Edgar Filing: SONOSITE INC

Form 10-Q for the quarterly period ended September 30, 2003

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the quarterly period ended September 30, 2003

Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the transition period from to to

Commission file number 0-23791

SONOSITE, INC.

(Exact name of registrant as specified in its charter)

Washington

(State or Other Jurisdiction

of Incorporation or Organization)

91-1405022

(I.R.S. Employer

Identification Number)

21919 30th Drive SE, Bothell, WA

(Address of Principal Executive Offices)

98021-3904

(Zip Code)

(425) 951-1200

(Registrant’s Telephone Number, Including Area Code)

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

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

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

Common Stock, $0.01 par value

(Class)

14,431,686

(Outstanding as of November 10, 2003)

SonoSite, Inc.

Quarterly Report on Form 10-Q

For the Quarter Ended September 30, 2003

Table of Contents

		Page No.
PART I	FINANCIAL INFORMATION

Item 1.	Financial Statements (unaudited)

	Condensed Consolidated Balance Sheets—September 30, 2003 and December 31, 2002	3

	Condensed Consolidated Statements of Operations—Three and nine months ended September 30, 2003 and 2002	4

	Condensed Consolidated Statements of Cash Flows—Nine months ended September 30, 2003 and 2002	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	25

Item 4.	Controls and Procedures	26

PART II	OTHER INFORMATION

Item 1.	Legal Proceedings	26

Item 4.	Submission of Matters to a Vote of Security Holders	27

Item 6.	Exhibits and Reports on Form 8-K	27

SIGNATURE		28

PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

SonoSite, Inc.

Condensed Consolidated Balance Sheets

(unaudited)

(In thousands, except share data)	September 30, 2003			December 31, 2002
Assets
Current assets:
Cash and cash equivalents	$	13,065		$	26,381
Short-term investment securities		34,188			10,019
Accounts receivable, less allowance for doubtful accounts of $902 and $832		18,669			20,101
Inventories		14,700			11,787
Prepaid expenses and other current assets		1,883			1,339

Total current assets		82,505			69,627

Property and equipment, net		5,322			6,092
Investment securities		14,315			29,421
Other assets		971			737

Total assets	$	103,113		$	105,877


Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	2,261		$	4,310
Accrued expenses		5,785			5,404
Current portion of long-term obligations		124			136
Deferred revenue		3,319			3,072

Total current liabilities		11,489			12,922

Deferred rent		284			253
Long-term obligations, less current portion		—			88

Total liabilities		11,773			13,263

Commitments and contingencies

Shareholders’ equity:
Preferred stock, $1.00 par value
Authorized shares – 6,000,000
Issued and outstanding shares – none		—			—
Common stock, $.01 par value:
Authorized shares – 50,000,000
Issued and outstanding shares:
As of September 30, 2003 – 14,428,361
As of December 31, 2002 – 14,195,280		144			142
Additional paid-in-capital		179,368			177,007
Accumulated deficit		(89,654	)		(85,632	)
Accumulated other comprehensive income		1,482			1,097

Total shareholders’ equity		91,340			92,614

Total liabilities and shareholders’ equity	$	103,113		$	105,877

See accompanying notes to condensed consolidated financial statements.

SonoSite, Inc.

Condensed Consolidated Statements of Operations

(unaudited)

(In thousands, except loss per share)	Three Months Ended September 30,						Nine Months Ended September 30,
	2003			2002			2003			2002
Revenue	$	20,225		$	18,468		$	57,503		$	47,911
Cost of revenue		7,391			7,485			21,252			19,824

Gross margin		12,834			10,983			36,251			28,087

Operating expenses:
Research and development		2,663			2,867			8,371			9,210
Sales and marketing		9,086			9,329			27,594			23,375
General and administrative		1,666			1,574			5,410			4,553

Total operating expenses		13,415			13,770			41,375			37,138

Other income (expense):
Interest income		226			371			746			666
Interest expense		(5	)		(8	)		(19	)		(23	)
Other income (expense)		199			(15	)		375			(192	)

Total other income		420			348			1,102			451

Net loss	$	(161	)	$	(2,439	)	$	(4,022	)	$	(8,600	)

Basic and diluted net loss per share	$	(0.01	)	$	(0.17	)	$	(0.28	)	$	(0.68	)

Weighted average common shares used in computing net loss per share		14,391			14,087			14,289			12,704

See accompanying notes to condensed consolidated financial statements.

