Tripath Imaging (TPTH) 10-Q 2006 Q1 Quarterly report

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period endedMarch 31, 2006

OR

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 0-22885

TRIPATH IMAGING, INC.

(Exact name of registrant as specified in its charter)

Delaware		56-1995728
(State or other jurisdiction of	(IRS Employer Identification No.)
incorporation or organization)
780 Plantation Drive, Burlington, North Carolina		27215
(Address of principal executive offices)	(Zip Code)

(336) 222-9707

(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. Yesþ Noo

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (Check one):

Large accelerated filero Accelerated Filerþ Non-accelerated filero

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso Noþ

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

Class	Outstanding at May 1, 2006
Common Stock, $.01 par value	38,399,029

TriPath Imaging, Inc.

Table of Contents

Part I. Financial Information
Item 1. Condensed Consolidated Financial Statements (Unaudited)	2
Condensed consolidated balance sheets as of March 31, 2006, and December 31, 2005	2
Condensed consolidated statements of income for the three months ended March 31, 2006 and 2005	3
Condensed consolidated statements of cash flows for the three months ended March 31, 2006 and 2005	4
Notes to condensed consolidated financial statements	5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	20
Item 3. Quantitative and Qualitative Disclosures About Market Risk	51
Item 4. Controls and Procedures	51
Part II. Other Information
Item 1. Legal Proceedings	52
Item 1A. Risk Factors	52
Item 6. Exhibits	52
Signatures	53
Exhibit Index	54

Note Regarding Trademarks

We have registered trademarks in the United States for SurePath^®, PrepStain^®, FocalPoint^®, AutoCyte^®, AutoCyte Quic^®, CytoRich^®, ImageTiter^®, PrepMate^®, SlideWizard^®, and TriPath Imaging^®. We have pending U.S. trademark applications for ProEx^TM, SureDetect^TM, and TriPath Oncology^TM. Foreign registrations are maintained for several of our trademarks in Argentina, Australia, Brazil, Canada, Chile, China, the European Union, Hong Kong, Indonesia, Israel, Japan, Norway, the Russian Federation, Switzerland, Taiwan and the United Kingdom. We have pending foreign trademark applications for ProEx^TM and SureDetect^TM. In addition to trademark activity, we include a copyright notice on all of our documentation and operating software. There can be no assurance that any trademarks or copyrights that we own will provide competitive advantages for our products or will not be challenged or circumvented by our competitors. All other products and company names are trademarks of their respective holders.

Part I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

TriPath Imaging, Inc.
Condensed Consolidated Balance Sheets

	March 31,
	2006			December 31,
	(Unaudited)			2005
	(In thousands, except share and
	per share amounts)
Assets
Current assets:
Cash and cash equivalents	$	23,059		$	22,457
Accounts and notes receivable, net		16,195			15,647
Net investment in sales-type leases		1,108			828
Inventory, net		12,443			12,564
Deferred tax asset, net		4			—
Other current assets		2,804			1,676
Total current assets		55,613			53,172
Customer use assets, net		8,019			8,044
Property and equipment, net		4,787			4,556
Other assets		2,011			2,362
Net investment in sales-type leases, net of current portion		1,978			1,807
Intangible assets		6,805			7,027
Total assets	$	79,213		$	76,968
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	5,233		$	4,459
Accrued expenses		4,248			5,323
Deferred revenue and customer deposits		1,110			1,106
Obligations under capital lease		23			23
Other current liabilities		384			—
Total current liabilities		10,998			10,911
Long-term portion of obligations under capital lease		92			98
Deferred tax liability, net		4			—
Commitments and contingencies (Note 9)
Stockholders’ equity:
Common stock, $0.01 par value; 98,000,000 shares authorized; 38,377,994 and 38,324,632 shares issued and outstanding at March 31, 2006 and December 31, 2005, respectively		384			383
Additional paid-in capital		291,898			291,561
Accumulated deficit		(224,170	)		(225,915	)
Accumulated other comprehensive income		88			11
Treasury stock, at cost, 10,000 shares at March 31, 2006 and December 31, 2005, respectively		(81	)		(81	)
Total stockholders’ equity		68,119			65,959
Total liabilities and stockholders’ equity	$	79,213		$	76,968

See accompanying notes to condensed consolidated financial statements

2

TriPath Imaging, Inc.
Condensed Consolidated Statements of Income
(Unaudited)

	Three months ended
	March 31,
	(in thousands, except per
	share amounts)
	2006			2005
Revenues	$	24,042		$	19,327
Cost of revenues		7,905			5,779
Gross profit		16,137			13,548
Operating expenses:
Research and development		3,594			3,129
Regulatory		1,111			752
Sales and marketing		6,182			4,942
General and administrative		3,564			3,895
		14,451			12,718
Operating income		1,686			830
Interest income		234			100
Interest expense		(4	)		(5	)
Income before income taxes		1,916			925
Income taxes		171			—
Net income	$	1,745		$	925
Earnings per common share
Basic	$	0.05		$	0.02
Diluted	$	0.04		$	0.02

See accompanying notes to condensed consolidated financial statements

3

TriPath Imaging, Inc.
Condensed Consolidated Statements of Cash Flows
(Unaudited)

	Three months ended
	March 31,
	2006			2005
	(in thousands)
Operating activities
Net income	$	1,745		$	925
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		1,197			1,264
Provision for doubtful accounts		100			—
Non-cash sales discount		195			432
Non-cash equity compensation		84			—
Provision for income taxes		48			—
Change in operating assets and liabilities:
Accounts, notes and lease receivables		(909	)		(1,373	)
Inventory		(682	)		(739	)
Accounts payable and other current liabilities		(347	)		1,676
Other		(561	)		(556	)
Net cash provided by operating activities		870			1,629
Investing activities
Purchases of property and equipment		(341	)		(259	)
Other		(562	)		—
Net cash used in investing activities		(903	)		(259	)
Financing activities
Proceeds from exercise of stock options		239			143
Principal payments on debt and leases		(5	)		(19	)
Other		384			—
Net cash provided by financing activities		618			124
Effect of exchange rate changes on cash		17			(196	)
Net increase in cash and cash equivalents		602			1,298
Cash and cash equivalents at beginning of period		22,457			18,949
Cash and cash equivalents at end of period	$	23,059		$	20,247

See accompanying notes to condensed consolidated financial statements

4

TriPath Imaging, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(In thousands, except share and per share amounts)
March 31, 2006

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by TriPath Imaging, Inc. in accordance with generally accepted accounting principles and applicable Securities and Exchange Commission regulations for interim financial information. These financial statements do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The balance sheet at December 31, 2005 has been derived from the audited financial statements at that date, but does not include all the information and footnotes required by generally accepted accounting principles for complete financial statements. The accompanying unaudited condensed consolidated financial statements reflect all adjustments (consisting of normal, recurring accruals) that, in our opinion, are necessary for a fair presentation of the results for the interim periods presented. The results of operations for such periods are not necessarily indicative of the results expected for the full year or for any future periods. The accompanying condensed consolidated financial statements and related notes should be read in conjunction with our audited consolidated financial statements and notes included in our Annual Report on Form 10-K (File No. 0-22885) for the year ended December 31, 2005.

Certain prior year amounts have been reclassified to conform to the 2006 presentation. These reclassifications had no effect on previously reported net income, cash flows or financial position.

2. Inventory

Inventory consists of the following:

	March 31,			December 31,
	2006			2005
Stage of production:
Raw materials	$	9,631		$	10,052
Work-in-process		1,182			861
Finished goods		4,488			4,355
		15,301			15,268
Reserves for obsolete and slow moving inventory		(2,858	)		(2,704	)
	$	12,443		$	12,564
Categories:
Instruments	$	12,997		$	13,197
Reagents and consumables		2,304			2,071
		15,301			15,268
Reserves for obsolete and slow moving inventory		(2,858	)		(2,704	)
	$	12,443		$	12,564

For the three months ended March 31, 2006 and 2005, net movements of $826 and $608, respectively, occurred between customer-use assets, property and equipment and inventory.

3. Product Warranty Obligation

We record a liability for product warranty obligations at the time of sale based upon historical warranty experience. The term of the warranty is generally twelve months. We also record an additional liability for specific warranty matters when they become known and are reasonably estimable. We typically do not

5

TriPath Imaging, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(In thousands, except share and per share amounts)

accept product returns. The product warranty obligations are recorded as a component of accrued expenses.

A summary of the product warranty obligation reserve activity is as follows:

	Three Months Ended
	March 31,
	2006			2005
Balance, beginning of period	$	(133	)	$	(159	)
Accruals		(58	)		—
Settlements made		—			65
Warranties expired/adjustments		—			—
Balance, end of period	$	(191	)	$	(94	)

4. Earnings Per Share of Common Stock

We follow the provisions of SFAS No. 128, “Earnings Per Share”, which requires us to present basic and diluted earnings per share. Basic earnings per share information is calculated by dividing the net income by the weighted-average number of shares of common stock outstanding during all periods presented. Diluted earnings per share is calculated by dividing net income by the weighted-average number of shares of common stock outstanding after giving effect to all potentially dilutive shares of common stock, as if they had been issued at the beginning of the period presented. Potentially dilutive shares of common stock result from our outstanding stock options and warrants. Certain potential shares, attributable to certain stock options and warrants, were excluded from diluted earnings per share because their impact was antidilutive.

The following represents a reconciliation of the weighted average shares used in the calculation of basic and diluted earnings per share:

	Three Months Ended
	March 31,
	2006		2005
Basic
Assumed conversion of:		38,360,908		38,155,477
Stock options		821,451		1,085,864
Warrants		47,947		16,727
Diluted		39,230,306		39,258,068

6

TriPath Imaging, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(In thousands, except share and per share amounts)

The following table summarizes the potential common shares not included in the computation of diluted earnings per share because their impact would have been antidilutive:

	March 31,
	2006		2005
Stock options		3,427,942		2,182,244
Warrants		1,500,000		800,000
		4,927,942		2,982,244

5. Lines of Credit

We had a $7,500 working capital facility with Silicon Valley Bank with an expiration date of April 27, 2006. The entire amount of the line was available as long as certain financial covenants were met. If these covenants were not met, the available balance is limited to an amount equal to 80% of eligible accounts receivable. At March 31, 2006, we were entitled to borrow the full amount of the line. However, due to real estate we aquired and a mortgage we assumed in connection with the relocation of a newly hired employee during the first three months of 2006, we violated one of the facility’s covenants, for which we received a waiver from the bank. The line offered either a prime-based (prime plus 0.25%) or LIBOR-based (LIBOR plus 2.0%) pricing option for advances made under it and was collateralized by substantially all of our assets. The line of credit carried customary covenants, including the maintenance of a minimum modified quick ratio, minimum tangible net worth, and other requirements. We had no outstanding borrowings under this agreement at March 31, 2006 and allowed the line to expire as of April 27, 2006.

As of April 27, 2006 we secured a new $7,500 working capital facility with Wachovia Bank, N.A. The new line carries a rate of interest equal to LIBOR plus 1.80% and has an expiration date of April 27, 2007. The line of credit carries customary covenants, including the maintenance of a minimum tangible net worth, a minimum fixed charge coverage ratio and other requirements. The line is collateralized by substantially all of our assets.

During April 2003, we obtained a $2,500 lease line of credit from General Electric Capital Corporation (“GE Capital”). Individual operating lease schedules under this lease line carry three-year terms. Financing charges are based on the fixed basic term lease rate factor. The interest rates on the various schedules, which are incorporated into the lease payments under this lease line, range from 2.85% to 3.45%. The lease line is being used as an alternative source of capital to obtain assets, primarily equipment, subject to operating leases. In July 2005, this line was renewed for a one-year term (effective March 2006) for $1,000 (in addition to amounts for assets already leased under the line). Terms of the new line are substantially the same as the expiring line. The primary difference is that lease terms under the new line range from 30 to 36 months. As of March 31, 2006 and December 31, 2005 assets with an original cost of $1,917 were leased under our lease lines with GE Capital. Future minimum lease payments under this lease line are $1,023 as of March 31, 2006. We allowed this line to expire as of March 31, 2006 with respect to our ability to lease additional assets under it, but the existing leases under the line will continue to their contractual maturities as described above.

As of April 1, 2006 we obtained a new $1,500 lease line of credit from GE Capital (in addition to amounts for assets already leased under the line). The lease terms of the new line range from 36 to 48 months. The new line has a term of one year and carries a rate of interest based on the Federal Reserve’s four and three year Treasury Constant Maturities Rate.

During August 2002, we obtained a $1,500 lease line of credit from Bank of America. Bank of America assigned the leases under this line to GE Capital in 2004. Amounts used under this lease line are secured by a letter of credit against our line of credit with Silicon Valley Bank discussed above. Assets leased under this lease line carry three-year lease terms. Lease rates are based on three-year constant Treasury Maturities. The interest rates on the various schedules under this lease line, which are incorporated into

7

TriPath Imaging, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(In thousands, except share and per share amounts)

the operating lease payments, range from 2.75% to 2.90%. The lease line was used as an alternative source of capital to obtain assets, primarily equipment, subject to operating leases. As of March 31, 2006 and December 31, 2005, assets with an original cost of $1,286 were leased under this lease line. Future minimum lease payments under this lease line are $216 as of March 31, 2006. As the lease line has expired, no further assets will be leased under this line of credit.

