PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Digirad Corporation

Consolidated Balance Sheets

(In thousands, except par value amounts)

	September 30, 2005			December 31, 2004
	(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	10,926		$	11,348
Securities available-for-sale	37,308			44,215
Accounts receivable, net	8,878			10,017
Inventories, net	6,462			6,980
Other current assets	1,746			1,620
Total current assets	65,320			74,180
Property and equipment, net	10,992			11,182
Intangibles, net	379			542
Restricted cash	120			120
Total assets	$	76,811		$	86,024

Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	2,694		$	4,313
Accrued compensation	2,195			2,410
Accrued warranty	865			1,219
Other accrued liabilities	3,758			2,651
Deferred revenue	3,033			2,344
Current portion of debt	890			2,228
Total current liabilities	13,435			15,165
Long-term debt, net of current portion	480			1,754
Other Long-term Liabilities	354			371
Commitments and contingencies

Stockholders’ equity:
Preferred stock, $0.0001 par value: 10,000 shares authorized at September 30, 2005 and December 31, 2004; no shares issued and outstanding at September 30, 2005 and December 31, 2004	—			—
Common stock, $0.0001 par value: 150,000 shares authorized at September 30, 2005 and December 31, 2004; 18,697 and 18,075 shares issued and outstanding at September 30, 2005 and December 31, 2004, respectively	2			2
Additional paid-in capital	150,056			149,845
Accumulated other comprehensive loss	(193		)	(97		)
Deferred compensation	(378		)	(920		)
Accumulated deficit	(86,945		)	(80,096		)
Total stockholders’ equity	62,542			68,734
Total liabilities and stockholders’ equity	$	76,811		$	86,024

See accompanying notes.

Digirad Corporation

Consolidated Statements of Operations

(In thousands, except per share amounts)

(Unaudited)

	Three months ended September 30,						Nine months ended September 30,
	2005			2004			2005			2004
Revenues:
DIS	$	12,604		$	11,023		$	38,166		$	32,725
Product	4,748			6,201			12,618			17,657
Total revenues	17,352			17,224			50,784			50,382
Cost of revenues:
DIS	9,185			7,702			27,031			22,476
Product	4,726			3,674			11,647			11,297
Stock-based compensation	32			96			129			342
Total cost of revenues	13,943			11,472			38,807			34,115
Gross profit	3,409			5,752			11,977			16,267
Operating expenses:
Research and development	899			872			2,712			2,197
Sales and marketing	1,817			1,852			5,519			5,492
General and administrative	3,694			2,521			11,069			7,164
Amortization of intangible assets	139			16			173			48
Stock-based compensation	71			172			282			610
Total operating expenses	6,620			5,433			19,755			15,511
Income (loss) from operations	(3,211		)	319			(7,778		)	756
Other income (expense):
Interest income	423			237			1,163			279
Interest expense	(49		)	(176		)	(185		)	(788		)
Other	10			6			(49		)	(24		)
Total other income (expense)	384			67			929			(533		)
Net income (loss)	(2,827		)	386			(6,849		)	223
Accretion of deferred issuance costs on preferred stock	—						—			(161		)
Net income (loss) applicable to common stockholders	$	(2,827	)	$	386		$	(6,849	)	$	62

Net income (loss) per common share - basic and diluted (1)	$	(0.15	)	$	0.02		$	(0.37	)	$	0.01
Shares used in computing net loss per common share:
Weighted average shares outstanding – basic	18,690			18,011			18,390			7,388
Weighted average shares outstanding – diluted	18,690			19,392			18,390			16,125

The composition of stock-based compensation is as follows:
Cost of product revenue	$	9		$	45		$	45		$	164
Cost of DIS revenue	23			51			84			178
Research and development	15			33			54			107
Sales and marketing	8			24			39			113
General and administrative	48			115			189			390
	$	103		$	268		$	411		$	952

(1)

As a result of the conversion of our preferred stock into 12.4 million shares of our common stock upon the completion of our initial public offering in June 2004 of 5,500,000 shares of our common stock, there is a lack of comparability in the basic and diluted net loss per share amounts for the periods presented above. Please refer to Note 7 for the pro forma basic and diluted net loss per share calculations for the periods presented.

See accompanying notes.

Digirad Corporation

Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

	Nine months ended September 30,
	2005			2004
Operating activities
Net loss	$	(6,849	)	$	223
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation	2,695			2,261
Loss on disposal of assets	65			30
Amortization of premium on securities available-for-sale	375			35
Amortization of intangibles	173			48
Stock-based compensation	411			952
Changes in operating assets and liabilities:
Accounts receivable	1,139			2,045
Inventories	587			(1,501		)
Other assets	(126		)	(535		)
Accounts payable	(1,619		)	(196		)
Accrued compensation	(215		)	54
Accrued warranty, deferred rent and other accrued liabilities	736			1,763
Deferred revenue	689			676
Net cash provided (used) by operating activities	(1,939		)	5,855
Investing activities
Purchases of securities available-for-sale	(21,964		)	(29,570		)
Maturities of securities available-for-sale	28,400			—
Purchases of property and equipment	(2,639		)	(3,135		)
Patents and other assets	(10		)	(45		)
Net cash provided (used) by investing activities	3,787			(32,750		)
Financing activities
Issuances of common stock	342			58,842
Net repayments under lines of credit	—			(9,356		)
Proceeds from capital lease financing	—			312
Repayment of obligations under capital leases	(2,612		)	(1,595		)
Repayment of notes payable to stockholders	—			(735		)
Net cash provided (used) by financing activities	(2,270		)	47,468
Net increase (decrease) in cash and cash equivalents	(422		)	20,573
Cash and cash equivalents at beginning of period	11,348			7,681
Cash and cash equivalents at end of period	$	10,926		$	28,254

Supplemental information:
Cash paid during the period for interest	$	145		$	159

See accompanying notes.

DIGIRAD CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share amounts)

1. Interim Financial Information

Organization

Digirad Corporation (“Digirad”), a Delaware corporation, designs, develops, manufactures, markets, sells and services solid-state digital gamma cameras for use in nuclear medicine. Through two subsidiaries, Digirad Imaging Solutions, Inc. and Digirad Imaging Systems, Inc., collectively “DIS,” Digirad provides in-office services for physicians, offering certified personnel, required licensure, an imaging system and other support and supplies as required or needed for the performance of nuclear imaging procedures under the supervision of our physician customers. DIS physician customers enter into annual lease contracts for imaging services delivered on a per-day basis.

Basis of Presentation

We have prepared the accompanying unaudited consolidated financial statements in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and disclosures required by generally accepted accounting principles for complete financial statements. In the opinion of our management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Intercompany accounts have been eliminated in consolidation. Operating results for the three and nine months ended September 30, 2005 are not necessarily indicative of the results that may be expected for the entire year. For further information see our financial statements and related disclosures thereto for the year ended December 31, 2004 in our Annual Report on Form 10-K filed with the Securities and Exchange Commission.

2. Inventories

Inventories consist of the following:

	September 30,			December 31,
	2005			2004
Raw materials.	$	2,474		$	2,308
Work-in-progress	4,149			4,046
Finished goods	715			1,041
	7,338			7,395
Less reserves for excess and obsolete inventories.	(876		)	(415		)
	$	6,462		$	6,980

3. Warranty

We provide a warranty on certain of our products and accrue the estimated cost at the time revenue is recorded. Warranty expense is charged to product cost of revenues. The majority of all warranty periods are 12 months before customer-sponsored maintenance begins. Warranty reserves are established based on historical experience with failure rates and repair costs and the number of gamma cameras covered by warranty. Warranty reserves are depleted as gamma cameras are repaired. The costs consist principally of materials, labor, overhead and transportation. We review warranty reserves periodically and, when appropriate, make adjustments.

The activities in our warranty reserve are as follows:

	Three months ended September 30,						Nine months ended September 30,
	2005			2004			2005			2004
Balance at beginning of period	$	930		$	1,269		$	1,219		$	1,051
Charges to cost of revenues	331			478			875			1,476
Applied to liability	(396		)	(433		)	(1,229		)	(1,213		)
Balance at end of period	$	865		$	1,314		$	865		$	1,314

4. Property and Equipment

Property and equipment consist of the following:

	September 30,			December 31,
	2005			2004
Machinery and equipment	$	20,293		$	19,226
Furniture and fixtures.	350			337
Computers and software	3,294			2,845
Leasehold improvements	701			516
Construction in process	189			22
	24,827			22,946
Less accumulated depreciation and amortization	(13,835		)	(11,764		)
	$	10,992		$	11,182

5. Comprehensive Income

Comprehensive income consists of the following components (in thousands):

	Three months ended September 30,						Nine months ended September 30,
	2005			2004			2005			2004
Net income (loss), as reported	$	(2,827	)	$	386		$	(6,849	)	$	223
Unrealized losses on marketable securities	(44		)	(6		)	(96		)	(6		)

Comprehensive income	$	(2,871	)	$	380		$	(6,945	)	$	217

6. Stock-Based Compensation

We have elected to follow Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations in accounting for our employee stock options as permitted by Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation. Under APB 25, if the exercise price of our employee stock options is not less than the fair value of the underlying stock on the date of grant, no compensation expense is recognized. The following table illustrates the effect on net earnings and earnings per share as if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation:

	Three months ended September 30,						Nine months ended September 30,
	2005			2004			2005			2004
Net income (loss) applicable to common stockholders, as reported	$	(2,827	)	$	386		$	(6,849	)	$	62
Add: total stock-based employee compensation included in reported net loss	103			268			411			952
Less: total stock-based employee compensation determined under the fair value method for all awards	(1,017		)	(682		)	(2,732		)	(1,448		)
Pro forma net loss	$	(3,741	)	$	(28	)	$	(9,170	)	$	(434	)

Basic and diluted net income (loss) per common share - as reported	$	(0.15	)	$	0.02		$	(0.37	)	$	0.01

Basic and diluted net loss per common share - pro forma	$	(0.20	)	$	—		$	(0.50	)	$	(0.06	)

The fair value of the options granted prior to the completion of our initial public offering was estimated at the date of grant using the minimum value pricing model. Upon completion of the initial public offering in June 2004, we began using the Black-Scholes model to estimate fair value. The estimated fair value of the options is amortized on an accelerated basis in accordance with FASB Interpretation (“FIN”) No. 28 over the vesting period.

The following assumptions were utilized for the calculations during each period:

	Three months ended September 30,				Nine months ended September 30,
	2005		2004		2005		2004

Expected dividend yield	—		—		—		—
Risk-free interest rate	3.98	%	3.50	%	3.99	%	3.27	%
Expected volatility	75	%	75	%	75	%	34	%
Expected life (in years)	5		5		5		5

Stock-based compensation expense for stock options and warrants granted to non-employees is recorded at fair value as determined in accordance with SFAS No. 123, and EITF No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction with Selling Goods or Services. The fair value of the unvested options, warrants, and other equity instruments is periodically remeasured and the related expense is adjusted as necessary.

7. Net Income (Loss) Per Share

We calculated net loss per share in accordance with SFAS No. 128, Earnings Per Share. Basic earnings per share (“EPS”) is calculated by dividing the net income or loss available to common stockholders by the weighted average number of common shares outstanding for the period, without consideration for common stock equivalents. Diluted EPS is computed by dividing the net income available to common stockholders by the weighted average number of common shares outstanding for the period and the weighted average number of dilutive common stock equivalents outstanding for the period determined using the treasury-stock method. For purposes of this calculation, common stock subject to repurchase by us, convertible preferred stock, options, and warrants are considered to be common stock equivalents and are only included in the calculation of diluted earnings per share when their effect is dilutive.

Upon the completion of our initial public offering, all of our previously outstanding preferred shares converted into 12.4 million shares of our common stock. As a result of the issuance of these common shares, there is a lack of comparability in both the basic and diluted net income per share amounts for the nine month period ended September 30, 2004. In order to provide a more relevant measure of our operating results, an unaudited pro forma net loss per share calculation has been included. The shares used to compute unaudited pro forma basic and diluted net income (loss) per share include the assumed conversion of all outstanding shares of preferred stock into shares of common stock using the as-if converted method as of the beginning of each period presented or the date of issuance, if later.

Historical and pro forma basic and diluted net income (loss) per share were calculated as follows:

	Three months ended September 30,					Nine months ended September 30,
	2005			2004		2005			2004
Historical:
Numerator:
Net income (loss)	$	(2,827	)	$	386	$	(6,849	)	$	223
Accretion of deferred issuance costs on preferred stock	—			—		—			(161		)
Net income (loss) applicable to common stockholders – basic and diluted	$	(2,827	)	$	386	$	(6,849	)	$	62
Denominator:
Weighted average common shares outstanding – basic	18,690			18,011		18,390			7,388
Effect of dilutive securities:
Conversion of preferred stock	—			—		—			7,357
Options .	—			1,360		—			1,359
Warrants	—			21		—			21

Weighted average common shares outstanding – diluted	18,690			19,392		18,390			16,125

Basic and diluted net income (loss) per common share	$	(0.15	)	$	0.02	$	(0.37	)	$	0.01

Pro forma:
Numerator:
Net income (loss)– basic and diluted	$	(2,827	)	$	386	$	(6,849	)	$	223
Denominator:

Weighted average common shares outstanding – basic	18,690			18,011		18,390			7,388
Pro forma adjustments to reflect weighted average effect of assumed conversion of preferred stock	—			—		—			7,357
Pro forma weighted average common shares outstanding – basic	18,690			18,011		18,390			14,745

Weighted average common shares outstanding – diluted	18,690			19,392		18,390			16,125

Pro forma adjustments	—			—		—			—
Pro forma weighted average common shares outstanding – diluted	18,690			19,392		18,390			16,125

Basic pro forma net income (loss) per common share	$	(0.15	)	$	0.02	$	(0.37	)	$	0.02
Diluted pro forma net income (loss) per common share	$	(0.15	)	$	0.02	$	(0.37	)	$	0.01

8. Segments

The Company has two reportable segments: DIS and Product. DIS collectively refers to our wholly-owned subsidiaries, Digirad Imaging Solutions, Inc. and Digirad Imaging Systems, Inc. Through DIS, we offer FlexImaging, our mobile and comprehensive leasing service for physicians who wish to perform nuclear cardiology and nuclear medicine procedures in their offices, but do not have the patient volume, capital, or personnel to justify purchasing an imaging system. Our product revenue results primarily from selling solid-state gamma cameras, imaging chairs, upgrades and accessories, such as printers, viewing workstations and networking solutions, and from our maintenance contracts. We sell our imaging systems to physician offices, hospitals, and imaging centers primarily in the United States, although we have sold a small number of imaging systems internationally. We have determined our reporting segments based on the nature of the products and/or services offered to customers or the nature of their function in the organization. We evaluate performance based on the operating income contributed by each segment.

