Cardiac Science 10-Q 2006 Q2 Quarterly report

UNITED STATES 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 ended June 30, 2006

OR

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

Commission File Number 000-51512

Cardiac Science Corporation

(Exact name of registrant as specified in its charter)

Delaware	94-3300396
(State of Incorporation)	(IRS Employer Identification No.)

3303 Monte Villa Parkway
Bothell, Washington 98021
(Address of principal executive offices)

(425) 402-2000
(Registrant’s telephone number)

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

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

     Indicate by check mark 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 check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).o Yesþ No

     The number of shares outstanding of the registrant’s common stock as of August 2, 2006 was 22,516,569.

TABLE OF CONTENTS

			Page
PART I — FINANCIAL INFORMATION
	Item 1.	Financial Statements (unaudited)		3
	Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations		19
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk		31
	Item 4.	Controls and Procedures		31
PART II — OTHER INFORMATION
	Item 1.	Legal Proceedings		32
	Item 1A.	Risk Factors		32
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		32
	Item 3.	Defaults Upon Senior Securities		32
	Item 4.	Submission of Matters to a Vote of Security Holders		32
	Item 5.	Other Information		32
	Item 6.	Exhibits		33
	SIGNATURE			34
EXHIBIT 10.32
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

Page 2 of 34

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

CARDIAC SCIENCE CORPORATION AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

	June 30,			December 31,
(In thousands)	2006			2005
ASSETS
Current Assets:
Cash and cash equivalents	$	8,746		$	3,546
Accounts receivable, net of allowance for doubtful accounts of $760 and $3,455, respectively		24,884			25,738
Inventories		18,765			22,052
Deferred income taxes		12,113			12,115
Prepaid expenses and other current assets		2,274			2,511
Total current assets		66,782			65,962
Other assets		508			100
Machinery and equipment, net of accumulated depreciation and amortization of $8,894 and $7,565, respectively		6,986			7,631
Deferred income taxes		30,258			27,849
Intangible assets, net of accumulated amortization of $4,377 and $2,642, respectively		33,603			35,338
Investment in unconsolidated entities		461			462
Goodwill		108,648			111,215
Total assets	$	247,246		$	248,557
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
Accounts payable	$	12,228		$	11,642
Accrued liabilities		9,037			11,918
Warranty liability		2,690			2,348
Deferred revenue		7,485			7,924
Total current liabilities		31,440			33,832
Other liabilities		1,024			1,806
Total liabilities		32,464			35,638
Minority interest in consolidated entity		102			128
Commitments and contingencies
Shareholders’ Equity:
Preferred stock (10,000,000 shares authorized), $0.001 par value, no shares issued or outstanding as of June 30, 2006 and December 31, 2005		—			—
Common stock (65,000,000 shares authorized), $0.001 par value, 22,508,433 and 22,410,344 shares issued and outstanding at June 30, 2006 and December 31, 2005, respectively		219,849			218,335
Accumulated other comprehensive income		(2	)		5
Accumulated deficit		(5,167	)		(5,549	)
Total shareholders’ equity		214,680			212,791
Total liabilities and shareholders’ equity	$	247,246		$	248,557

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

Page 3 of 34

CARDIAC SCIENCE CORPORATION AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

	Three months ended						Six months ended
	June 30,						June 30,
(In thousands, except share and per share data)	2006			2005			2006			2005
Revenues:
Products	$	35,007		$	19,073		$	69,576		$	37,417
Service		4,214			2,895			8,760			5,881
Total revenues		39,221			21,968			78,336			43,298
Cost of Revenues:
Products		17,511			10,198			35,191			19,880
Service		3,120			1,895			6,162			3,777
Total cost of revenues		20,631			12,093			41,353			23,657
Gross profit		18,590			9,875			36,983			19,641
Operating Expenses:
Research and development		2,875			1,908			5,845			3,717
Sales and marketing		9,914			4,592			19,297			9,249
General and administrative		5,916			2,266			11,727			4,311
Total operating expenses		18,705			8,766			36,869			17,277
Operating income (loss)		(115	)		1,109			114			2,364
Other Income (Expense):
Interest income (expense), net		(5	)		145			(55	)		258
Other income, net		274			53			505			114
Total other income		269			198			450			372
Income before income taxes and minority interest in loss of consolidated entity		154			1,307			564			2,736
Income tax expense		(49	)		(434	)		(208	)		(904	)
Income before minority interest in loss of consolidated entity		105			873			356			1,832
Minority interest in loss of consolidated entity		13			6			26			26
Net income	$	118		$	879		$	382		$	1,858
Net income per share — basic	$	0.01		$	0.08		$	0.02		$	0.17
Net income per share — diluted	$	0.01		$	0.08		$	0.02		$	0.16
Weighted average shares outstanding — basic		22,486,564			10,876,303			22,458,843			10,867,145
Weighted average shares outstanding — diluted		22,522,902			11,319,497			22,565,413			11,362,952

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

Page 4 of 34

CARDIAC SCIENCE CORPORATION AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

	Three months ended						Six months ended
	June 30,						June 30,
(In thousands)	2006			2005			2006			2005
Operating Activities:
Net income	$	118		$	879		$	382		$	1,858
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		1,543			410			3,100			814
Deferred income taxes		49			398			112			832
Stock-based compensation		567			15			1,016			39
Minority interest in loss of consolidated entity		(13	)		(6	)		(26	)		(26	)
Gain on sale of marketable equity securities		—			(15	)		—			(15	)
Changes in operating assets and liabilities, net of business acquired:
Accounts receivable		864			(786	)		898			641
Inventories		(280	)		307			1,774			(385	)
Prepaid expenses and other current assets		370			(148	)		986			(135	)
Accounts payable		760			(500	)		878			(103	)
Accrued liabilities		(751	)		447			(2,348	)		(1,417	)
Warranty liability		52			43			63			(34	)
Deferred revenue		(104	)		333			(91	)		308
Net cash flows provided by operating activities		3,175			1,377			6,744			2,377
Investing Activities:
Purchases of machinery and equipment		(400	)		(140	)		(796	)		(327	)
Payments related to the purchase of Cardiac Science, Inc.		(441	)		(1,018	)		(1,214	)		(1,097	)
Proceeds from sales of marketable equity securities		—			625			—			625
Net cash flows used in investing activities		(841	)		(533	)		(2,010	)		(799	)
Financing Activities:
Proceeds from exercise of stock options and issuance of shares under employee purchase plan		243			165			466			350
Net cash flows provided by financing activities		243			165			466			350
Net change in cash and cash equivalents		2,577			1,009			5,200			1,928
Cash and cash equivalents, beginning of period		6,169			22,821			3,546			21,902
Cash and cash equivalents, end of period	$	8,746		$	23,830		$	8,746		$	23,830
Supplemental disclosures of cash flow information:
Cash paid for income taxes	$	169		$	120		$	191		$	129
Cash paid for interest		63			7			141			135
Supplemental disclosures of non-cash investing and financing activities:
Accounts payable recorded for acquisition related costs	$	—		$	260		$	—		$	260

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

Page 5 of 34

CARDIAC SCIENCE CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Summary of Significant Accounting Policies

  Organization and Description of Business

     Cardiac Science Corporation was incorporated in Delaware on February 24, 2005 as CSQ Holding Company to effect the business combination of Quinton Cardiology Systems, Inc. (“Quinton”) and Cardiac Science, Inc. (“CSI”), which we refer to as the “merger transaction.” The merger transaction was consummated on September 1, 2005. In connection with the merger transaction, the outstanding shares of common stock of Quinton and CSI were cancelled and stockholders of Quinton and CSI were issued common stock of Cardiac Science Corporation in consideration of their shares of Quinton and CSI common stock.

     We develop, manufacture and market a family of advanced cardiac monitoring and therapeutic cardiology devices and systems, including automated external defibrillators (“AEDs”), electrocardiographs, stress test systems, Holter monitoring systems, hospital defibrillators, cardiac rehabilitation telemetry systems, patient monitor defibrillators and cardiology data management systems. We also sell a variety of related products and consumables and provide a comprehensive portfolio of training, maintenance and support services. We market our products under the Burdick, Powerheart and Quinton brand names.

  Basis of Presentation

     The condensed financial statements present the financial condition and results of operations of the Company on a consolidated basis. All intercompany accounts and transactions have been eliminated. The condensed consolidated balance sheet dated June 30, 2006, the condensed consolidated statements of operations for the three and six-month periods ended June 30, 2006 and 2005 and the condensed consolidated statements of cash flows for the three and six-month periods ended June 30, 2006 and 2005 have been prepared by the Company and are unaudited. The condensed consolidated balance sheet dated December 31, 2005 was derived from the Company’s audited financial statements. Certain information and note disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The notes to the audited consolidated financial statements included in Cardiac Science Corporation’s annual report on Form 10-K for the fiscal year ended December 31, 2005 provide a summary of significant accounting policies and additional financial information that should be read in conjunction with this report. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position of the Company for the interim periods presented, have been made. The results of operations for such interim periods are not necessarily indicative of the results for the full year or any future period.

  Use of Estimates

     The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the periods reported. These estimates include the allocation of the purchase price, collectability of accounts receivable, the recoverability of inventory, the adequacy of warranty liabilities, the valuation of stock awards, the realizability of investments, the realizability of deferred tax assets and valuation and useful lives of tangible and intangible assets, among others. The market for the Company’s products is characterized by intense competition, rapid technological development and frequent new product introductions, all of which could affect the future realizability of the Company’s assets. Estimates and assumptions are reviewed periodically, and the effects of revisions are reflected in the consolidated financial statements in the period they are determined to be necessary.

  Net Income Per Share

     In accordance with SFAS No. 128, “Computation of Earnings Per Share,” basic income per share is computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted income per share is computed by dividing net income by the weighted average number of common and dilutive common equivalent shares outstanding during the period. Common equivalent shares consist of shares issuable upon the exercise of stock options and warrants using the treasury stock method. Common equivalent shares are excluded from the calculation if their effect is antidilutive.

Page 6 of 34

     The following table sets forth the computation of basic and diluted net income per share:

	Three months ended				Six months ended
	June 30,				June 30,
(in thousands, except share data)	2006		2005		2006		2005
Numerator:
Net income	$	118	$	879	$	382	$	1,858
Denominator:
Weighted average shares for basic calculation		22,486,564		10,876,303		22,458,843		10,867,145
Incremental shares from employee stock options		36,338		443,194		106,570		495,807
Weighted average shares for diluted calculation		22,522,902		11,319,497		22,565,413		11,362,952

     The following table sets forth the number of antidilutive shares issuable upon exercise of stock options and warrants excluded from the computation of diluted income per share:

	Three months ended				Six months ended
	June 30,				June 30,
	2006		2005		2006		2005
Antidilutive shares issuable upon exercise of stock options		2,306,074		760,054		2,113,709		408,971
Antidilutive shares issuable upon exercise of warrants		330,909		—		330,909		—
Total		2,636,983		760,054		2,444,618		408,971

  Customer and Vendor Concentrations

     The following table summarizes the customers accounting for 10% or more of our total revenues:

	Three months ended						Six months ended
	June 30,						June 30,
Customer	2006			2005			2006			2005
Customer 1		14.2	%		*			11.9	%		*
Customer 2		*			11.1	%		10.2	%		15.9	%

* Did not exceed 10%.

     The following table summarizes the vendors accounting for 10% or more of our purchases:

	Three months ended						Six months ended
	June 30,						June 30,
Vendor	2006			2005			2006			2005
Vendor 1		14.1	%		18.1	%		13.7	%		20.0	%
Vendor 2		11.4	%		*			*			*
Vendor 3		*			11.1	%		*			*

* Did not exceed 10%.