6. Comprehensive Income

Comprehensive income is net income plus certain other items that are recorded directly to shareholders’ equity, which consists of foreign currency translation. Comprehensive income was $1,822 and $795 for the three months ended March 31, 2006 and 2005, respectively.

7. Stock-Based Compensation

We have stock option plans (the “Plans”) under which incentive and non-statutory stock options, stock appreciation rights and restricted stock may be granted to our employees, directors or consultants.

In November 1996, we adopted the 1996 Equity Plan. Pursuant to the 1996 Equity Plan, our employees, employees of our subsidiaries, directors and consultants may receive options to purchase common stock and other common stock awards. The 1996 Equity Plan is administered by the Compensation Committee. A maximum of 7,996,325 shares have been authorized to cover grants and awards under the 1996 Equity Plan.

In June 1997, we adopted the 1997 Director Plan. Pursuant to the 1997 Director Plan, eligible directors may receive options to purchase common stock. Additionally, each time an eligible director is elected or re-elected to the Board of Directors, the eligible director is automatically granted an option to purchase 30,000 shares of our common stock. The 1997 Director Plan is administered by the Board of Directors. A maximum of 450,000 shares have been authorized to cover grants and awards under the 1997 Director Plan.

We also have two plans from our merger with NeoPath, Inc. in 1999, the NeoPath 1989 Stock Option Plan and NeoPath 1999 Plan. No further shares of common stock are available for grant or award under these plans, which have balances of unexercised shares of 97,453 and 45,741, respectively as of March 31, 2006.

For periods covered by this report, stock options are the only instrument granted or issued under these plans. For directors, stock options granted prior to May 2005 vested ratably over 36 months. On May 31, 2005, the Board of Directors amended the vesting schedule under the Plan so that new options granted under the Plan vest as to 50% of the shares subject to the grant on December 31 of the year in which the grant is made and then vest as to the remainder of the shares subject to the grant in three equal installments on the first three anniversaries of the grant.

Stock options granted to employees prior to May 2005 vest ratably every 12 months and are fully vested after 48 months. Starting with option grants made to employees in May 2005, new options granted to employees vest as to 50% of the shares subject to the grant on December 31 of the year in which the grant is made and then vest as to the remainder of the shares subject to the grant in three equal installments on the first three anniversaries of the grant.

8

TriPath Imaging, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(In thousands, except share and per share amounts)

The exercise price of options granted, as determined by the Compensation Committee or Board of Directors, approximates fair market value of our common stock at the time of the grant.

On May 31, 2005 and December 30, 2005, respectively, we accelerated the vesting of stock options that were both unvested and “out-of-the-money” and held by current employees, officers and directors with exercise prices greater than or equal to $8.89, which was $0.25 higher than the closing sales price of our common stock on the Nasdaq National Market on May 27, 2005, and $7.00, which was $0.97 higher than the closing sales price of our common stock on the Nasdaq National Market on December 29, 2005. The primary purpose of the vesting acceleration was to enable us to minimize future compensation expense associated with the accelerated options upon our planned adoption of Statement of Financial Accounting Standards No. 123(R),“Accounting for Stock-Based Compensation,” (SFAS 123(R)) in January 2006.

In 2002, we introduced our TriPath Imaging, Inc. Employee Stock Purchase Plan with 1,000,000 shares of common stock for authorized issuance. The plan qualifies as an “employee stock purchase plan” under Section 423 of the Internal Revenue Code and permits substantially all employees to purchase a limited number of shares of the Corporation’s stock at 85% of market value.

On January 1, 2006, we adopted SFAS 123(R), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, including employee stock options, restricted stock units and restricted stock awards based on estimated fair values. SFAS 123(R) supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), which we previously applied.

We adopted SFAS 123(R) using the modified prospective transition method, which requires application of the accounting standard as of January 1, 2006, the first day of our fiscal year 2006. Our Condensed Consolidated Financial Statements as of and for the three months ended March 31, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, our Condensed Consolidated Financial Statements for prior periods have not been restated to reflect the impact of SFAS 123(R). Therefore, the results as of March 31, 2006 are not directly comparable to the same period in the prior year.

SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service period. Share-based compensation expense recognized in our Condensed Consolidated Statements of Income for the first quarter of fiscal 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123(R). Compensation expense for the share-based payment awards granted subsequent to January 1, 2006 is based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). Share-based compensation expense recognized in the Condensed Consolidated Statements of Income for the first quarter of fiscal 2006 is based on awards ultimately expected to vest, and therefore it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ materially from those estimates.

Prior to the adoption of SFAS 123(R), we accounted for share-based awards using the intrinsic value method in accordance with APB 25 as allowed under SFAS 123. Under the intrinsic value method, no share-based compensation expense had been recognized in our Condensed Consolidated Statements of

9

TriPath Imaging, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(In thousands, except share and per share amounts)

Operations. For stock options granted at exercise prices below fair value, we recorded deferred compensation expense for the difference between the exercise price of the shares and the fair value. Amortization expense of $0 and $3 was recorded for the three months ending March 31, 2006 and 2005, respectively.

For purposes of determining the estimated fair value of share-based payment awards on the date of grant under SFAS 123(R), we used the Black-Scholes option-pricing model (Black-Scholes Model). The Black-Scholes Model requires the input of certain assumptions that involve judgment. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the input assumptions can materially affect the fair value estimate, the existing models may not provide a reliable single measure of the fair value of our employee stock options. Management will continue to assess the assumptions and methodologies used to calculate estimated fair value of share-based compensation. Circumstances may change and additional data may become available over time, which could result in changes to these assumptions and methodologies, and thereby materially impact our fair value determination.

The fair value of each common stock option granted was estimated using the following weighted-average assumptions:

	March 31,
	2006			2005
Dividend yield		0	%		0	%
Expected volatility		47.0	%		75.0	%
Risk free interest rate		4.47	%		3.59	%
Expected option life (in years)		3.7			4.0

Expected volatility is based on the historical volatility of common stock. We use historical data on exercises of stock options and other factors to estimate the expected term of the stock options granted. The risk free rate is based on the U.S. Treasury yield curve in effect at the date of grant over the expected option life.

Stock option activity for the three months ended March 31, 2006 is as follows:

						Weighted-
						Average
				Weighted-		Remaining
				Average		Contractual
				Exercise		Term (in
	Options			Price		years)
Outstanding at January 1, 2006		5,813,162		$	7.37
Granted		72,000			6.61
Exercised		(64,304	)		4.64
Cancelled and expired		(22,347	)		10.54
Outstanding at March 31, 2006		5,798,511		$	7.38		6.5
Vested and exercisable at March 31, 2006		5,586,905		$	7.47		6.4

10

TriPath Imaging, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(In thousands, except share and per share amounts)

At March 31, 2006, there was $491 of compensation expense that has yet to be recognized related to nonvested stock options. This expense is expected to be recognized over a weighted-average period of 1.0 years.

At March 31, 2006, the aggregate intrinsic value of options issued and outstanding was $5,611, and the aggregate intrinsic value of options exercisable was $5,152. Total intrinsic value of options exercised was $186 for the three months ended March 31, 2006. The weighted-average grant-date fair value of stock options granted during the first quarter of 2006 was $2.67.

Nonvested stock option activity for the three months ended March 31, 2006 is as follows:

	Options
Nonvested stock options outstanding at January 1, 2006		178,081
Stock options granted		72,000
Stock options vested, cancelled and expired		38,475
Nonvested stock options outstanding at March 31, 2006		211,606

Share-based compensation recognized under SFAS 123(R) for the three months ended March 31, 2006 was $84. The share-based compensation expense is calculated on a straight-line basis over the vesting periods of the related share-based awards. On an earnings per share basis, the adoption of SFAS 123(R) had no effect on basic and diluted earnings per share.

As required by SFAS 123(R), we have presented disclosures of our pro forma income and income per share for both basic and diluted shares for prior periods as illustrated below.

	Three Months
	Ended
	March 31, 2005
Net income, as reported	$	925
Stock-based compensation included in reported net income		3
Stock-based compensation expense under fair value based method for all plans		(1,037	)
Pro forma net loss	$	(109	)
Net earnings per common share (basic & diluted):
Basic:
As reported	$	0.02
Pro forma	$	0.00
Diluted
As reported	$	0.02
Pro forma	$	0.00

Accounting for Warrants issued to Quest Diagnostics

11

TriPath Imaging, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(In thousands, except share and per share amounts)

In May 2004, we entered into a multi-year agreement with Quest Diagnostics Incorporated (“Quest Diagnostics”) pursuant to the terms of which Quest Diagnostics uses our SurePath and PrepStain products. In connection with the agreement, we issued Quest Diagnostics warrants with respect to an aggregate of 4,000,000 shares of our common stock, which are described in the following table:

	Shares Subject to	Exercise Price	Warrant
Warrant	Warrants	(per share)	Expiration Date	Vesting Status
First Tranche	800,000	$  9.25	May 2007	Currently Exercisable
Second Tranche	200,000	$10.18	May 2007	Currently Exercisable
Third Tranche	500,000	$10.64	May 2007	Currently Exercisable
Fourth Tranche	1,000,000	$11.56	May 2008	Exercisable Upon Achievement of Sales Milestone
Fifth Tranche	1,500,000	$12.03	May 2008	Exercisable Upon Achievement of Sales Milestone

The warrants permit exercise on a net issuance basis and are subject to a lock-up provision, which prohibits sales and other transfers of the underlying shares for a two-year period ending in May 2006, at which point 50% of the shares underlying warrants then exercisable may be transferred, and subjects the remaining underlying shares to an additional one year lock-up.

— First Tranche Warrants

The First Tranche warrants were exercisable upon the commencement of the agreement with Quest Diagnostics. Using the guidance in the FASB’s Emerging Issues Task Force Release 01-9,“Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products),” these warrants were valued (on the basis of the fair value of the warrants at the date of grant) using a Black-Scholes pricing model upon issuance at $3,896, which represented a deferred sales discount. The value of the warrants was recorded as additional paid-in capital and the resulting deferred sales discount is being amortized on a straight-line basis against revenues over the five-year term of the agreement. Non-cash sales discounts of $195 were recorded for the three months ended March 31, 2006 and 2005 in connection with the First Tranche warrants.

— Sales-Based Milestone Warrants

Our agreement with Quest Diagnostics links the exercisability of the Second Tranche, Third Tranche, Fourth Tranche and Fifth Tranche warrants to the achievement of sales-based milestones, which have been met for the Second Tranche and Third Tranche. These milestones are based on the volume of SurePath tests purchased by Quest Diagnostics within specified time periods. When it becomes probable that a tranche of warrants will become exercisable upon the achievement of the applicable sales-based milestone, we accrue the resulting sales discounts.

12

TriPath Imaging, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(In thousands, except share and per share amounts)

— Second and Third Tranche Warrants

During the second quarter of 2005, the Second and Third Tranche warrants vested upon the achievement of the sales-based milestone applicable to those warrants. Using the guidance in the FASB’s Emerging Issues Task Force Release 96-18,“Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”(“EITF 96-18”), the 200,000 Second Tranche warrants were valued at $224 using a Black-Scholes pricing model, which was recorded as a reduction of revenues with a corresponding credit to additional paid-in capital. Additionally, the 500,000 Third Tranche warrants were valued at $275 using a Black-Scholes pricing model, which was recorded as a reduction of revenues with a corresponding credit to additional paid-in capital.

When and if it becomes apparent that any of the remaining tranches of currently unexercisable warrants held by Quest may vest upon the achievement of the applicable sales-based milestone, we will accrue the resulting deferred sales discounts over the related number of tests in the six-month period for which the warrants were earned.

— Summary

During both the three months ended March 31, 2006 and 2005, respectively, we recorded $195 of amortization of deferred sales discount as a reduction of revenues. During the three months ended March 31, 2005, we recorded $237 of accrued sales discount as a reduction of revenues. Included in ‘other current assets’ and ‘other assets’ at March 31, 2006 are unamortized balances of $779 and $1,623, respectively. Included in ‘other current assets’ and ‘other assets’ at December 31, 2005 are unamortized balances of $779 and $1,819, respectively.

8. Operations by Industry Segment

Description of Products and Services by Segment

We currently operate in two business segments: Commercial Operations and TriPath Oncology.

Measurement of Segment Profit or Loss and Segment Assets

We evaluate performance and allocate resources based on operating income or loss. Inter-segment transfers are recorded at cost.

Factors Management Used to Identify the Company’s Reportable Segments

Our reportable segments are business units that offer or seek to develop different products and services. The reportable segments are each managed separately because they do or seek to develop and commercialize distinct products. The segments operate as separate entities.