Segment results are as follows:

	Three months ended September 30,						Nine months ended September 30,
	2005			2004			2005			2004

Gross profit by segment:
DIS	$	3,397		$	3,271		$	11,051		$	10,072
Product	12			2,481			926			6,195
Consolidated gross profit	$	3,409		$	5,752		$	11,977		$	16,267

Income (loss) from operations by segment:
DIS	$	(230	)	$	472		$	181		$	1,925
Product	(2,981		)	(153		)	(7,959		)	(1, 169		)
Consolidated income (loss) from operations	$	(3,211	)	$	319		$	(7,778	)	$	756

Depreciation, and amortization of intangible assets by segment:
DIS	$	628		$	566		$	1,855		$	1,599
Product	410			244			1,012			711
Consolidated depreciation and amortization	$	1,038		$	810		$	2,867		$	2,310

Identifiable assets by segment:
DIS	$	16,546		$	16,606		$	16,546		$	16,606
Product	60,265			69,517			60,265			69,517
Consolidated assets	$	76,811		$	86,123		$	76,811		$	86,123

Foreign sales have not been significant in any of the periods presented.

9. Recent Accounting Pronouncements

In March 2005, the SEC released Staff Accounting Bulletin (SAB) No. 107, “Share-Based Payment” (SAB 107). SAB 107 provides the SEC staff position regarding the application of SFAS No. 123R. SAB 107 contains interpretive guidance related to the interaction between SFAS No. 123R and certain SEC rules and regulations, as well as provides the Staff’s views regarding the valuation of share-based payment arrangements for public companies. SAB 107 also highlights the importance of disclosures made related to the accounting for share-based payment transactions. The Company is currently reviewing the effect of SAB 107 on its condensed consolidated financial statements as it prepares to adopt SFAS 123R.

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R), which is a revision of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123). SFAS 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends Statement of Financial Accounting Standards No. 95, “Statement of Cash Flows” (SFAS 95). Generally, the approach in SFAS 123R is similar to the approach described in SFAS 123. However, SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. SFAS 123R must be adopted no later than January 1, 2006. Early adoption will be permitted in periods in which financial statements have not yet been issued. The Company expects to adopt SFAS 123R on January 1, 2006.

As permitted by SFAS 123, the Company currently accounts for share-based payments to employees using Opinion 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123R’s fair value method will have a significant impact on our results of operations, although it will have no impact on our overall financial position. Determining the exact impact of adoption of SFAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future and the assumptions for the variables which impact the computation. However, had the Company adopted SFAS 123R in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net income and earnings per share elsewhere in Note 1 of the Company’s condensed consolidated financial statements. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce the Company’s net operating cash flows and increase net financing cash flows in periods after adoption.

10. Commitments and Contingencies

Compliance with Laws and Regulations

We are directly or indirectly through our clients, subject to extensive regulation by both the federal government and the states and foreign countries in which we conduct business. The healthcare laws applicable to us are complex and are subject to variable interpretations. We have established a compliance program to identify any compliance issues, correct any identified issues and assist us in remaining in compliance with the applicable healthcare laws and have instituted other safeguards intended to help prevent any violations of the laws and to remedy any situations that could give rise to violations.

Legal Matters

In January 2005, a complaint was served on a physician, who is a DIS customer, his medical practice and two DIS technicians, individually and in their capacity as agents of the medical practice. The complaint was filed in the Circuit Court of the Fifth Judicial Circuit, County of Vermilion, Danville, Illinois and alleges negligence claims in connection with the death of a patient purportedly arising from the administration of a stress imaging test. We have tendered the matter to the physician practice for indemnification and defense pursuant to our contract with the practice. While the technicians deny the allegations and we will vigorously defend them in the matter, we cannot assure you that this matter will be resolved in their favor.

In September 2005, we received notice from the Nuclear Regulatory Commission of an apparent license violation relating to findings by the Commission’s Office of Investigation of (a) the deliberate submission of inaccurate information to us by a physician listed as an authorized user on our license; and (b) our submission of that information to the Commission, not knowing that the information was false. We have agreed to attend a mediation in the matter. The mediation could result in an agreement by us to make certain payments and implement corrective action. An unsuccessful mediation could result in enforcement action, including the imposition of fines and restrictions on or conditions to our license.

In the normal course of business, we have been and will likely continue to be subject to litigation or administrative proceedings incidental to our business, such as claims related to customer disputes, employment practices, including lay-offs, product liability, professional liability, commercial disputes, licensure restrictions or denials, warranty or patent infringement. Responding to litigation or administrative proceedings, regardless of whether it has merit, can be expensive and disruptive to normal business operations. As litigation and the administrative proceedings are inherently uncertain, we cannot predict the outcome of such matters. We can provide no assurance that the ultimate outcome, either individually or in the aggregate, will not have a material adverse effect on our business or financial results.

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

Forward-Looking Statements May Prove Inaccurate

The following discussion and analysis should be read in conjunction with our financial statements and notes thereto included in this report on Form 10-Q, and the audited financial statements and notes thereto as of and for the year ended December 31, 2004 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 3, 2005. Operating results are not necessarily indicative of results that may occur in future periods.

This report includes various forward-looking statements that are subject to risks and uncertainties, many of which are beyond our control. Our actual results could differ materially from those anticipated in these forward looking statements as a result of various factors, including those set forth below under the caption “Risk Factors.” Forward-looking statements discuss matters that are not historical facts. Forward-looking statements include, but are not limited to, discussions regarding our operating strategy, growth strategy, product development, cost savings initiatives, industry, economic conditions, financial condition, liquidity and capital resources and results of operations. In this report, for example, we make forward-looking statements regarding our expectations about the revenue growth in DIS as we expand into new markets and continue to penetrate existing markets, expectations of increasing sales shifting from our dual head to triple head cameras, continuing to strengthen our sales team and focus on DIS expansion and various research and development initiatives, persistent pricing pressures affecting our sales of dual-headed gamma cameras, the length of the sales cycle in our DIS business for some of our customers, the effect on our business of changes to the Stark Law, continuing investments in research and development initiatives to enhance our system software, improve system sensitivity, reduce product costs and enhance reliability, the testing and roll-out of our Cardius-3 camera into DIS and the value it can represent to our customers, our belief that DIS revenue will continue to represent a larger percentage of our consolidated revenue than our product business revenue, and considerations for the assessment of our DIS camera fleet, and the effects of the new appropriateness criteria for cardiac imaging. Such statements include, but are not limited to, statements preceded by, followed by or that otherwise include the words “believes,” “expects,” “anticipates,” “intends,” “estimates,” “projects,” “can,” “could,” “may,” “will,” “would,” or similar expressions. For those statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. You should not

unduly rely on these forward-looking statements, which speak only as of the date on which they were made. We undertake no obligation to update publicly or revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless required by law.

Overview

We are a leader in the development, manufacture and distribution of solid-state nuclear imaging products and services and we were the first company to develop and commercialize a solid-state medical gamma camera for the detection of cardiovascular disease and other medical conditions. Our imaging systems are mobile as well as fixed and provide enhanced operability and improved patient comfort and utilization when compared to traditional vacuum tube cameras. The cameras and accompanying equipment fit easily into floor spaces as small as seven feet by eight feet and facilitate the delivery of nuclear medicine procedures directly in a physician’s office, an outpatient hospital setting or within multiple departments of a hospital.

Revenues

Our revenues are generated within two primary operating segments: our DIS business and product sales. DIS collectively refers to our wholly-owned subsidiaries, Digirad Imaging Solutions, Inc. and Digirad Imaging Systems, Inc. Through DIS, we offer FlexImaging, our mobile and comprehensive leasing service for physicians who wish to perform nuclear cardiology and nuclear medicine procedures in their offices, but prefer not to purchase an imaging system. We also offer DigiTech leases, a service similar to FlexImaging services, except that the physician office, hospital or imaging center owns its camera. DIS leasing services are currently provided in 22 states and the District of Columbia. Physicians enter into annual contracts for imaging services delivered on a per-day basis. Our typical annual lease contracts provide service coverage ranging from once per month to three times or more per week, adjusted for holidays and vacations. We experience some seasonality in our DIS business as a result of holidays, inclement weather and summer slowdowns, principally relating to vacations. Historically, these variables have had the most effect on our third quarter operating results.

Our product revenue results primarily from selling solid-state gamma cameras, imaging chairs, upgrades and accessories, such as printers, viewing workstations and networking solutions, and from our maintenance contracts. We sell our imaging systems to physician offices, hospitals and imaging centers primarily in the United States, although we have sold a small number of imaging systems internationally. Currently, we purchase some components, including key components of the detector heads and the processing and control software utilized in our gamma cameras, from sole source providers but are either qualifying or seeking second source providers in an effort to limit our reliance on these suppliers. If we were unable to obtain these components, our ability to build gamma cameras could be materially affected. We are currently outsourcing some portions of our production process and may outsource additional production activities in the future.

Trends and Drivers

Continued DIS growth in the first nine months of 2005 as compared to the same period in 2004, was due to expansion of our DIS services to new customers, increasing services to existing customers and higher customer retention. However, we also saw a decrease in our rate of growth during this time frame as DIS attracted fewer new customers, the number of lease days per new customer declined and our efforts to expand into new territories were slower than expected. We believe this trend was driven mainly by sales management vacancies, underperformance by our sales force and an increasing proportion of our sales being to internists whose practice volumes are lower than those of cardiologists and we believe result in a moderate lengthening in the DIS sales cycle. Furthermore, there was a decrease in the number of new DigiTech leases entered into in the first nine months of 2005 compared to the same period in 2004.

In the product business, data from the National Electrical Manufactures’ Association, or NEMA, suggests that orders for nuclear medicine cardiology imaging systems in the United States will stay at approximately the same levels for 2005 as compared to 2004, and that purchases of multi-head cameras will far outpace those of single-head cameras. Historically, our single head gamma cameras have represented the majority of our camera sales. However, consistent with the NEMA data, we have seen an increasing percentage of our sales shifting to our dual head and triple head cameras. Due mainly to sales management vacancies and underperformance by our sales force, our third quarter 2005 results were lower than results for the comparable quarter of 2004. The third quarter of 2005 product orders improved significantly after what we believe was a transient drop in orders in the second quarter of 2005, attributable to organizational changes.

In the third quarter of 2005, we hired a President for DIS, began to fill vacancies in sales management, marketing and operations, and continued to assess our existing sales team, including those in new geographical areas. We will continue to attempt to strengthen our sales team and focus on DIS expansion and various research and development initiatives designed to achieve clinical leadership in our field. During the third quarter of 2005, we deployed two cameras into DIS. Consolidated margins were negatively affected by a lack of production in the product business creating a significant excess capacity charge. As we focused on improving manufacturing efficiencies, our net inventory decreased by $2.4 million from the end of the last quarter. We have not yet been able to gain greater traction in the multi-head camera market with our Cardius-2 dual-head camera or our recently launched Cardius-3 triple-head camera. Acceptance of our Cardius-3 triple-head camera, featuring high count imaging statistics and high patient throughput, continues to lag behind our expectations, as we sold only eight of these cameras during the first nine months of the year. Our main market obstacles in the multi-headed camera segment are downward pricing pressure from competitors, product feature gaps compared to competitors, such as

software, leading to our inability to fully exploit the differential advantages of solid-state technology. Our marketing efforts are focused on obtaining additional clinical validation and luminary acceptance of our premium products.

Our market is affected by continuing pressures by third party payors to reduce healthcare expenditures. In August 2005, the Centers for Medicare and Medicaid Services, or CMS, proposed changes to the relative value units under the Resource Based Relative Value Scale physician reimbursement system that, if finalized as proposed, could decrease overall reimbursements for nuclear medicine procedures by some five percent. This estimate reflects CMS’s proposed changes to the universe of nuclear medicine procedures and the specific impact for solely diagnostic imaging procedures is unclear. Because we charge customers based on a flat lease rate, we cannot predict whether or to what extent the proposed Medicare reimbursement reduction, if finalized, will impact our business. CMS also proposed including nuclear medicine procedures to the list of designated health services subject to the physician self-referral prohibitions under the Ethics in Patient Referrals Act of 1989, also known as the Stark Law. However, this proposed change, if finalized, should not significantly affect our business based on the potential availability of exceptions of the Stark Law. Also, several third party payors in geographic locations currently served by us issued guidelines prohibiting our physician customers from obtaining reimbursement for procedures they perform unless they own or lease our cameras on a full time basis. These and other payors also require physicians and providers to obtain certain accreditations or certifications in order to obtain reimbursement for nuclear imaging procedures. Should such accreditation or certification requirements become more frequent, non-cardiologists may not be able to obtain reimbursement for nuclear imaging procedures, a trend that could decrease sales in our product and DIS businesses. Consistent with our commitment to providing high quality services and to comply with what may be an emerging reimbursement requirement trend among payors, we have obtained accreditation of one of our hub locations by the Intersocietal Commission for the Accreditation of Nuclear Medicine Laboratories, and are seeking such accreditation for our other DIS hubs and fixed sites.

Looking forward, we expect to continue to invest in research and development initiatives to enhance our system software, improve system sensitivity, reduce product costs and enhance reliability. Testing of a mobile version of the Cardius-3 imager continues, and we believe that this camera, subject to its successful clinical and beta-testing and a measured roll-out into DIS, can provide value to our DIS customer physicians. Our efforts in DIS will be focused on improving operational efficiencies, decreasing costs of delivery, improving service to our existing customers and attracting new customers in existing and expansion territories.