     Although products are available from other sources, the vendor’s inability or unwillingness to supply products in a timely manner or on terms acceptable to the Company could adversely affect the Company’s ability to meet customers’ demands.

  Taxes Collected from Customers and Remitted to Governmental Authorities

     The Company uses the net method for reporting taxes that are assessed by a governmental authority that are directly imposed on revenue-producing transactions, i.e. sales, use, value added. These taxes are not included in the Company’s revenue numbers.

  Recent Accounting Pronouncements

     In July 2006, the FASB issued Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109.” FIN 48 clarifies the recognition threshold and measurement attribute for the

Page 7 of 34

financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company will adopt this interpretation as required. The Company is currently evaluating the impact of this interpretation on its financial statements.

2. Merger Transaction with Cardiac Science, Inc.

     On September 1, 2005, the Company, Quinton and CSI completed the merger transaction which was accounted for as an acquisition of CSI by Quinton under the purchase method of accounting. Quinton was the acquiring entity for financial reporting purposes based on the criteria for determining the acquirer set forth in Statement 141. Under the purchase method of accounting, the total estimated purchase price is allocated to the tangible and identifiable intangible assets acquired and liabilities assumed in connection with the merger transaction, based on their fair values as of the closing date. The excess of purchase price over the tangible and identifiable intangible assets acquired net of liabilities assumed is allocated to goodwill. Valuation specialists have conducted valuations in order to assist management in determining the fair values of the intangible and certain tangible assets acquired. The work performed by valuation specialists has been considered in management’s estimates of fair values.

     Additionally, deferred income tax adjustments recorded in connection with the merger transaction are preliminary because management has not yet obtained all information that it has arranged to obtain and that is known to be available. Management has not recorded a deferred tax asset valuation allowance as part of the merger transaction based on its assessment that it is more likely than not that the Company will realize the benefit of acquired deferred tax assets. However, adjustments to deferred tax assets and liabilities resulting from management obtaining all information that it has arranged to obtain will require management to re-evaluate its assessment of the Company’s ability to realize the benefit of acquired deferred tax assets and may result in the recording of a deferred tax asset valuation allowance as part of its final purchase price allocation.

     As a result of the merger transaction, there has been an ownership change within the meaning of Sections 382 and 383 of the Internal Revenue Code. As a result of such ownership change, the amount of taxable income in any year (or portions of a year) subsequent to the ownership change that may be offset by Quinton’s and CSI’s net operating losses (“NOL”s) from periods prior to the date of such ownership change generally cannot exceed the Section 382 limitation. Based on currently available information, it is not expected that the ownership change will materially affect the ultimate availability of Quinton’s NOLs or tax credit carryforwards to reduce tax liabilities in future taxable periods. The ownership change reduces the availability of a significant portion of CSI’s NOLs, and its tax credit carryforwards, to reduce future income tax liabilities.

     The purchase consideration of $181,075,000 was allocated to CSI assets and liabilities and consisted of the following:

• 11,467,753 shares of common stock valued at approximately $146,911,000 issued to CSI stockholders and senior note holders. The fair value of common stock issued is based on a per share value of $12.81, which is equal to Quinton’s average closing price per share as reported on The Nasdaq National Market for the trading-day period two days before and after February 28, 2005, the announcement date of the merger transaction, adjusted by the Quinton exchange ratio.

• Cash payment of $20,000,000 to the CSI senior note holders.

• 1,229,881 vested options to purchase shares of common stock issued to CSI option holders, valued at $7,402,000 calculated using the Black-Scholes option-pricing model.

• 330,909 exercisable warrants to purchase shares of common stock issued to certain CSI warrant holders, valued at $1,320,000 calculated using the Black-Scholes option-pricing model.

• $3,198,000 in accrued liabilities related to estimated exit and severance costs.

• $2,244,000 in estimated transaction related costs of Quinton.

Page 8 of 34

     The following table summarizes total purchase consideration:

	(in thousands)
Cash	$	20,000
Shares		146,911
Options		7,402
Warrants		1,320
Accrued liabilities		3,198
Transaction costs		2,244
Total	$	181,075

     The following table summarizes the estimated fair values of assets acquired and liabilities assumed at September 1, 2005, the date on which the merger transaction was completed, with some fair values adjusted in the six months ended June 30, 2006 as additional information became available. The initial allocations of purchase cost were recorded at fair value based upon the best information available to management and are finalized when we obtain information related to pre-acquisition contingencies which we identified at September 1, 2005 for which the allocation has not been finalized. The fair values of property and equipment and intangible assets and liabilities were valued by an independent third party. The fair values of specific assets and liabilities, including deferred tax assets, certain accrued expenses, including income taxes and foreign taxes, and certain unresolved contingencies have not been finally determined because the Company is in the process of obtaining additional information in order to properly assess and finalize the potential impact, if any, to the consolidated financial statements. During the six months ended June 30, 2006, certain purchase accounting adjustments related to uncertainties of income tax matters resulting from the business combination and adjustments to other assets and liabilities were made as a result of obtaining information which the Company had previously arranged to obtain. Accordingly, there was a decrease to goodwill of approximately $2,567,000. Any additional valuation adjustments that would need to be recorded will be offset with a corresponding adjustment to goodwill.

     The adjusted preliminary allocation of the purchase price is as follows:

	(in thousands)
Cash and cash equivalents	$	6,295
Accounts receivable, net of allowance for doubtful accounts		7,098
Inventories		11,826
Net deferred tax assets, current		7,699
Prepaid expenses and other current assets		2,548
Machinery and equipment		3,979
Net deferred tax assets, non-current		24,017
Other long-term assets		661
Intangible assets		31,360
Goodwill		100,025
Total assets acquired		195,508
Liabilities assumed		(14,433	)
Net assets acquired	$	181,075

      The adjustments made to goodwill for the six months ended June 30, 2006 were as follows:

(in thousands)		Six months ended
		June 30, 2006
Goodwill, beginning of period	$	102,592
Increase in accounts receivable, net of allowance for doubtful accounts		(44	)
Decrease in inventories		1,513
Increase in prepaid expenses and other current assets		(1,135	)
Increase in net deferred tax assets, non-current		(2,517	)
Decrease in liabilities assumed		(384	)
Goodwill, end of period	$	100,025

     CSI’s finished goods inventories acquired as a part of the merger transaction were recorded at estimated selling prices less the sum of costs of disposal and a reasonable profit allowance for the selling effort, and raw materials inventories were recorded at estimated replacement cost. The purchase price allocated to inventories at September 1, 2005 exceeded CSI’s net book value by approximately $1.8 million. The increase in finished goods inventory value is being recorded as a cost of revenues over the period that the related inventory is sold, of which approximately $1.6 million was charged to cost of sales during the year ended December 31, 2005 and $0.2 million during the quarter ended March 31, 2006. The remaining increase in the finished goods inventory valuation will be charged to cost of sales in the future as the associated inventories are sold in the normal course of business.

     Intangible assets recorded in the business combination consist of the Cardiac Science trade name of $11,380,000, developed technology of $11,330,000 and customer relationships of $8,650,000. Management has not assigned value to any in-process research and development.

     The estimate of useful lives of each intangible asset was based on an analysis by management of all pertinent factors. These factors include the expected use of the asset by the Company, the expected useful life of another asset or a group of assets to which the useful life of an asset may relate, any legal, regulatory, or contractual provisions that may limit the useful life, any legal, regulatory, or contractual provisions that enable renewal or extension of the asset’s legal or contractual life

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without substantial cost, the effects of obsolescence, demand, competition, and other economic factors, and the level of maintenance expenditures required to obtain the expected future cash flows from the asset.

     Management estimated intangible asset useful lives as eight years for developed technology and five years for customer based intangibles, resulting in a weighted average useful life of acquired amortizable intangible assets of 6.7 years as of the acquisition date. Estimated annual expense for amortization of identifiable intangible assets approximates $3.1 million for the first five years and $1.4 million for the next three years.

     Management has concluded that no legal, regulatory, contractual, competitive, economic, or other factors limit the useful life of the Cardiac Science trade name and accordingly has considered the useful life of the trade name to be indefinite.

     Goodwill relating to previous CSI acquisitions of approximately $38.1 million is expected to be deductible for tax purposes.

     The following unaudited pro forma data summarizes the results of operations for the three and six months ended June 30, 2005 as if the merger transaction had been completed as of January 1, 2005. The pro forma data gives effect to actual operating results prior to the merger transaction, adjusted to include the pro forma effect of, among other things, increases in amortization expense of identified intangible assets, elimination of interest expense on retired debt and interest income on cash utilized to retire debt, and amortization of the increase in inventory:

	Three months ended		Six months ended
(in thousands, except per share data)	June 30, 2005		June 30, 2005
Revenues	$	37,444	$	73,185
Net loss	$	(3,352)	$	(54,231)
Basic net loss per share	$	(0.15)	$	(2.43)

     Pro forma operating data for the six months ended June 30, 2005 include a goodwill impairment charge of $47.3 million recorded by CSI during March 2005.

     Pro forma income tax benefits have been recorded for the three and six months ended June 30, 2005 on pro forma losses before income tax and minority interest calculated by applying the Company’s estimated pro forma effective tax rate of approximately 36%.

3. Segment Reporting

     The Company’s chief operating decision makers are the Chief Executive Officer and other senior executive officers of the Company. Based on evaluation of the Company’s financial information, management believes that the Company operates in one reportable segment with its various cardiology products and services.

     The Company’s chief operating decision makers evaluate revenue performance of product lines, both domestically and internationally. However, operating, strategic and resource allocation decisions are based primarily on the Company’s overall performance in its operating segment.

     The following table summarizes revenues by product line:

	Three months ended				Six months ended
	June 30,				June 30,
(in thousands)	2006		2005		2006		2005
Cardiac monitoring products	$	17,727	$	19,073	$	37,576	$	37,417
Defibrillation products		17,280		—		32,000		—
Service		4,214		2,895		8,760		5,881
Total	$	39,221	$	21,968	$	78,336	$	43,298

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     The following table summarizes revenues, which are attributed based on the geographic location of the customers:

	Three months ended				Six months ended
	June 30,				June 30,
(in thousands)	2006		2005		2006		2005
Domestic	$	29,247	$	20,510	$	59,600	$	39,986
Foreign		9,974		1,458		18,736		3,312
Total	$	39,221	$	21,968	$	78,336	$	43,298

     All intangible assets are domestic. Long-lived assets located outside of the United States are not material.

4. Restructuring Costs

     The merger transaction resulted in excess facilities and redundant employee positions. The Company accrued $1,418,000 as part of the merger transaction purchase price for lease exit costs associated with the Irvine, California Minnetonka, Minnesota facilities and other operating leases. In addition, a restructuring liability with a preliminarily estimated fair value of $1,291,000 was acquired in the merger transaction for facilities in Solon and Warrensville, Ohio, which had been previously vacated by CSI.

     Accrued exit costs relating to the Irvine, California lease were paid mainly in the first quarter of 2006. Accrued amounts for other vacated facilities will be paid over the lease terms of the Minnetonka, Minnesota and Solon and Warransville, Ohio facilities, which end in August 2007 and January 2009, respectively.

     The Company recorded charges of $1,589,000 for the year ended December 31, 2005 and $60,000 and $212,000 for the three months and six months ended June 30, 2006, respectively, which consisted of employee retention costs and other benefits resulting from a reduction in force of 101 employees across all Company functions.