13

TriPath Imaging, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(In thousands, except share and per share amounts)

Results by Segment

The results, by segment, for the three months ended March 31, 2006 and 2005, are as follows:

	Three Months Ended March 31, 2006
	Commercial			TriPath
	Operations			Oncology			Total
Revenues	$	23,512		$	530		$	24,042
Cost of revenues		7,453			452			7,905
Gross profit		16,059			78			16,137
Gross margin		68.3	%		14.7	%		67.1	%
Operating expenses:
Research and development		673			2,921			3,594
Regulatory		461			650			1,111
Sales and marketing		5,961			221			6,182
General and administrative		2,147			1,417			3,564
Total operating expenses		9,242			5,209			14,451
Operating income/(loss)	$	6,817		$	(5,131	)	$	1,686

	Three Months Ended March 31, 2005
	Commercial			TriPath
	Operations			Oncology			Total
Revenues	$	19,079		$	248		$	19,327
Cost of revenues		5,619			160			5,779
Gross profit		13,460			88			13,548
Gross margin		70.5	%		35.5	%		70.1	%
Operating expenses:
Research and development		476			2,653			3,129
Regulatory		551			201			752
Sales and marketing		4,905			37			4,942
General and administrative		2,678			1,217			3,895
Total operating expenses		8,610			4,108			12,718
Operating income/(loss)	$	4,850		$	(4,020	)	$	830

All sales reflected in the tables above were generated from external customers. Inter-segment revenues of $452 and $160 during the three months ended March 31, 2006 and 2005, respectively, were eliminated on consolidation. Sales to external customers in our business segments for the three months ended March 31, 2006 and 2005, respectively, include the following:

	Three Months Ended
Commercial Operations	March 31,
	2006		2005
Reagents	$	18,554	$	15,058
Instruments		2,447		1,857
Fee-per-use and other		2,511		2,164
Total revenues — Commercial Operations	$	23,512	$	19,079

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TriPath Imaging, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(In thousands, except share and per share amounts)

	Three Months Ended
TriPath Oncology	March 31,
	2006		2005
Reagents	$	27	$	—
Instruments		467		248
Fee-per-use and other		36		—
Total revenues — TriPath Oncology	$	530	$	248

Reagent revenues for the three months ended March 31, 2006 and 2005 in our Commercial Operations segment are net of $195 and $432, respectively, of amortization and accrual of the non-cash sales discount related to the Quest Diagnostics warrants (see Note 7 above).

The tables below disclose certain other selected segment information:

	Three Months Ended
	March 31,
	2006		2005
Depreciation and amortization Commercial Operations	$	1,117	$	1,208
TriPath Oncology		80		56
Total consolidated depreciation and amortization	$	1,197	$	1,264
Purchases of property and equipment Commercial Operations		286		165
TriPath Oncology		55		94
Total consolidated purchases of property and equipment	$	341	$	259

	March 31,			December 31,
	2006			2005
Segment assets
Commercial Operations	$	133,044		$	125,845
TriPath Oncology		1,903			1,669
Total segment assets	$	134,947		$	127,514
Reconciling item
Inter-segment loan account		(55,734	)		(50,546	)
Total consolidated assets	$	79,213		$	76,968

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TriPath Imaging, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(In thousands, except share and per share amounts)

Geographic Area Data

Our Commercial Operation’s domestic revenues are generated primarily by direct sales activities. Domestic revenue is primarily obtained through our agreements with the large commercial laboratories. International revenues continue to be derived primarily through distributors, except in Canada where we sell directly to our laboratory customers. Revenues by geographic area (or country) are reflected in the tables below:

	Three-Months Ended March 31,
	2006				2005
United States	$	17,123	71	%	$	14,223	74	%
International		6,919	29	%		5,104	26	%
Total Revenues	$	24,042			$	19,327

	Three Months Ended
	March 31,
	2006		2005
International Revenues
Europe	$	3,832	$	1,658
Canada		1,510		2,679
Asia		1,490		697
Rest of world		87		70
Total international revenues	$	6,919	$	5,104

Reagent revenues for the three months ended March 31, 2006 and 2005, respectively, were recorded as follows:

	Three Months Ended
	March 31,
	2006		2005
Domestic	$	14,083	$	11,728
International:
Europe		2,309		1,020
Canada		1,418		1,651
Asia		685		590
Rest of world		86		69
Total international		4,498		3,330
Total reagent revenues	$	18,581	$	15,058

Revenues are attributed to geographic area (or country) based on the location of our customers, which include both distributors and end-users. Revenues recorded in our TriPath Oncology segment were all attributable to domestic customers.

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TriPath Imaging, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(In thousands, except share and per share amounts)

9. Commitments and Contingencies

We compete with Cytyc Corporation (Cytyc) with respect to the sale of our FocalPoint and Cytyc’s sale of its ThinPrep Imaging System. We believe Cytyc’s ThinPrep Imaging System infringes our patents. In 2003 we filed a lawsuit seeking damages and injunctive relief to stop such infringement, and Cytyc filed a separate action seeking a declaratory judgment in their favor. On January 5, 2004, those suits were consolidated into a single action in the United States District Court for the District of Massachusetts. The case numbers for the consolidated action are 1:03-CV-12630-DPW and 1:03-CV-11142-DPW. The case numbers are for reference only and the corresponding pleadings are expressly not incorporated into this document by reference. Fact and expert discovery have been completed. A claim construction or Markman ruling was issued by the court on November 28, 2005. The parties conducted mediation in March 2006 pursuant to the Court’s scheduling order. The parties are scheduled to file summary judgment motions by May 15, 2006. We anticipate that a trial will be scheduled sometime in the first half of 2007. We are unable to predict the ultimate outcome. Similarly, we are unable to predict the potential effect on our business and results of operations that any outcome may ultimately have.

Furthermore, in the ordinary course of business, we are the subject of, or party to, various pending or threatened claims and litigation. In the opinion of management, settlement of such claims and litigation will not have a material effect on our operations or financial position.

10. Change in Accounting Estimate

Effective October 1, 2005 we increased the estimated salvage value of our FocalPoint instruments from $0 to $60 per instrument. We believe the revised amount reflects the historical experience and more appropriately reflects the salvage value of these assets. This change in accounting estimate decreased first quarter 2006 depreciation expense by approximately $170, when compared to the comparable period for 2005.

11. Recently Issued Accounting Standards

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs—an Amendment of ARB No. 43, Chapter 4”(SFAS No.151) to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously stated that “. . . under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and re-handling costs may be so abnormal as to require treatment as current period charges. . . .”. SFAS No.151 requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” In addition, SFAS No.151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of SFAS No.151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005, with earlier adoption permitted. The provisions of SFAS No.151 shall be applied prospectively. We adopted SFAS No.151 as of January 1, 2006 and the adoption did not have a material impact on our consolidated financial statements.

In December 2004, the FASB issued Statement No. 153, “Exchanges of Nonmonetary Assets – an amendment of APB Opinion No. 29” (SFAS No. 153). SFAS No. 153 addresses the measurement of exchanges of non-monetary assets. The guidance in APB Opinion No. 29, “Accounting for Nonmonetary

17

TriPath Imaging, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(In thousands, except share and per share amounts)

Transactions”, is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. The guidance in that Opinion, however, included certain exceptions to that principle. SFAS No. 153 amends APB Opinion No. 29 to eliminate the exception of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is effective for financial statements for fiscal years beginning after June 15, 2005. Earlier application is permitted for nonmonetary asset exchanges incurred during fiscal years beginning after the date this Statement is issued. We adopted SFAS No.153 as of January 1, 2006 and the adoption did not have a material impact on our consolidated financial statements.

In May 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3” (SFAS No. 154). SFAS No. 154 changes the requirements for the accounting and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accounting principles. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not contain specific transition provisions. When a pronouncement includes specific transition provisions, those provisions will continue to be followed. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Earlier application is permitted for accounting changes and corrections of errors made occurring in fiscal years beginning after June 1, 2005. We adopted SFAS No.154 as of January 1, 2006 and the adoption did not have a material impact on our consolidated financial statements.

In June 2005, the Emerging Issues Task Force issued Issue No. 05-6, “Determining the Amortization Period for Leasehold Improvements Purchased After Lease Inception or Acquired in a Business Combination” (EITF No. 05-6). EITF No. 05-6 states that leasehold improvements that are placed in service significantly after, and not contemplated at or near the beginning of the lease term, should be amortized over the shorter of the useful life of the assets or a term that includes the required lease periods and renewals that are deemed to be reasonably assured at the date the leasehold improvements are purchased. Leasehold improvements acquired in a business combination should be amortized over the shorter of the useful life of the assets or a term that includes required lease periods and renewals that are deemed to be reasonably assured at the date of acquisition. We are required to apply EITF No. 05-6 to leasehold improvements that are purchased or acquired in reporting periods beginning after June 29, 2005. The adoption of EITF No. 05-6 did not have a material impact on our consolidated financial statements.

In February 2006, the FASB issued Statement No. 155, “Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140” (SFAS No. 155). SFAS No. 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133, establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives and amends Statement 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. This Statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The fair value election provided for in paragraph 4(c) of this Statement may also be applied upon adoption of this Statement for hybrid financial

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TriPath Imaging, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(In thousands, except share and per share amounts)

instruments that had been bifurcated under paragraph 12 of Statement 133 prior to the adoption of this Statement. Earlier adoption is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements, including financial statements for any interim period for that fiscal year. We do not expect the adoption of SFAS No. 155 to have a material impact on our consolidated financial statements.

In March 2006, the FASB issued Statement No. 156, “Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140” (SFAS 156). SFAS 156 amends FASB Statement No. 140 with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS 156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in any of the following situations: a transfer of the servicer’s financial assets that meets the requirements for sale accounting, a transfer of the servicer’s financial assets to a qualifying special-purpose entity in a guaranteed mortgage securitization in which the transferor retains all of the resulting securities and classifies them as either available-for-sale securities or trading securities in accordance with FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities,”or an acquisition or assumption of an obligation to service a financial asset that does not relate to financial assets of the servicer or its consolidated affiliates. SFAS 156 also requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable and permits an entity to choose either the amortization method or fair value method as subsequent measurement methods for each class of separately recognized servicing assets and servicing liabilities. At its initial adoption, SFAS 156 permits a one-time reclassification of available-for-sale securities to trading securities by entities with recognized servicing rights, without calling into question the treatment of other available-for-sale securities under Statement 115, provided that the available-for-sale securities are identified in some manner as offsetting the entity’s exposure to changes in fair value of servicing assets or servicing liabilities that a servicer elects to subsequently measure at fair value. This Statement is effective as of the beginning of an entity’s first fiscal year that begins after September 15, 2006. Earlier adoption is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements, including financial statements for any interim period for that fiscal year. We do not expect the adoption of SFAS No. 156 to have a material impact on our consolidated financial statements.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
(amounts in thousands, except share and per share amounts)

The following discussion of our financial condition and results of operations should be read in conjunction with the Condensed Consolidated Financial Statements and Notes thereto included in Item 1 of this Quarterly Report on Form 10-Q.

This report on Form 10-Q contains forward-looking statements based on our current plans and expectations of our management. Important information about the basis for these plans and expectations and certain factors that may cause our actual results to differ materially from these statements are contained below and in “Certain Factors Which May Affect Future Operations and Results,” below.

Overview

We create solutions that redefine the early detection and clinical management of cancer. Specifically, we develop, manufacture, market, and sell proprietary products for cancer detection, diagnosis, staging, and treatment selection. We are using our proprietary technologies and expertise to create an array of products designed to improve the clinical management of cancer. We have developed and marketed an integrated solution for cervical cancer screening and other products that deliver image management, data handling, and prognostic tools for cell diagnosis, cytopathology and histopathology. We have created new opportunities and applications for our proprietary technology by applying recent advances in genomics, biology, and informatics to our efforts to develop new molecular diagnostic products for malignant melanoma and cancers of the cervix, breast, ovary, and prostate.

We are organized into two operating units: (1) Commercial Operations, through which we manage the market introduction, sales, service, manufacturing and ongoing development of our current products; and (2) TriPath Oncology, our wholly-owned subsidiary through which we manage the development and market introduction of molecular diagnostic products for cancer.

Commercial Operations

Our Commercial Operations unit is a commercial engine organized to grow sales, drive margin and generate cash. Today, our revenues are primarily generated through our Commercial Operations unit from the sale of our cervical cytology screening products, and in particular, the SurePath liquid-based Pap test.

We record revenue from the sale, rental and/or lease of our systems and from the sale of related consumables. Additionally, we record revenue from service contracts on our systems and other miscellaneous revenues.

In the case of system sales to end-users, revenue recognition on system sales occurs at the time the instrument is installed and accepted at the customer site. In the case of instrument sales to distributors, revenue recognition on system sales occurs based upon the contract governing the transaction, typically at the time the instrument is shipped from our facility. This is the predominant vehicle for international instrument sales. If, however, we sell an instrument directly to an international end user, we record the revenue upon installation and acceptance of the instrument, consistent with our treatment in the U.S.

We also offer leasing alternatives. Under these transactions, we may, or may not, recognize revenue on system hardware depending on the particular details of the lease. We respond to customer needs by offering both capital and operating lease alternatives. Under the capital lease alternative, revenue is recognized initially as an instrument sale with part of the lease payments being allocated to interest income, and service revenues, if applicable, over the lease term. Under operating leases, we do not recognize any revenue related to the instrument sale, but recognize revenue as rental income over the lease term.

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Sales of consumable products are recorded on shipment. Billings and costs related to shipping products to customers are included in both revenues and cost of revenues, respectively.

For system rentals, systems are placed at the customer’s site free of charge and the customer is obligated either to purchase reagent kits for a fixed term, or are charged fees based on monthly minimum, or actual, usage. Under these transactions, revenue recognition occurs at the time of shipment of the reagent kits or on a monthly basis based on the actual or minimum usage. There is no capital equipment revenue recognized under these transactions.