Results of Operations

The following table sets forth our results from operations, expressed as percentages of revenues for the three and nine months ended September 30, 2005 and 2004:

	Three months ended September 30,				Nine months ended September 30,
	2005		2004		2005		2004
Revenues:
DIS	72.6	%	64.0	%	75.2	%	65.0	%
Product	27.4		36.0		24.8		35.0
Total revenues	100.0		100.0		100.0		100.0
Cost of revenues:
DIS	52.9		44.7		53.2		44.6
Product	27.3		21.3		22.9		22.4
Stock-based compensation	0.2		0.6		0.3		0.7
Total cost of revenues	80.4		66.6		76.4		67.7
Gross profit	19.6		33.4		23.6		32.3
Operating expenses:
Research and development	5.2		5.1		5.3		4.4
Sales and marketing	10.5		10.8		10.9		10.9
General and administrative	21.3		14.6		21.8		14.2
Amortization and impairment of intangible assets	0.8		0.1		0.3		0.1
Stock-based compensation	0.4		1.0		0.6		1.2
Total operating expenses	38.2		31.6		38.9		30.8
Income (loss) from operations	(18.6	)	1.8		(15.3	)	1.5
Other income (expense)	2.3		0.4		1.8		(1.1	)
Accretion of deferred issuance costs on preferred stock	—		—		—		(0.3	)
Net loss applicable to common stockholders	(16.3	)%	2.2	%	(13.5	)%	0.1	%

Comparison of Three Months Ended September 30, 2005 and 2004

Revenues

Consolidated. Consolidated revenues increased to $17.4 million for the three months ended September 30, 2005 from $17.2 million for the three months ended September 30, 2004, which represented an increase of $0.2 million, or 0.7%, primarily as a result of an increase in demand for our DIS imaging services which more than offset a decrease in gamma camera sales. DIS and product revenue accounted for 72.6% and 27.4%, respectively, of total revenues for the three months ended September 30, 2005, compared to 64.0% and 36.0%, respectively, for the three months ended September 30, 2004. We expect DIS revenue to continue to represent the greater percentage of our consolidated revenue, compared to our product revenue.

DIS. Our DIS revenue increased to $12.6 million for the three months ended September 30, 2005 from $11.0 million for the three months ended September 30, 2004, which represented an increase of $1.6 million, or 14.3%. The increase in DIS revenue resulted from an increase in the number of DIS service days to 3,471 for the three months ended September 30, 2005 from 3,048 for the three months ended September 30, 2004, which was primarily attributable to an increase in the number of physicians entering into our DIS services contracts. Our DIS business operated 76 imaging systems as of September 30, 2005 compared to 67 as of September 30, 2004. DIS revenue for the three months ended September 30, 2005 declined by approximately $0.6 million from the previous fiscal quarter due principally to summer seasonality and a lower number of new customers entering into lease contracts in the third quarter of 2005.

Product. Our product revenue decreased to $4.7 million for the three months ended September 30, 2005 from $6.2 million for the three months ended September 30, 2004, which represented a decrease of $1.5 million, or 23.4%. The decrease in product revenues is attributable to a decline in the sales of gamma cameras which we believe resulted primarily from vacancies in our sales organization and disruptions in sales activities during the third quarter resulting from changes in the management structure of the sales organization. We sold 13 new cameras and one upgrade in the third quarter of 2005 compared to 22 cameras without upgrades in the third quarter of 2004. We have historically experienced pricing pressures on our dual head gamma cameras and we expect this pricing pressure to persist.

Gross Profit

Consolidated. Consolidated gross profit decreased to $3.4 million for the three months ended September 30, 2005 from $5.8 million for the three months ended September 30, 2004, which represents a decrease of $2.4 million, or 40.7%. The decrease in consolidated gross profit is principally attributable to the decline in our Product segment gross profit. Consolidated gross profit as a percentage of revenue decreased to 19.6% for the three months ended September 30, 2005 from 33.4% for the three months ended September 30, 2004, primarily as a result of the product segment generating a near zero gross profit margin due principally to excess manufacturing capacity costs of $0.7 million resulting from low production volume.

DIS. Cost of DIS revenue consists primarily of labor, radiopharmaceuticals, equipment depreciation and other costs associated with the provision of services. Cost of DIS revenue increased to $9.2 million for the three months ended September 30, 2005 from $7.7 million for the three months ended September 30, 2004, which represents an increase of $1.5 million, or 19.3%, primarily as a result of an increase in DIS lease days. Our clinical headcount relating to our DIS business increased to 186 employees at September 30, 2005 from 158 employees at September 30, 2004. Employee turnover in DIS remains at high levels, in part due to the rigors of the DIS operational day. The retention of our clinical staff is a key element in maintaining our DIS gross profit margins, and accordingly, we are implementing programs designed to increase our DIS employee retention. DIS gross profit increased to $3.4 million for the three months ended September 30, 2005 from $3.3 million for the three months ended September 30, 2004, which represents an increase of $0.1 million, or 3.0%, as a result of increased DIS revenues generated in providing our imaging services. DIS gross profit as a percentage of DIS revenue was 27.1% for the three months ended September 30, 2005 compared to 30.1% for the three months ended September 30, 2004 mainly due to the impact of adjustments in radiopharmaceutical expenses and increased labor costs.

Product. Cost of goods sold primarily consists of materials, labor and overhead costs associated with the manufacturing and warranty of our products. Warranty costs are charged to cost of goods sold in the period our cameras are sold and are based on our historical experience with failure rates and repair costs. Cost of goods sold increased to $4.7 million for the three months ended September 30, 2005 from $3.7 million for the three months ended September 30, 2004, which represents an increase of $1.0 million, or 28.6%. Product gross profit decreased to $22,000 for the three months ended September 30, 2005 from $2.5 million for the three months ended September 30, 2004, which represents a decrease of $2.5 million, or 99.1%, due to the decline in the number of cameras sold during the quarter and unfavorable absorption variances attributable to a significant reduction in our production volume resulting in excess capacity costs of $0.7 million. Product gross profit as a percentage of product revenue decreased to 0.5% for the three months ended September 30, 2005 from 40.8% for the three months ended September 30, 2004.

Operating Expenses

Research and Development. Research and development expenses consist primarily of costs associated with the design,

development, testing, and enhancement of our products and with engineering materials. The primary costs are salaries and fringe benefits, consulting fees, facilities and overhead costs and nonrecurring engineering costs. Research and development expenses were $0.9 million for the three months ended September 30, 2005, and were unchanged from the comparable prior year period. For the three months ended September 30, 2005, research and development expenses were 5.2% of total revenue, compared to 5.1% for the three months ended September 30, 2004. Our research and development efforts occur principally within our products segment. In the future, we expect to increase our investment on research and development as we seek to innovate and continue to improve our existing technology.

Sales and Marketing. Sales and marketing expenses consist primarily of salaries, commissions, bonuses, recruiting costs, travel, marketing and collateral materials and tradeshow costs. Sales and marketing expenses decreased to $1.8 million for the three months ended September 30, 2005, from $1.9 million for the three months ended September 30, 2004, which represents a decrease of $0.1 million, or 1.9%. This decrease was primarily attributable to a decrease in sales commission costs in the product segment due to a low number of camera sales. For the three months ended September 30, 2005, sales and marketing expenses were 10.5% of total revenue, compared to 10.8% for the three months ended September 30, 2004.

General and Administrative. General and administrative expenses consist primarily of salaries and other related costs for finance and accounting, human resources and other personnel, as well as legal and other professional fees and insurance. General and administrative expenses increased to $3.7 million for the three months ended September 30, 2005 from $2.5 million for the three months ended September 30, 2004, which represents an increase of $1.2 million, or 46.5%. Increases in headcount, recruiting costs, professional fees and other costs primarily related to our internal control efforts to comply with section 404 of the Sarbanes-Oxley Act and costs, as well as $0.2 million incurred to settle ongoing legal matters, all contributed to increased general and administrative expenses. For the three months ended September 30, 2005, general and administrative expenses amounted to 21.3% of total revenue compared to 14.6% for the three months ended September 30, 2004. In addition, in the normal course of business, we have been and will likely continue to be subject to routine litigation incidental to our business, such as claims related to customer disputes, employment practices, product liability, warranty or patent infringement. As our business continues to grow, we anticipate that the volume of these claims is likely to increase. The substantial costs of litigation or an adverse outcome could materially increase our anticipated operating expenses.

Stock-Based Compensation Charges. Deferred compensation for stock options granted to employees has been determined as the difference between the exercise price and the fair value of our common stock on the date of grant. Options or awards issued to non-employees are recorded at their fair value in accordance with SFAS No. 123 and periodically remeasured in accordance with EITF 96-18 and recognized over the respective service or vesting period. These amounts are initially recorded as a component of stockholders’ equity and are amortized, on an accelerated basis, as a non-cash charge to cost of revenues and operations over the vesting period of the options. In connection with the grant of stock options to employees, we recorded amortization of stock-based compensation of $0.1 million and $0.3 million for the three months ended September 30, 2005 and 2004, respectively.

Other Income (Expense)

Interest income increased to $0.4 million for the three months ended September 30, 2005 from $0.2 million for the three months ended September 30, 2004. This increase is primarily due to higher average interest rates and associated return on investments.

Interest expense decreased to $49,000 for the three months ended September 30, 2005 from $0.2 million for the three months ended September 30, 2004. The reduction is a result of the reduction of amounts outstanding under capital leases.

Net Loss

Net loss was $2.8 million for the three months ended September 30, 2005 compared to net income of $0.4 million for the three months ended September 30, 2004, primarily due to a decline in gamma camera sales, manufacturing variances from low manufacturing volumes and an increase in general and administrative expenses discussed above.

Comparison of Nine Months Ended September 30, 2005 and 2004

Revenues

Consolidated. Consolidated revenues increased to $50.8 million for the nine months ended September 30, 2005 from $50.4 million for the nine months ended September 30, 2004, which represented an increase of $0.4 million, or 0.8%, primarily as a result of increased demand for our DIS imaging services which offset the decrease in revenue from our product segment. DIS and product revenue accounted for 75.2% and 24.8%, respectively, of total revenues for the nine months ended September 30, 2005, compared to 65.0% and 35.0%, respectively, for the nine months ended September 30, 2004.

DIS. Our DIS revenue increased to $38.2 million for the nine months ended September 30, 2005 from $32.7 million for the nine months ended September 30, 2004, which represented an increase of $5.5 million, or 16.6%. The increase in DIS revenue resulted from an increase in the number of DIS service days to 10,465 for the nine months ended September 30, 2005 from 8,747 for the nine months ended September 30, 2004, which was primarily attributable to an increase in the number of physicians entering into our DIS services contracts and an increase in the retention of current DIS customers.

Product. Our product revenue decreased to $12.6 million for the nine months ended September 30, 2005 from $17.7 million for the nine months ended September 30, 2004, which represented a decrease of $5.1 million, or 28.5%. The decrease in product revenues is attributable to a decline in the sales of gamma cameras resulting primarily from vacancies in the sales organization and disruptions in sales activities resulting from changes in the management of the sales organization, and a decline in the number of single head cameras sold.

Gross Profit

Consolidated. Consolidated gross profit decreased to $12.0 million for the nine months ended September 30, 2005 from $16.3 million for the nine months ended September 30, 2004, which represents a decrease of $4.3 million, or 26.4%. The decrease in consolidated gross profit is primarily attributable to the decline in the number of gamma cameras sold, unfavorable variances attributable to a reduction in production volumes resulting in excess capacity costs of $0.7 million in the third quarter of 2005 and inventory-related charges of $0.6 million recorded in the second quarter of 2005. Consolidated gross profit as a percentage of revenue decreased to 23.6% for the nine months ended September 30, 2005 from 32.3% for the nine months ended September 30, 2004.

DIS. Cost of DIS revenue increased to $27.0 million for the nine months ended September 30, 2005 from $22.5 million for the nine months ended September 30, 2004, which represents an increase of $4.5 million, or 20.3%, primarily as a result of an increase in the number of DIS leasing days resulting from new contracts with new physicians. DIS gross profit increased to $11.1 million for the nine months ended September 30, 2005 from $10.2 million for the nine months ended September 30, 2004, which represents an increase of $0.9 million, or 8.6%, as a result of increased DIS revenues generated in providing our imaging services. DIS gross profit as a percentage of revenue was 29.2% for the nine months ended September 30, 2005 compared to 31.3% for the nine months ended September 30, 2004.

Product. Cost of goods sold increased to $11.6 million for the nine months ended September 30, 2005 from $11.3 million for the nine months ended September 30, 2004, which represents an increase of $0.3 million, or 3.1%. Product gross profit decreased to $1.0 million for the nine months ended September 30, 2005 from $6.4 million for the nine months ended September 30, 2004, which represents a decrease of $5.4 million, or 84.7%, primarily as a result of a decline in the number of gamma cameras sold, unfavorable variances attributable to a reduction in production volumes resulting in excess capacity costs of $0.7 million in the third quarter of 2005 and inventory-related charges of $0.6 million recorded in the second quarter of 2005. Product gross profit as a percentage of revenue decreased to 7.7% for the nine months ended September 30, 2005 from 36.0% for the nine months ended September 30, 2004.

Operating Expenses

Research and Development. Research and development expenses increased to $2.7 million for the nine months ended September 30, 2005 from $2.2 million for the nine months ended September 30, 2004, which represents an increase of $0.5 million, or 23.4%. This increase was primarily attributable to increased headcount. For the nine months ended September 30, 2005, research and development expenses were 5.3% of total revenue, compared to 4.4% for the nine months ended September 30, 2004.

Sales and Marketing. Sales and marketing expenses totaled $5.5 million for the nine months ended September 30, 2005 and were unchanged from the comparable prior year period. Sales and marketing expenses were 10.9% of total revenue in both 2005 and 2004.

General and Administrative. General and administrative expenses increased to $11.1 million for the nine months ended September 30, 2005 from $7.2 million for the nine months ended September 30, 2004, which represents an increase of $3.9 million, or 54.5%. Increases in headcount, recruiting costs, professional fees, costs related to our internal control efforts to comply with section 404 of the Sarbanes-Oxley Act and other costs related to operating as a public company all contributed to increased general and administrative expenses. For the nine months ended September 30, 2005, general and administrative expenses amounted to 21.8% of total revenue compared to 14.2% for the nine months ended September 30, 2004.

Stock-Based Compensation Charges. We recorded amortization of stock-based compensation of $0.4 million and $1.0 million for the nine months ended September 30, 2005 and 2004, respectively.

Other Income (Expense). Interest income increased to $1.2 million for the nine months ended September 30, 2005 from $0.3 million for the nine months ended September 30, 2004. This increase is primarily due to higher average cash and investment balances as a result of the proceeds from our initial public offering in June 2004.

Interest expense decreased to $0.2 million for the nine months ended September 30, 2005 from $0.8 million for the nine months ended September 30, 2004. The reduction is a result of the repayment of two credit lines and a reduction of amounts outstanding on capital leases.

Net Loss. The net loss was $6.8 million for the nine months ended September 30, 2005 compared to net income of $0.2 million for the nine months ended September 30, 2004, primarily due to the decline in gamma camera sales, unfavorable variances attributable to a reduction in production volumes and inventory-related charges of $0.6 million recorded in the second quarter of 2005 and the increase in general and administrative expenses discussed above.