     Of the restructuring costs accrued at June 30, 2006, $1,024,000 was included in Other Liabilities and $1,127,000 was included in Accrued Liabilities. The remaining employee severance and retention costs will be paid out through August 2007.

     The following tables summarize restructuring activity during the year ended December 31, 2005 and the six months ended June 30, 2006:

	Balance at		Accrued as Part							Balance at
	December 31,		of the Merger				Cash			December 31,
(in thousands)	2004		Transaction		Additions		Expenditures			2005
Vacated facilities	$	—	$	2,709	$	56	$	(514	)	$	2,251
Employee severance and retention costs		—		1,702		1,589		(1,478	)		1,813

	Balance at										Balance at
	December 31,				Cash						June 30,
(in thousands)	2005		Additions		Expenditures			Adjustments			2006
Vacated facilities	$	2,251	$	65	$	(574	)	$	(152	)	$	1,590
Employee severance and retention costs		1,813		212		(1,464	)		—			561

5. Inventories

     Inventories are valued at the lower of cost, on an average cost basis, or market and were comprised of the following:

	June 30,		December 31,
(in thousands)	2006		2005
Raw materials	$	15,945	$	18,746
Finished goods		2,820		3,306
Total inventories	$	18,765	$	22,052

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6. Credit Facility

     In connection with the 2003 acquisition of Spacelabs Burdick, Inc., the Company established a line of credit in December 2002. The credit agreement was amended in September 2005, and expires in September 2007. Borrowings under the line of credit are currently limited to the lesser of $20,000,000 or an amount based on eligible accounts receivable and eligible inventories. Substantially all of the Company’s assets are pledged as collateral for the line of credit. This line of credit bears interest based at a rate equal to the lender’s prime rate, provided that the interest rate in effect shall not be less than 6.25% on any day. In addition, unused balances under this facility bear monthly fees equal to 0.25% per annum on the difference between the maximum credit limit and the sum of (i) the average daily principal balance during the month and (ii) the face amount of any letters of credit.

     As of June 30, 2006, the Company had capacity to borrow $20,000,000 based on eligible accounts receivable and eligible inventory, less letters of credit outstanding of $364,000. The credit facility contains standard negative covenants and restrictions on actions by the Company, including but not limited to, activity related to common stock repurchases, liens, investments, capital expenditures, indebtedness, restricted payments including cash payments of dividends, and fundamental changes in, or disposition of assets. Certain of these actions may be taken with the consent of the lender. In addition, the credit agreement requires that the Company meet certain financial covenants, namely a minimum tangible net worth measure, an adjusted quick ratio and certain reporting requirements. At June 30, 2006, the Company was in compliance with all covenants under the credit facility. At June 30, 2006 and December 31, 2005, the Company did not have any borrowings under this line of credit.

7. Warranty Liability

     Changes in the warranty liability for the six months ended June 30, 2006 were as follows:

	Six months ended
(in thousands)	June 30, 2006
Warranty liability, beginning of the period	$	2,348
Charged to cost of revenues		1,059
Adjustment to estimated fair value of acquired warranty		279
Warranty expenditures		(996	)
Warranty liability, end of the period	$	2,690

8. Stock-Based Compensation Plans

     The Company maintains several stock equity incentive plans under which it may grant non-qualified stock options, incentive stock options and non-vested stock awards to employees, non-employee directors and consultants. The Company also has an employee stock purchase plan (“ESPP”).

     Prior to the January 1, 2006 adoption of the Financial Accounting Standards Board (“FASB”) Statement No. 123(R), “Share-Based Payment” (“SFAS 123R”), the Company accounted for stock-based compensation to employees using the intrinsic value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, because the stock option grant price equaled the market price on the date of grant, and any purchase discounts under the Company’s stock purchase plans were within statutory limits, no compensation expense was recognized by the Company for stock-based compensation. As permitted by SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), stock-based compensation was included as a pro forma disclosure in the notes to the consolidated financial statements.

     Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS 123R, and applied the provisions of Staff Accounting Bulletin No. 107, “Share-Based Payment”, using the modified-prospective transition method. Under this transition method, stock-based compensation expense is recognized in the consolidated financial statements for grants of stock options and for purchases under the ESPP since the ESPP purchase discounts exceed the amount allowed under SFAS 123R for non-compensatory treatment. Compensation expense recognized includes the estimated expense for stock options granted on and subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R, and the estimated expense for the portion vesting in the period for options granted prior to, but not vested as of December 31, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. Further, as required under SFAS 123R, forfeitures are estimated for share-based awards that are not expected to vest. Results for prior periods have not been restated, in accordance with the modified-prospective transition method. Prior to the adoption of SFAS 123R, benefits of tax deductions in excess of recognized compensation costs were reported as operating

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cash flows. SFAS 123R requires the benefits of tax deductions in excess of the compensation cost recognized for those options to be classified as financing cash inflows rather than operating cash inflows, on a prospective basis. This amount would be shown as “Excess tax benefit from exercise of stock options” on the consolidated statement of cash flows. There were no realized excess tax benefits in the three and six months ended June 30, 2006.

     Total stock-based compensation expense recognized in the consolidated statement of operations for the three and six months ended June 30, 2006 was approximately $567,000 and $1,016,000, respectively, before income taxes. Stock-based compensation of $29,000 was capitalized and included in inventory in the consolidated balance sheet at June 30, 2006. Total stock-based compensation (including capitalized costs) consisted of stock option, ESPP, non-vested stock awards and vested stock awards expense totaling $422,000, $69,000, $63,000 and $13,000, respectively for the three months ended June 30, 2006 and $768,000, $138,000, $126,000 and $13,000, respectively for the six months ended June 30, 2006. The Company issues new shares upon the exercise of stock options, grants of stock awards and purchases through the ESPP.

     The following table presents the impact of the Company’s adoption of SFAS 123R on selected line items from the Company’s condensed consolidated financial statements for the three and six months ended June 30, 2006:

	Three months ended					Six months ended
	June 30, 2006					June 30, 2006
	As Reported			If Reported		As Reported		If Reported
	Following			Following		Following		Following
(in thousands, except per share data)	SFAS 123R			APB 25		SFAS 123R		APB 25
Condensed Consolidated Statement of Operations:
Operating income (loss)	$	(115	)	$	376	$	114	$	991
Income before income taxes and minority interest in loss of consolidated entity	$	154		$	645	$	564	$	1,441
Net income	$	118		$	545	$	382	$	1,134
Net income per share:
Basic	$	0.01		$	0.02	$	0.02	$	0.05
Diluted	$	0.01		$	0.02	$	0.02	$	0.05
Condensed Consolidated Statement of Cash Flows:
Net cash provided by operating activities	$	3,175		$	3,175	$	6,744	$	6,744
Net cash provided by financing activities	$	243		$	243	$	466	$	466

     The following table shows the effect on net earnings and earnings per share for the three and six months ended June 30, 2005 had compensation cost been recognized based upon the estimated fair value on the grant date of stock options (or the purchase date of the stock purchased under the ESPP, as applicable), in accordance with SFAS 123, as amended by SFAS No. 148 “Accounting for Stock-Based Compensation – Transition and Disclosure” for the three and six months ended June 30, 2005. Disclosures for the three and six months ended June 30, 2006 are not presented because the amounts are recognized in the consolidated financial statements.

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	Three months ended			Six months ended
	June 30,			June 30,
(in thousands, except per share data)	2005			2005
Net income — as reported	$	879		$	1,858
Add back: Stock-based employee compensation expense included in reported income, net of related tax effects		15			39
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effect of $54 and $111, respectively		(552	)		(1,095	)
Net income — pro forma	$	342		$	802
Net income per share as reported — basic	$	0.08		$	0.17
Net income per share as reported — diluted	$	0.08		$	0.16
Net income per share pro forma — basic	$	0.03		$	0.07
Net income per share pro forma — diluted	$	0.03		$	0.07

     The following table sets forth, consistent with the provisions of SFAS No. 128, the denominator for calculating pro forma diluted net income per share for the three and six months ended June 30, 2005:

	Three		Six
	months ended		months ended
	June 30, 2005		June 30, 2005
Weighted average shares outstanding		10,876,303		10,867,145
Pro forma incremental shares from employee stock options		402		83,113
Pro forma weighted average shares for diluted calculation		10,876,705		10,950,258

     The fair value of each option grant and ESPP purchase is estimated using the Black-Scholes option-pricing model with the following weighted-average assumptions, and the fair value of the non-vested stock awards is calculated based on the market value of the shares awarded at date of grant:

	Three months ended						Six months ended
	June 30,						June 30,
	2006			2005			2006			2005
				(pro forma)						(pro forma)
Stock options plans:*
Volatility		—			—			56.0	%		62.0	%
Expected term (years)		—			—			6.25			6.25
Risk-free interest rate		—			—			4.6	%		4.5	%
Expected dividend yield		—			—			—			—
Fair value of options granted	$	—		$	—		$	6.49		$	8.05
Employee stock purchase plan:
Volatility		34.0	%		64.6	%		34.0	%		64.6	%
Expected term (years)		0.5			0.5			0.5			0.5
Risk-free interest rate		4.4	%		2.7	%		4.4	%		2.7	%
Expected dividend yield		—			—			—			—
Fair value of employee stock purchase rights	$	2.37		$	4.44		$	2.37		$	4.44
Non-vested stock:
Fair value of non-vested stock awards granted	$	9.62		$	—		$	9.98		$	—

* Stock options were not issued in the three months ended June 30, 2006 or 2005.

     Volatility is based exclusively on historical volatility of the Company’s common stock as the Company believes this is representative of future volatility. Expected term represents the estimated period of time until exercise and is based on historical experience of similar awards, giving consideration to the contractual terms, vesting schedules and expectations of

Page 14 of 34

future employee behavior. The risk-free interest rate is based on the implied yield available on U.S. Treasury zero-coupon issues with an equivalent remaining term. The Company has not paid dividends in the past and does not plan to pay any dividends in the near future.

     The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, particularly for the expected term and expected stock price volatility. The Company’s employee stock options have characteristics significantly different from those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimate. While estimates of fair value and the associated charge to earnings materially affect the Company’s results of operations, it has no impact on the Company’s cash position. Because Company stock options do not trade on a secondary exchange, employees do not derive a benefit from holding stock options unless there is an increase, above the exercise price, in the market price of the Company’s stock. Such an increase in stock price would benefit all shareholders commensurately.

     Stock Option Plans- Stock options to purchase the Company’s common stock are granted at prices at or above the fair market value on the date of grant. Options held by employees generally vest¹/4 after one year from the date of the grant and then monthly thereafter and generally expire 10 years from the date of grant. Options granted to non-employee directors generally vest over one year.

     The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes option valuation model. The assumptions used to calculate the fair value of options granted are evaluated and revised, as necessary, to reflect market conditions and the Company’s experience. Compensation expense is recognized only for those options expected to vest, with forfeitures estimated at the date of grant based on the Company’s historical experience and future expectations. Prior to the adoption of SFAS 123R, the effect of forfeitures on the pro forma expense amounts was not included as an assumption affecting disclosed pro forma compensation.

     The aggregate intrinsic values indicated in the tables below are before applicable income taxes, based on the Company’s closing stock price of $7.89 as of the last business day of the three and six month period ended June 30, 2006, which would have been received by the optionees had all options been exercised on that date.