SonoSite, Inc.

Condensed Consolidated Statements of Cash Flows

(unaudited)

(In thousands)	Nine Months Ended September 30,
	2003			2002
Operating activities:
Net loss	$	(4,022	)	$	(8,600	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		1,830			1,870
Equity in loss of affiliates		25			192
Net gain on investments		(66	)		—
Amortization of premiums on investment securities		528			—
Changes in operating assets and liabilities:
Accounts receivable		1,712			(320	)
Inventories		(2,758	)		(3,394	)
Prepaid expenses and other assets		(803	)		(392	)
Accounts payable		(2,061	)		3,399
Accrued expenses		323			1,145
Deferred liabilities		271			1,344

Net cash used in operating activities		(5,021	)		(4,756	)

Investing activities:
Purchase of investments		(46,818	)		(31,802	)
Proceeds from sales/maturities of investments		37,104			643
Purchase of property and equipment		(1,044	)		(2,214	)

Net cash used in investing activities		(10,758	)		(33,373	)

Financing activities:
Net proceeds from sale of common shares		—			42,614
Exercise of stock options		2,363			175
Repayment of long-term obligations		(100	)		(61	)

Net cash provided by financing activities		2,263			42,728

Effect of exchange rate changes on cash and cash equivalents		200			195

Net change in cash and cash equivalents		(13,316	)		4,794
Cash and cash equivalents at beginning of period		26,381			33,116

Cash and cash equivalents at end of period	$	13,065		$	37,910

Supplemental disclosure of cash flow information:
Cash paid for interest	$	19		$	23

Supplemental disclosure of non-cash investing and financing activities:
Unrealized loss on investments	$	(189	)	$	—

See accompanying notes to condensed consolidated financial statements.

SonoSite, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

Interim Financial Information

Basis of Presentation

The information contained herein has been prepared in accordance with instructions for Form 10-Q and Article 10 of Regulation S-X. The information furnished reflects, in the opinion of SonoSite, Inc. management, all adjustments necessary (which are of a normal and recurring nature) for a fair presentation of the results for the interim periods presented. The results of operations for the three months and nine months ended September 30, 2003 are not necessarily indicative of our expected results for the entire year ending December 31, 2003 or for any other fiscal period. These financial statements do not include all disclosures required by generally accepted accounting principles. For a presentation including all disclosures required by generally accepted accounting principles, these financial statements should be read in conjunction with the audited financial statements for the year ended December 31, 2002, included in our Annual Report on Form 10-K. Certain amounts reported in previous periods have been reclassified to conform to current presentation.

Stock-based Compensation

At September 30, 2003, we had five stock-based compensation plans. We account for those plans under the intrinsic value method in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees.” Accordingly, compensation cost related to stock option grants to employees has been recognized only to the extent that the fair market value of the stock exceeds the exercise price of the stock option at the date of the grant. The following table illustrates the effect on net loss and net loss per share if we had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation (in thousands, except per share data):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2003			2002			2003			2002
Net loss, as reported	$	(161	)	$	(2,439	)	$	(4,022	)	$	(8,600	)
Less: Stock-based employee compensation expense determined under fair value based method		(1,403	)		(1,629	)		(4,070	)		(5,583	)

Pro forma net loss	$	(1,564	)	$	(4,068	)	$	(8,092	)	$	(14,183	)

Basic and diluted net loss per share:
As reported	$	(0.01	)	$	(0.17	)	$	(0.28	)	$	(0.68	)

Pro forma	$	(0.11	)	$	(0.29	)	$	(0.57	)	$	(1.12	)

Financial Instruments

Cash equivalents

Cash equivalents consist of money market accounts with major U.S. banks and highly liquid debt instruments with original or remaining maturities at purchase of three months or less.

Investment securities

Investment securities consist of high-grade U.S. government or corporate debt. While our intent is to hold our securities until maturity, we classify all securities as available-for-sale, as the sale of such securities may be required prior to maturity to implement management strategies. These securities are carried at fair value, with the unrealized gains and losses reported as a component of other comprehensive income (loss) until realized. Realized gains and losses from the sale of available-for-sale securities, if any, are determined on a specific identification basis.