Liquidity and Capital Resources

We require capital principally for working capital, debt service and capital expenditures. Working capital is required principally to finance accounts receivable and inventory. Our working capital requirements vary from period to period depending on manufacturing volumes, the timing of deliveries and the payment cycles of our customers. Our capital expenditures consist primarily of DIS cameras and vans, computer hardware and software. Through May 2004, we funded our operations principally through private placements of equity securities. In June 2004, we completed our initial public offering and received net proceeds of $58.8 million. As of September 30, 2005, we had cash, cash equivalents and investments totaling $48.2 million. We currently invest our cash reserves in money market funds, high-grade auction rate securities and U.S. government or corporate debt securities. Based upon our current level of expenditures, we believe the proceeds from our initial public offering, together with cash flows from operating activities will be adequate to meet our anticipated cash requirements for working capital, debt service and capital expenditures for at least the next 12 months.

Net cash used by operations was approximately $1.9 million for the nine months ended September 30, 2005. The net use of cash during the period resulted from the net loss for the period (net of non-cash expenses such as depreciation and amortization of stock-based compensation), partially offset by a reduction in working capital requirements as accounts receivable levels were reduced during the period.

Net cash provided by investing activities amounted to approximately $3.8 million for the nine months ended September 30, 2005, and reflects $6.4 million of net maturities of our securities available-for-sale, partially offset by $2.6 million of capital expenditures primarily associated with our DIS operations.

Net cash used by financing activities amounted to approximately $2.3 million for the nine months ended September 30, 2005, and primarily reflects the repayment of capital lease obligations, net of proceeds of $0.3 million arising from the exercise of stock options.

As part of our strategy to provide excellence in our DIS nuclear imaging service, we are undertaking an assessment of our current DIS camera fleet to determine whether and when to deploy newer and more technically advanced models. As part of this assessment, we will determine whether to replace or refurbish a number of cameras, and whether to launch an associated program to sell cameras we decide to replace. Should we decide to sell the cameras taken out of the fleet, we may experience an impairment charge if we conclude that the sales value is less than the net book value. The results of our assessment could also result in a reduction in the depreciable life of our DIS cameras, which is currently seven years.

Critical Accounting Policies

There were no significant changes in critical accounting policies or estimates from those at December 31, 2004. As discussed above, we are undertaking an assessment of our current DIS camera fleet. The results of our assessment will include significant estimates concerning the sales value and the useful lives of this used equipment and therefore could also result in an impairment charge and a reduction of the depreciable lives of our DIS cameras. For information on recent accounting pronouncements affecting our business, see Note 9 of the Notes to Unaudited Condensed Consolidated Financial Statements in Item 1.

Corporate Information

As of September 30, 2005, we hold trademark registrations in the United States for the following marks: 2020tc Imager^®, CardiusSST^®, Digirad^®, Digirad Logo^®, Digirad Imaging Solutions^®, FlexImaging^® Cardius^®, and SPECTour^®. We have trademark applications pending in the United States for the following marks: DigiServ^TM, DigiTech^TM, Solidium^TM, SeeQuanta^TM, AcqSmart^TM, and SPECTpak Plus^TM. We have obtained and sought trademark protection for some of these listed marks in the European Community and Japan.

Risk Factors

You should carefully consider the risks and uncertainties described below, together with all other information included in this quarterly report and in our other public filings, before making any investment decision regarding our stock. If any of the following risks actually occurs, our business, financial condition, results of operations and future prospects would likely be materially and adversely affected. In that event, the market price of our stock could decline and you could lose all or part of your investment.

Risks Related to Our Business and Industry

We sell our imaging systems and provide our services in a highly competitive industry, and we often compete against large, well-established competitors that have significantly greater financial resources than we have.

The medical device industry, including the market for imaging systems and services, is highly competitive, subject to rapid change and significantly affected by new product introductions and market activities of other industry participants. Our primary competitors with respect to imaging systems include several large medical device manufacturers, including Philips Medical Systems, General Electric Healthcare, Siemens Medical Systems and Toshiba Medical Systems. All of these competitors offer a full line of imaging cameras for each diagnostic imaging technology, including x-ray, magnetic resonance imaging, computerized tomography, ultrasound and nuclear medicine. The existing imaging systems sold by our competitors have been in use for a longer time than our products and are more widely recognized and used by physicians and hospitals for nuclear imaging. Many of our competitors and potential competitors enjoy significant competitive advantages over us, including:

• significantly greater name recognition and financial, technical, service and marketing resources;

• established relationships with healthcare professionals, customers and third-party payors;

• established distribution networks;

• technical features our current products do not possess;

• additional lines of products and the ability to offer rebates or bundle products to offer discounts or incentives; and

• greater resources for product development, sales and marketing.

The competitive nature of the nuclear imaging industry has had an impact on the price of our gamma cameras. We experienced significant declines in product sales in the second quarter of 2005, and we believe that the market for single-headed cameras has recently experienced a moderate decline. While we experienced increased product sales in the third quarter of 2005 as compared to the second quarter, our quarterly performance has not yet returned to levels we achieved in 2004. Further, we anticipate that pricing pressures, including on our dual-headed cameras, will continue to impact our gamma camera product revenue and gross profit.

We are aware of certain major medical device companies that are attempting to develop solid-state cameras and we believe these efforts will continue. In addition, we are aware of a privately-held company, Gamma Medica, which is currently marketing a solid-state gamma camera for breast imaging. We do not believe that this camera can be used in a cardiac application. However, we cannot assure you that Gamma Medica will not attempt to modify its existing camera for use in the cardiac segment in the future, or develop another gamma camera for cardiac applications. Because of the size of the potential market, we anticipate that companies will dedicate significant resources to developing competing products and services. Current or future competitors may develop technologies and products, including hybrid technologies, that demonstrate better image quality, ease of use or mobility than our imaging systems. For example, there are hybrid modalities commercially available that combine the technologies of positron emission tomography, or PET, with computed tomography, or CT, as well as others that combine single photon emission computed tomography, or SPECT, with CT technology. Our ability to compete successfully will depend on our ability to develop proprietary products that reach the market in a timely manner, receive adequate reimbursement and are less expensive and/or perform better than alternatives available for the same purpose. If we are unable to compete effectively against our existing and future competitors, our sales will decline and our business will be harmed.

In providing comprehensive mobile nuclear imaging solutions, we generally compete against small businesses employing traditional vacuum tube cameras that must be transported in large vehicles and cannot be moved in and out of physician offices. We also compete against a number of physicians or companies who use Digirad cameras in relatively small mobile imaging businesses which have the advantage of a lower cost structure. In addition, we compete against a number of imaging centers that install nuclear gamma cameras and make them available to referring physicians in their geographic vicinity.

Changes in domestic and international laws, regulations, or coverage and reimbursement policies of third-party payors may adversely impact our ability to market and sell our products and services.

Physicians and hospitals purchasing and using our products rely on adequate third-party payor coverage and reimbursement to maintain their operations. Changes in domestic and international laws, regulations or coverage and reimbursement policies of third-party payors may adversely affect the demand for our existing and future products and services and may limit our ability to market and sell our products and services on a profitable basis. For example, on December 8, 2003, President Bush signed into law the Medicare Prescription Drug, Improvement and Modernization Act of 2003, or the Medicare Modernization Act, which contains a wide variety of changes that impact Medicare reimbursement. We cannot predict what changes may be made to such laws, regulations, or coverage and reimbursement policies, but we believe that future coverage and reimbursement may be subject to increased restrictions both in the United States and in international markets. Additionally, we cannot be certain that under prospective payment systems, or established fee schedule payment formulas, under which healthcare providers may be reimbursed a fixed amount based on the patient’s condition or the type of procedure performed, the costs of our products and services will be justified and incorporated into the overall payment for the procedure. In August 2005, CMS proposed changes to the relative value units under the Resource Based Relative Value Scale physician reimbursement system that, if finalized as proposed, could decrease overall reimbursements for nuclear medicine procedures by some five percent. This estimate reflects CMS’s proposed changes to the universe of nuclear medicine procedures and the specific impact for solely diagnostic imaging procedures is unclear. Because we charge customers based on a flat lease rate, we cannot predict whether or to what extent the proposed Medicare reimbursement reduction, if finalized, will impact our business. If reimbursement limitations increase, sales of our gamma cameras could suffer and we may receive pressure from our customers to terminate or otherwise modify the lease arrangements for our DIS services. Under such circumstances, our business, financial condition and results of operations could be materially adversely affected. On March 1, 2005, the Medicare Payment Advisory Commission (“MedPac”) issued its semi-annual report to Congress, setting out, among other things, certain recommendations relative to diagnostic imaging, including requiring all providers who bill Medicare for the performance and interpretation of diagnostic imaging to meet certain standards, to include nuclear medicine as a designated health service under the Ethics in Patient Referrals Act and to improve coding edits for imaging studies. It is impossible to predict whether any of the recommendations will be adopted; however, such recommendations, if adopted, could have an adverse effect on utilization of our services and products. Third-party payors continue to act to contain or reduce healthcare costs through various means, including the movement to managed care systems where healthcare providers contract to provide comprehensive healthcare for a fixed fee per patient. We are aware of a number of third party payors in geographic locations currently served by us that issued guidelines prohibiting our physician customers from obtaining reimbursement for procedures they perform unless they own or lease our cameras on a full time basis. These and other payors are also requiring physicians to be accredited by either the Intersocietal Commission for the Accreditation of Nuclear Medicine Laboratories or by the American College of Radiology, and to meet certain other privileging standards, in order to obtain reimbursement for nuclear imaging procedures. These privileging standards also exclude physicians who are not radiologists or cardiologists from obtaining reimbursements for nuclear imaging procedures. We cannot assure you that these guidelines will be changed, or that they will not be adopted by other third party payors, including Medicaid and private insurers. These continued efforts have resulted in several instances where third-party payors have refused to reimburse patients or healthcare providers for our imaging services. Further, in October 2005, the American College of Cardiology Foundation and the American Society of Nuclear Cardiology issued new appropriateness criteria for cardiac imaging that we believe may result in a decrease of the overall number of nuclear imaging procedures being performed. Any such decrease could negatively affect our DIS business and product sales.

A loss of key executives or failure to attract qualified managers, engineers and imaging technologists, or high employee attrition rates, could limit our growth and adversely affect our business.

Our success is dependent on the efforts of our key executives and technical, sales and managerial personnel and our ability to retain them. The loss of any one or more of these individuals could place a significant strain on our remaining management team and we may have difficulty replacing any of these individuals. We do not have any employment agreements with, or key person insurance on, any of our employees except with Mark Casner, the DIS President.

As previously reported, we recently hired Gerhard F. Burbach as our President and Chief Executive Officer, Peter Sullivan as our Senior Vice President of Operations, and Randy Weatherhead as our VP of Marketing. In October 2005, we hired Mark Casner as DIS President. Because of these changes, our senior management team has not worked together as a group for a significant length of time. If our new management team is unable to work together effectively to implement our strategies, manage our operations and accomplish our objectives, our business, operations and financial results could be severely impaired.

Furthermore, our future growth will depend in part upon our ability to identify, hire and retain nuclear imaging technologists, certified cardiographic technicians, nurses, radiation safety officers, engineers, management, sales personnel and other highly skilled personnel.

Hiring qualified management and technical personnel will be difficult due to the limited number of qualified candidates. Competition for these types of employees, particularly nuclear imaging technologists and engineers, is intense in the medical imaging field. Given the competition for such qualified personnel, we cannot assure you that we will be able to continue to

attract, hire and retain the personnel necessary to maintain and develop our business. Failure to attract, hire and retain key personnel could have an adverse effect on our business, financial condition and results of operations. In addition, we have experienced an increasing rate of employee turnover, currently at an annualized rate of above 40 % for the combined service and product segments. If we are unable to reverse this trend, our business and financial condition could be seriously affected.

Our imaging systems and DIS services may become obsolete, and we may not be able to timely develop new products, product enhancements or services that will be accepted by the market.

Our nuclear imaging system and DIS services may become obsolete or unmarketable if other products or services utilizing new technologies or the development of hybrid imaging modalities, such as those combining PET and CT or SPECT and CT, or any other imaging modality, are introduced by our competitors or new industry standards emerge. We have recently observed a moderate decline in the market for single-headed imaging systems, and we cannot assure you that we will be able to compensate for this decline by introducing alternative or more competitive products. Our technical know-how and intellectual property have limited applications. Furthermore, although our nuclear imaging systems and DIS services are principally targeted towards the cardiology market, internal medicine practices have become an increasingly significant portion of the nuclear imaging market. We cannot assure you that we will be able to develop or market successful new products and services or enhancements to our existing products. Nor can we assure you that our future products and enhancements will be accepted by our current or potential customers or by the third-party payors who financially support many of the procedures performed with our products. Any of these circumstances may cause us to lose customers, disrupt our business operations and harm our product sales and services. To be successful, we will need to enhance our products or services and to design, develop and market new products that successfully respond to competitive developments, all of which efforts may be expensive and time consuming.

The success of any new product offering or enhancement to an existing product will depend on several factors, including our ability to:

• properly identify and anticipate physician and patient needs;

• develop new products or enhancements in a timely manner;

• obtain the necessary regulatory approvals or clearances for new products or product enhancements in a timely manner;

• provide adequate training to users of our products;

• price our products competitively;

• obtain required licensure;

• obtain appropriate coverage and receive adequate reimbursement notifications and respond to them in a commercially viable way;

• comply with changing or new regulatory requirements; and

• develop an effective marketing, sales and distribution network.

If we do not develop and obtain regulatory approvals or clearances for new products, necessary licensure, services or product enhancements in time to meet market demand, or if there is insufficient demand for these products, services or enhancements, our business, financial condition and results of operations will likely suffer. In addition, even if our customers acquire new products, services or product enhancements we may offer, the revenues from any such products, services or enhancements may not be sufficient to offset the significant costs associated with developing and offering such products, services or enhancements to customers. In addition, any announcements of new products, services or enhancements may cause customers to decline or cancel their purchasing decisions in anticipation of such products, services or enhancements.

If our imaging systems and DIS services are not accepted by physicians or hospitals, we may be unable to develop a sustainable, profitable business.