     As of June 30, 2006, total unrecognized stock-based compensation expense related to nonvested stock options was approximately $2,237,000, which is expected to be recognized over a weighted average period of approximately 1.9 years. The total intrinsic value of stock options exercised during the three and six months ended June 30, 2006 was $5,000 and $385,000, respectively, and for the three and six months ended June 30, 2005 was $12,000 and $44,000, respectively. The Company issues new shares of common stock upon the exercise of options.

     The following shares of common stock have been reserved for issuance under the Company’s stock-based compensation plans as of June 30, 2006:

Outstanding shares - 2002 Plan	1,915,297
Outstanding shares - 1997 Plan	1,249,648
Stock options available for grant	554,337
Outstanding restricted stock grants	98,750
Employee stock purchase plan shares available for issuance	612,373
Total common shares reserved for future issuance	4,430,405

     2002 Plan —In February 2002, Quinton’s board of directors adopted and Quinton’s shareholders approved the 2002 Stock Incentive Plan (“the 2002 Plan”), which became effective upon completion of Quinton’s initial public offering in May 2002 and was assumed by the Company in connection with the merger transaction. The 2002 Plan replaced Quinton’s 1998 Equity Incentive Plan (“the 1998 Plan”) for purposes of all future incentive stock awards. The 2002 Plan allows the Company to issue awards of incentive or nonqualified stock options, shares of common stock or units denominated in common stock, all of which may be subject to restrictions. The 2002 Plan authorizes annual increases in shares for issuance equal to the lesser of (i) 526,261 shares, (ii) 3% of the number of shares of common stock outstanding on a fully diluted basis as of the end of the Company’s immediately preceding fiscal year, and (iii) a lesser amount established by the Company’s board of directors. Any shares from increases in previous years that are not issued will continue to be included in the aggregate number of shares available for future issuance.

     Options held by employees generally vest¹/4 after one year from the date of the grant and then monthly thereafter over a three and one-half to four year period. The term of the options is for a period of ten years or less. Options generally

Page 15 of 34

expire 90 days after termination of employment. The Company has also adopted a stock option grant program for non-employee directors, administered under the terms and conditions of the 2002 Plan.

     The following table summarizes information about the 2002 Plan option activity during the three and six months ended June 30, 2006:

	Shares			Weighted Average		Weighted Average		Aggregate Intrinsic
	Subject to			Exercise Price		Remaining		Value
	Options			per Share		Contractual Life		(in thousands)
Outstanding, January 1, 2006		1,960,525		$	7.67	6.8 years
Granted		75,000			11.13	9.8 years
Exercised		(41,124	)		0.84	2.9 years
Cancelled		(66,023	)		10.26	7.7 years
Outstanding, March 31, 2006		1,928,378			7.86	6.9 years		$	4,297
Granted		—			—		—
Exercised		(7,796	)		8.80	6.2 years
Cancelled		(5,285	)		10.21	7.7 years
Outstanding, June 30, 2006		1,915,297		$	7.86	6.6 years		$	3,222
Exercisable, June 30, 2006		1,617,563		$	7.18	6.4 years		$	2,809

     The following information is provided for 2002 Plan options outstanding and exercisable at June 30, 2006:

	Outstanding					Exercisable
					Weighted-
			Weighted-		Average			Weighted-
			Average		Remaining			Average
	Number of		Exercise		Contractual	Number of		Exercise
Range of Exercise Prices	Options		Price		Life	Options		Price
$0.00 - $1.08		32,358	$	0.29	2.4 years		32,358	$	0.29
$1.09 - $2.42		6,138		1.31	2.9 years		6,138		1.31
$2.43 - $3.25		567,048		2.85	4.2 years		567,048		2.85
$3.26 - $4.51		13,095		4.28	5.5 years		13,095		4.28
$4.52 - $7.59		7,718		7.00	6.7 years		7,718		7.00
$7.60 - $8.79		199,847		7.77	6.5 years		166,896		7.77
$8.80 - $10.84		614,791		9.82	7.9 years		592,702		9.79
$10.85 - $12.95		462,725		12.01	8.0 years		220,031		11.86
$12.96 - $14.25		11,577		13.38	8.0 years		11,577		13.38
$0.00 - $14.25		1,915,297	$	7.86	6.6 years		1,617,563	$	7.18

     1997 Plan —The Company assumed CSI’s 1997 Stock Option/Stock Issuance Plan (the “1997 Plan”) in connection with the merger transaction. The 1997 Plan provides for the granting of incentive or nonqualified stock options, subject to the limitations under applicable Nasdaq rules described below, to employees of the Company, including officers, and nonqualified stock options to employees, including officers and directors of the Company, as well as to certain consultants and advisors. Shares authorized under the 1997 Plan are subject to adjustment upon the occurrence of certain events, including, but not limited to, stock dividends, stock splits, combinations, mergers, consolidations, reorganizations, reclassifications, exchanges, or other capital adjustments. Shares that are forfeited or repurchased or otherwise cease to be subject to awards without shares being issued under the 1997 Plan will again be available for issuance under the 1997 Plan.

     All options outstanding under the 1997 Plan immediately prior to the merger transaction became fully vested and immediately exercisable as a result of the merger transaction. Pursuant to Nasdaq rules, (a) employees, directors, independent contractors, and advisors of CSI prior to the merger transaction and any new employees, directors, independent contractors, and advisors of the Company after the merger transaction, will be eligible to receive awards under the 1997 Plan and (b) any employees, directors, independent contractors, or advisors of Quinton prior to the merger transaction will not be eligible to receive awards under the 1997 Plan.

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     The following table summarizes information about the 1997 Plan option activity during the three and six months ended June 30, 2006:

	Shares			Weighted Average		Weighted Average	Aggregate Intrinsic
	Subject to			Exercise Price		Remaining	Value
	Options			per Share		Contractual Life	(in thousands)
Outstanding, January 1, 2006		1,274,748		$	25.04	6.8 years
Cancelled		(18,350	)		23.35	7.5 years
Outstanding, March 31, 2006		1,256,398			25.07	6.6 years	$	6
Cancelled		(6,750	)		26.29	7.7 years
Outstanding and exercisable, June 30, 2006		1,249,648		$	25.06	6.3 years	$	—

     The following information is provided for 1997 Plan options outstanding and exercisable at June 30, 2006:

			Weighted-		Average
			Average		Remaining
	Number of		Exercise		Contractual
Range of Exercise Prices	Options		Price		Life
$9.05		75,000	$	9.05	9.3 years
$10.20 - $11.10		18,875		10.82	8.7 years
$16.00 - $17.50		126,875		17.35	6.2 years
$19.30 - $20.60		600,365		20.26	5.8 years
$21.20 - $22.40		22,315		22.09	7.1 years
$24.00 - $24.60		59,595		24.19	6.1 years
$26.00 - $26.00		32,000		26.00	6.8 years
$35.20 - $36.50		28,540		35.21	7.3 years
$38.30 - $41.50		215,941		39.98	6.5 years
$45.30 - $50.70		36,750		46.62	6.7 years
$54.40 - $60.00		33,392		58.44	4.0 years
$9.05 - $60.00		1,249,648	$	25.06	6.3 years

  Non-vested Stock Awards -

     In the fourth quarter of 2005, the Company began granting employees non-vested stock awards in addition to stock options. The stock award program offers employees the opportunity to earn shares of our stock over time, rather than options that give employees the right to purchase stock at a set price.

     Non-vested stock awards are grants that entitle the holder to shares of common stock as the award vests. Our stock awards generally vest ratably over a four-year period in annual increments. The non-vested stock awards require no payment from the employee and compensation cost is recorded based on the market price on the grant date and is recorded equally over the vesting period of four years. Compensation expense related to non-vested stock awards approximated $63,000 and $126,000 during the three months and six months ended June 30, 2006, respectively.

     As of June 30, 2006, total unrecognized stock-based compensation expense related to non-vested stock awards was approximately $870,000, which is expected to be recognized over a weighted average period of approximately 3.4 years.

     The following table summarizes information about the non-vested stock awards activity during the three and six months ended June 30, 2006:

Page 17 of 34

				Weighted Average
	Shares			Grant-Date Fair Value
Non-vested balance, January 1, 2006		104,350		$	9.38
Granted		3,700			10.12
Non-vested balance, March 31, 2006		108,050			9.41
Granted		1,450			9.62
Vested		(1,450	)		9.62
Cancelled		(9,300	)		9.40
Non-vested balance, June 30, 2006		98,750		$	9.41

Employee Stock Purchase Plan -

     Quinton adopted the 2002 Employee Stock Purchase Plan (“ESPP”) in February 2002. The ESPP was implemented upon the effectiveness of Quinton’s initial public stock offering in May 2002 and was assumed by the Company in connection with the merger transaction. The ESPP permits eligible employees to purchase common stock through payroll deductions. Shares of our common stock may presently be purchased by employees at three month intervals at the lower of 85% of the fair market value on first day of the offering period or the last day of each three month purchase period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period, not to exceed 525 shares during an offering period. The Company initially reserved 175,420 shares for issuance under the ESPP. In addition, the ESPP authorizes annual increases in shares for issuance equal to the lesser of (i) 175,420 shares, (ii) 2% of the number of shares of common stock outstanding on a fully diluted basis as of the end of the Company’s immediately preceding fiscal year, and (iii) a lesser amount established by the Company’s board of directors. Any shares from increases in previous years that are not actually issued will continue to be included in the aggregate number of shares available for future issuance.

     The Company issued 23,819 and 47,720 shares of common stock during the three and six months ended June 30, 2006 in connection with the ESPP and received total proceeds of $178,000 and $368,000, respectively. Prior to the adoption of SFAS 123R, the Company did not record compensation expense related to the ESPP. During the three and six months ended June 30, 2006, the Company recorded stock-based compensation expense for the ESPP of approximately $69,000 and $138,000, respectively.

9. Comprehensive Income

     The Company records all changes in equity during the period from non-owner sources as other comprehensive income or loss, such as unrealized gains and losses on the Company’s available-for-sale securities. Comprehensive income, net of any related tax effects, was as follows:

	Three months ended					Six months ended
	June 30,					June 30,
(in thousands)	2006			2005		2006			2005
Net income	$	118		$	879	$	382		$	1,858
Other comprehensive income (loss), net of related tax effects of $2, $1, $5 and $13 respectively		(21	)		4		(7	)		(22	)
Total comprehensive income	$	97		$	883	$	375		$	1,836

10. Commitments and Contingencies

  Other Commitments

     As of June 30, 2006, the Company had purchase obligations of approximately $30,025,000 consisting of outstanding purchase orders issued in the normal course of business.

     Guarantees and Indemnities

     During its normal course of business, the Company has made certain guarantees, indemnities and commitments under which it may be required to make payments in relation to certain transactions. These indemnities include intellectual property and other indemnities to the Company’s customers and suppliers in connection with the sales of its products, and indemnities to directors and officers of the Company to the maximum extent permitted under the laws of the State of Delaware.

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Historically, we have not incurred any losses or recorded any liabilities related to performance under these types of indemnities.

  Legal Proceedings

     In February 2003, a patent infringement action was brought initially by CSI against Philips Medical Systems North America, Inc., Philips Electronics North America Corporation and Koninklijke Philips Electronics N.V. (“Philips”) in the United States District Court for the District of Minnesota. The suit alleges that Philips’ automated external defibrillators sold under the names “HeartStart OnSite Defibrillator”,“HeartStart”,“HeartStart FR2,” and the “HeartStart Home Defibrillator,” infringe certain of the Company’s United States patents. In the same action, Philips counterclaimed for infringement of certain of its patents and the Company has sought a declaration from the Court that its products do not infringe such patents. Many of the Philips defibrillators’ are promoted by Philips as including, among other things, pre-connected disposable defibrillation electrodes and daily self-testing of electrodes and battery, features that the suit alleges are key competitive advantages of the Company’s Powerheart and Survivalink AEDs and are covered under the Company’s patents. At this stage, the Company is unable to predict the outcome of this litigation and has not established an accrual for this matter because a loss is not determined to be probable. The Company intends to defend this counter claim vigorously.

