announcements, under a penalty of €25,000 for each document used contrary to this prohibition; and (iii) to order the destruction of the inventory of products held by Euromedix that violate the Company’s trademarks, which have been imported into the EEA without the Company’s permission.

     A hearing was held on April 29, 2003 regarding certain procedural issues. In a judgment rendered on May 27, 2003, the Judge of Seizures of the Court of First Instance referred the complaint to the Constitutional Court before rendering a final decision. The Judge of Seizures asked the Constitutional Court to render an opinion regarding certain constitutional issues related to the trademark infringement arguments the Company raised at the hearing. On March 24, 2004, the Constitutional Court issued its judgment which supported the Company’s claims. A hearing was scheduled for November 9, 2004 by the Judge of Seizures of the Court of First Instance to hear additional submissions. On December 21, 2004, the Judge of Seizures of the Court of First Instance decided against Euromedix’s opposition to certain procedural issues.

     After the decisions of the Judge of Seizures of the Court of First Instance, the Company filed requests for a procedural calendar in the three trademark infringement proceedings against Euromedix of which two are pending before the President of the Commercial Court of Leuven and one before the Commercial Court of Leuven. Both parties have exchanged submissions. All three cases have been pleaded at a hearing on June 21, 2005 and have been taken into deliberation. A judgment has not yet been rendered.

     Euromedix has filed a request for a procedural calendar in the case pending before the Commercial Court of Leuven regarding the termination of the business relationship on July 11, 2002. The Company has filed submissions and will file additional submissions by August 18, 2005. The case is set for pleadings at a hearing on November 8, 2005.

     On March 26, 2004, a putative class action lawsuit captioned Northshore Dermatology Center, S.C. v. Cholestech Corporation, and Does 1-10, Case No. 04CH05342, was filed in the Circuit Court of Cook County, Illinois. The Company was served with the complaint and summons on March 31, 2004. The complaint alleged that the Company violated the federal Telephone Consumer Protection Act and various Illinois state laws by sending unsolicited advertisements via facsimile transmission to residents of Illinois. The complaint sought class certification and statutory damages of $500 to $1,500 each on behalf of a class that would include all residents of Illinois who received an unsolicited facsimile advertisement from the Company. On January 18, 2005 the parties entered into an agreement to settle all claims on behalf of a nationwide class. Under the terms of the settlement, the Company paid $625,000 in cash to settle all claims, $600,000 of which was funded by insurance. The Company also agreed to pay up to $50,000 for providing notice to the class and for processing claims. The Court gave final approval to the settlement on July 11, 2005, and a final accounting is scheduled for November 2005.

     The Company is also subject to various additional legal claims and assessments in the ordinary course of business, none of which are expected by management to result in a material adverse effect on the financial statements.

ITEM 6. EXHIBITS

10.61		Transition Agreement dated July 25, 2005 between Registrant and Thomas E. Worthy
31.1		Certification of Chief Executive Officer under Rule 13a-14(a)
31.2		Certification of Chief Financial Officer under Rule 13a-14(a)
32		Certifications of Chief Executive Officer and Chief Financial Officer under Rule 13a-14(b)

SIGNATURES

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

CHOLESTECH CORPORATION

Date: August 3, 2005		/s/ Warren E. Pinckert II
		Warren E. Pinckert II
		President and Chief Executive Officer
		(Principal Executive Officer)
Date: August 3, 2005		/s/ John F. Glenn
		John F. Glenn
		Vice President of Finance, Chief
		Financial Officer, Treasurer and Secretary
		(Principal Financial and Accounting Officer)

INDEX TO EXHIBITS

Exhibit No.		Description
10.61		Transition Agreement dated July 25, 2005 between Registrant and Thomas E. Worthy
31.1		Certification of Chief Executive Officer under Rule 13a-14(a)
31.2		Certification of Chief Financial Officer under Rule 13a-14(b)
32		Certifications of Chief Executive and Chief Financial Officer under Rule 13a-14(b)