We expect that substantially all of our revenue in the foreseeable future will be derived from sales of our products in the nuclear imaging market and our leasing services offered through DIS. Our solid-state gamma cameras and DIS services represent a new approach in the nuclear imaging market. We began full commercial release of our imaging systems in March 2000 and established DIS in September 2000. Because of the recent commercial introduction of our nuclear imaging systems, we have limited product and brand recognition and our imaging systems have been used by a limited number of physicians and hospitals. Physicians and hospitals may generally be slow to adopt our products and leasing services for a number of reasons, including:

• perceived liability risks generally associated with the use of new technologies for nuclear imaging;

• availability of reimbursement from health care payors for procedures using our system;

• lack of experience with our products and services;

• costs associated with the purchase or lease of our products and services;

• the presence of competing products sold by companies with longer operating histories, more recognizable names and more established distribution networks;

• the introduction or existence of competing products and services or technologies that may be more effective, easier to use or that produce better images;

• our ability to retain our current customers;

• creation of competing mobile imaging businesses by physicians and others who may purchase mobile cameras that are part of our existing installed base of over 400 cameras;

• the growth of imaging centers that seek referrals of patients from physicians that otherwise might have used our DIS leasing services or purchased our cameras; and

• physician and hospital perceptions of our imaging systems as compared to those of competitors.

Our success in the nuclear imaging market depends on whether physicians and hospitals view our imaging systems and DIS services as effective and economically beneficial and as attractive alternatives to vacuum tube imaging systems. We also believe that recommendations and support of our products and services by influential physicians and other health care providers are essential for market acceptance and adoption. We cannot assure you that physicians or hospitals will adopt or accept our imaging systems or DIS services. If physicians and hospitals do not adopt our imaging systems or DIS services, our operating results and business will be harmed.

If we are unable to expand our DIS business, our growth rates could be significantly diminished and our business could be materially harmed.

We plan to grow our DIS business by expanding into several new states, adding new hub locations in states in which we currently operate and increasing hub utilization by adding physician customers and routes. As we undertake this expansion, we have hired and will need to continue to hire, train and retain qualified personnel. Our progress in expanding into new geographies has been slower than anticipated, and we cannot assure you that the new sales personnel we hire will be able to sell our leasing services at the rates we anticipate, or that physicians or hospitals in these new markets will accept our imaging products or services. Our expansion into additional domestic markets is subject to inherent risks, including those associated with compliance with applicable state laws regulations, including but not limited to laws and regulations concerning the use, storage, handling and disposal of radioactive materials, the acquisition of required licensures, compliance with state scope-of-practice laws, and difficulties in staffing and managing operations. Our inability to expand into new markets for any of these reasons could diminish our prospects for growth and profitability. We may find the laws of states in which we do not currently operate preclude us from operating our DIS business, or require us to change the structure in which we operate our DIS business in such states.

Because our imaging systems and DIS services are not widely diversified, a decrease in sales of our products and leasing services could seriously harm our business.

Our current product and leasing service offerings consist primarily of our line of gamma cameras, including our Cardius-1, Cardius-2, Cardius-3, 2020tc Imager and SPECTpak PLUS camera systems, each of which is designed for use in the nuclear imaging market segment and all of which utilize the same solid-state technology. In addition, we offer a mobile imaging leasing service through DIS, which includes an imaging system, certified personnel, required licensure and other support for nuclear imaging procedures. As such, our line of products and services is not as diversified as those of some of our competitors. In the second quarter of 2005, we experienced a major decline in our product sales. While our performance in product sales improved in the third quarter of 2005, we were unable to return to product sales levels we achieved in 2004 and the first quarter of 2005. If such declines in the sales of our products or leasing services were to continue, our business would be seriously harmed, and it would likely be difficult for us to recover because we do not have the breadth of products or services that would enable us to sustain our business while seeking to develop new types of products or services or other markets for our existing products and services. In addition, because our technical know-how and intellectual property have limited applications, we may be unable to leverage our technical know-how and intellectual property to diversify our products and services or to develop other products or sources of revenue outside of the nuclear imaging market.

If we experience problems with the technologies used in our imaging systems or if delivery of our DIS services are delayed, public perception of our products and service offerings could be harmed and cause us to lose customers and revenue.

Our gamma cameras have only recently been introduced into the marketplace. Most of our cameras currently in use are less than four years old. We have experienced some reliability issues with a prior version of our detector heads. In July 2003, we began selling most of our gamma cameras with a new version of our detector heads which has shown increased reliability, although other reliability issues remain, including with our recently launched Cardius-3 cameras. In addition, as the period of use of our cameras increases, other significant defects may occur. If significant defects do arise with our gamma cameras, our reputation among physicians and hospitals could be damaged and our business would be harmed.

Additionally, physicians rely on our DIS services to provide nuclear imaging procedures to their patients on the dates and at the times they have leased. Many factors could prevent us from delivering our DIS services on a timely basis, including equipment failures, weather and the availability of staffing, transportation and necessary supplies. If we are unable to provide physicians or hospitals our DIS services in a timely and effective manner, our reputation among physicians and hospitals could be damaged and our business would be harmed.

The performance and reliability of our products and services are critical to our reputation and to our ability to achieve market acceptance of those products and services. Widespread or other failures of our cameras and other products consistently to meet the expectations of purchasers or customers that use our DIS services could adversely affect our reputation, our ability to provide our DIS services, our relations with current customers and our business operations. Such failures could also reduce the attractiveness of our products and services to potential customers. Equipment failures could result from any number of causes, including equipment aging, ordinary wear and tear due to regular transportation and relocation, failure to perform routine maintenance and latent hardware or software defects of which we are unaware. Such failures, whether actual or perceived, could adversely affect our business even if we correct the underlying problems.

We are subject to the financial risks associated with providing services through our DIS business.

There are numerous risks associated with any leasing arrangement, including the possibility that physicians may fail to make the required payments under the terms and provisions of their lease commitments. Our DIS business is also affected by

the ability of physicians to pay us, which in turn may be affected by general economic and business conditions and the availability of reimbursement for the physicians. In addition, typically, a small number of our DIS customers decide to purchase their own cameras, made by us or by one of our competitors, rather than continue to use our DIS leasing service. If purchases by DIS customers of cameras made by our competitors were to increase beyond the levels we have historically experienced, our business and financial condition could be adversely affected.

Our manufacturing operations are highly dependent upon third-party suppliers, making us vulnerable to supply problems and price fluctuations, which could harm our business.

We rely on a limited number of third parties to manufacture and supply certain of the key components of our products. While many of the components used in our products are available from multiple sources, we obtain some components from single sources, and alternative sources for them may not be readily available. For example, key components of the detector heads and the processing and control software utilized in our gamma cameras are manufactured or supplied by a single source. If we were unable to obtain these components, our ability to build gamma cameras could be materially affected. To be successful, our contract manufacturers and suppliers must provide us with the components of our systems in requisite quantities, in compliance with regulatory requirements, in accordance with agreed-upon specifications, at acceptable cost and on a timely basis. Segami Corporation, or Segami, has developed image processing software for our camera under a non-exclusive license agreement. In the event that Segami attempts to terminate the license agreement, refuses to extend the term of the license or seeks to impose unreasonable pricing or terms, we would have to find an alternative software system to use in our gamma camera that may not be readily available. Our reliance on these outside suppliers subjects us to a number of risks that could harm our business, including:

• suppliers may make errors in manufacturing components that could adversely affect the efficacy or safety of our products or cause delays in shipment of our products;

• we may not be able to obtain adequate supply in a timely manner or on commercially reasonable terms;

• we may have difficulty locating and qualifying alternative suppliers for our components;

• once we identify alternative suppliers, we could experience significant delays in production due to the need to evaluate and test the products delivered by alternative suppliers and to obtain regulatory qualification for them;

• we are not a major customer of many of our suppliers, and these suppliers may therefore give other customers’ needs higher priority than ours;

• we use some suppliers that are small, privately-held companies, and these suppliers could encounter financial or other difficulties that could cause them to modify or discontinue their operations at any time;

• our suppliers manufacture products for a range of customers, and fluctuations in demand for the products those suppliers manufacture for others may affect their ability to deliver components to us in a timely manner; and

• our suppliers may encounter financial hardships unrelated to our demand for components, which could inhibit their ability to fulfill our orders and meet our requirements.

Any interruption or delay in the supply of components or materials, or our inability to obtain components or materials from alternate sources at acceptable prices in a timely manner, could impair our ability to meet the demand of our customers and cause them to cancel orders or switch to competitive products or services. These events could harm our business and operating results.

We have limited marketing, sales and distribution capabilities.

We began commercial production and shipped our first imaging products in 2000, and therefore have limited experience in marketing, selling and distributing our products and services. Additionally, while we have a direct sales team focused on domestic marketing, sales and distribution, we also use one independent distributor in the United States and two independent, international sales distributors to market, sell and distribute our products and services. As a result, we are dependent in part upon the marketing, sales and distribution efforts of our third-party distributors. Our domestic third-party distributor is generally permitted to market, sell and distribute competing imaging products that are used or refurbished and meet specified age requirements. Our international distributors are prohibited from promoting or distributing any other gamma camera product, but are not prohibited from offering competing services.

Our future revenue growth will depend in large part on our success in maintaining and expanding our marketing, sales and distribution channels, which will likely be an expensive and time-consuming process. We are highly dependent upon the efforts of our sales force and third-party distributors to increase our revenue. We face intense competition for qualified sales employees and may be unable to hire, train, manage and retain such personnel, which could adversely affect our ability to maintain and expand our marketing, sales and distribution network, which would negatively affect our ability to compete effectively as a distributor of nuclear imaging devices. Additionally, even if we are able to expand our sales force and enter into agreements with additional third-party distributors on commercially reasonable terms, they may not commit the necessary resources effectively to market, sell and distribute our products and services domestically and internationally. If we are unable to maintain and expand our direct and third-party marketing, sales and distribution networks, we may be unable to sell enough of our products and imaging services for our business to be profitable and our financial condition and results of operations will likely suffer accordingly.

We are exposed to risks relating to product liability, product recalls, property damage and personal injury and death for which insurance coverage is expensive, limited and potentially inadequate, and our business may be negatively affected by increased insurance costs.

Our operations entail risks relating to product liability claims, product recalls, property damage and personal injury and death. We currently maintain insurance that we believe is adequate with respect to the nature of the risks insured against, including product liability insurance, professional liability insurance, automobile insurance, property insurance, workers compensation insurance and general liability insurance. In many cases such insurance is expensive and difficult to obtain, and no assurance can be given that we will be able to maintain our current insurance or that we will be able to obtain or maintain comparable or additional insurance in the future on reasonable terms, if at all. If we are unable to obtain insurance, we could be subject to large uninsured claims for which we might not have adequate reserves. Additionally, costs associated with maintaining our insurance, including workers compensation insurance, could become prohibitively expensive, and our ability to become profitable could be diminished.

If we choose to acquire new or complementary businesses, products or technologies instead of developing them ourselves, we may be unable to complete those acquisitions or to successfully integrate them in a cost-effective and non-disruptive manner.

Our success depends on our ability to continually enhance and broaden our product and service offerings in response to changing customer demands, competitive pressures and technologies. While we have no current commitments regarding any acquisitions of new or complementary businesses, products or technologies, we may in the future choose to pursue such acquisitions instead of developing those businesses, products or technologies ourselves. We cannot assure you, however, that we would be able to successfully complete any acquisition we choose to pursue, or that we would be able to successfully integrate any acquired business, product or technology into our company in a cost-effective and non-disruptive manner. Furthermore, there is no certainty that we would be able to attract, hire or retain key employees associated with any acquired businesses, products or technologies.

Integrating any acquired businesses, products or technologies could be expensive and time consuming, disrupt our ongoing business and divert the attention and resources of our management. If we are unable to integrate any acquired businesses, products or technologies effectively, our business will likely suffer. Additionally, any amortization of assets or charges resulting from the costs of acquisitions could harm our business and operating results.

Our manufacturing operations and executive offices are located at a single facility that may be at risk from fire, earthquakes or other natural or man-made disasters or crises.

Our manufacturing operations and executive offices are located at a single facility in Poway, California, near known fire areas and earthquake fault zones. This facility is located a short distance from the wildfires that destroyed many homes and businesses in San Diego County, California in 2003. We have taken precautions to safeguard our facilities, including insurance and health and safety protocols. However, any future natural disaster, such as a fire or an earthquake, could cause substantial delays in our operations, damage to or destroy our manufacturing equipment or inventory, and cause us to incur additional expenses. A disaster could significantly harm our business and results of operations. The insurance we maintain against fires and other natural disasters may not be adequate to cover our losses in any particular case.

Additionally, electrical power is vital to our operations and we rely on a continuous power supply to conduct our business. California has experienced significant electrical power shortages and price volatility in recent years, and such shortages and price volatility may occur in the future. In the event of an acute power shortage, the California system operator has on some occasions implemented, and may in the future implement, rolling blackouts throughout California. If our energy costs substantially increase or blackouts interrupt our power supply frequently or for more than a few days, we may have to reduce or temporarily discontinue our normal operations. In addition, the cost of our research and development efforts may increase because of the disruption to our operations. Any such reduction or disruption of our operations at our facilities could harm our business.

Risks Related to Government Regulation

We must be licensed to handle and use hazardous materials and may be liable for contamination or other harm caused by hazardous materials that we use.

We use hazardous and radioactive materials in our research and development and manufacturing processes, as well as in the provision of our imaging services. We are subject to federal, state and local laws and regulations governing use, storage, handling and disposal of hazardous and radioactive materials and waste products, or hazardous materials. We are currently licensed to handle such hazardous materials in all states in which we operate, but there can be no assurances that we will be able to retain those licenses in the future. In addition, we must become licensed to handle hazardous materials in all states in which we plan to expand. Obtaining those additional hazardous materials licenses is an expensive and time consuming process. If we are unable to obtain those licenses at all, we will not be able to expand into those stated and our ability to grow and become profitable will be reduced.

Although we believe that our procedures for use, handling, storing and disposing of these hazardous materials comply with legally prescribed standards, we cannot completely eliminate the risk of contamination or injury resulting from hazardous materials and we may incur liability as a result of any such contamination or injury. In the event of an accident, we could be held liable for damages or penalized with fines, and the liability could exceed our resources.

We have also incurred and may continue to incur expenses related to compliance with environmental laws. Such future expenses or liability could have a significant negative impact on our business, financial condition and results of operations. Further, we cannot assure you that the cost of complying with these laws and regulations will not materially increase in the

future.

We spend considerable time and money complying with federal, state and foreign laws, regulations, and other rules, and, if we are unable to fully comply with such laws, regulations and other rules, we could face substantial penalties.