     In March 2004, William S. Parker brought suit initially against CSI for patent infringement in the United States District Court for the Eastern Division of Michigan. The Parker patent generally covers the use of a synthesized voice to instruct a person to perform certain tasks. The Complaint alleges that certain of the Company’s AEDs infringe the patent. The patent is now expired. The Company has filed an Answer to the Complaint stating the patent is not infringed and is otherwise invalid and unenforceable. The patent was submitted for reexamination before the United States Patent and Trademark Office and emerged from reexamination in December 2005. In January 2006, the District Court issued an order lifting the stay in the litigation. Currently, the litigation is proceeding through discovery. At this stage, the Company is unable to predict the outcome of this litigation. The Company has not established an accrual for this matter because a loss is not determined to be probable. The Company intends to defend against this suit vigorously.

     We are subject to other various legal proceedings arising in the normal course of business. In the opinion of management, the ultimate resolution of these proceedings is not expected to have a material effect on our consolidated financial position, results of operations or cash flows.

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

     This Quarterly Report onForm 10-Q contains forward-looking statements relating to Cardiac Science Corporation. Except for historical information, the following discussion contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact, including future results of operations or financial position, made in this Quarterly Report onForm 10-Q are forward looking. The words “believe,” “expect,” “intend,” “anticipate,” variations of such words, and similar expressions identify forward-looking statements, but their absence does not mean that the statement is not forward-looking. These forward-looking statements reflect management’s current expectations and involve risks and uncertainties. Our actual results could differ materially from results that may be anticipated by such forward-looking statements. The principal factors that could cause or contribute to such differences include, but are not limited to, those discussed in the section entitled “Risk Factors” in Part 1 – Item 1A of our Annual Report onForm 10-K/A for the year ended December 31, 2005 and those discussed elsewhere in this report. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to revise any forward-looking statements to reflect events or circumstances that may subsequently arise. Readers are urged to review and consider carefully the various disclosures made in this report and in our other filings made with the SEC that attempt to advise interested parties of the risks and factors that may affect our business, prospects and results of operations.

     You should read the following discussion and analysis in conjunction with our unaudited condensed consolidated financial statements and related notes included elsewhere in this report. Operating results for the three and six month periods ended June 30, 2006 are not necessarily indicative of the results that may be expected for any future periods, including the full fiscal year. Reference should also be made to the Annual Consolidated Financial Statements, Notes thereto, and Management’s Discussion and Analysis of Financial Condition and Results of Operations and “Risk Factors” contained in the Cardiac Science Corporation Annual Report on Form 10-K for the year ended December 31, 2005.

  Business Overview

     Cardiac Science Corporation was incorporated in Delaware on February 24, 2005 as CSQ Holding Company to effect the business combination of Quinton Cardiology Systems, Inc. (“Quinton”) and Cardiac Science, Inc. (“CSI”), which we refer to as the “merger transaction.” The merger transaction was consummated on September 1, 2005. In connection with the

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merger transaction, the outstanding shares of common stock of Quinton and CSI were cancelled and stockholders of Quinton and CSI were issued common stock of Cardiac Science Corporation in consideration of their shares of Quinton and CSI common stock.

     Stockholders of Quinton received 0.77184895 share of our common stock for each common share of Quinton held, representing approximately 48.8% of our total outstanding common stock as of the date of closing, and holders of CSI common stock received 0.10 share of our common stock for each common share of CSI held, which, together with 2,843,915 shares of our common stock issued to the holders of senior notes and related warrants of CSI in connection with the merger transaction, represented approximately 51.2% of our total outstanding common stock as of the date of closing. In addition, we assumed each outstanding option and other warrant to purchase common stock issued by Quinton and CSI.

     For accounting purposes, the merger transaction was treated as an acquisition by Quinton of CSI as of September 1, 2005. Since we are deemed to be the successor to Quinton for accounting purposes, our consolidated financial statements represent the historical statements of Quinton and include CSI’s results of operations since September 1, 2005. All share and per share data have been retroactively adjusted to reflect the conversion of Quinton shares into Cardiac Science Corporation shares at the exchange ratio set forth in the merger agreement.

     We develop, manufacture and market a family of advanced cardiac monitoring and therapeutic cardiology devices and systems, including automated external defibrillators (“AEDs’), electrocardiographs, stress test systems, Holter monitoring systems, hospital defibrillators, cardiac rehabilitation telemetry systems, patient monitor defibrillators and cardiology data management systems. We also sell a variety of related products and consumables and provide a comprehensive portfolio of training, maintenance and support services. We market our products under the Burdick, Powerheart and Quinton brand names.

  Critical Accounting Estimates and Policies

     To prepare financial statements that conform with accounting principles generally accepted in the United States of America, we must select and apply accounting policies and make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our accounting estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

  Critical Accounting Estimates

     There are certain critical accounting estimates that we believe require significant judgment in the preparation of our consolidated financial statements. We consider an accounting estimate to be critical if it requires us to make assumptions because information was not available at the time or it included matters that were highly uncertain at the time we were making the estimate,and changes in the estimate or different estimates that we reasonably could have selected would have had a material impact on our financial condition or results of operations.

     Stock-based Compensation

     We account for stock-based compensation in accordance with Financial Accounting Standards Board (“FASB”) Statement No. 123(R), “Share-Based Payment” (“SFAS 123R”). Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the vesting period. Determining the fair value of share-based awards at the grant date requires judgment, including estimating expected dividends and the amount of share-based awards that are expected to be forfeited. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be materially impacted.

     Purchase Price Allocations

     In connection with the merger transaction in September 2005, we have allocated the purchase price plus transaction costs and the fair value of liabilities assumed to the estimated fair values of CSI assets acquired. The purchase price allocation estimates were made based on our estimates of fair values. Had these estimates been different, reported amounts allocated to assets and liabilities and results of operations subsequent to the acquisitions could be materially impacted.

     Under the purchase method of accounting, the total estimated purchase price is allocated to the tangible and identifiable intangible assets acquired and liabilities assumed in connection with the merger transaction, based on their fair values as of the closing date. The excess of purchase price over the tangible and identifiable intangible assets acquired net of liabilities assumed is allocated to goodwill. Valuation specialists have conducted valuations in order to assist management in determining the fair values of the identifiable intangible and certain tangible assets acquired. The work performed by valuation specialists has been considered in management’s estimates of fair values. The initial allocations of purchase cost were recorded at fair value based upon the best information available to management and are finalized when we obtain information

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related to pre-acquisition contingencies which we identified at September 1, 2005 for which the allocation has not been finalized. We may have additional adjustments which could result in a future impact on our results of operations.

     Additionally, deferred income tax adjustments recorded in connection with the merger transaction will differ from amounts initially recorded as management obtains all information that we will likely obtain, and adjusts the allocation of purchase price, accordingly. Management has not recorded a deferred tax asset valuation allowance as part of the merger transaction based on its preliminary assessment that it is more likely than not that we will realize the benefit of preliminarily determined acquired deferred tax assets. However, adjustments to deferred tax assets and liabilities resulting from management obtaining all information that it has arranged to obtain will require management to re-evaluate its assessment of our ability to realize the benefit of acquired deferred tax assets and may result in the recording of a deferred tax asset valuation allowance as part of its final purchase price allocation.

     Accounts Receivable

     Accounts receivable represent a significant portion of our assets. We must make estimates of the collectability of accounts receivable. We analyze historical write-offs, changes in our internal credit policies and customer concentrations when evaluating the adequacy of our allowance for doubtful accounts. Different estimates regarding the collectability of accounts receivable may have a material impact on the timing and amount of reported bad debt expense and on the carrying value of accounts receivable.

     Inventories

     Inventories represent a significant portion of our assets. We value inventories at the lower of cost, on an average cost basis, or market. We regularly perform a detailed analysis of our inventories to determine whether adjustments are necessary to reduce inventory values to estimated realizable value. We consider various factors in making this determination, including the salability of individual items or classes of items, recent sales history and predicted trends, industry market conditions and general economic conditions. Different estimates regarding the realizable value of inventories could have a material impact on our reported net inventory and cost of sales, and thus could have a material impact on the financial statements as a whole.

     Goodwill

     Goodwill represents the excess of cost over the estimated fair value of net assets acquired in connection with acquisitions of our medical treadmill product line, Burdick and CSI. We test goodwill for impairment on an annual basis, and between annual tests in certain circumstances, for each reporting unit identified for purposes of accounting for goodwill. A reporting unit represents a portion of our business for which we regularly review certain discrete financial information and operational results. We have determined that we have two reporting units, consisting of our general cardiology products, which includes our product service business, and the Shanghai-Quinton joint venture, both of which operate in the cardiology market and have similar economic and operating characteristics.

     Application of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, and determining the fair value of each reporting unit. Significant judgments required to estimate the fair value of reporting units include estimating future cash flows, determining appropriate discount rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value for each reporting unit, and potentially result in recognition of an impairment of goodwill, which would be reflected as a loss on our statement of operations and as a reduction in the carrying value of goodwill.

     Intangible Assets

     Our intangible assets are comprised primarily of trade names, developed technology and customer relationships, all of which were acquired in our acquisition of Burdick in 2003 and the merger transaction with CSI. We use our judgment to estimate the fair value of each of these intangible assets. Our judgment about fair value is based on our expectation of future cash flows and an appropriate discount rate. We also use our judgment to estimate the useful lives of each intangible asset.

     We believe the Burdick and Cardiac Science trade names have indefinite lives and, accordingly, we do not amortize the trade names. We evaluate this conclusion annually or more frequently if events and circumstances indicate that the asset might be impaired and make a judgment about whether there are factors that would limit our ability to benefit from the trade name in the future. If there were such factors, we would start amortizing the trade name over the expected remaining period in which we believed it would continue to provide benefit. With respect to our developed technology and customer relationship intangible assets, we also evaluate the remaining useful lives annually.

     We evaluate whether our intangible assets are impaired. For our trade names, this evaluation is performed annually or more frequently if events occur that suggest there may be an impairment loss, and involves comparing the carrying amount to

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our estimate of fair value. For our developed technology and customer relationship intangible assets, this evaluation would be performed if events occur that suggest there may be an impairment loss. If we conclude that any of our intangible assets is impaired, we would record this as a loss on our statement of operations and as a reduction to the intangible asset.

     Valuation of Long-Lived Assets

     We review long-lived assets, such as property, plant, and equipment, and intangible assets subject to amortization, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Recoverability of asset groups to be held and used is measured by a comparison of the carrying amount of an asset group to estimated undiscounted future cash flows expected to be generated by the asset group. If the carrying amount of an asset group exceeds its estimated future cash flows, an impairment charge is recognized on our statement of operations and as a reduction to value of the asset group on our balance sheet if it is concluded that the fair value of the asset group is less than its carrying value. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposal group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet.

     Warranty

     We provide warranty service covering the systems we sell. We estimate and accrue for future costs of providing warranty service, which relate principally to the hardware components of the systems, when the systems are sold. Our estimates are based in part on our warranty claims history and our cost to perform warranty service. Differences could result in the amount of the recorded warranty liability and cost of sales if we made different judgments or used different estimates.