A decline in market value of any available-for-sale security below cost that is determined to be other than temporary results in a revaluation of its carrying amount to fair value. The impairment is charged to earnings and a new cost basis for the security is established. Premiums and discounts are amortized or accreted over the life of the related security as an adjustment to yield using the effective interest method. Interest income is recognized when earned.

Accounts receivable

In the ordinary course of business, we grant credit to a broad customer base. Of the accounts receivable balance at September 30, 2003, 57% and 43% were receivable from domestic and international parties, prior to any allowance for doubtful accounts. The same percentages as of December 31, 2002 were 49% and 51% prior to any allowance for doubtful accounts.

For the three months ended September 30, 2003, revenue was 67% domestic and 33% international, compared to 60% domestic and 40% international for the three months ended September 30, 2002. For the nine months ended September 30, 2003, revenue was 64% domestic and 36% international, compared to 58% domestic and 42% international for the nine months ended September 30, 2002.

The following tables present individual customers whose outstanding receivable balances as a percentage of total trade receivables and/or revenue as a percentage of total revenue exceeded 10%:

Accounts Receivable:
	September 30, 2003		December 31, 2002
Japanese distributor	—	%	12	%
U.S. direct customer	—	%	12	%

Totals	—	%	24	%

Revenue:
	Three Months Ended September 30,				Nine Months Ended September 30,
	2003		2002		2003		2002
Japanese distributor	—	%	10	%	—	%	10	%

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. When we determine that amounts owed from customers are uncollectible, such amounts are charged off against the allowances for doubtful accounts. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Fair value of financial instruments

The carrying value of our financial instruments, including cash and cash equivalents, accounts receivable, accounts payable, certain other long-term assets and debt, approximate fair value. Cash and cash equivalents, accounts receivable and accounts payable approximate fair value due to their short-term nature. Other long-term assets and debt approximate fair value as interest rates on these notes approximate market. Investment securities are carried at fair value.

Inventories

Inventories are stated at the lower of cost or market, on a first-in, first-out method. Included in our inventories balance are demonstration products used by our sales representatives and marketing department, and items that have been shipped to customers for which revenue recognition requirements have not been met, including products whose title and custody have passed to the customer. Adjustments to cost are recorded for obsolete material, earlier generation products and refurbished products held either as saleable inventory or as demonstration product. The adjustments reduce their carrying values to amounts not lower than that which will result in approximately normal profit margins upon sale. Inventory items for which title has passed to customers are evaluated for recoverability based on the same process we use to evaluate collection of accounts receivable. If market conditions are less favorable than those projected by management, additional downward inventory cost adjustments may be required.

Inventories consist of the following (in thousands):

	As of
	September 30, 2003		December 31, 2002
Raw material	$	5,184	$	4,678
Work-in-process		593		120
Demonstration inventory		2,793		2,680
Finished goods		6,130		4,309

Total	$	14,700	$	11,787

At September 30, 2003 and December 31, 2002, finished goods includes approximately $0.3 million and $0.5 million of inventory whose title had passed to the customer and for which revenue has not yet been recognized.

Property and Equipment

Property and equipment are stated at historical cost, less accumulated depreciation and amortization. Maintenance and repair costs are expensed as incurred, with additions and improvements to property and equipment capitalized.

Depreciation and amortization are calculated using the straight-line method over estimated useful lives as follows:

Asset		Estimated Useful Lives
Equipment, other than computer		3-7 years
Software		3 years
Computer equipment		3-5 years
Furniture and fixtures		5 years
Leasehold improvements		Lesser of estimated useful life or expected remaining lease term

Direct internal and external costs for computer software developed for internal use are capitalized in accordance with SOP 98-1, “Accounting for Costs of Computer Software Developed or Obtained for Internal Use.” Capitalized costs are amortized using the straight-line method over the estimated useful lives beginning when each module is complete and ready for use. Such costs are insignificant for all periods presented.