We are directly, or indirectly through our clients, subject to extensive regulation by both the federal government and the states and foreign countries in which we conduct our business. The laws that directly or indirectly affect our ability to operate our business include, but are not limited to, the following:

• the federal Medicare and Medicaid Anti-Kickback Law, which prohibits persons from knowingly and willfully soliciting, offering, receiving or providing remuneration, directly or indirectly, in cash or in kind, to induce either the referral of an individual, or furnishing or arranging for a good or service, for which payment may be made under federal healthcare programs such as the Medicare and Medicaid Programs;

• other Medicare laws, regulations, rules, manual provisions, and policies that prescribe the requirements for coverage and payment for services performed by us and our DIS customers, including the amount of such payment;

• the federal false claims statutes, which impose civil and criminal liability on individuals and entities who submit, or cause to be submitted, false or fraudulent claims for payment to the government;

• the federal Health Insurance Portability and Accountability Act of 1996, or HIPAA, which, among other things, prohibits executing a scheme to defraud any healthcare benefit program, including private payors and, further, requires us to comply with standards regarding the privacy and security of individually identifiable health information and conduct certain electronic transactions using standardized code sets. In addition, regulations have been issued under HIPAA that require us to comply with additional security regulations, and that will require us to adopt unique health identifiers for use in filing and processing healthcare claims and other transactions by May 2007;

• the federal False Statements Statute, which prohibits knowingly and willfully falsifying, concealing or covering up a material fact or making any materially false statement in connection with the delivery of or payment for healthcare benefits, items or services;

• the Stark Law, which, in the absence of a statutory or regulatory exception, prohibits the referral of Medicare or Medicaid patients by a physician to an entity for the provision of certain designated healthcare services, if the physician or a member of the physician’s immediate family has a direct or indirect financial relationship, including an ownership interest in, or a compensation arrangement with, the entity and also prohibits that entity from submitting a bill to a federal payor for services rendered pursuant to a prohibited referral;

• the federal Food, Drug and Cosmetic Act, which regulates the manufacture, labeling, marketing, distribution and sale of prescription drugs and medical devices;

• state and foreign law equivalents of the foregoing;

• federal and state radioactive materials laws, which govern the procurement, use, transfer and storage of radioactive materials;

• state food and drug laws, pharmacy acts, state pharmacy board regulations, and other state health care laws and regulations which govern the sale, distribution, use, administration, storage, handling, documentation and prescribing of prescription drugs;

• state laws that prohibit the practice of medicine by non-physicians and fee-splitting arrangements between physicians and non-physicians, as well as state law equivalents to the federal Medicare and Medicaid Anti-Kickback Law, the False Claims Act and the Stark Law, which may not be limited to government reimbursed items or services;

• State scope-of-practice laws that either require specific licenses or certifications for our personnel or that require direct supervision of our personnel by the site physician to perform certain tasks in the absence of such licensures or certifications,; and

• federal laws, regulations, rules and policies that permit physicians to bill and receive payment for certain diagnostic tests under the Medicare Physician Fee Schedule only if certain conditions are satisfied, including the requirement that the physician personally perform, or adequately supervise the performance of, the test using equipment they own or lease, and that prohibit physicians from marking up the cost of tests they “purchase,” rather than perform or supervise, for Medicare patients.

We implemented a compliance program in 2002 to help assure that we identify any compliance issues, correct any compliance issues, and remain in compliance with the above and other applicable laws, to provide training of employees, to conduct auditing and monitoring of the Company’s operations, to provide for a compliance hotline, and to achieve other compliance goals. Like most companies with active and effective compliance programs, we occasionally discover compliance concerns. In such cases, and in accordance with our compliance program, we take responsive action, including,

when necessary, corrective measures. There can be no assurance that the Company’s responsive actions will insulate us from liability associated with any such detected compliance concerns.

If our past or present operations are found to be in violation of any of the laws, regulations, rules or policies described above or the other governmental laws or regulations to which we or our customers are subject, or if the interpretation of the foregoing changes, we may be subject to civil and criminal penalties, damages, fines, exclusion from the Medicare and Medicaid programs and the curtailment or restructuring of our operations. Similarly, if our customers are found non-compliant with applicable laws, they may be subject to sanctions, which could also have a negative impact on us. In addition, if we are required to obtain permits or licensure under these laws that we do not already possess, we may become subject to substantial additional regulation or incur significant expense. Any penalties, damages, fines, curtailment or restructuring of our operations would adversely affect our ability to operate our business and our financial results. The risk of our being found in violation of these laws is increased by the fact that many of them have not been fully interpreted by the regulatory authorities or the courts, and their provisions are open to a variety of interpretations, and additional legal or regulatory change. Any action against us for violation of these laws, even if we successfully defend against it, could cause us to incur significant legal expenses, divert our management’s attention from the operation of our business and damage our reputation.

Legislative or regulatory reform of the healthcare system may affect our ability to sell our products.

In both the United States and certain other foreign jurisdictions, there have been a number of legislative and regulatory proposals to change the healthcare system in ways that could impact our ability to sell our products and services profitably. In the United States, federal and state lawmakers regularly propose and, at times, enact new legislation establishing significant changes in the healthcare system. President Bush signed into law the Medicare Modernization Act, which contains a wide variety of reforms that impact Medicare reimbursements to hospitals and physicians including changes to Medicare payment methodologies for radiopharmaceuticals and other drugs dispensed by hospital outpatient departments and for drugs dispensed by physician offices. We cannot predict the full impact that such new legislation will have nor whether new federal legislation will be enacted in the future, however, these changes reduced payment amounts for some of the drugs used in conjunction with our imaging procedures, although the physician fee schedule payment rates applicable to nuclear cardiology increased slightly in each of 2003, 2004 and 2005. Because the new reimbursement system is based on the prices of radiopharmaceuticals and other drugs reported to CMS by manufacturers on a quarterly basis, we cannot predict the amount of future reimbursement, however downward changes to Medicare reimbursement rates may adversely impact reimbursement to customers or potential customers that use or could use our cameras and services, and may therefore affect us. We cannot predict the full impact that such new legislation will have nor whether new federal legislation will be enacted in the future; however downward changes to Medicare reimbursement rates may adversely impact reimbursement to customers or potential customers that use or could use our cameras and services. In August 2005, CMS proposed changes to the relative value units under the Resource Based Relative Value Scale physician reimbursement system that, if adopted, could decrease our customer’s Medicare reimbursements for nuclear imaging procedures performed with our cameras by some five percent. This estimate reflects CMS’s proposed changes to the universe of nuclear medicine procedures and the specific impact for solely diagnostic imaging procedures is unclear. Because we charge customers based on a flat lease rate for our equipment and personnel, we cannot predict whether or to what extent the proposed Medicare reimbursement reduction, if finalized, will impact our DIS business. If these reimbursement limitations increase, sales of our gamma cameras would suffer and we may receive pressure from our customers to terminate or otherwise modify the lease arrangements for our DIS services. Under such circumstances, our business, financial condition and results of operations could be materially adversely affected. Also, CMS proposed including nuclear medicine procedures to the list of designated health services subject to the physician self-referral prohibitions under the Stark Law. However, this proposed change might not significantly affect our business based on the potential availability of exceptions to the Stark Law. The potential for adoption of healthcare reform proposals on a state-by-state basis could require us to develop state-specific marketing and sales approaches. In addition, we may experience pricing pressures in connection with the sale of our products and services due to additional legislative proposals or healthcare reform initiatives. Our results of operations and our business could therefore be adversely affected by future healthcare reforms.

Regulatory changes could have a negative impact on camera sales to and leases with hospitals desiring to use our cameras and services in their outpatient facilities.

In order for hospitals to receive certain payments for their outpatient facilities as hospital outpatient services, including services that utilize our products, these services must be furnished in a “provider-based” organization or facility or be covered services furnished “under arrangement” with the hospital. Failure to meet these requirements may result in reduced payments to the hospitals for their services. The Medicare program has published and revised rules establishing criteria for classifying a facility as “provider-based” or a service as furnished “under arrangement.” These rules require an analysis of the facts and circumstances surrounding the delivery by a hospital of a particular service, and hospitals that use our products or DIS services in their outpatient facilities will need to determine if they meet the applicable “provider-based” or “under arrangement” requirements. Hospitals that cannot obtain sufficient payments for these services may not purchase a camera from us or enter into arrangements with us for provision of services.

If we fail to comply with various licensure or certification laws, regulations or standards, we may be subject to civil, criminal and/or administrative penalties, which would adversely affect our operations.

All of the states in which we operate require that the imaging technicians that operate our cameras be licensed or certified and such licensing and certification requirements are subject to change. Obtaining such licenses may take significant time as we expand into additional states or if the applicable requirements change. Any lapse in the licensure or certification of our technicians could increase our costs and adversely affect our operations and financial results.

In addition, our lease services business involves administering and furnishing radiopharmaceuticals and pharmacological stress agents, which are regulated as drugs by state and federal agencies, including the FDA and state pharmacy boards. We have initiated a process to apply for state drug distribution licensure and permits. If a state regulatory authority were to determine that we have operated our business without required permits or licensure, we could be subject to civil, criminal and/or administrative penalties, including the curtailing or halting of our business. In addition, an inability to obtain licenses or permits in any of the states in which we currently conduct business, or in states where we plan to expand, would require us to modify the types of business models we can utilize in the affected jurisdictions. In either case, we would incur substantial expense and could encounter substantial operational burdens.

In the healthcare industry, various types of organizations are accredited to facilitate meeting certain Medicare certification requirements, expedite third-party payment and fulfill state licensure requirements. Some managed care providers prefer to contract with accredited organizations. We are aware of a number of third party payors in geographies in which we do business that are requiring physicians to obtain certain accreditations or certifications in order to obtain reimbursement for imaging procedures, and to meet specified privileging standards. In our DIS business, although the majority of our customers continue to be cardiologists, an increasing number of new customers are non-cardiologists who would not currently meet the certifications required by payors in certain other geographies. We have obtained certification from the Intersocietal Commission for the Accreditation of Nuclear Medicine Laboratories for one of our hub locations, and are in the process of applying for certifications for additional hub locations. We cannot assure you that we will be successful in obtaining those additional certifications. If it becomes necessary for us or our customers to obtain any additional accreditations or certifications in the future in order to satisfy the requirements of third-party payors or regulatory agencies, there can be no assurances that we or they will be able to obtain or continuously maintain this accreditation, and our business could be adversely affected.

Compliance with extensive product regulations could be expensive and time consuming, and any failure to comply with those regulations could harm our ability to sell and market our products and imaging services.

U.S. and foreign regulatory agencies, including the FDA, govern the testing, marketing and registration of new medical devices or modifications to medical devices, in addition to regulating manufacturing practices, reporting, labeling and recordkeeping procedures.

The regulatory process makes it longer, harder and more costly to bring our products to market, and we cannot assure you that any of our future products will be cleared or approved. All of our planned services, products and manufacturing activities, as well as the manufacturing activities of third-party medical device manufacturers who supply components to us, are subject to these regulations. Generally, we and our third-party manufacturers are or will be required to:

• undergo rigorous inspections by domestic and international agencies;

• obtain the prior clearance or approval of those agencies before we can market and sell our medical device products; and

• satisfy content and format requirements for all of our sales and promotional materials.

Compliance with the regulations of those agencies may delay or prevent us from introducing new or improved products, which could in turn affect our ability to achieve or maintain profitability. We may be subject to sanctions, including Warning Letters, monetary fines and criminal penalties, the temporary or permanent suspension of operations, product recalls and marketing restrictions, if we fail to comply with the laws and regulations applicable to our business. Our third-party component manufacturers may also be subject to the same sanctions and, as a result, may be unable to supply components for our products. Any failure to retain governmental approvals that we currently hold or obtain additional similar approvals could prevent us from successfully marketing our products and technology and could harm our operating results. Furthermore, changes in the applicable governmental regulations could prevent further commercialization of our products and technologies and could harm our business.

Even if regulatory approval or clearance of a product is granted, regulatory agencies could impose limitations on uses for which the product may be labeled and promoted. Further, for a marketed product, its manufacturer and manufacturing facilities are subject to periodic review and inspection. Later discovery of problems with a product, manufacturer or facility may result in restrictions on the product, manufacturer or facility, including withdrawal of the product from the market or other enforcement actions.

Our products are subject to reporting requirements and recalls even after receiving FDA clearance or approval, which could harm our reputation, business and financial results.

We are subject to medical device reporting regulations that require us to report to the FDA or similar governmental bodies in other countries if our products cause or contribute to a death or serious injury or malfunction in a way that would be reasonably likely to contribute to death or serious injury if the malfunction were to recur. In addition, the FDA and similar governmental bodies in other countries have the authority to require the recall of our products in the event of material deficiencies or defects in design or manufacture that could cause adverse health consequences. A government mandated or

voluntary recall by us could occur as a result of component failures, manufacturing errors or design defects, including defects in labeling. Any recall would divert management attention and financial resources and harm our reputation with customers. A recall involving one of our products could harm the reputation of the product and our company and would be particularly harmful to our business and financial results.

If we fail to obtain, or are significantly delayed in obtaining, FDA or foreign regulatory clearances or approvals for future products or product enhancements, or if we or our third party contractors fail to comply with FDA’s Quality System Regulation, or the quality regulations of foreign governments, our ability to market and distribute our products will suffer.

Our products are subject to rigorous regulation by the FDA, and numerous other federal, state and foreign governmental authorities. In the U.S., the FDA regulates virtually all aspects of a medical device’s testing, manufacture, safety, labeling, storage, recordkeeping, reporting, promotion and distribution. Our failure to comply with those regulations could lead to the imposition of administrative or judicial sanctions, including Warning Letters, injunctions, suspensions or the loss of regulatory clearances or approvals, product recalls, termination of distribution, product seizures, or injunctions. In the most egregious cases, criminal sanctions or closure of our manufacturing facilities are possible. The process of obtaining regulatory clearances or approvals to market a medical device, particularly from the FDA, can be costly and time consuming, and there can be no assurance that such clearances or approvals will be granted on a timely basis, if at all. In particular, unless exempt, the FDA permits commercial distribution of a new medical device only after the device has received 510(k) clearance or is the subject of an approved PMA. The FDA will clear marketing of a medical device through the 510(k) process if it is demonstrated that the new product is substantially equivalent to a legally marketed predicate device. The PMA approval process is more costly, lengthy and uncertain than the 510(k) clearance process, and must be supported by extensive data, including data from preclinical studies and human clinical trials. Because we cannot assure you that any new products we develop, or any product enhancements, will be subject to the generally shorter 510(k) clearance process, significant delays in the introduction of any new products or product enhancements may occur. While we have not been required to obtain PMA approval for any of our products, there is no assurance that the FDA will not require a new product or product enhancement to go through the more lengthy, burdensome, and expensive PMA approval process. Further, pursuant to FDA regulations, we can only market our products for cleared or approved uses. If our products are used for purposes other than those cleared or approved by the FDA, the FDA could object to such off-label uses.