     Deferred Tax Assets and Income Taxes

     As part of the process of preparing our consolidated financial statements, we are required to determine our income taxes. This process involves calculating our current tax obligation or refund and assessing the nature and measurements of temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. In each period, we assess the likelihood that our deferred tax assets will be recovered from existing deferred tax liabilities or future taxable income. When appropriate, we will recognize a valuation allowance to reduce such deferred tax assets to amounts that are more likely than not to be ultimately realized. To the extent that we establish a valuation allowance or change this allowance in a period, we adjust our tax provision or tax benefit in the statement of operations. We use our judgment to determine our provision or benefit for income taxes, and any valuation allowance recorded against our net deferred tax assets.

     Litigation and Other Contingencies

     We regularly evaluate our exposure to threatened or pending litigation and other business contingencies. Because of the uncertainties related to the amount of loss from litigation and other business contingencies, the recording of losses related to such exposures requires significant judgment about the potential range of outcomes. We are not presently affected by any litigation or other contingencies that have had, or are currently anticipated to have, a material impact on our results of operations or financial position. As additional information about current or future litigation or other contingencies becomes available, we will assess whether such information warrants the recording of additional expense relating to these contingencies. A loss contingency, to be recorded as an expense, must generally be both probable and measurable.

     Restructuring Costs

     Our merger transaction with CSI caused excess facilities and redundant employee positions. In 2005 we recorded an estimated restructuring accrual of $4,381,000 in connection with the merger transaction. Determining the necessary restructuring accrual required us to estimate future sublease income for vacated excess facilities.

     Software Revenue Recognition

     We account for the licensing of software in accordance with American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-9. The application of SOP 97-2 requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (VSOE) of fair value exists for those elements. Customers may receive certain elements of our products over a period of time. These elements include post-delivery telephone support and the right to receive unspecified upgrades/enhancements (on a when-and-if available basis), the fair value of which is recognized over the product’s estimated life cycle. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and changes to a product’s estimated life cycle could materially impact the

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amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products.

     Sales Returns

     The Company provides a reserve against revenue for estimated product returns. The amount of this reserve is evaluated quarterly based upon historical trends.

     Critical Accounting Policies

     Segment Reporting

     Accounting standards require companies to disclose certain information about each of their reportable segments. Based on the similar economic and operating characteristics of the components of our business, we have determined that we currently have only one reportable segment, which markets various non-invasive cardiology products and services.

     Revenue Recognition

     Revenue from sales of hardware products is generally recognized when title transfers to the customer, typically upon shipment. Some of our customers are distributors that sell goods to third party end users. Except for certain identified distributors where collection may be contingent on distributor resale, we recognize revenue on sales of products made to distributors when title transfers to the distributor and all significant obligations have been satisfied. In making a determination of whether significant obligations have been met, we evaluate any installation or integration obligations to determine whether those obligations are inconsequential or perfunctory. In cases where the remaining installation or integration obligation is not determined to be inconsequential or perfunctory, we defer the portion of revenue associated with the fair value of the installation and integration obligation until these services have been completed.

     Distributors do not have price protection and generally do not have product return rights, except in cases upon termination of the distributor agreement or if product is defective. For certain identified distributors where collection may be contingent on the distributor’s resale, revenue recognition is deferred and recognized on a “sell through” or cash basis. The determination of whether sales to distributors are contingent on resale is subjective because we must assess the financial wherewithal of the distributor to pay regardless of resale. For sales to distributors, we consider several factors, including past payment history, where available, trade references, bank account balances, Dun & Bradstreet reports and any other financial information provided by the distributor, in assessing whether the distributor has the financial wherewithal to pay regardless of, or prior to, resale of the product and that collection of the receivable is not contingent on resale.

     We offer limited volume price discounts and rebates to certain distributors. Volume price discounts are on a per order basis based on the size of the order and are netted against the revenue recorded at the time of shipment. We have no arrangements that provide for volume discounts based on meeting certain quarterly or annual purchase levels. Rebates are paid quarterly or annually and are accrued for as incurred.

     With respect to arrangements where software is considered more than incidental, the vendor specific objective evidence of undelivered support is deferred and the residual fair value of delivered software is recognized. Revenue from software implementation services is recognized as the services are provided (based on vendor specific objective evidence of fair value). When significant implementation activities are required, we recognize revenue from software and services upon installation. We occasionally sell software and hardware upgrades on a stand alone basis.

     We consider program management packages and training and other services as separate units of accounting and apply the provisions of EITF 00-21 when sold with an AED based on the fact that the items have value to the customer on a stand alone basis and could be acquired from another vendor. Fair value is determined to be the price at which they are sold to customers on a stand alone basis. Training revenue is deferred and recognized at the time the training occurs. AED program management services revenue, pursuant to agreements that exist with some customers pursuant to annual or multi-year terms, are deferred and amortized on a straight-line basis over the related contract period.

     We offer optional extended service contracts to customers. Fair value is determined to be the price at which they are sold to customers on a stand alone basis. Service contract revenues are recognized on a straight-line basis over the term of the extended service contracts, which generally begin after the expiration of the original warranty period. For services performed, other than pursuant to warranty and extended service contract obligations, revenue is recognized when the service is performed and collection of the resulting receivable is reasonably assured.

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     Accounting for Stock-Based Compensation

     Prior to the January 1, 2006 adoption of the Financial Accounting Standards Board (“FASB”) Statement No. 123(R), “Share-Based Payment” (“SFAS 123R”), we accounted for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, because the stock option grant price equaled the market price on the date of grant, and any purchase discounts under our stock purchase plans were within statutory limits, no compensation expense was recognized by for stock-based compensation. As permitted by SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), stock-based compensation was included as a pro forma disclosure in the notes to the consolidated financial statements.

     Effective January 1, 2006 we adopted the fair value recognition provisions of SFAS 123R, and applied the provisions of Staff Accounting Bulletin No. 107, “Share-Based Payment”, using the modified-prospective transition method. Under this transition method, stock-based compensation expense was recognized in the consolidated financial statements for granted stock options and for expense related to the ESPP, since the related purchase discounts exceeded the amount allowed under SFAS 123R for non-compensatory treatment. Compensation expense recognized included the estimated expense for stock options granted on and subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R, and the estimated expense for the portion vesting in the period for options granted prior to, but not vested as of December 31, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. Further, as required under SFAS 123R, forfeitures are estimated for share-based awards that are not expected to vest. Compensation expense for non-vested stock awards is based on the market price on the grant date and is recorded equally over the vesting period. Results for prior periods have not been restated, as provided for under the modified-prospective transition method.

Results of Operations

     Overview of Results for the Three and Six Months Ended June 30, 2006

• Revenue of $39.2 million for the three months ended June 30, 2006 and $78.3 million for the six months then ended increased by 79% and 81%, respectively, over the reported amounts for the comparable periods in the prior year.

• Gross margin improved to approximately 47% for both the three and six month periods ended June 30, 2006 from approximately 45% for both of the comparable respective periods in the prior years.

• Inclusive of year to date litigation expenses of $2.0 million and merger related charges in the first quarter of over $0.4 million, the Company has generated net income of $0.4 million in the first six months of 2006.

• In the first six months of 2006, the Company has generated cash from operations of $6.7 million, compared with reported (Quinton only) cash from operations of $2.4 million for the first half of 2005.

     Looking Forward

     We expect continued revenue growth in the future. We expect modest growth, over time, in our cardiac monitoring product revenue as we increase our sales in both the domestic and international markets. We expect significant growth, over time, in sales of our defibrillation products as we continue to participate in the growing overall AED market. Sales of both cardiac monitoring and defibrillation products in any given period may fluctuate, however, due to timing of orders and other factors. We expect service revenue to remain consistent with the second quarter or to decline slightly in the near term as we continue to develop our defibrillation service offerings. We expect modest growth in service revenue over the longer term.

     We expect our overall margin to increase slightly in the future as sales of our higher margin AEDs grow faster than sales of other lower margin products and as a result of future product cost productions. However, our gross margin may fluctuate from period to period, based on fluctuations in product sales mix, competitive impact on AED pricing, the effect of product cost reductions and other factors. We expect continued growth in gross profit from our product and service lines as our revenues increase in the future.

     As revenues increase, we expect our operating expenses to increase also, though at a slower rate than our overall revenue growth. We are devoting substantial resources to the continued development of new versions of our products to meet the changing requirements of our customers. As a result, our research and development expenses are expected to increase in the future. In addition, we intend to expand our sales and marketing activities both domestically and internationally, in order to increase sales of our products and services. We expect that sales and marketing expenses will increase as we expand our sales efforts in both domestic and international locations, hire additional marketing personnel and initiate additional marketing programs. Finally, we expect general and administrative expenses to increase in future periods as we continue to develop our corporate infrastructure in support of the growth of our business. We expect to continue to incur significant legal expenses related to our patent litigation through the respective trials. The trials in both of our patent infringement cases are currently scheduled for the first quarter of 2007. In addition to these operating expenses, we expect stock-based compensation expense to continue to be a significant ongoing expense.

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  Three-Month Period Ended June 30, 2006 Compared to the Three-Month Period Ended June 30, 2005

  Revenues

     We derive our revenues primarily from the sale of our cardiology products and related consumables, and to a lesser extent, from services. We categorize our revenues as (1) cardiac monitoring products, which includes capital equipment, software products and related accessories and supplies; (2) defibrillation products, which includes our AEDs, hospital defibrillators and related accessories; and (3) service, which includes service contracts, CPR/AED training services, AED management program services, equipment maintenance and repair, replacement part sales and other services. We derive a portion of our service revenue from sales of separate extended maintenance arrangements. We defer and recognize these revenues over the applicable maintenance period.

     Revenues for the three months ended June 30, 2006 and 2005 were as follows:

	Three months ended						Three months ended
	June 30,			% Change			June 30,
(dollars in thousands)	2006			2005 to 2006			2005
Cardiac monitoring products	$	17,727			(7.1	%)	$	19,073
% of revenue		45.2	%					86.8	%
Defibrillation products		17,280			100.0	%		—
% of revenue		44.1	%					0.0	%
Service		4,214			45.6	%		2,895
% of revenue		10.7	%					13.2	%
Total revenues	$	39,221			78.5	%	$	21,968

     Cardiac monitoring products revenue decreased by $1,346,000, or 7.1%, to $17,727,000 for the three-month period ended June 30, 2006, from $19,073,000 for the comparable period in 2005. This decrease was primarily due to lower sales of certain products and lower international sales, both generally due to timing of significant orders. We believe this is a temporary fluctuation and do not expect significant sustained reductions in sales of cardiac monitoring products in the future.

     Defibrillation products revenue increased by $17,280,000, or 100.0%, to $17,280,000 for the three-month period ended June 30, 2006, from $0 for the comparable period in 2005. This increase was due to the addition of defibrillation products revenue from CSI, which have been integrated with those of Quinton since September 1, 2005 and to growth in sales of defibrillation products of approximately 27.3% over that reported by CSI for the comparable period in the prior year.

     Service revenue increased by $1,319,000, or 45.6%, to $4,214,000 for the three-month period ended June 30, 2006 from $2,895,000 for the comparable period in 2005. This increase was primarily due to the impact of the addition of defibrillation-related service revenue. Service revenues in future quarters may decrease as certain service contracts assumed in the acquisition of CSI were cancelled during the second quarter of 2006. These contracts were generally for services that management did not consider a part of our core services offering. We do not expect significant additional contract cancellations beyond those that occurred in the first half of 2006.