Our marketing strategy is focused on providing solutions that address the unmet needs of our three broad market stakeholders: clinical laboratories, clinicians and third-party payors. We have expanded our presence in the marketplace through increased advertising and promotion, company-sponsored seminars and trade shows, and peer selling activities. During 2005, we completed the expansion of our domestic sales force that we initiated in the third quarter of 2004 to leverage the opportunity created by our growing relationship with the large commercial laboratories (see below) and to meet the challenge associated with expanding our cervical cytology business in this heavily contested market segment while maintaining and growing our business within our traditional customer base.

TriPath Oncology

TriPath Oncology is the development engine of a broad based gene discovery program created to develop new molecular products for the early detection and clinical management of cancer and focuses on developing molecular diagnostic products for malignant melanoma and cancers of the cervix, breast, ovary, and prostate. In 2005, for the first time in our history, we generated significant revenues from the sale of some of the molecular products that we are developing in TriPath Oncology. To date in 2006, we have introduced a new microscopic slide based reagent and further expanded the test menu supported by VIAS, the Ventana Medical Systems, Inc. (Ventana) branded and distributed version of our interactive histology imaging system. Throughout the remainder of 2006, we expect to continue to generate revenues from the early commercialization of some of TriPath Oncology’s molecular diagnostic reagents and molecular imaging systems and we believe that sales related to these developing products will significantly impact our growth in the future.

Our molecular oncology program focuses on using new discoveries in genomics and proteomics research to develop and commercialize molecular diagnostic products to improve the early detection and clinical management of certain types of cancer. We have active programs in development seeking to create tests to identify individuals with certain types of cancer at the earliest possible stage of the disease, provide individualized predictive and prognostic information, guide treatment selection for patients with cancer, and predict disease recurrence. The core products and services we are developing will be based upon genomic and proteomic markers that were identified through discovery research conducted at Millennium Pharmaceuticals, Inc. (Millennium) under its research and development agreement with Becton, Dickinson and Company (BD) as well as other markers that have been or may be identified independently of that agreement. We have sublicensed certain of BD’s rights to the proprietary markers. Our approach to marker discovery, identification, and prioritization is based on correlation with patient outcome and includes the evaluation of markers that have been previously identified by others as well as novel markers that have not been previously associated with our specific product indications. As a result, to ensure our freedom to utilize known markers and integrate them into our product candidates, we have in certain instances licensed them from third parties. We are concurrently pursuing intellectual property protection for novel markers that we have identified and proprietary formulations that we are creating from the combination of either novel or known markers as well as for molecular imaging systems. However, we cannot be sure that we will be able to license additional markers on a “go-forward” basis, on acceptable

21

terms, if at all, or establish intellectual property protection of our novel markers, proprietary formulations or molecular imaging systems. During 2004 and 2005, and during the first quarter of 2006 we filed U.S. provisional, U.S. non-provisional and international (PCT) patent applications that covered our discoveries, validation, and clinical assay format development in our cervical screening, breast prognosis and ovarian molecular oncology programs and obtained exclusive licenses from third parties to intellectual property relating to two potentially constituent biomarkers. We anticipate filing additional applications in 2006 related to our discoveries, validation, and clinical assay format development in our programs. We cannot be sure that our products or technologies do not infringe patents that may be granted in the future pursuant to pending patent applications or that our products do not infringe any patents or proprietary rights of third parties or that all of our issued patents are valid.

Our interactive histology imaging system has been launched by Ventana pursuant to our five-year global supply agreement under which Ventana obtained exclusive rights to sell and distribute worldwide a Ventana-branded version of the system. We believe the agreement provides the potential for capital equipment and fee-per-use revenues in 2006 should Ventana be successful in placing the instrument with its end user customer laboratories.

The following tables describes the stage of development of the product candidates in our molecular oncology pipeline, and indicates what year we have released (marked by an asterisk) or expect to release the product in the indicated format. In the table, “RUO” means “Research Use Only”, “ASR” means “Analyte Specific Reagent”, “IUO” means “Investigational Use Only”, “IHC” means “Immuno Histochemistry” and “IVD” means “In Vitro Diagnostic”.

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Our Developing Molecular Oncology Pipeline

		Release Date/
		Estimated
Application	Format	Target Date
Reagents
Microscopic Slide Based
Melanoma	ASR		2003	*
Cervical Cancer	RUO		2004	*
Breast Cancer	RUO		2004	*
ProEx C	ASR		2005	*
ProEx Br	ASR		2005	*
Cervical Cancer Staging	Assay Kit (Outside U.S.)		2005	*
SurePath Molecular Pap	IUO		2005	*
Breast Cancer Staging	IUO		2005	*
ProEx C	Class I IHC		2006	*
SurePath Molecular Pap	IVD Assay Kit (U.S.) in clinical trials		2007
Breast Cancer Staging	IVD Assay Kit (U.S.) in clinical trials		2007
Blood Based
Ovarian Cancer	RUO		2005	*
Breast Cancer	RUO		2007
Prostate Cancer	RUO		2008
Ovarian Cancer Screening	IVD Assay Kit		2008
Breast Cancer Screening	IVD Assay Kit		2009
Prostate Cancer Screening	IVD Assay Kit		2010
Reagent Enabling Products
SureDetect General Purpose Reag	ents U.S. (included in Outside U.S. kit)		2005	*
SMS 3600 Automated Stainer	U.S. & Outside U.S.		2005	*
Imaging Platforms
Interactive Histology Imager	ER/PR 510(k)		2005	*
	HER-2/Neu 510(k)		2005	*
	Ki-67 510(k)		2006	*
	Additional “known” marker		2006
	Breast Staging IUO		2005	*
	Other Applications		2007

While the dates provided above represent our estimated target dates for the respective products, there can be no assurance that these dates will be achieved by the dates targeted, or ever. Further, there can be no assurance that FDA approvals necessary to reach our target dates for IVD format products will be achieved when we expect, if at all, or that any foreign regulatory approvals necessary for any foreign releases will be achieved when we expect, if at all.

Developments

In the first quarter of 2006 we generated revenues of $24,042, a 24.4% increase from the first three months of 2005, gross profit of $16,137, a 19.1% increase from the first three months of 2005, and net income of $1,745 or $0.04 per diluted share, an $820 improvement from net income of $925 in the first three months of 2005.

As expected, our growth in revenues in the first quarter of 2006 was primarily driven by the sale of SurePath reagents and disposables. Worldwide sales of SurePath reagents and disposables increased 23.4% from the first three months of 2005 and accounted for 77.3% of total revenues generated in the first three months of 2006. Revenues generated from the sale of reagents and disposables in the first three months of 2006 reflect a $237 decrease in non-cash sales discount related to our agreement with Quest Diagnostics. This non-cash sales discount resulted from the amortization of the initial 800,000 warrants

23

held by Quest Diagnostics as defined by our agreement. Revenues generated from instrument sales accounted for 12.1% of total revenues. Our Commercial Operations segment, which today primarily reflects our cervical cytology business, was highly profitable and generated operating income of $6,817 in the first three months of 2006, a 40.6% improvement from the first three months of 2005. We remained cash flow positive for the quarter, generating cash at an average monthly rate of approximately $ 201 per month.

We estimate that the SurePath liquid-based Pap test’s share of the total Pap test market in the U.S. increased to almost 22% in the first quarter of 2006 as compared to 16% in the first quarter of 2005 and 21% in the fourth quarter of 2005. SurePath tests sold to all customers in the U.S. during the first quarter of 2006 increased 32.5% from the first quarter of 2005 and 0.9% from the fourth quarter of 2005. The increase in tests sold in the U.S. primarily reflected the growth in tests sold to the large commercial laboratories. During the first quarter of 2006, SurePath tests sold to the large commercial laboratories increased 92.1% from the first quarter of 2005 and 12.4% from the fourth quarter of 2005. Tests sold to the large commercial laboratories accounted for 48.5% of SurePath tests sold in the U.S. in the quarter as compared to 33.4% in the first quarter of 2005 and 43.5% in the fourth quarter of 2005.

The number of tests sold to our more regionally focused traditional customer base in the first quarter of 2006 grew 2.5% from the first quarter of 2005, essentially the same as the number of tests sold in the third quarter of 2005, but 8.0% less than in the fourth quarter of 2005. We believe that the sequential decline in growth in our more fully penetrated traditional customer base reflects a pattern of utilization that has been exhibited in prior years as we have focused increasingly on large laboratory customers. We placed 11 Prepstain slide processors with new customers from this market segment in the first quarter of 2006.

Revenues generated in the first quarter of 2006 from the sale of SurePath reagents and disposables outside the U.S. increased 35.1% from the first quarter of 2005, with significant gains in Europe. We have been awarded contracts for cumulative commitments of over 36% of the market in the U.K., 39% in England and Wales to supply our SurePath liquid-based Pap test. The United Kingdom National Health Service, which plans to convert completely to liquid-based cytology, represents growth potential for our products. We are currently participating in a U.K. evaluation of screening of liquid based slides using the FocalPoint GS Imaging system.

Revenues generated from the sale of instruments accounted for 12.1% of total revenues in the first quarter of 2006 as compared to 10.9% in the first quarter of 2005 and 11.7% in the fourth quarter of 2005. Instrument sales increased $809, or 38.4%, from the first quarter of 2005 and $133, or 4.8% from the fourth quarter of 2005. Our instrument sales have historically reflected quarter-to-quarter variability due to the fact that the sale of capital equipment is a one time event that is not associated with a recurring revenue stream, the expense associated with the purchase of capital equipment, and the attendant length of the selling cycle. We expect that instrument revenues as a percentage of total revenues should remain at historic levels of between 10% and 12%.

Revenues derived from VIAS, the Ventana branded and distributed version of our interactive histology imaging system increased $219 to $467 from $248, or 88.3%, in the first quarter of 2006 compared to the first quarter of 2005. We expanded the test menu supported by VIAS in April 2006 when we obtained 510(k) clearance from the U.S. Food and Drug Administration (FDA) for processing of Ventana’s assay for Ki-67, a cell proliferation biomarker used to assist with diagnosis and prognostic assessment of breast cancer. We expect that the ramp up of revenues derived from VIAS will accelerate as the test menu continues to expand.

In April of 2006, we introduced a Class I IHC kit for ProEx C detection of aberrant S phase induction in biopsied tissues. Aberrant S phase induction has been observed with cancer of the cervix, esophagus,

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skin, prostate, ovary and colon. This Class I IHC reagent will be employed by pathologists as an adjunct to histopathology.

In the fourth quarter of 2005, we resubmitted our pre-market approval supplement (PMAS) submission to the FDA to seek approval for expanded claims for the SurePath liquid based Pap test to include testing of cervical cells collected using the SurePath test Pack for the presence of high risk HPV DNA with Digene hc2 High Risk HPV DNA Test^TM. This submission is currently under review. In the fourth quarter of 2005, we initiated our clinical trial designed to provide data in support of an FDA submission regarding our ProEx Br microscopic slide based breast cancer staging test. We continued to collect data as part of the clinical trial during the first quarter of 2006. We expect to submit these data to the FDA in the second half of 2006. In the first quarter of 2006, we initiated enrollment of patient samples to collect new data in support of a FocalPoint GS PMAS application that we expect to make later this year. Additionally, we initiated patient enrollment for our clinical trial to provide data in support of a planned pre-market approval (PMA) for the SurePath Molecular Pap test. Given the prevalence of cervical cancer and its precursors and the breadth of the study required, we anticipate submitting these data to FDA in early 2007. There can be no assurance that we will obtain FDA approval for any of these products when expected, if at all, and the failure to achieve such approvals may materially impact our revenues.

Challenges

Our primary challenges in 2006 relate to leveraging the pathways for growth that we have created over the past five years.

We have made significant progress in penetrating the cervical cytology marketplace with our SurePath liquid-based Pap test since its regulatory approval in 1999. We continue to believe that there is additional ground to be gained despite the fact that we continue to face significant competitive pressure. Our growing relationship with large commercial laboratory customers presents a significant continuing growth opportunity in 2006. Our success in 2006 will in large part depend on our ability to continue conversion of current and other large commercial laboratory customers. We continue to face the challenge of expanding our cervical cytology business in a heavily contested market segment while maintaining and growing our business within our traditional customer base. We will need to succeed at both if we are to achieve the revenues we have forecasted for 2006 (see Outlook below).

During 2005, we completed the expansion of our domestic sales force that we initiated in the third quarter of 2004. We face the challenge of ensuring the earliest possible return on this increased investment in sales and marketing by accelerating our growth in revenues generated from increased sales to our large commercial laboratory customers as well as maintaining and growing our traditional customer base. The expanded sales organization also presents new challenges for our sales management, given our increased size and expanded geographic coverage.

Given the accelerated traction we gained outside the U.S. in 2004 and 2005, we expect that our sales outside the U.S. will contribute significantly to our growth in 2006 and beyond. The primary challenges we face outside the U.S. include governmental decisions regarding licensing and reimbursement, competition and regional variations in practices and product acceptance. In addition, since we sell predominantly through regional distributors in all markets outside the U.S. except for Canada, we face the challenges associated with managing these independent sales distributors in most international markets and our success, to a large extent, is dictated by the performance of the regional distributors. In Canada, where we sell through our own sales force, our greatest challenge in 2006 relates to our ability to translate the success we have enjoyed to date in the province of Ontario to other population centers.