Our manufacturing processes and those of our third-party manufacturers are required to comply with the FDA’s Quality System Regulation, which covers the design, testing, production processes, controls, quality assurance, labeling, packaging, storage and shipping of our devices. In addition, we must engage in extensive recordkeeping and reporting and must make available our manufacturing facility and records for periodic unscheduled inspections by federal, state and foreign agencies, including the FDA. Our failure or our third-party manufacturers’ failure to pass a Quality System Regulation inspection or to comply with these and other applicable regulatory requirements could result in disruption of our operations and manufacturing delays, and a failure to take adequate corrective action could result in, among other things, Warning Letter(s), withdrawal of our medical device clearances, seizure or recall of our devices, or other civil or criminal enforcement actions.

Foreign governmental authorities that regulate the manufacture and sale of medical devices have become increasingly stringent and, to the extent we now or in the future market and sell our products in foreign countries, we may be subject to rigorous regulation by those foreign governmental authorities. In such circumstances, we would rely significantly on our foreign independent distributors to comply with the varying regulations, and any failures on their part could result in restrictions on the sale of our products in foreign countries.

Modifications to our products may require new 510(k) clearances or pre-market approvals, or may require us to cease marketing or recall the modified products until clearances are obtained.

Any modification to a 510(k)-cleared device that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance or, possibly, approval of a PMA. The FDA requires every manufacturer to make this determination in the first instance, but the FDA may review any manufacturer’s decision. The FDA may not agree with our decisions regarding whether new clearances or approvals are necessary. If the FDA requires us to seek 510(k) clearance or PMA approval for modification of a previously cleared product for which we have concluded that no clearances or approvals are necessary, we may be required to cease marketing or to recall the modified product until we obtain clearance or approval, and we may be subject to significant regulatory fines or penalties. Further, our products could be subject to recall if the FDA determines, for any reason, that our products are not safe or effective. Any recall or FDA requirement that we seek additional approvals or clearances could result in delays, fines, costs associated with modification of a product, loss of revenue and potential operating restrictions imposed by the FDA, any of which would harm our business.

Audits or denials of claims submitted by us or by our DIS customers, by government agencies or contractors could reduce our revenues or profits and expose us to claims.

For services we provided until August 2004 under our “mixed bill” model, we submitted claims directly to and received payments directly from the Medicare program. Therefore, we remain subject to extensive government regulation, including requirements for maintaining certain documentation to support our claims. Government agencies and Medicare contractors also may conduct inspections or surveys of our facilities, payment reviews and other audits of our claims and operations. We cannot assure you that such scrutiny will not result in material delays in payment, as well as material recoupments or denials, which could reduce our revenue or profits. Our DIS customers also submit claims to Medicare and other third-party payors, are subject to the same types of regulation and scrutiny and may experience the same types of problems. This could adversely affect our ability to market our leases and services and to maintain existing contracts.

Risks Related to Our Financial Results and Need for Financing

Our quarterly financial results are difficult to predict and are likely to fluctuate significantly from period to period because our business prospects are uncertain and due to the seasonality of our DIS leasing services business.

Our revenue and results of operations at any given time will be primarily based on the following factors, many of which we cannot control:

• physician, healthcare provider and patient acceptance of our products and services;

• demand and pricing of our products and services;

• levels of third-party payor reimbursement for our products and services;

• accreditation and credentialing requirements imposed by third-party payors on physicians and providers of mobile imaging services;

• reimbursement prohibitions imposed by third party payors on providers of mobile imaging services;

• customer profiles and lengthening sales cycles associated with such profiles;

• success and timing of new product offerings, acquisitions, licenses or other significant events by us or our competitors;

• camera purchases by DIS customers;

• our ability to establish and maintain a productive manufacturing, marketing, sales and distribution force;

• the ability of our suppliers to timely provide us with an adequate supply of necessary components;

• timing and magnitude of our expenditures;

• our ability to reduce our expenses quickly enough to respond to any declines in revenue;

• regulatory approvals and legislative changes affecting the products we may offer or those of our competitors;

• the effect of competing technological and market developments;

• our addition or termination of research programs or funding support;

• interruption in the manufacturing or distribution of our products and services; and

• changes in our ability to obtain FDA approval or clearance for our products.

Furthermore, we have experienced seasonality in the leasing services offered by DIS. While our physicians are obligated to pay us for all lease days to which they have committed, our contracts permit some flexibility in scheduling when services are to be performed. This accounts for some of the seasonality of our DIS revenues. For example, our daily services have typically declined from our second fiscal quarter to our third fiscal quarter due to summer holidays and vacation schedules. We have also experienced declining daily services in December due to holidays and in our first quarter due to weather conditions in certain parts of the United States. We cannot predict with certainty the degree to which seasonal circumstances such as the summer slowdown, winter holiday variations and weather conditions may make our revenue unpredictable or lead to fluctuations in our quarterly operating results in the future.

In addition, due to the way that customers in our target markets acquire our products, a large percentage of our orders of gamma cameras is booked during the last month of each quarterly accounting period. As such, a delivery delay of only a few days may significantly impact our quarter-to-quarter comparisons.

For these reasons, we believe that quarterly sales and operating results may vary significantly in the future and that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indicators of future performance. We cannot assure you that our sales will increase or be sustained in future periods. Accordingly, we have experienced, and may continue to experience, significant, unanticipated quarterly losses. Because of these and other factors, our operating results in one or more future quarters may fail to meet the expectations of securities analysts or investors, which could cause our stock price to decline significantly.

We have incurred significant and recurring operating losses since our inception in 1985 and we expect to incur such losses and increased operating expenses in the near term.

We have incurred significant cumulative net losses since our inception in November 1985 and expect to incur such losses and increased operating expenses in the near term as we, among other things:

• expand our manufacturing operations and DIS business;

• increase marketing, sales and distribution of our current products; and

• conduct research and development to develop next-generation products and to enhance our existing products.

As a result of these activities, we may not be able to become profitable or, if we do, maintain profitability. If our revenue grows more slowly than anticipated, or if our operating expenses exceed our expectations, our ability to achieve our

development and expansion goals would be adversely affected.

If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results. As a result, current and potential stockholders could lose confidence in our financial reporting, which would harm our business and the trading price of our stock.

Effective internal controls are necessary for us to provide reliable financial reports. If we cannot provide reliable financial reports, our business and operating results could be harmed.

We have in the past discovered, and may in the future discover, areas of our internal controls that need improvement. Our independent auditors notified us in April 2005, in connection with an investigation being conducted by the Audit Committee of our Board of Directors, of the existence of a material weakness in our internal controls, as defined by the Public Company Accounting Oversight Board’s Auditing Standard No. 2, which we have confirmed. A material weakness in internal controls over financial reporting is considered to be a significant deficiency, or a combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

As a result of these findings, we have implemented, and continue to implement, actions to address these deficiencies and to enhance the reliability and effectiveness of our internal controls and operations. However, we cannot assure you that we will maintain adequate controls over our financial process and reporting in the future, or that additional material weaknesses or significant deficiencies in our internal controls will not be discovered.

Any failure to remediate the material weakness discussed above or implement required new or improved controls, difficulties encountered in their implementation or future weaknesses could harm our operating results, cause us to fail to meet our reporting obligations, result in material misstatements in our financial statements and cause us to incur additional costs and adverse publicity. Inferior internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our stock.

Our reliance on a limited number of customers may cause our sales to be volatile.

We currently have a small number of customers, whom we typically bill after the delivery of our products and imaging services. If orders for our gamma cameras were to be cancelled, or our leasing service customers stopped using us or do not renew their lease agreements with us, or decide to purchase their own camera, our business would be adversely affected. Furthermore, in view of our small customer base, our failure to gain additional customers, the loss of any current customers or a significant reduction in the level of leasing services provided to any one customer could disrupt our business, harm our reputation and adversely affect our sales.

The sales cycle for our gamma cameras is typically lengthy, which may result in significant fluctuations in our revenue.

Our sales efforts for our gamma cameras are dependent on the capital expenditures budgets of the physicians and hospitals to which we market. Often physicians and hospitals require a significant amount of lead time to plan for a major acquisition such as the purchase of our imaging systems. We may spend substantial time, effort and expense long before we actually consummate an order of our cameras and with no assurance that we will ultimately be successful in achieving any such orders. As a result, we may experience significant fluctuations in our revenues. Furthermore, evaluating and predicting our future sales and operating performance is difficult and may not be as accurate as it could be if we had shorter sales cycles.

Our future capital needs are uncertain and we may need to raise additional funds in the future, and such funds may not be available on acceptable terms, if at all.

Although we believe that our current cash and cash equivalents will be sufficient to meet our projected operating requirements for at least the next twelve months, our capital requirements will depend on many factors, including:

• the revenue generated by sales of our products and services;

• the costs associated with expanding our manufacturing, marketing, sales and distribution efforts;

• the rate of progress and cost of our research and development activities;

• the costs of obtaining and maintaining FDA and other regulatory clearance of our products and products in development;

• the costs of obtaining and maintaining radioactive materials licenses and radiation safety procedures;

• the effects of competing technological and market developments;

• the number and timing of acquisitions and other strategic transactions; and

• the costs associated with our expansion, if any.

As a result of these factors, we may need to raise additional funds, and we cannot be certain that such funds will be available to us on acceptable terms, if at all. Furthermore, if we issue equity or debt securities to raise additional funds, our existing stockholders may experience dilution and the new equity or debt securities may have rights, preferences and privileges senior to those of our existing stockholders. In addition, if we raise additional funds through collaboration, licensing or other similar arrangements, it may be necessary to relinquish potentially valuable rights to our future products or

proprietary technologies, or grant licenses on terms that are not favorable to us. If we cannot raise funds on acceptable terms, we may not be able to expand our operations, develop new products, take advantage of future opportunities or respond to competitive pressures or unanticipated customer requirements.

Risks Related to Our Intellectual Property and Potential Litigation

Our ability to protect our intellectual property and proprietary technology through patents and other means is uncertain.

Our success depends significantly on our ability to protect our proprietary rights to the technologies used in our products. We rely on patent protection, as well as a combination of copyright, trade secret and trademark laws, and nondisclosure, confidentiality and other contractual restrictions to protect our proprietary technology. However, these legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keep any competitive advantage. Our pending U.S. and foreign patent applications, which include claims to material aspects of our products and procedures that are not currently protected by issued patents, may not issue as patents in a form that will be advantageous to us. Any patents we have obtained or do obtain may be challenged by re-examination or otherwise invalidated or eventually found unenforceable. Both the patent application process and the process of managing patent disputes can be time consuming and expensive. Competitors may attempt to challenge or invalidate our patents, or may be able to design alternative techniques or devices that avoid infringement of our patents, or develop products with functionalities that are comparable to ours. Although we have taken steps to protect our intellectual property and proprietary technology, including entering into confidentiality agreements and intellectual property assignment agreements with our employees, consultants, advisors and corporate partners, such agreements may not be enforceable or may not provide meaningful protection for our trade secrets or other proprietary information in the event of unauthorized use or disclosure or other breaches of the agreements. Furthermore, the laws of some foreign countries may not protect our intellectual property rights to the same extent as do the laws of the United States.

In the event a competitor infringes upon our patent or other intellectual property rights, litigation to enforce our intellectual property rights or to defend our patents against challenge, even if successful, could be expensive and time consuming and could require significant time and attention from our management. We may not have sufficient resources to enforce our intellectual property rights or to defend our patents against challenges from others.

The medical device industry is characterized by patent litigation and we could become subject to litigation that could be costly, result in the diversion of our management’s time and efforts, and require us to pay damages.

The medical device industry is characterized by extensive litigation and administrative proceedings over patent and other intellectual property rights. Whether a product infringes a patent involves complex legal and factual issues, the determination of which is often uncertain. Our competitors may assert that our products, their components or the methods we employ in the use of our products are covered by U.S. or foreign patents held by them. In addition, they may claim that their patents have priority over ours because their patents were filed or invented earlier. Because patent applications can take many years to issue, there may be applications now pending of which we are unaware, which may later result in issued patents that our products may infringe. There could also be existing patents that one or more components of our products may be infringing of which we are unaware. As the number of participants in our industry increases, the possibility of patent infringement claims against us also increases.

Any litigation or claims against us, or claims we bring against others, may cause us to incur substantial costs, could place a significant strain on our financial resources, divert the attention of our management from our core business and harm our reputation. If the relevant patents were upheld as valid and enforceable and we were found to be inadvertently infringing, we could be required to pay substantial damages and/or royalties and could be prevented from selling our products unless we could obtain a license or were able to redesign our system to avoid infringement. Any such license may not be available on reasonable terms, if at all. If we fail to obtain any required licenses or make any necessary changes to our products or technologies, we may be unable to commercialize one or more of our products.

If we become subject to product liability or warranty claims, we may experience reduced demand for our products or be required to pay damages that exceed our insurance coverage.

The sale and support of our products entails the risk of product liability or warranty claims, such as those based on claims that the failure of one of our products resulted in a misdiagnosis, personal injury or death, among other issues. The medical device industry has been subject to significant products liability litigation. We may incur significant liability in the event of any such litigation, regardless of the merit of the action. Although we maintain product liability insurance, we cannot be sure that this coverage is adequate or that it will continue to be available on acceptable terms, if at all. We also may face warranty exposure, which could adversely affect our operating results. Any unforeseen warranty exposure or insufficient insurance could harm our business, financial condition and results of operations. Finally, even a meritless or unsuccessful product liability claim could harm our reputation in the industry, lead to significant legal fees and could result in the diversion of management’s attention from managing our business.

We may be subject to lawsuits and actions brought by our employees.

We may from time to time be subject to employment litigation or administrative actions resulting from claims against us by current or former employees. Any employment litigation could significantly divert our management’s time and attention and could result in monetary or other damages that could negatively impact our financial results.

We rely significantly on a license agreement with Segami Corporation for imaging processing software for our digital gamma camera, and the loss of the license could result in delivery delays, loss of customers and loss of revenue.