  Gross Profit

     Cost of revenues consists primarily of the costs associated with manufacturing, assembling and testing our products, related overhead costs, stock based compensation expense and compensation and other costs related to manufacturing support and logistics. We rely on third parties to manufacture certain of our product components. Accordingly, a significant portion of our cost of revenues consists of payments to these manufacturers. Cost of service revenue consists of customer support costs, training and professional service expenses, parts and compensation. Our hardware products include a warranty period that includes factory repair services or replacement parts. We accrue estimated expenses for warranty obligations at the time products are shipped.

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     Gross profit for the three months ended June 30, 2006 and 2005 was as follows:

	Three months ended						Three months ended
	June 30,			% Change			June 30,
(dollars in thousands)	2006			2005 to 2006			2005
Products	$	17,496			97.1	%	$	8,875
% of products revenue		50.0	%					46.5	%
Service		1,094			9.4	%		1,000
% of service revenue		26.0	%					34.5	%
Total gross profit	$	18,590			88.3	%	$	9,875
% of total revenue		47.4	%					45.0	%

     Gross profit increased by $8,715,000, or 88.3%, to $18,590,000 for the three-month period ended June 30, 2006, from $9,875,000 for the comparable period in 2005, principally as a result of the acquisition of CSI and the related defibrillation product and service gross profit and, to a lesser extent, improvement in gross margin on our cardiac monitoring products and services.

     Gross margin from products increased to 50.0% for the three-month period ended June 30, 2006, from 46.5% for the comparable period in 2005. This increase in products gross margin was primarily attributable to the addition of higher margin defibrillation products as the result of the acquisition of CSI, and, to a lesser extent, to an increase in gross margin on the cardiac monitoring product line, resulting from product cost reductions and changes in product mix.

     Gross profit from service increased by $94,000, or 9.4%, to $1,094,000 for the three-month period ended June 30, 2006, from $1,000,000 for the comparable period in 2005, principally due to the addition of defibrillation-related service revenue acquired from CSI. Gross margin from service decreased to 26.0% for the three-month period ended June 30, 2006, from 34.5% for the comparable period in 2005 due to the lower gross margins on the acquired CSI service revenue and the cancellation of non-core service contracts in the second quarter of 2006.

  Operating Expenses

     Operating expenses consisted of expenses related to research and development, sales and marketing and other expenses required to run our business.

     Research and development expenses consisted primarily of salaries and related expenses for development and engineering personnel, including stock based compensation expense, fees paid to consultants, and prototype costs related to the design, development, testing and enhancement of products. We expense research and development costs as incurred. Several components of our research and development effort require significant funding, the timing of which can cause significant quarterly variability in our expenses.

     Sales and marketing expenses consisted primarily of salaries, commissions, stock based compensation expense and related expenses for personnel engaged in sales, marketing and sales support functions as well as costs associated with promotional and other marketing activities.

     General and administrative expenses consisted primarily of employee salaries and related expenses, including stock based compensation expense for executive, finance, accounting, information technology, regulatory and human resources personnel, professional fees, legal fees, including fees associated with our patent litigation, and corporate expenses.

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     Operating expenses for the three months ended June 30, 2006 and 2005 were as follows:

	Three months ended						Three months ended
	June 30,			% Change			June 30,
(dollars in thousands)	2006			2005 to 2006			2005
Research and development (including stock based compensation expense of $89 and $0)	$	2,875			50.7	%	$	1,908
% of total revenue		7.3	%					8.7	%
Sales and marketing (including stock based compensation expense of $215 and $0)		9,914			115.9	%		4,592
% of total revenue		25.3	%					20.9	%
General and administrative (including stock based compensation expense of $175 and $15)		5,916			161.1	%		2,266
% of total revenue		15.1	%					10.4	%
Total operating expenses	$	18,705			113.4	%	$	8,766
% of total revenue		47.7	%					40.0	%

     Research and development expenses increased by $967,000, or 50.7%, to $2,875,000 for the three-month period ended June 30, 2006, from $1,908,000 for the comparable period in 2005. This increase was primarily due to the impact of additional research and development expenses relating to the CSI business and recognition of stock-based compensation expense in 2006. The increase in research and development expenses was net of cost reductions that were realized after the merger transaction.

     Sales and marketing expenses increased by $5,322,000, or 115.9%, to $9,914,000 for the three-month period ended June 30, 2006, from $4,592,000 for the comparable period in 2005. This increase was primarily due to the impact of additional sales and marketing expenses relating to the CSI business and recognition of stock-based compensation expense in 2006. To a lesser extent, the increase was also due to increases in our staffing related expenses and other investments in marketing to facilitate future growth. The increase in sales and marketing expenses was net of cost reductions that were realized after the merger transaction.

     General and administrative expenses increased by $3,650,000, or 161.1%, to $5,916,000 for the three-month period ended June 30, 2006, from $2,266,000 for the comparable period in 2005. This increase was primarily due to the impact of additional general and administrative expenses relating to the CSI business, an increase in amortization expense of $433,000 related to intangible assets acquired in the merger, an increase in legal expenses of $1,283,000, mostly related to our patent litigation, and recognition of stock-based compensation expense in 2006. The increase in general and administrative expenses was net of cost reductions that were realized after the merger transaction.

  Other Income and Expense

     Total other income was $269,000 for the three-month period ended June 30, 2006. Other income for the three month period ended June 30, 2006 consisted of income of $163,000 related to foreign exchange transaction gains, $60,000 received during the period representing contingent consideration relating to the sale of our hemodynamic monitoring business in an earlier period and interest income of $58,000. The increase in other income relating to foreign exchange transaction gains offset a decrease in interest income earned on our decreased average cash balances for the three-month period ended June 30, 2006 over the comparable period in 2005.

  Income Taxes

	Three months ended						Three months ended
	June 30,			% Change			June 30,
(dollars in thousands)	2006			2005 to 2006			2005
Income before taxes	$	154			(88.2	%)	$	1,307
Income tax expense	$	49			(88.7	%)	$	434
Effective tax rate		31.8	%		(4.2	%)		33.2	%

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     During the fourth quarter of 2004, we removed all of the valuation allowance against the deferred tax assets of our predecessor company. We will continue to evaluate our ability to utilize those net operating loss carryforwards in future periods and, in compliance with SFAS No. 109, “Accounting for Income Taxes”, record any resulting adjustments to deferred income tax expense. In addition, we will reduce the deferred tax asset for the benefits of net operating loss carryforwards which are utilized.

     We have not recorded a valuation allowance against the deferred tax assets acquired in the merger transaction based on management’s assessment that it is more likely than not that we will realize the benefit of these deferred tax assets. However adjustments to deferred tax assets and liabilities resulting from management obtaining all information that it has arranged to obtain will require management to re-evaluate its assessment of our ability to realize the benefit of acquired deferred tax assets and may result in the recording of a valuation allowance as part of the final purchase price allocation.

     Our effective tax rate for the three-month period ended June 30, 2006 was 31.8%, compared to an effective rate of 33.2% for the same period in the prior year. This decrease results primarily from changes in the Company’s estimates of pre-tax income. We estimate the effective rate for the year will approximate 37%.

  Six-Month Period Ended June 30, 2006 Compared to the Six-Month Period Ended June 30, 2005

  Revenues

     Revenues for the six months ended June 30, 2006 and 2005 were as follows:

	Six months ended						Six months ended
	June 30,			% Change			June 30,
(dollars in thousands)	2006			2005 to 2006			2005
Cardiac monitoring products	$	37,576			0.4	%	$	37,417
% of revenue		48.0	%					86.4	%
Defibrillation products		32,000			100.0	%		—
% of revenue		40.8	%					0.0	%
Service		8,760			49.0	%		5,881
% of revenue		11.2	%					13.6	%
Total revenues	$	78,336			80.9	%	$	43,298

     Cardiac monitoring products revenue increased by $159,000, or 0.4%, to $37,576,000 for the six-month period ended June 30, 2006, from $37,417,000 for the comparable period in 2005. This increase was primarily due to organic domestic growth offset by lower sales of certain products and lower international sales.

     Defibrillation products revenue increased by $32,000,000, or 100.0%, to $32,000,000 for the six-month period ended June 30, 2006, from $0 for the comparable period in 2005. This increase was due to the addition of defibrillation products revenue from CSI, which have been integrated with those of Quinton since September 1, 2005 and to growth in sales of defibrillation products of approximately 20.0% over that reported by CSI for the comparable period in the prior year.

     Service revenue increased by $2,879,000, or 49.0%, to $8,760,000 for the six-month period ended June 30, 2006 from $5,881,000 for the comparable period in 2005. This increase was primarily due to the impact of the addition of defibrillation-related service revenue. Service revenues in future quarters may decrease as certain service contracts assumed in the acquisition of CSI were cancelled during the second quarter of 2006. These contracts were generally for services that management did not consider a part of our core services offering.

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  Gross Profit

     Gross profit for the six months ended June 30, 2006 and 2005 was as follows:

	Six months ended						Six months ended
	June 30,			% Change			June 30,
(dollars in thousands)	2006			2005 to 2006			2005
Products	$	34,385			96.1	%	$	17,537
% of products revenue		49.4	%					46.9	%
Service		2,598			23.5	%		2,104
% of service revenue		29.7	%					35.8	%
Total gross profit	$	36,983			88.3	%	$	19,641
% of total revenue		47.2	%					45.4	%

     Gross profit increased by $17,342,000, or 88.3%, to $36,983,000 for the six-month period ended June 30, 2006, from $19,641,000 for the comparable period in 2005, principally as a result of the acquisition of CSI and, to a lesser extent, improvement in gross margin on our pre-existing revenue streams.

     Gross margin from products increased to 49.4% for the six-month period ended June 30, 2006, from 46.9% for the comparable period in 2005. The increase in products gross margin was primarily attributable to the addition of higher margin products to our line as the result of the acquisition of CSI, and, to a lesser extent, to an increase in gross margin on the pre-existing product line, resulting from product cost reductions and changes in product mix.

     Gross profit from service increased by $494,000, or 23.5%, to $2,598,000 for the six-month period ended June 30, 2006, from $2,104,000 for the comparable period in 2005, principally due to the addition of defibrillation-related service revenue acquired from CSI. Gross margin from service decreased to 29.7% for the six-month period ended June 30, 2006, from 35.8% for the comparable period in 2005 due to the lower gross margins on the acquired CSI service revenue and the cancellation of non-core service contracts in the second quarter of 2006.

  Operating Expenses

     Operating expenses for the six months ended June 30, 2006 and 2005 were as follows:

	Six months ended						Six months ended
	June 30,			% Change			June 30,
(dollars in thousands)	2006			2005 to 2006			2005
Research and development (including stock based compensation expense of $166 and $0)	$	5,845			57.3	%	$	3,717
% of total revenue		7.5	%					8.6	%
Sales and marketing (including stock based compensation expense of $372 and $0)		19,297			108.6	%		9,249
% of total revenue		24.6	%					21.4	%
General and administrative (including stock based compensation expense of $331 and $39)		11,727			172.0	%		4,311
% of total revenue		15.0	%					10.0	%
Total operating expenses	$	36,869			113.4	%	$	17,277
% of total revenue		47.1	%					39.9	%

     Research and development expenses increased by $2,128,000, or 57.3%, to $5,845,000 for the six-month period ended June 30, 2006, from $3,717,000 for the comparable period in 2005. This increase was primarily due to the impact of additional research and development expenses relating to the CSI business and recognition of stock-based compensation expense in 2006. The increase in research and development expenses was net of cost reductions that were realized after the merger transaction.