Successful movement of some of our cytology product offerings through the FDA approval process is a continuing challenge that we will face in 2006. In September 2005, we withdrew the PMAS we had

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submitted to the FDA for the FocalPoint GS Imaging System, having been notified by the FDA that the PMAS must be amended to include additional data. We initiated enrollment of patient samples to collect new data in support of a FocalPoint GS PMAS application in the first quarter of 2006, and we expect to resubmit our PMAS in the third quarter of 2006. In the first quarter of 2005 we announced that we had withdrawn our pre-market approval supplement (PMAS) submission to the FDA to seek approval for expanded claims for the SurePath liquid-based Pap test for testing cervical cells collected using the SurePath Test Pack for the presence of high risk HPV DNA with the Digene hc2 High-Risk HPV DNA Test™. We resubmitted this PMAS, using new and existing data and data analyses, in the fourth quarter of 2005. There can be no assurance that we will obtain FDA approval for our HPV-related application or for FocalPoint GS when expected, if at all, and the failure to achieve such approvals may materially impact our revenues.

In 2006, we also face the challenges and risks associated with the execution of new clinical trials in support of FDA submissions that we intend to make in 2006 and 2007 relating to our developing molecular diagnostic products, including new 510(k) notifications to process additional Ventana assays on our interactive histology imaging system and Pre-Market Approval applications for our molecular product for breast cancer staging and the SurePath Molecular Pap test. The length, size, complexity, cost, and potential outcome of these clinical trials will be driven by our ability to craft and execute a reasonable and well-designed clinical trial protocol. Successful execution of these clinical trials will ultimately impact revenues that we expect to generate from the sale of these products in the future. There can be no assurance that we will obtain FDA clearance for additional applications for VIAS or approval for our molecular product for breast cancer staging and the SurePath Molecular Pap test.

We face challenges and risks in 2006 that primarily reflect the progress we have made in our molecular diagnostics development programs to date and the fact that some of these programs will now move into the next stages of development. Our approach to marker discovery, identification and prioritization is based on correlation with patient outcome and includes the evaluation of markers that have been previously identified by others as well as novel markers that have not been previously associated with our specific product indications. As a result, to ensure our freedom to utilize known markers and integrate them into our product candidates, we will in certain instances be required to license them from third parties. We are, concurrently, pursuing intellectual property protection for the novel markers that we have identified as well as the proprietary formulations that we are creating from the combination of either novel or known markers. There can be no assurance that we will be able to license markers on acceptable terms, if at all, or establish intellectual property protection for our novel markers and proprietary formulations or molecular imaging systems.

We expect that domestic and international sales of some of our molecular reagents and molecular imaging systems will increasingly contribute to our revenues for 2006 (see Outlook below). As a result, we will face the challenge of introducing these as either RUO products, ASRs or Class I IHCs in the U.S. as well as the challenges associated with the international introduction of products not yet approved for use in the U.S. The success of our slide based cervical staging, cervical screening and breast staging products, our blood-based ovarian screening product, and our molecular imaging systems will depend, to a large extent, on the outcome of our ongoing in-house studies, as well as external research studies that are being generated by independent investigators and clinical trials. As we collect data from both internal and external research studies we face the challenge of building the clinical case for the value of these developing products and the challenge of positioning ourselves for clinical trials; and for those product candidates in clinical trials, we face the challenge of translating the results of these studies into market opportunity, the challenges of securing regulatory approval, and the challenge related to preparing the market for a broader introduction of these products in 2006 and beyond. We also face the challenges associated with the late stage development of our ovarian screening assay, selection of a multiplexing testing platform for our blood based screening assays which would allow for simultaneous testing for multiple markers on a small volume of blood, adaptation of our ELISA formatted RUO ovarian screening

26

reagents to the multiplexing testing platform that we select and for continuing clinical studies related to our melanoma staging product.

Our sales and distribution agreement with Ventana is of both short and long term significance. In the short term, it is an opportunity to penetrate the Anatomic Pathology marketplace with our interactive imager and, as a result, to generate new revenue streams as the agreement provides for potential capital equipment and fee per use revenues which began in 2005. In the long term, it is an opportunity to achieve placement of our molecular imaging system in advance of the commercial introduction of our slide-based breast staging product along with a battery of complementary assays from Ventana. The challenges that we will face as a result of this venture include obtaining additional FDA clearances for Ventana assays to be processed on the product and, if necessary, additional FDA or other regulatory clearances or approvals with respect to the assays and imager, and the challenges associated with supporting Ventana in its market introduction of the product.

As always, we face the ongoing challenges associated with balancing our existing cash reserves against the costs associated with effective research, development, marketing and selling programs.

Litigation with Cytyc Corporation

We compete with Cytyc Corporation (Cytyc) with respect to the sale of our FocalPoint and Cytyc’s sale of its ThinPrep Imaging System. We believe Cytyc’s ThinPrep Imaging System infringes our patents. In 2003 we filed a lawsuit seeking damages and injunctive relief to stop such infringement, and Cytyc filed a separate action seeking a declaratory judgment in their favor. On January 5, 2004, those suits were consolidated into a single action in the United States District Court for the District of Massachusetts. The case numbers for the consolidated action are 1:03-CV-12630-DPW and 1:03-CV-11142-DPW. The case numbers are for reference only and the corresponding pleadings are expressly not incorporated into this document by reference. Fact and expert discovery have been completed. A claim construction or Markman ruling was issued by the court on November 28, 2005. The parties conducted mediation in March 2006 pursuant to the Court’s scheduling order. The parties are scheduled to file summary judgment motions by May 15, 2006. We anticipate that a trial will be scheduled sometime in the first half of 2007. We are unable to predict the ultimate outcome. Similarly, we are unable to predict the potential effect on our business and results of operations that any outcome may ultimately have.

Critical Accounting Policies

In our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, we identified our judgments and assumptions with respect to revenue recognition, allowance for doubtful accounts receivable, inventory, valuation of long-lived and other intangible assets and income taxes and valuation allowances as most critical to the accounting estimates used in the preparation of our financial statements. We reviewed our policies and estimates and determined that those policies require the most critical judgments and assumptions for the three months ended March 31, 2006. We did not make any changes in those policies during the quarter.

Results of Operations
(In thousands, except share and per share amounts)

Non-GAAP Financial Measures

In May 2004, we entered into a multi-year agreement with Quest Diagnostics pursuant to the terms of which Quest Diagnostics uses our SurePath and PrepStain products. In connection with the agreement, we issued Quest Diagnostics warrants with respect to an aggregate of 4,000,000 shares of our common stock, which are described in the following table:

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	Shares Subject to		Exercise Price		Warrant
Warrant	Warrants		(per share)		Expiration Date	Vesting Status
First Tranche		800,000	$	9.25	May 2007	Currently Exercisable
Second Tranche		200,000	$	10.18	May 2007	Currently Exercisable
Third Tranche		500,000	$	10.64	May 2007	Currently Exercisable
Fourth Tranche		1,000,000	$	11.56	May 2008	Exercisable Upon Achievement of Sales Milestone
Fifth Tranche		1,500,000	$	12.03	May 2008	Exercisable Upon Achievement of Sales Milestone

The warrants permit exercise on a net issuance basis and are subject to a lock-up provision, which prohibits sales and other transfers of the underlying shares for a two-year period ending in May 2006, at which point 50% of the shares underlying warrants then exercisable may be transferred, and subjects the remaining underlying shares to an additional one year lock-up.

—First Tranche Warrants

The First Tranche warrants were exercisable upon the commencement of the agreement with Quest Diagnostics. Using the guidance in the FASB’s Emerging Issues Task Force Release 01-9,“Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products),” these warrants were valued (on the basis of the fair value of the warrants at the date of grant) using a Black-Scholes pricing model upon issuance at $3,896, which represented a deferred sales discount. The value of the warrants was recorded as additional paid-in capital and the resulting deferred sales discount is being amortized on a straight-line basis against revenues over the five-year term of the agreement. During the three months ended March 31, 2006, we recorded $195 of amortization as a reduction of revenues related to the First Tranche warrants. For the corresponding period of 2005, we also recorded $195 of amortization as a reduction of revenues in respect of the First Tranche. We will continue to record a non-cash sales discount of $65 per month, attributable to the initial warrants, over the remainder of the 60-month life of our agreement with Quest Diagnostics. Included in ‘other current assets’ and ‘other assets’ at March 31, 2006 and December 31, 2005 are the unamortized balances of deferred sales discount of $779 and $779 in other current assets and $1,623 and $1,819 in other assets, respectively.

—Sales-Based Milestone Warrants

Our agreement with Quest Diagnostics links the exercisability of the Second Tranche, Third Tranche, Fourth Tranche and Fifth Tranche warrants to the achievement of sales-based milestones, which have been met for the Second Tranche and Third Tranche. These milestones are based on the volume of SurePath tests purchased by Quest Diagnostics within specified time periods. When it becomes probable that a tranche of warrants will become exercisable upon the achievement of the applicable sales-based milestone, we accrue the resulting sales discounts over the related number of tests in the six-month period for which the milestone is achieved as further described below. Since the sales discount relating to these tranches of warrants will be accrued over only six months, if and when such warrants vest, the quarterly impact upon the future quarters in which they are recorded may be disproportionately large compared to the ongoing quarterly non-cash sales discount of $195 recorded in connection with the initial warrants.

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— Second and Third Tranche Warrants

During 2005, the Second and Third Tranche warrants vested upon the achievement of the sales-based milestone applicable to those warrants. Using the guidance in the FASB’s Emerging Issues Task Force Release 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” (“EITF 96-18”), the 200,000 Second Tranche warrants were valued at $224 using a Black-Scholes pricing model, which was recorded as a reduction of revenues with a corresponding credit to additional paid-in capital. Additionally, the 500,000 Third Tranche warrants were valued at $275 using a Black-Scholes pricing model, which was recorded as a reduction of revenues with a corresponding credit to additional paid-in capital.

When and if it becomes apparent that any of the remaining tranches of currently unexercisable warrants held by Quest may vest upon the achievement of the applicable sales-based milestone, we will accrue the resulting deferred sales discounts over the related number of tests in the six-month period for which the warrants were earned.

—Summary

We recorded non-cash sales discount of $195 for the three months ended March 31, 2006, attributable to amortization and accrual of the discount, all related to the First Tranche warrants. For the corresponding period of 2005, we recorded $195 related to the First Tranche warrants and $237 of non-cash sales discount related to the Second Tranche warrants.

The (i) non-cash sales discount for the three months ended March 31, 2006 and 2005 and (ii) the amortization schedules associated with the warrants that are currently exercisable are summarized in the following table:

					Aggregate Value
	Non-Cash Sales		Non-Cash		(non-cash sales
	Discount		Sales		discount) of
	(Three Months		Discount		Tranche (as most		Amortization
	Ended		(Three Months Ended		recently		and Accrual
Warrant Tranche	March 31, 2006)		March 31, 2005)		calculated) (2)		Schedules (1)
First Tranche	$	195	$	195	$	3,896	Five Years (ending May 2009)
Second Tranche		—		237		224	Six Months (ended June 2005)
Third Tranche		—		—		275	Six Months (ended September 2005)
Total	$	195	$	432

(1)	Amortization relates to deferred discount in connection with First Tranche; accrual of sales discount relates to all other Tranches.
(2)	Represents the aggregate amount of non-cash sales discount recorded or to be recorded for the Tranche.

The following tables present pro forma versions of our revenues, gross profit, net income and earnings per share (basic and diluted) to illustrate our results from operations excluding the recorded non-cash sales discounts relating to the warrants held by Quest Diagnostics. The tables present the most comparable GAAP measure to each non-GAAP measure, as well as the reconciliation to the corresponding GAAP measure. Our management believes that these non-GAAP financial measures provide a useful measure of our results of operations, excluding discounts that are not necessarily reflective of, or directly attributable

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to, our operations. We believe that these non-GAAP measures will allow investors to monitor our ongoing operating results and trends, gain a better understanding of our period-to-period performance, and gain a better understanding of our business and prospects for future performance. These non-GAAP results are not in accordance with, or an alternative for, generally accepted accounting principles and may be different from similar non-GAAP measures used by other companies.