Segami Corporation, or Segami, has developed image processing software for our camera under a non-exclusive license agreement. While we have amended our agreement with Segami and now own the image acquisition software, we remain dependent on Segami for the processing software. In the event that Segami attempts to terminate the license agreement, refuses to extend the term of the license or seeks to impose unreasonable pricing or terms, we would have to find an alternative software system to use in our gamma camera. To our knowledge, there are a limited number of companies that would be able to develop and implement a software system similar to what we use in our gamma camera. As a result, in the event that we were unable to continue to use the software under the license from Segami, we could have delays in the production of our gamma camera as we attempted to find a substitute software provider. Furthermore, we cannot guarantee that alternative software providers would be able to meet our requirements or that their software would be available to us at favorable prices, if at all. To the extent we were unable to find an alternative source for the software, we may have to develop our own software system. We cannot guarantee that we could internally develop such a software system or that such efforts would not divert resources away from the development of other features of our camera. As a result, locating an alternative software system or developing our own software system could interrupt the manufacture and delivery of our products for an extended period of time and may cause the loss of customers and revenue.

We may be subject to damages resulting from claims that we, or our employees, have wrongfully used or disclosed alleged trade secrets of their former employers.

Many of our employees were previously employed at other medical device companies, including our competitors or potential competitors. Although no claims against us are currently pending, we may be subject to claims that we or our employees have inadvertently or otherwise used or disclosed trade secrets or other proprietary information of their former employers. Litigation may be necessary to defend against these claims. Even if we are successful in defending against these claims, litigation could result in substantial costs and be a distraction to management. If we fail in defending such claims, in addition to paying money damages, we may lose valuable intellectual property rights or personnel. A loss of key research personnel or their work product could hinder or preclude our ability to commercialize our products, which could severely harm our business.

Risks Related to the Securities Markets and Ownership of Our Common Stock

Our stock price may be volatile.

The market price for our common stock has been and is likely to continue to be volatile. In addition, the market price of our common stock may fluctuate significantly in response to a number of factors, most of which we cannot control, including:

• volume and timing of orders for our products and services;

• the introduction of new products, product enhancements, services or technologies by us or our competitors;

• quarterly variations in our or our competitors’ results of operations;

• conditions or trends in the medical device industry and the imaging service industry;

• disputes or other developments with respect to intellectual property rights, product liability claims or other litigation;

• our ability to develop, obtain regulatory clearance for, and market, new and enhanced products on a timely basis, or changes in governmental regulations or in the status of our regulatory approvals or applications;

• additions or departures of key personnel;

• sales of large blocks of our common stock, including sales by our executive officers and directors;

• changes in the availability of third-party reimbursement in the United States or other countries;

• changes in earnings estimates or recommendations by securities analysts; and

• general market conditions and other factors, including factors unrelated to our operating performance or the operating performance of our competitors.

Future sales of our common stock may cause our stock price to decline.

A small number of our current stockholders hold a substantial number of shares of our common stock that they may sell in the public market. Sales by our current stockholders of a substantial number of shares, or the expectation that such sale may occur, could significantly reduce the market price of our common stock. Moreover, the holders of a substantial number of our shares of common stock, including shares issued upon the exercise of certain of our warrants, have rights, subject to some conditions, to require us to file registration statements to permit the resale of their shares in the public market or to include their shares in registration statements that we may file for ourselves or other stockholders. We have also registered all common stock that we may issue under our employee benefit plans. Accordingly, these shares can be freely sold in the public market upon issuance, subject to restrictions under the securities laws and the lock-up agreements described above. If any of these stockholders cause a large number of securities to be sold in the public market, the sales could reduce the trading price of our common stock. These sales also could impede our ability to raise future capital.

Our common stock has been publicly traded for a short time and an active trading market may not be sustained.

Although we are currently listed for trading on the Nasdaq National Market, an active trading market for our common stock may not be sustained. An inactive market may impair your ability to sell your shares at the time you wish to sell them or at a price that you consider reasonable. Furthermore, an inactive market may impair our ability to raise capital by selling shares and may impair our ability to acquire other businesses, products and technologies by using our shares as consideration.

Anti-takeover provisions in our organizational documents and Delaware law may discourage or prevent a change in control, even if an acquisition would be beneficial to our stockholders, which could affect our stock price adversely and prevent attempts by our stockholders to replace or remove our current management.

Our restated certificate of incorporation and restated bylaws contain provisions that may delay or prevent a change in control, discourage bids at a premium over the market price of our common stock and adversely affect the market price of our common stock and the voting and other rights of the holders of our common stock. These provisions include:

• prohibiting our stockholders from calling a special meeting of stockholders unless they hold not less than 20% of the total number of votes to be cast at such a meeting;

• permitting the issuance of additional shares of our common stock or preferred stock without stockholder approval;

• prohibiting our stockholders from making certain changes to our restated certificate of incorporation or restated bylaws except with 66-²/3% stockholder approval; and

• requiring advance notice for raising matters of business or making nominations at stockholders’ meetings.

We are also subject to provisions of the Delaware corporation law that, in general, prohibit any business combination with a beneficial owner of 15% or more of our common stock for five years unless the holder’s acquisition of our stock was approved in advance by our board of directors. Although we believe these provisions collectively provide for an opportunity to receive higher bids by requiring potential acquirors to negotiate with our board of directors, they would apply even if the offer may be considered beneficial by some stockholders. In addition, these provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our board of directors, which is responsible for appointing the members of our management.

If our officers, directors and principal stockholders choose to act together, they may be able to control our management and operations, acting in their best interests and not in the best interests of other stockholders.

Our officers, directors and holders of 5% or more of our outstanding common stock beneficially own a significant amount of our outstanding common stock. As a result, these stockholders, acting together, will be able to significantly influence all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions. The interests of this group of stockholders may not always coincide with our interests or the interests of other stockholders, and they may act in a manner that advances their best interests and not necessarily those of other stockholders. As a result of their actions or inactions our stock price may decline.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market risk due to changes in interest rates relates primarily to the increase or decrease in the amount of interest income we can earn on our investment portfolio. Our risk associated with fluctuating interest rates is limited to our investments in interest rate sensitive financial instruments. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. We attempt to increase the safety and preservation of our invested principal funds by limiting default risk, market risk and reinvestment risk. We mitigate default risk by investing in investment grade securities. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest sensitive financial instruments. Changes in interest rates over time will increase or decrease our interest income.

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports pursuant to the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by Rule 13a-15(b) of the Securities Exchange of 1934, as amended, we carried out an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the quarter covered by

this report.

During April 2005, we identified an event described below which occurred in March 2004, which we concluded was a material weakness. Accordingly, our chief executive officer and chief financial officer have concluded that our disclosure controls and procedures were not effective as of March 31, 2005 and for all prior reporting periods.

Audit Committee Investigation and Material Weakness

On April 5, 2005, the Audit Committee of our Board of Directors engaged independent, outside counsel to conduct an investigation into whether we properly recognized revenue with respect to the sale and delivery of a single digital gamma camera in the first quarter of 2004 and related matters. Based upon the results of the investigation, we, with the concurrence of our independent auditors, confirmed the propriety of the revenue recognition with respect to the camera sale transaction. As a result, we and our independent auditors concluded that no adjustment to our recorded revenue was necessary and that no restatement of our prior issued financial statements was required.

Based upon the results of the investigation, however, the independent auditors notified us of the existence of a material weakness in our internal controls, as defined by the Public Company Accounting Oversight Board’s Auditing Standard No. 2, which we have confirmed. A material weakness in internal controls over financial reporting is considered to be a significant deficiency, or a combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Because the Audit Committee and our Board of Directors determined that certain of our employees attempted to circumvent our internal controls over financial reporting or failed to reveal facts related to the delivery of the camera at issue, our independent auditors determined that such facts gave rise to a material weakness in our internal controls. We found no evidence of any other material departure from our internal control policies.

To address the results of the investigation and the determination of the existence of a material weakness in our internal controls, we implemented a series of remedial actions, including requesting and receiving the resignation of our then President and Chief Executive Officer, and terminating the employment of our then Senior Vice President of Operations. In addition, we requested and received the resignation of one sales employee, terminated the employment of another sales employee, assigned more senior accounting personnel to oversee revenue recognition for product revenues and adopted new and more stringent controls over delivery procedures and documentation.

Changes in Internal Control over Financial Reporting.

There has been no change in our internal controls over financial reporting during our most recent fiscal quarter, other than as discussed above in connection with the identification and remediation of the material weakness, that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In January 2005, a complaint was served on a DIS customer physician, his medical practice and two DIS technicians, individually, and in their capacity as agents of the medical practice. The complaint was filed in the Circuit Court of the Fifth Judicial Circuit, County of Vermilion, Danville, Illinois and alleges negligence claims in connection with the death of a patient purportedly arising from the administration of a stress imaging test. We have tendered the matter to the physician practice for indemnification and defense pursuant to our contract with the practice. While the technicians deny the allegations and we will vigorously defend them in the matter, we cannot assure you that this matter will be resolved in their favor.

In September 2005, we received notice from the Nuclear Regulatory Commission of an apparent license violation regarding findings by the Commission’s Office of Investigation of (a) the deliberate submission of inaccurate information to us by a physician listed as an authorized user on our license; and (b) our submission of that information to the Commission, not knowing that the information was false. We have agreed to attend a mediation in the matter. The mediation could result in an agreement by us to pay certain fines and implement corrective action. An unsuccessful mediation could result in enforcement action, including the imposition of fines and restrictions on or conditions to our license.

In the normal course of business, we have been and will likely continue to be subject to litigation incidental to our business, such as claims related to customer disputes, employment practices, product liability, warranty or patent infringement. Responding to litigation, regardless of whether it has merit, can be expensive and disruptive to normal business operations. We dispute the merits of all such current claims and plan to vigorously defend against them. However, as litigation is inherently uncertain, we cannot predict the outcome of such matters. We can provide no assurance that the

ultimate outcome, either individually or in the aggregate, will not have a material adverse effect on our financial statements.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

We effected the initial public offering of our common stock pursuant to a Registration Statement on Form S-1 (File No. 333-113760) that was declared effective by the Securities and Exchange Commission on June 9, 2004.

As of September 30, 2005, we had used approximately $14.2 million of the net proceeds from our initial public offering to repay our lines of credit, capital leases and notes payable, none of which was paid directly or indirectly to any of our directors or officers (or their associates) or persons owning ten percent or more of any class of our equity securities or to any other affiliates. In addition, we had used $7.4 million to fund operations and capital equipment purchases. We invested the remainder of the proceeds in investment-grade, interest bearing instruments, pending their use to fund working capital and capital expenditures.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

Exhibit Number		Description
3.1(1)		Restated Certificate of Incorporation
3.2(1)		Restated Bylaws
4.1(2)		Form of Specimen Stock Certificate
4.2 (3)		Amended and Restated Investors’ Rights Agreement by and among Digirad Corporation and the investors listed on the schedule attached thereto, dated April 23, 2002, as amended
10.1		Executive Employment Agreement between Digirad Corporation and Mark Casner dated September 14, 2005
10.2 (4)		Form of 2005 Inducement Stock Incentive Plan
10.3 (4)		Form of 2005 Inducement Stock Incentive Plan Award Agreement
31.1		Certification of Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated pursuant to the Securities Exchange Act of 1934, as amended
31.2		Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated pursuant to the Securities Exchange Act of 1934, as amended
32.1		Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2		Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1)		Incorporated by reference to the Company’s quarterly report on Form 10-Q filed with the Securities and Exchange Commission on August 11, 2004.

(2)		Incorporated by reference to the Registration Statement on Form S-1 (File No. 333-113760) originally filed with the Securities and Exchange Commission on March 19, 2004, as amended thereafter.

(3)		Incorporated by reference to the Company’s quarterly report on Form 10-Q filed with the Securities and Exchange Commission on November 2, 2004.

(4)		Incorporated by reference to the Company’s current report on Form 8-K filed with the Securities and Exchange Commission on September 15, 2005.

INDEX TO EXHIBITS

Exhibit Number		Description
3.1(1)		Restated Certificate of Incorporation
3.2(1)		Restated Bylaws
4.1(2)		Form of Specimen Stock Certificate
4.2 (3)		Amended and Restated Investors’ Rights Agreement by and among Digirad Corporation and the investors listed on the schedule attached thereto, dated April 23, 2002, as amended
10.1		Executive Employment Agreement between Digirad Corporation and Mark Casner dated September 14, 2005
10.2 (4)		Form of 2005 Inducement Stock Incentive Plan
10.3 (4)		Form of 2005 Inducement Stock Incentive Plan Award Agreement
31.1		Certification of Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated pursuant to the Securities Exchange Act of 1934, as amended
31.2		Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated pursuant to the Securities Exchange Act of 1934, as amended
32.1		Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2		Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1)		Incorporated by reference to the Company’s quarterly report on Form 10-Q filed with the Securities and Exchange Commission on August 11, 2004.

(2)		Incorporated by reference to the Registration Statement on Form S-1 (File No. 333-113760) originally filed with the Securities and Exchange Commission on March 19, 2004, as amended thereafter.

(3)		Incorporated by reference to the Company’s quarterly report on Form 10-Q filed with the Securities and Exchange Commission on November 2, 2004.

(4)		Incorporated by reference to the Company’s current report on Form 8-K filed with the Securities and Exchange Commission on September 15, 2005.

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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005

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

FOR THE TRANSITION PERIOD FROM TO

Delaware		33-0145723
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

13950 Stowe Drive, Poway, CA		92064
(Address of Principal Executive Offices)		(Zip Code)

PART I. FINANCIAL INFORMATION
	Item 1. Financial Statements
	Consolidated Balance Sheets as of September 30, 2005 (Unaudited) and December 31, 2004
	Unaudited Consolidated Statements of Operations for the three and nine months ended September 30, 2005 and 2004
	Unaudited Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004
	Notes to Unaudited Consolidated Financial Statements
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosure about Market Risk
	Item 4. Controls and Procedures
PART II. OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
	Item 3. Defaults Upon Senior Securities
	Item 4. Submission of Matters to a Vote of Security Holders
	Item 5. Other Information
	Item 6. Exhibits
SIGNATURES
	EXHIBIT 31.1
	EXHIBIT 31.2
	EXHIBIT 32.1
	EXHIBIT 32.2

		DIGIRAD CORPORATION

Date: November 4, 2005		By: /s/ Gerhard F. Burbach

		Gerhard F. Burbach
		President and Chief Executive Officer
		(Principal Executive Officer)

Date: November 4, 2005		By: /s/ Todd P. Clyde

		Todd P. Clyde
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

o

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

DIGIRAD CORPORATION

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

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

Forward-Looking Statements May Prove Inaccurate

Overview

Liquidity and Capital Resources

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

ITEM 4. CONTROLS AND PROCEDURES