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     Sales and marketing expenses increased by $10,048,000, or 108.6%, to $19,297,000 for the six-month period ended June 30, 2006, from $9,249,000 for the comparable period in 2005. This increase was primarily due to the impact of additional sales and marketing expenses relating to the CSI business and recognition of stock-based compensation expense in 2006. To a lesser extent, the increase was also due to increases in our staffing related expenses and other investments in marketing to facilitate future growth. The increase in sales and marketing expenses was net of cost reductions that were realized after the merger transaction.

     General and administrative expenses increased by $7,416,000, or 172.0%, to $11,727,000 for the six-month period ended June 30, 2006, from $4,311,000 for the comparable period in 2005. This increase was primarily due to the impact of additional general and administrative expenses relating to the CSI business, an increase in amortization expense of $865,000 related to intangible assets acquired in the merger transaction, an increase in legal expenses of $2,179,000, mostly related to our patent litigation, and recognition of stock-based compensation expense in 2006. The increase in general and administrative expenses was net of cost reductions that were realized after the merger transaction.

  Other Income and Expense

     Total other income was $450,000 for the six-month period ended June 30, 2006. Other income for the six month period ended June 30, 2006 consisted of income of $225,000 related to the release of a liability to the city of Deerfield, WI (the location of our manufacturing facilities), $171,000 related to foreign exchange transaction gains, $60,000 received during the period representing contingent consideration relating to the sale of our hemodynamic monitoring business in an earlier period and interest income of $86,000. The increase in other income relating to the release of the liability in Deerfield, WI and foreign exchange transaction gains offset a decrease in interest income earned on our decreased average cash balances for the six-month period ended June 30, 2006 over the comparable period in 2005.

  Income Taxes

	Six months ended						Six months ended
	June 30,			% Change			June 30,
(dollars in thousands)	2006			2005 to 2006			2005
Income before taxes	$	564			(79.4	%)	$	2,736
Income tax expense	$	208			(77.0	%)	$	904
Effective tax rate		36.9	%		11.8	%		33.0	%

     Our effective tax rate for the six-month period ended June 30, 2006 was 36.9%, compared to an effective rate of 33.0% for the same period in the prior year. This increase results primarily from our adoption of FAS 123R, which requires us to expense stock-based compensation, and the expiration, as of December 31, 2005, of the federal research and development credit. We estimate the effective rate for the year will approximate 37%.

  Consolidation of Operations

     As a result of the merger transaction, we acquired CSI’s manufacturing and production facilities located in Minnetonka, Minnesota and corporate and administrative facilities in Irvine, California. During the third quarter of 2005, we announced plans to consolidate our Deerfield, Wisconsin and Minnetonka, Minnesota manufacturing and production activities to the Deerfield location. In addition, during the third quarter of 2005, we announced plans to consolidate our Bothell, Washington and Irvine, California corporate and administrative activities to the Bothell location. As a result of the related transition activities, we incurred certain charges relating to retention and relocation of certain employees in the first quarter of 2006 of $184,000 and none in the second quarter of 2006. We do not expect these transition related activities to materially adversely affect revenues in 2006.

  Liquidity and Capital Resources

     Net cash flows provided by operating activities were $3,175,000 for the three-month period ended June 30, 2006, compared to net cash flows provided by operating activities of $1,377,000 for the comparable period in 2005. Net cash flows provided by operating activities for the three-month period ended June 30, 2006 resulted from net income of $118,000, increased by non-cash stock-based compensation and other non-cash charges of $2,146,000 and net decreases in other working capital of $911,000.

     Net cash flows provided by operating activities were $6,744,000 for the six-month period ended June 30, 2006, compared to net cash flows provided by operating activities of $2,377,000 for the comparable period in 2005. Net cash flows

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provided by operating activities for the six-month period ended June 30, 2006 resulted from net income of $382,000, increased by non-cash stock-based compensation and other non-cash charges of $4,202,000 and net decreases in other working capital of $2,160,000. Included in net cash flows provided by operating activities for the six-month period ended June 30, 2006 were payments of $751,000 for merger related charges.

     Net cash flows used in investing activities of $841,000 for the three-month period ended June 30, 2006 consisted of payments of $441,000 for acquisition costs related to the merger transaction and payments of $400,000 for capital expenditures. Net cash flows used in investing activities of $533,000 for the three-month period ended June 30, 2005 consisted of payments of $1,018,000 for acquisition costs related to the merger transaction, payments of $140,000 for capital expenditures and proceeds from sale of marketable equity securities of $625,000.

     Net cash flows used in investing activities of $2,010,000 for the six-month period ended June 30, 2006 consisted of payments of $1,214,000 for acquisition costs related to the merger transaction and payments of $796,000 for capital expenditures. Net cash flows used in investing activities of $799,000 for the six-month period ended June 30, 2005 consisted of payments of $1,097,000 for acquisition costs related to the merger transaction, payments of $327,000 for capital expenditures and proceeds from sale of marketable equity securities of $625,000.

     Net cash flows provided by financing activities of $243,000 and $165,000 for the three-month periods ended June 30, 2006 and June 30, 2005, respectively, resulted from proceeds from exercises of stock options and issuances of common stock under our ESPP.

     Net cash flows provided by financing activities of $466,000 and $350,000 for the six-month periods ended June 30, 2006 and June 30, 2005, respectively, resulted from proceeds from exercises of stock options and issuances of common stock under our ESPP.

     Cash and cash equivalents at June 30, 2006 increased from balances at December 31, 2005 due primarily to net cash flows from operating activities, as described above.

     We anticipate that, for 2006, our existing cash and cash equivalents and future expected operating cash flow will be sufficient to meet operating expenses, working capital requirements, capital expenditures and other obligations for at least 12 months. We may be affected by economic, financial, competitive, legislative, regulatory, business and other factors beyond our control. In addition, we are continually considering other acquisitions that complement or expand our existing business or that may enable us to expand into new markets. Future acquisitions may require additional debt, equity financing or both. We may not be able to obtain any additional financing, or may not be able to obtain additional financing on acceptable terms.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     We develop products in the U.S. and sell them worldwide. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. Since the majority of our revenues are currently priced in U.S. dollars and are translated to local currency amounts, a strengthening of the dollar could make our products less competitive in foreign markets.

Item 4. Controls and Procedures

     Our chief executive officer and chief financial officer evaluated our disclosure controls and procedures as of the end of the period covered by this quarterly report on Form 10-Q and have determined that our disclosure controls and procedures are effective to ensure that information required to be disclosed in our filings under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. In addition, our chief executive officer and chief financial officer concluded as of the end of the period covered by this quarterly report on Form 10-Q that our disclosure controls and procedures are effective to ensure that information required to be disclosed in reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our chief executive officer and chief financial officer, to allow timely decisions regarding required disclosure.

     There were no changes in our internal control over financial reporting that occurred during our fiscal quarter ended June 30, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II — OTHER INFORMATION

Item 1. Legal Proceedings

     In February 2003, a patent infringement action was brought initially by CSI against Philips Medical Systems North America, Inc., Philips Electronics North America Corporation and Koninklijke Philips Electronics N.V. (“Philips”) in the United States District Court for the District of Minnesota. The suit alleges that Philips’ automated external defibrillators sold under the names “HeartStart OnSite Defibrillator”,“HeartStart”,“HeartStart FR2,” and the “HeartStart Home Defibrillator,” infringe certain of the Company’s United States patents. In the same action, Philips counterclaimed for infringement of certain of its patents and the Company has sought a declaration from the Court that its products do not infringe such patents. Many of the Philips defibrillators’ are promoted by Philips as including, among other things, pre-connected disposable defibrillation electrodes and daily self-testing of electrodes and battery, features that the suit alleges are key competitive advantages of the Company’s Powerheart and Survivalink AEDs and are covered under the Company’s patents. At this stage, the Company is unable to predict the outcome of this litigation and has not established an accrual for this matter because a loss is not determined to be probable. The Company intends to defend this counter claim vigorously.

     In March 2004, William S. Parker brought suit initially against CSI for patent infringement in the United States District Court for the Eastern Division of Michigan. The Parker patent generally covers the use of a synthesized voice to instruct a person to perform certain tasks. The Complaint alleges that certain of our AEDs infringe the patent. The patent is now expired. We have filed an Answer to the Complaint stating the patent is not infringed and is otherwise invalid and unenforceable. The patent was submitted for reexamination before the United States Patent and Trademark Office and emerged from reexamination in December 2005. In January 2006, the District Court issued an order lifting the stay in the litigation. Currently, the litigation is proceeding through discovery. At this stage, we are unable to predict the outcome of this litigation. We have not established an accrual for this matter because a loss is not determined to be probable. We intend to defend against this suit vigorously.

     We are subject to various legal proceedings arising in the normal course of business. In the opinion of management, the ultimate resolution of these proceedings is not expected to have a material effect on our consolidated financial position, results of operations or cash flows.

Item 1A. Risk Factors

     Information regarding risk factors appears in the first paragraph in Part I — Item 2 of this Form 10-Q and in Part I — Item 1A of our Report on Form 10-K for the fiscal year ended December 31, 2005 (the “2005 10-K”). There have been no material changes from the risk factors previously disclosed in the 2005 Form 10-K.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

     None.

Item 3. Defaults Upon Senior Securities

     None.

Item 4. Submission of Matters to a Vote of Security Holders

     None.

Item 5. Other Information

     We have re-scheduled our 2006 annual meeting of stockholders from Friday, July 28, 2006 to Friday, October 27, 2006. The decision to postpone the annual meeting was made in part due to our evaluation of our compliance with Nasdaq’s rule requiring a majority of the board of directors to be independent in the wake of the resignation of an independent director in May 2006. That evaluation was dependent in part on interpretive advice sought from Nasdaq, which was recently obtained. Based on the outcome of that evaluation, we do not expect our board of directors to nominate a director to fill the vacancy created by the resignation of that independent director. Our board of directors has determined that a majority of the current directors are independent, and we intend to maintain a board of directors composed of at least a majority of independent directors in the future.

     Proposals of stockholders that are intended to be presented at the 2006 annual meeting must be received by us a reasonable time before we begin to print and mail it proxy materials, which we expect to occur on or before September 22, 2006, in order to be included in the proxy statement and proxy relating to that annual meeting. A stockholder must have continuously held at least $2,000 in market value, or 1%, of our outstanding stock for at least one year by the date of submitting the proposal, and such stockholder must continue to own such stock through the date of the meeting. If we do not

Page 32 of 34

receive notice of a stockholder proposal a reasonable time before mailing the proxy materials, the persons named as proxies in the proxy statement for the 2006 annual meeting of stockholders will have discretionary authority to vote on such proposal at the meeting. Stockholders are also advised to review our bylaws that contain additional requirements with respect to advance notice of stockholder proposals and director nominations. These advance notice provisions apply regardless of whether a stockholder seeks to include such proposals in the proxy statement relating to the 2006 annual meeting of stockholders.

Item 6. Exhibits

Exhibits
10.32	Form of Stock Option Grant Notice and Stock Option Agreement for grants made pursuant to the Cardiac Science Corporation 2002 Stock Incentive Plan.
31.1	Certification of Chief Executive Officer pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Chief Financial Officer pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.
32.1	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURE

     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.

	CARDIAC SCIENCE CORPORATION
By:	/s/ Michael K. MatysikMichael K. Matysik
	Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)
	Date: August 9, 2006

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