	Three months ended March 31, 2006
			Reconciliation:
			Add Back Non-
			Cash Sales
	GAAP		Discount		Non-GAAP
Revenues	$	24,042	$	195	$	24,237
Gross profit		16,137		195		16,332
Net income		1,745		195		1,940
Earnings per share:
Basic	$	0.05	$195 to revenues used in calculation		$	0.05
Diluted	$	0.04	$195 to revenues used in calculation		$	0.05

	Three months ended March 31, 2005
			Reconciliation:
			Add Back Non-
			Cash Sales
	GAAP		Discount		Non-GAAP
Revenues	$	19,327	$	432	$	19,759
Gross profit		13,548		432		13,980
Net income		925		432		1,357
Earnings per share:
Basic	$	0.02	$432 to revenues used in calculation		$	0.04
Diluted	$	0.02	$432 to revenues used in calculation		$	0.03

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Three Months Ended March 31, 2006 and 2005

The tables below summarize our segment results for the three months ended March 31, 2006 and 2005. All intersegment revenues have been eliminated. Comments made throughout this discussion related to our segments refer to the figures in these tables:

	Total
	Three Months Ended
	March 31,						Change			%
	2006			2005			vs 2005			Change
Revenues	$	24,042		$	19,327		$	4,715			24.4
Cost of revenues		7,905			5,779			2,126			36.8
Gross profit		16,137			13,548			2,589			19.1
Gross margin		67.1	%		70.1	%		—
Operating expenses:
Research and development		3,594			3,129			465			14.9
Regulatory		1,111			752			359			47.7
Sales and marketing		6,182			4,942			1,240			25.1
General and administrative		3,564			3,895			(331	)		(8.5	)
		14,451			12,718			1,733			13.6
Operating income	$	1,686		$	830		$	856			103.1

	Commercial Operations
	Three Months Ended
	March 31,						Change			%
	2006			2005			vs 2005			Change
Revenues	$	23,512		$	19,079		$	4,433			23.2
Cost of revenues		7,453			5,619			1,834			32.6
Gross profit		16,059			13,460			2,599			19.3
Gross margin		68.3	%		70.5	%		—
Operating expenses:
Research and development		673			476			197			41.4
Regulatory		461			551			(90	)		(16.3	)
Sales and marketing		5,961			4,905			1,056			21.5
General and administrative		2,147			2,678			(531	)		(19.8	)
		9,242			8,610			632			7.3
Operating income	$	6,817		$	4,850		$	1,967			40.6

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	TriPath Oncology
	Three Months Ended
	March 31,
							Change			%
	2006			2005			vs 2005			Change
Revenues	$	530		$	248		$	282			113.7
Cost of revenues		452			160			292			182.5
Gross profit		78			88			(10	)		(11.4	)
Gross margin		14.7	%		35.5	%		—
Operating expenses:
Research and development		2,921			2,653			268			10.1
Regulatory		650			201			449			223.4
Sales and marketing		221			37			184			497.3
General and administrative		1,417			1,217			200			16.4
		5,209			4,108			1,101			26.8
Operating loss	$	(5,131	)	$	(4,020	)	$	(1,111	)		(27.6	)

Revenues

Total Revenues —Total revenues for the first quarter of 2006 were $24,042, representing an increase of $4,715, or 24.4%, compared to revenues of $19,327 in the first quarter of 2005. Total revenues for the three months ended March 31, 2006 include a reduction of $195, compared to $432 in the first quarter of 2005, related to a non-cash sales discount in connection with warrants issued to Quest Diagnostics which is discussed below in connection with sales of reagents (see also “Non-GAAP Financial Measures”above). The most significant component of our increased revenues was from increased sales of reagents and disposables in our commercial operations segment, as discussed further below.

Commercial Operations Revenues —Revenues for the first quarter of 2006 in our Commercial Operations segment were $23,512, net of a $195 non-cash sales discount related to reagents and disposable sales versus $19,079, net of a $432 non-cash sales discount in the first quarter of 2005, representing an increase of $4,433, or 23.2%.

In the first quarter of 2006, reagent revenues increased by $3,496, or 23.2%, versus the first quarter of 2005. Domestic sales of our SurePath and PrepStain reagents, which reflects the impact of a $195 non-cash sales discount in the first quarter of 2006 versus $432 in the first quarter of 2005, increased $2,345, or 20.0%, while international reagent and disposable sales increased $1,151, or 34.6%, over the same period in 2005. Revenues generated from domestic sales of reagents and disposables decreased by 3.5% from the fourth quarter of 2005. Worldwide, we shipped 21 PrepStain instruments, including 10 sales and 11 reagent rentals in the first quarter of 2006. In the U.S., we shipped 11 PrepStain instruments to new and existing customers, all of which were reagent rentals. During the first quarter of 2006, we gained 11 new laboratory customers in the U.S. Domestic sales of test kit units increased by 32.5% from the first quarter of 2005 and by 0.9% from the fourth quarter of 2005. Revenues generated from the sale of cervical cytology test kits to the large commercial laboratories increased 92.1% in the first quarter of 2006 over the first quarter of 2005. The large commercial laboratories accounted for 48.5% of all SurePath cervical cytology test kits sold by us in the U.S. in the first quarter of 2006 as compared to 33.4% in the first quarter of 2005 and 43.5% in the fourth quarter of 2005. The increase in business from

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large commercial laboratory customers continues to result from our relationships with Quest Diagnostics, LabCorp and AmeriPath and increasing focus of our sales and marketing efforts on the large commercial laboratories. In addition, SurePath tests sold to our traditional customer base increased 2.5% from the first quarter of 2005. We estimate that our SurePath Test Pack share of the domestic Pap smear testing market in the U.S. was almost 22% for the first quarter of 2006 versus approximately 16% for the first quarter of 2005.

Instrument revenues increased $590, or 31.8%, for the first quarter of 2006 versus the first quarter of 2005. Sales of PrepStain instruments worldwide decreased by $495, or 58.4%, for the first quarter of 2006 over the first quarter of 2005, comprised of a domestic decrease of $37 and a decrease of $458 internationally, largely due to significant sales in Canada during the first quarter of 2005. Worldwide sales of FocalPoint Slide Profiler systems increased approximately $987, or 98.8%, during the first quarter of 2006 compared to the first quarter of 2005, with a domestic increase of $321, or 75.9%, and an international increase of $666, or 115.6%. In aggregate, a net of one FocalPoint slide profiler was returned, since there were two placements and three returns in the U.S. during the quarter. This brings the total of FocalPoint slide profiler customers in the U.S. to 58, representing 109 instruments. Approximately 79% of FocalPoint customers in the U.S. utilize our integrating software to process both conventional Pap smears and SurePath slides. Sales related to our Extended SlideWizard instruments were $109 during the first quarter of 2006, all international, and increased $98, or 893.9% versus $11 in the first quarter of 2005, also all international.

Other revenues increased by $347, or 16.0%, from the first quarter of 2005 to the first quarter of 2006. The major components of this overall net increase were service revenue increases of $86, other SlideWizard-related increases of $83, freight and royalty increases of $51 and other consumable revenue increases of $192. Offsetting these increases were decreases in FocalPoint fee-per-use revenues totaling $65.

TriPath Oncology Revenues— Our TriPath Oncology business has been focused, since its inception, on developing molecular diagnostic products for malignant melanoma and cancers of the cervix, breast, ovary, and prostate. Our TriPath Oncology segment recorded $530 of revenues in the first quarter of 2006, primarily attributable to sales of the VIAS instrument, an increase of $282, or 113.7% compared with $248 in the same period of 2005, which was entirely attributable to sales of the VIAS instrument.

Gross Margin

Total Gross Margin— Total gross margin for the first quarter of 2006 was 67.1%, a decrease from 70.1% in the comparable period of 2005. This decreased gross margin resulted primarily from our growth in reagent revenues from our large commercial laboratory customers, due to typically lower selling prices to these higher-volume customers, and to a lesser degree from increased revenues in our lower margin instrument revenues, particularly VIAS, during the comparable quarters. Overall, gross profit increased by $2,589, or 19.1%, to $16,137 in the first three months of 2006 versus $13,548 in the first three months of 2005. Our Commercial Operations segment is primarily responsible for the increase in gross profit because of continued growth in reagent and disposable sales and lean-based efficiencies in our manufacturing operations, which includes tools such as Value Stream Mapping, One-Piece Flow, Kanban Materials Management and Kaizen implementation methodology. TriPath Oncology recorded decreased gross profit primarily related to increased sales of lower margin fee-per-use VIAS instruments during the first quarter of 2006 compared with 2005.

Commercial Operations Gross Margin— Gross margin for the first quarter of 2006 in our commercial operations segment was 68.3%, a decrease from 70.5% in the comparable period of 2005. Overall, this resulted in an increase in gross profit of $2,599, or 19.3%, between the comparable quarters. Gross profit

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decreased as the result of continued growth in reagent revenues in the large laboratory customer segment of our business as discussed above.

TriPath Oncology Gross Margin— Gross margin for the first quarter of 2006 in our TriPath Oncology segment was 14.7%, compared with 35.5% in the comparable period of 2005. TriPath Oncology had a relatively minor impact on overall gross margin in the first quarter of 2005, but did reduce overall gross margin by 1.2% in the first quarter of 2006. Gross margin in the first quarters of 2006 and 2005 resulted substantially from sales of the VIAS instrument. The gross margin differences between the comparable quarters resulted from increased sales of lower margin fee-per-use VIAS instruments during the first quarter of 2006 compared with 2005.

Research and Development

Total Research and Development— Research and development expenses include salaries and benefits of scientific and engineering personnel, depreciation of testing equipment, relevant consulting and professional services, components for prototypes and certain facility costs. Total research and development expenses for the first quarter of 2006 were $3,594, a $465, or 14.9%, increase from $3,129 in the first quarter of 2005.

Commercial Operations Research and Development— Research and development expenditures relating to our Commercial Operations segment reflect research activity related to our cervical cytology product line and the development of manufacturing capabilities for new molecular tests that we are developing. As our manufacturing operations are managed through our Commercial Operations segment, costs related to the manufacture of our new molecular tests will be assigned to our Commercial Operations segment. Commercial Operations research and development expenses increased by $197, or 41.4%, to $673 in the first quarter of 2006, from $476 in the first quarter of 2005, largely due to personnel related expenses.

TriPath Oncology Research and Development— Research and development expenses related to our TriPath Oncology segment increased by $268, or 10.1%, to $2,921 in the first quarter of 2006 from $2,653 in the first quarter of 2005. The increase predominantly reflects actions taken relative to the transition of our breast cancer staging assay and SurePath Molecular Pap test development efforts into clinical trials. In connection with this transition, we completed a number of development activities related to these products and took certain actions in the first quarter of 2006 that will result in cost reductions beginning in the second quarter. Personnel separation costs related to these cost reducing actions were principally reflected in the first quarter of 2006.

Regulatory

Total Regulatory— Regulatory expenses include salaries and benefits of regulatory and quality personnel, costs related to clinical studies and submissions to the FDA, and relevant consulting services. Total regulatory expenses for the first quarter of 2006 were $1,111, a $359, or 47.7%, increase from $752 in the first quarter of 2005.

Commercial Operations Regulatory— Regulatory expenses in our Commercial Operations segment decreased by $90, or 16.3%, to $461 in the first quarter of 2006, from $551 in the first quarter of 2005. This decrease was primarily attributable to the transfer of the majority of our clinical trials personnel to our TriPath Oncology segment in anticipation of our planned trials related to our cervical screening and breast staging assays.

TriPath Oncology Regulatory— Regulatory expenses in our TriPath Oncology segment increased by $449, or 223.4%, to $650 in the first quarter of 2006 from $201 in the first quarter of 2005. This increase in

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regulatory expenses reflects increased activities relating to our planned clinical trials for our cervical screening and breast staging assays including staffing, protocol finalization, site selection and preparation and initial sample procurement.

Sales and Marketing

Total Sales and Marketing —Sales and marketing expenses include salaries and benefits of sales, marketing, sales support and service personnel, and their related expenses. In addition, non-personnel-related expenses associated with marketing our products are also included in sales and marketing expenses. Total sales and marketing expenses for the first quarter of 2006 were $6,182, an increase of $1,240, or 25.1%, from $4,942 in the first quarter of 2005.

Commercial Operations Sales and Marketing —Sales and marketing costs in our Commercial Operations segment for the first quarter of 2006 were $5,961, an increase of $1,056, or 21.5%, compared to $4,905 in the corresponding quarter of 2005. This expense increase continues to predominantly reflect the reorganization and expansion of our sales and marketing activities which was initiated in the third quarter of 2004 and completed in 2005.

TriPath Oncology Sales and Marketing —Sales and marketing expenses in our TriPath Oncology segment for the first quarter of 2006 were $221, an increase of $184, or 497.3%, compared to $37 in the first quarter of 2005. This expense increase reflects expenses related to preparation for the potential launch of our future molecular diagnostic products.

General and Administrative

Total General and Administrative —General and administrative expenses include salaries and benefits for administrative personnel, legal and other professional fees and certain facility costs. Total general and administrative expenses for the first quarter of 2006 were $3,564, which represents a decrease of $331, or 8.5%, versus $3,895 recorded in the same period in 2005.

Commercial Operations General and Administrative —Commercial Operations recorded general and administrative expenses of $2,147 in the first quarter of 2006, a decrease of $531, or 19.8%, compared to $2,678 recorded in the same quarter in 2005. This was primarily attributable to lower costs related to litigation and to initial compliance with Section 404 of the Sarbanes-Oxley Act than we experienced in the first quarter of 2005.

TriPath Oncology General and Administrative —TriPath Oncology recorded general and administrative expenses of $1,417 in the first quarter of 2006, an increase of $200, or 16.4%, compared to $1,217 recorded in the same quarter in 2005. This was largely due to higher personnel expenditures.

Operating Income/(Loss)

Total Operating Income. Operating income during the first quarter of 2006 was $1,686, an improvement of $856, or 103.1%, compared with operating income of $830 in the first quarter of 2005. The improvement in operating income largely reflects incremental gross profit on new sales of reagents offset partially by increased operating expenses related to the reorganization and expansion of our sales and marketing activities, as described above. Total increases in gross profit contributed $2,589, or 19.1%, to the net improvement in operating income in the first quarter of 2006 compared with the same period in 2005. The increase in gross profit was partially offset by an increase in operating expenses of $1,733 or 13.6%, as described above.

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Commercial Operations Operating Income. Operating income during the first quarter of 2006 attributable to Commercial Operations was $6,817, a $1,967, or 40.6%, improvement from operating income of $4,850 in the first quarter of 2005. The improvement in operating income largely reflects incremental gross profit on new sales of reagents partially offset by operating expenses related to the reorganization and expansion of our sales and marketing activities, as described above. Total increases in gross profit contributed $2,599, or 19.3%, to the net improvement in operating income in the first quarter of 2006, compared with the first quarter of 2005. The increase in gross profit was partially offset by an increase in operating expenses of $632, or 7.3%, as described above.