The carrying value of long-lived assets is evaluated for impairment when events or changes in circumstances occur, which may indicate the carrying amount of the asset may not be recoverable. We evaluate the carrying value of the assets by comparing the estimated future undiscounted cash flows generated from the use of the asset and its eventual disposition with the assets’ reported net book value.

Warranty liability

Our typical warranty period is one year and is included with the original purchase of our ultrasound imaging systems. The warranty liability is summarized as follows (in thousands):

Balance at

December 31,
2002

Charged to

cost of
revenue

Applied to
liability

Balance at

September 30,

2003

Nine months ended September 30, 2003

331

268

(218

)

381

Concentration of credit and supply risk

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash equivalents, investments and accounts receivable.

We depend on some single-source suppliers to provide highly specialized parts and other components, and may experience an interruption of supply if a supplier is unable or unwilling to meet our time, quantity and quality requirements. There are relatively few alternative sources of supply for some of these items. A change in demand for some parts by other companies in our industry could also interrupt our supply of components. For example, in March 2003, one of our component suppliers, Philips Semiconductor (“Philips”), informed us that, commencing in September 2003, it would discontinue production of our integrated circuit chips using 0.35-micron technology. We have designed and implemented a new chip using 0.2-micron technology that will continue to be produced by Philips to replace all but one of the discontinued chips. We expect to design and implement an additional new chip to replace the remaining 0.35-micron chip by early 2005. In the second quarter of 2003, we entered into a purchase commitment totaling approximately $3.6 million for supplies of 0.35-micron chips from Philips for our anticipated manufacturing needs until new chips have been incorporated in all of our products. We pay for these chips at the time deliveries are made to us. As of September 30, 2003, our remaining purchase commitment was approximately $3.4 million. On December 31, 2004, we are required to take possession of, and pay for, the balance of the undelivered chips. Demand for our products, however, may exceed our forecasts, in which case we would require additional 0.35-micron chips to manufacture additional products. Conversely, if demand for our products falls short of our forecasts, we may experience excess inventory of 0.35-micron chips. If our actual demand for these chips varies significantly from our forecasted demand, we may experience delays in manufacturing, lost sales, a write-down of inventory or a deterioration in gross margin.

In addition, we are transferring the production of our main circuit board to a new supplier, Celestica, Inc., who will produce the board in their Thailand manufacturing facility. We expect his transfer to be completed in the first quarter of 2004. If, as a result of this transfer, we experience delays in the receipt of this component, a deterioration in product yields or an increase in costs, we may experience delays in manufacturing, lost sales or a deterioration in gross margin.

Accumulated Other Comprehensive Income

Unrealized gains or losses on our available-for-sale securities and foreign currency translation adjustments are included in accumulated other comprehensive income.

The following presents the components of comprehensive loss (in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2003			2002			2003			2002
Net loss	$	(161	)	$	(2,439	)	$	(4,022	)	$	(8,600	)
Other comprehensive income (loss):
Foreign currency translation adjustment		(204	)		163			574			359
Unrealized holding gains (losses) arising during the period		(85	)		258			(123	)		258
Less reclassification adjustment for gains included in net loss		(49	)		—			(66	)		—

Comprehensive loss	$	(499	)	$	(2,018	)	$	(3,637	)	$	(7,983	)

Net Loss per Share

Basic and diluted net loss per share was computed by dividing the net loss by the weighted average common shares outstanding. Outstanding options to purchase our shares were not included in the computations of diluted net loss per share because to do so would be antidilutive. For the three and nine months ended September 30, 2003, our outstanding options totaled 3,101,337. For the three and nine months ended September 30, 2002, our outstanding options totaled 2,980,139.

Foreign Currency Translation

The functional currencies of our international subsidiaries are the local currency of the country in which the subsidiary is located. Assets and liabilities denominated in foreign currencies are translated at the exchange rate on the balance sheet date. Net sales, costs and expenses of international operations are translated at average rates of exchange prevailing during the period. Net realized and unrealized gains on currency transactions were $157,000 and $320,000 for the three and nine months ended September 30, 2003, and none for the three and nine months ended September 30, 2002.