TriPath Oncology Operating Loss.Net operating loss during the first quarter of 2006 attributable to TriPath Oncology was $5,131, a $1,111, or 27.6%, larger operating loss compared with $4,020 in the first quarter of 2005. The larger net operating loss reflects decreased gross profit of $10, or 11.4%, and increased operating expenses of $1,101, or 26.8%, as described above.

Interest Income and Expense

Interest Income and Expense —Interest income for the first quarter of 2006 was $234, a $134 or 134.0%, increase from $100 during the first quarter of 2005. This increase was primarily attributable to higher interest rates compared with the first quarter of 2005 and due to higher average cash balances. There was $4 of interest expense for the first quarter of 2006 compared with $5 in the first quarter of 2005.

Net Income

We recorded net income in the first quarter of 2006 of $1,745, which compares with net income of $925 in the first quarter of 2005, an improvement of $820, or 88.6%. Although we recorded net income in the first quarters of 2006 and 2005, we had consolidated losses for regular federal income tax purposes in all periods presented, thus requiring no provision for regular federal income taxes. Income tax expense for the quarter ended March 31, 2006 equated to an effective tax rate of 8.9% compared to 0.0% for the quarter ended March 31, 2005. The primary difference between income tax expense and the U.S. statutory rate for the quarter ended March 31, 2006 was a change in the deferred tax valuation allowance resulting from utilization of federal net operating loss carryovers. The increase in the effective tax rate for the quarter ended March 31, 2006 compared to the quarter ended March 31, 2005 resulted primarily from federal Alternative Minimum Tax and increased expense for states with no or fully utilized loss carryovers.

Recently Issued Accounting Standards

In accordance with recently issued accounting pronouncements, we are required to comply with certain changes in accounting rules and regulations. Specifically, in accordance with SFAS Statement No. 123(R), “Share-Based Payment,” effective January 1, 2006, we have begun to record the value of stock options and other forms of equity-based long term incentives as a direct expense in our financial statements. See Note 7 to the Condensed Consolidated Financial Statements included herein and Developments (above).

Liquidity and Capital Resources
(In thousands, except share and per share amounts)

Since our formation and until 2004, our expenses had significantly exceeded our revenues each quarter, resulting in an accumulated deficit of $224,110 as of March 31, 2006. We have funded our operations primarily through the private placement and public sale of equity securities, debt facilities and product sales. We had cash and cash equivalents of $23,059 at March 31, 2006 compared with $22,457 at December 31, 2005.

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We funded our operations in the first three months of 2006 from cash and cash equivalents on hand and revenues from both our Commercial Operations and TriPath Oncology segments.

The table below summarizes certain key components of our cash flow and working capital for the three months ended March 31, 2006 and 2005. Comments made throughout this discussion related to our cash-related activities refer to the figures in this table.

	Three Months Ended March 31,
	2006			2005			$ Change			% Change
Cash Flow Type: source/(use)
Operating	$	870		$	1,629		$	(759	)		(46.6	)
Investing		(903	)		(259	)		(644	)		(248.6	)
Financing		618			124			494			398.4
Cash and cash equivalents at March 31	$	23,059		$	20,247		$	2,812			13.9

Operating

Cash provided by operating activities was $870 during the three months ended March 31, 2006 compared with net cash provided of $1,629 during the corresponding period of 2005, a reduction of $759. The decrease in net cash provided by operations between the first three months of 2006 and 2005 was attributable to several factors. We recorded net income of $1,745 for the three months ended March 31, 2006 compared with $925 for the three months ended March 31, 2005, an improvement of $820. This improvement in earnings was offset by $1,579, comprised of a decrease in non-cash items of $72 and a net increase of $1,507 in the use of cash in operating assets and liabilities between the first three months of 2005 and the first three months of 2006.

The decrease in non-cash items of $72 between the first three months of 2006 and 2005 was primarily due to a decrease in non-cash sales discount of $237 and decreased depreciation and amortization of $67. Offsetting these decreases were increases of $100 of bad debt expense, $84 related to compensation expense recorded under SFAS 123(R) and an increase of $48 in income taxes provision.

The net increase of $1,507 in the use of cash in operating assets and liabilities between the first three months of 2005 and the first three months of 2006 was primarily attributable to an increase in working capital applied to accounts payable and accrued expenses of $2,023, offset by a decrease in working capital applied to accounts, notes and lease receivables of $464 and inventory of $57. The increase in working capital applied to accounts payable and accrued expenses was primarily attributable to personnel-related expenses, inventory purchases and clinical trial payments. The decrease in working capital applied to accounts, notes and lease receivables was attributable to stronger collections. Other changes in operating assets and liabilities reflected a net source of cash of $5.

Investing

Cash used by investing activities decreased by $644 from $259 during the first quarter of 2005 to $903 during the first quarter of 2006. Capital expenditures were $341 during the three months ended March 31, 2006 and $259 during the corresponding period of 2005, an increase of $82, primarily attributable to the purchase of machinery and equipment. We have no material commitments for capital expenditures. Additionally during the first three months of 2006, we acquired real estate and a mortgage in connection with the relocation of a newly hired employee. We initially recorded the real estate at $562 and have classified it as an other current asset.

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Financing

Our cash provided by financing activities for the first three months of 2006 compared to the first three months of 2005 increased by $494, from $124 in the first three months of 2005 to $618 in the same period of 2006. These cash flows were most impacted by debt activity and stock option exercises. We had no traditional borrowings during the first three months of 2006 or in 2005, but as mentioned above, we acquired real estate and a mortgage in connection with the relocation of a newly hired employee. The mortgage was assumed at a value of $384 when it was aquired during the first quarter of 2006. Additionally, cash received from stock option exercises in the first three months of 2006 increased by $96 compared to the first three months of 2005. Additionally, payments on debt and leases in the first three months of 2006 were lower by $14 than in the first three months of 2005.

Until its expiration on April 27, 2006, we had a $7,500 working capital facility with Silicon Valley Bank. The entire amount of the line was available as long as certain financial covenants were met. If these covenants were not met, the available balance is limited to an amount equal to 80% of eligible accounts receivable. At March 31, 2006, we were entitled to borrow the full amount of the line. However, due to the assumed mortgage discussed above, we violated one of the facility’s covenants, for which we received a waiver from the bank. The line offered either a prime-based (prime plus 0.25%) or LIBOR-based (LIBOR plus 2.0%) pricing option for advances made under it and was collateralized by substantially all of our assets. The line of credit carried customary covenants, including the maintenance of a minimum modified quick ratio, minimum tangible net worth, and other requirements. We had no outstanding borrowings under this agreement at March 31, 2006 and allowed the line to expire as of April 27, 2006.

As of April 27, 2006 we secured a new $7,500 working capital facility with Wachovia Bank, N.A. The new line carries a rate of interest equal to LIBOR plus 1.80% and has an expiration date of April 27, 2007. The line of credit carries customary covenants, including the maintenance of a minimum tangible net worth, a minimum fixed charge coverage ratio and other requirements. The line is collateralized by substantially all of our assets. As of the date hereof, we have no oustanding borrowings under this facility.

From April 2003 until its expiration in March 2006, we maintained a $2,500 lease line of credit from General Electric Capital Corporation (“GE Capital”). Individual operating lease schedules under the lease line carry three-year terms. Financing charges are based on the fixed basic term lease rate factor. The interest rates on the various schedules, which are incorporated into the lease payments under this lease line, which are incorporated into the operating lease payments, range from 2.85% to 3.45%. The lease line was being used as an alternative source of capital to obtain assets, primarily equipment, subject to operating leases. In July 2005, this line was renewed for a one-year term (effective March 2005) for $1,000 (in addition to amounts for assets already leased under the line). Terms of the new line were substantially the same as the expiring line. As of both March 31, 2006 and December 31, 2005, assets with an original cost of $1,917 were leased under our lease lines with GE Capital. No new assets were added to the line during the first quarter of 2006. Future minimum lease payments under this lease line are $1,023 as of March 31, 2006. We allowed this line to expire in March 2006 with respect to our ability to lease additional assets under it, but the existing leases under the line will continue to their contractual maturities as described above. As the lease line has expired, no further assets will be leased under this line of credit.

As of April 1, 2006 we obtained a new $1,500 lease line of credit from GE Capital that replaced the lease line discussed above that expired in March 2006. The lease terms of the new line range from 36 to 48 months. The new line has a term of 1 year and carries a rate of interest based on the Federal Reserve’s 4 and 3 year Treasury Constant Maturities Rate. This lease line will be used as an alternative source of capital to obtain assets, primarily equipment, subject to leases.

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During August 2002, we obtained a $1,500 lease line of credit from Bank of America. Bank of America assigned the leases under this line to GE Capital in 2004. Amounts used under this lease line are secured by a letter of credit against our line of credit with Silicon Valley Bank discussed above. Assets leased under this lease line carry three-year lease terms. Financing charges are based on three-year constant Treasury Maturities. The interest rates on the various schedules under this lease line, which are incorporated into the operating lease payments, range from 2.75% to 2.90%. The lease line was used as an alternative source of capital to obtain assets, primarily equipment, subject to operating leases. As of March 31, 2006 and December 31, 2005, assets with an original cost of $1,286 were leased under this lease line. Future minimum lease payments under this lease line were $216 as of March 31, 2006. As the lease line has expired, no further assets will be leased under this line of credit.

During 2004 the Federal Reserve began a policy of increasing its Federal funds interest rates from 46-year lows of 1.0%. By December 31, 2004, the Federal Reserve had increased this key interest rate to 2.25% with additional increases during 2005, to 4.25% by December 2005. At March 31, 2006 this key rate stood at 4.75%. This is up from 1.0% at the beginning of 2004. While this increasing interest rate environment, if it continues, will positively impact earnings on our invested cash, it will also negatively affect our earnings and our cash if we are required to incur additional debt.

Off-Balance Sheet Arrangements

We have no other long-term debt commitments and no other off-balance sheet financing vehicles.

Outlook

Our success in 2006 will depend on our ability to continue to take advantage of the opportunities for growth that we have created over the past five years, our ability to balance the costs associated with effective research, development, and marketing and selling programs with revenue growth, and the extent to which we can continue to leverage our operating infrastructure.

We estimate that full year revenues for 2006 will be in the range of $102,000 to $105,000 and will reflect continued growth in our cervical cytology business as well as revenues generated from the early commercialization of some of our molecular diagnostic reagents and molecular imaging systems. Revenues for any particular period will depend upon the timing of certain remaining deferred sales discounts that we would amortize over a six-month period if and when it becomes probable that any of two currently unexercisable tranches of warrants held by Quest Diagnostics may vest upon achievement of certain sales-based milestones. Quest Diagnostics earned the warrants under two of the four sales-based milestones in 2005, leaving two to be earned in future periods. While not certain, it is possible that certain sales-based milestones for these two tranches of warrants will be achieved by Quest Diagnostics that, if met, will result in additional non-cash sales discounts of up to $1,619 in 2006.

We expect that our growth in revenues in 2006 will be primarily driven by the sale of reagents and disposables as well as growth from the sum of sales, rentals and usage fees derived from new and existing placements of our instruments. We expect that revenues from our cytology products will grow approximately 18% to 20% and that revenues generated from some of our molecular reagents and interactive histology imaging system will increase by approximately 100% from 2005.

Given our anticipated revenue mix, we expect that our gross margins will fall into a range of between 67% and 70% in 2006. As we continue our focus on large commercial laboratory customers, we expect to continue to face a corresponding deceleration in the relative growth of business within our traditional and more fully penetrated customer base. As sales to large commercial laboratories continue to increase, there may be some downward pressure on gross margin as the selling prices of our tests to higher volume customers, such as these large commercial laboratories, tend to be lower than selling prices to our other laboratory customers. We anticipate this downward trend may be somewhat offset as continued

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improvements to our manufacturing costs, due to higher volumes and efficiencies from our lean-based manufacturing programs, continue to favorably impact cost of goods sold. The extent to which gross margin is affected as the result of this trend will depend upon the relative number of tests sold to the higher volume laboratories at any point in time.

The structure of our agreement with Ventana relating to the sale of a Ventana branded version (VIAS) of our interactive histology imager may also impact our gross margin in the remainder of 2006. Pursuant to the agreement we will receive a fixed payment for each imager manufactured for Ventana and usage fees for each Ventana test processed on each imaging system after placement with a Ventana customer. The instrument transfer price includes a small premium over our cost of manufacture and, as a result, will generate a gross margin for each instrument sold that is lower than is typical for our instrument sales. The anticipated gross margin associated with the usage fees approaches 100%. Since most of the activity in the first year of this agreement will logically relate to the initial placement of imaging systems, we anticipate that most revenues generated from this relationship in the second quarter of 2006, as it did during the first quarter of 2006, will reflect the lower gross margin associated with the instrument transfer price. We expect that this downward trend will be offset by the higher gross margin generated over time from usage fees, which we anticipate will become more significant during the latter half of 2006. The extent to which the overall gross margin is affected will depend on the extent to which Ventana is successful in placing instruments and generating tests from each instrument placed.

We expect our operating expenses to increase in 2006 by 15% to 20% from those from those reported in 2005. The most significant increase in operating expenses that we expect in 2006 will occur in our regulatory and clinical affairs programs. We expect that these expenses will increase by $6,500 to $7,000 in 2006 as we invest in our breast cancer staging and cervical screening (SurePath Molecular Pap test) clinical trials and collect additional data in support of a resubmission to the FDA relating to our FocalPoint GS Imaging System. We expect that expenses related to our clinical trials will be greatest in the second and third quarters of 2006 and will begin to decline in the fourth quarter. As we have transitioned our molecular imaging system, our breast cancer staging assay, and the SurePath Molecular Pap test either into the market place or into clinical trials, we have completed a number of development activities related to these products. We therefore expect to reduce research and development costs by approximately 10% in 2006 overall. We expect that the impact of the actions taken in January 2006 related to the completion of these development activities will result in cost reductions beginning in the second quarter as, termination costs related to these cost reductions were principally reflected in the first quarter of 2006. We expect that sales and marketing expenses will increase by approximately 15% to 20% in 2006 as we experience the full-year impact of the expanded sales and marketing activities that we implemented in 2005. We expect that general and administrative expenses will be comparable to those recorded in 2005.

Our Commercial Operations segment has been profitable for over three years and generated operating income of $22,075 in 2005, an increase of 49.7% over 2004. Additionally, operating income in the segment increased 40.6% from the first quarter of 2005 to the first quarter of 2006. We expect that this segment will continue to generate significant operating income and cash. The excess cash flow generated from the Commercial Operations segment has been, and will continue to be utilized in part to fund the operations of our TriPath Oncology segment. We anticipate that the TriPath Oncology segment, which includes all research and development, regulatory, sales and marketing, and administrative expenses relating to our molecular diagnostic programs, will incur $1,500 to $2,000 of expenses per month during the remainder of 2006, as it did during the first quarter of 2006, as we engage in clinical trials with respect to our cervical screening and breast staging assays, generate internal and external research studies on our RUO reagents for ovarian screening, select a multiplexing testing platform for our blood based screening assays that will allow for simultaneous detection of multiple markers from a very small volume of blood, adapt our ovarian screening assay to this testing platform in advance of anticipated clinical trials in 2007, follow-up on the April 2006 introduction of

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the Class I IHC kits that incorporate our Pro Ex C biomarkers, and continue to expand the VIAS testing menu.

We believe that we can continue to manage our cash to minimize the need for additional outside sources of cash in 2006. For the second straight year, we experienced positive cash flow from the business during 2005. While our positive cash flow is an important milestone, we may experience one or two additional quarters of negative cash flow in any given period, but we anticipate generating positive cash flow for the full year 2006 as a whole and beyond. We expect that our capital expenditures for 2006 may range from $1,000 to $1,500. We may borrow from our line of credit to finance part, or all, of those capital expenditures. While the existing line expired in April 2006, we secured a new $7,500 working capital facility with Wachovia Bank, N.A., as discussed above. We have availability under a $2,000 lease line of credit that can be used for equipment placed under operating leases. We believe that our existing cash, our expectation of continuing to generate positive cash flow for the full-year 2006, anticipated additional debt and/or lease financing for internal use assets, rental placements of PrepStain and fee-per-use placements of FocalPoint instruments will be sufficient to enable us to meet our future cash obligations for at least the next 12 months.

While it is expected that marketing and sales expenditures for the continued SurePath commercial rollout for gynecological uses in the United States will increase, and it is possible that, capital expenditures associated with placements of PrepStain units and FocalPoint fee-per-use instruments, and expenditures related to clinical trials, manufacturing, the TriPath Oncology segment and other administrative costs may increase, we anticipate that our future sales growth and the cost control measures we have implemented should allow us to avoid raising additional funds for operating purposes in the near future. If, however, our existing resources prove insufficient to satisfy our liquidity requirements, or if we need cash for any non-routine purpose, we may need to raise additional funds through bank facilities, the sale of additional equity or debt securities or other sources of capital. In addition, we may opportunistically take advantage of favorable conditions in the capital markets and raise debt or equity publicly if such conditions are present and such financing is advisable. The sale of any equity or debt securities, if required, may result in additional dilution to our stockholders. We cannot be certain that additional financing will be available in amounts, or on terms, acceptable to us, if at all. Our failure to participate in such financing, if needed, could have a material adverse effect on our liquidity and capital resources, business, financial condition and results of operations.

In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R))”, which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation.” The adoption of SFAS 123(R)’s fair value method had a minor impact on our results of operations and operating cash flows for the three months ended March 31, 2006. The full-year impact of our adoption of SFAS 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted SFAS 123(R) in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of Pro Forma net loss and loss per share in footnote 2 (Stock Based Compensation) of our financial statements. SFAS 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. Our current estimate for the non-cash impact of implementing SFAS 123(R) on existing stock-based compensation instruments is less than $0.01 per share for full year 2006. However, if we issue annual grants of stock-based compensation instruments during 2006, as we typically do around the time of our annual shareholders’ meeting in May, there will be additional impact on our earnings per share. Since the majority of our outstanding options were vested in 2005 or prior, our current estimate of the total stock-based compensation expense in 2006, if stock-based compensation is granted, is an impact to earnings per share of between $0.01 and $0.02 per share, principally during the second half of 2006. This is discussed further above in footnote 7, “Stock-Based Compensation.”

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We provide for income taxes in accordance with the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. We review our deferred tax asset on a quarterly basis to determine if a valuation allowance is required, primarily based on our estimates of future taxable income. As of March 31, 2006 our net deferred tax asset is fully reserved through the valuation allowance. Changes in our assessment of the need for a valuation allowance could give rise to additional valuation allowance or release of the valuation allowance previously established against our deferred tax assets and either a related expense or benefit in the period of change.

This Outlook section contains forward-looking statements and should be read in conjunction with the forward-looking statements disclosure at the beginning of this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” above.

Certain Factors Which May Affect Future Operations and Results

This Management’s Discussion and Analysis contains certain forward-looking statements based on current expectations of our management. Generally, those forward-looking statements use words like “expect,” “believe,” “continue,” “anticipate,” “estimate,” “may,” “will,” “could,” “opportunity,” “future,” “project,” and similar expressions. Such statements are subject to risks and uncertainties, including those described below that could cause actual results to differ from those projected. The forward-looking statements include those made in the section entitled “Outlook” above, as well as statements about our: projected timetables for the pre-clinical and clinical development of, regulatory submissions and approvals for, and market introduction and commercialization of our products and services; advancement of TriPath Oncology’s product development programs; expected future revenues, profitability, margins, operations and expenditures; sales and marketing force expansion; anticipated progress in the large commercial laboratories and projected cash needs. We caution investors not to place undue reliance on the forward-looking statements contained in this report, which speak only as of the date hereof. We undertake no obligation to update these statements to reflect events or circumstances occurring after the date of this report or to reflect the occurrence of unanticipated events, except as required by law.

Certain factors, among others, that could cause our actual results to differ materially from what is expressed in those forward-looking statements include the following:

— we may be unable to increase sales and revenues at our historical rates;

— we may not receive revenues when or in the amounts anticipated;

— we may not be able to maintain profitability;

— we may have to reflect non-cash sales discounts in connection with warrants held by Quest Diagnostics for different financial periods than we expect, depending upon if and when it becomes probable that certain sales-based milestones may be met in connection with our agreement with Quest Diagnostics;

— we may not be able to continue to increase our penetration of the very competitive large commercial laboratories to the extent we expect, and we may not be able to maintain and grow our business within our traditional customer base to the extent we expect or at all;

— we may not achieve revenues to the degree expected from our relationship with Ventana and the sale of analyte-specific reagents and research use only products derived from our molecular oncology development program;

— our expanded sales and marketing presence may not have the expected impact, and we may face attrition issues customary for such an expansion;

— we may incur greater expenses than we expect generally and with our clinical trials and sales and marketing efforts specifically;

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— our clinical trials may take longer to complete than we expect and may be unsuccessful; - - we may not receive FDA approval for our FocalPoint GS and HPV-related applications;

— the clinical trials for our breast cancer staging assay and SurePath Molecular Pap test may not be successful;

— we may not receive FDA clearance for processing additional Ventana assays on the interactive histology imager on schedule or at all, and we may be required to obtain additional FDA and other regulatory approvals for the interactive histology imager, along with approvals for processing the assays, which we may not receive in a timely manner or at all;

— revenues from our agreement with Ventana may not materialize to the extent we expect;

— we may not be successful in selling TriPath Oncology’s pre-IVD (in-vitro diagnostic) products and services;

— sales of our stock by Roche Holdings, Inc., which owns approximately 20% of our stock, may significantly impact our stock price;

— we may need to obtain additional financing in the future;

— we may be unable to obtain and maintain adequate patent and other proprietary rights protection of our products and services;

— our products may not receive regulatory, pricing and reimbursement approval when we expect, if at all;

— we may be unable to comply with the extensive domestic and international governmental regulatory, pricing and reimbursement approval and review procedures and other regulatory requirements to which the manufacture and sale of our products are subject, or lack the financial resources to bear the expense associated with such compliance;

— our products may not be accepted by the market to the extent we expect and the frequency of use of our screening products may decline;

— TriPath Oncology may be unable to successfully develop and commercialize molecular diagnostic oncology products when anticipated, if at all;

— external studies of our product candidates may not come to the conclusions we expect;

— TriPath Oncology may be unable to license markers needed to optimize its product candidates;

— we may be unable to establish and maintain licenses, strategic collaborations and distribution arrangements;

— we and laboratories using our products may not obtain adequate levels of third-party reimbursement for our products;

— we may lack the financial resources necessary to further develop our marketing and sales capabilities domestically and internationally or to expand our manufacturing capability;

— competition and technological, scientific and medical, changes may make our products or potential products and technologies less attractive, used less frequently, or obsolete;

— our promotional discounts, sales and marketing programs and strategies may not have their expected effect; and

— uncertainties resulting from the initiation and continuation of our litigation with a competitor could have a material adverse effect on our ability to continue our operations.

Some of these factors and others are discussed in more detail in Exhibit 99.1 “Factors Affecting Future Operating Results” to our Annual Report on Form 10-K for the year ended December 31, 2005, which exhibit is incorporated into this report by reference.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We do not participate in derivative financial instruments, other financial instruments for which the fair value disclosure would be required under SFAS No. 107, or derivative commodity instruments. All of our investments are in short term, investment grade commercial paper, corporate bonds and U.S. Government and agency securities that are carried at fair value on our books. Accordingly, we have no quantitative information concerning the market risk of participating in such investments.

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Our primary market risk exposures are in the areas of interest rate risk and foreign currency exchange rate risk. Our financial results and cash flows are subject to fluctuation due to changes in interest rates, primarily from our investment of available cash balances in highly rated institutions. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. See “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” under “Liquidity and Capital Resources” for further discussion of the impact of interest rates on our financial results. We operate in several foreign countries and are subject to fluctuations in foreign currencies to a minor extent. We have no foreign exchange contracts, option contracts, or other foreign hedging arrangements. However, the impact of fluctuations in foreign currencies on our financial results has not been material and are unlikely to have a material adverse effect on our business, financial condition or results of operations in the future.

Item 4. Controls and Procedures

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, the “Exchange Act”) as of the end of the period covered by this quarterly report. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that these disclosure controls and procedures are effective and designed to ensure that the information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the requisite time periods.

Changes in Internal Control

There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) identified in connection with the evaluation of our internal control that occurred during our first fiscal quarter ended March 31, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

We are currently engaged in litigation with Cytyc Corporation, as more fully described in Note 9 of the Condensed Consolidated Financial Statements and in Item 2., Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Quarterly Report on Form 10-Q.

Item 1A. Risk Factors

There have been no material changes in our risk factors from those disclosed in Exhibit 99.1 “Factors Affecting Future Operating Results” to our Annual Report on Form 10-K (File No. 0-22885) for the year ended December 31, 2005.

Also, information concerning certain risk factors is discussed in Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Certain Factors Which May Affect Future Operations and Results” of this Report on Form 10-Q.

Item 6. Exhibits

See Exhibit Index immediately following the Signatures.

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TRIPATH IMAGING, INC.
FORM 10-Q
March 31, 2006

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.

	TRIPATH IMAGING, INC.
DATE: May 1, 2006		BY:	/s/ Stephen P. Hall
		Stephen P. Hall Senior Vice-President and Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)

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EXHIBIT INDEX

Exhibit	Description
3.1	Restated Certificate of Incorporation. Filed as Exhibit 3.1 to the Company’s Form 10-Q for the quarter ended June 30, 2002 (File No. 0-22885) and incorporated herein by reference.
3.2	Amended and Restated By-laws of the Company. Filed as Exhibit 3.2 to the Company’s Form 10-Q for the quarter ended June 30, 2002 (File No. 0-22885) and incorporated herein by reference.
10.1*	Form of Stock Appreciation Rights Agreement under the Amended and Restated 1996 Equity Incentive Plan. Filed herewith.
31.1	Certifications of the Chief Executive Officer pursuant to Section 240.13a-14 or Section 240.15d-14 of the Securities Exchange Act of 1934, as amended. Filed herewith.
31.2	Certifications of the Chief Financial Officer pursuant to Section 240.13a-14 or Section 240.15d-14 of the Securities Exchange Act of 1934, as amended. Filed herewith.
32	Certification of the Chief Executive Officer and the Chief Financial Officer pursuant to 18 U.S.C. Section 1350. Filed herewith.

* Indicates a management contract or compensatory plan.

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