Litigation

On July 24, 2001, Neutrino Development Corporation filed a complaint against us in U.S. District Court, Southern District of Texas, Houston Division, alleging infringement of U.S. Patent 6,221,021, or the ‘021 patent, by SonoSite as a result of our use, sale and manufacture of the SonoSite 180, SonoSite 180 PLUS, SonoHeart and SonoHeart PLUS devices. The complaint asserts claims for preliminary and permanent injunctive relief enjoining all alleged acts of infringement, compensatory and enhanced damages, attorney’s fees and costs, and pre- and post-judgment interest. On August 14, 2001, we filed an answer asserting affirmative defenses of non-infringement and patent invalidity, and included a counterclaim seeking a declaratory judgment of non-infringement and invalidity regarding Neutrino’s patent. On October 4, 2001, the court denied a request by Neutrino for preliminary injunctive relief to prevent us from manufacturing and selling our products pending the ultimate disposition of the litigation. On February 20, 2002, in what is known as a “Markman” hearing, the parties presented their arguments regarding the proper construction of Neutrino’s patent claims.

On August 20, 2003, the U.S. District Court in the Southern District of Texas issued a decision interpreting certain terms used in the ‘021 patent. This decision does not discuss whether the patent is valid or whether the patent would apply to any of SonoSite’s products. In the order, the court, in resolving disputed terms in the Markman hearing, adopted SonoSite’s construction of the term “a portable body designed to be hand held”, and adopted Neutrino’s construction of the terms “the moveably connected transducer mounting assembly” and “ultrasound emitter”. The court denied SonoSite’s motion for summary judgment. SonoSite subsequently filed a new summary judgment motion using the court’s construction of the claim language that the ‘021 patent is invalid based on prior art. Neutrino has filed a summary judgment motion based on its allegations of infringement.

SonoSite also has asked the Texas court to stay proceedings in Neutrino’s suit filed in the Middle District of Florida against a former SonoSite distributor alleging that the sale of SonoSite’s products by such distributor infringes the ‘021 patent, and to enjoin Neutrino from filing similar suits against other sellers of SonoSite products. Neutrino had previously filed such a suit in the Middle District of Tennessee against another medical device distributor for selling a SonoSite product. That Tennessee case has been dismissed based on a final judgment and permanent injunction filed a month after the case was filed. The Tennessee judgment has no effect on the Texas proceedings.

We believe that we have good and sufficient defenses to the claims of patent infringement asserted against us by Neutrino and we are vigorously defending ourselves in this matter. If we are not successful in our defense of these claims, we could be forced to modify or discontinue selling our products or enter royalty or licensing agreements, which may not be available on terms acceptable to us, if at all, and which could adversely affect our financial condition. Sales of the allegedly infringing products represented the majority of our revenue for the three and nine month periods ended September 30, 2003 and 2002.

SonoSite does not consider a negative litigation outcome to be probable and has not accrued any amounts for potential losses related to these proceedings. Because of uncertainties related to both the amount and range of loss on the pending litigation, management is unable to make a reasonable estimate of the liability that could result from an unfavorable outcome. As additional information becomes available, SonoSite will assess the potential liability related to its pending litigation. SonoSite will record accruals for losses if and when SonoSite determines the negative outcome of such matters to be probable and reasonably estimable. SonoSite’s estimates regarding such losses could differ from actual results. Revisions in SonoSite’s estimates of the potential liability could materially impact SonoSite’s results of operations and financial position.

Segment Reporting

We currently have one reporting segment. We market our products in the United States and internationally through our direct sales force and our indirect distribution channels. Our chief operating decision maker evaluates resource allocation decisions and our performance based upon revenue recorded in geographic regions and does not receive financial information about expense allocation on a disaggregated basis. Geographic regions are determined by the shipping destination. Revenue by geographic location is as follows (in thousands):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2003		2002		2003		2002
United States	$	13,550	$	11,127	$	36,756	$	27,766
Japan		253		1,902		578		4,958
Europe, Africa and the Middle East		4,667		3,676		13,860		9,577
Canada, Australia, South and Latin America		850		631		3,153		2,522
Other Asia (a)		905		1,132		3,156		3,088

Total revenue	$	20,225	$	18,468	$	57,503	$	47,911

(a) Other Asia includes primarily China, India and Taiwan.

New Accounting Pronouncements

In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” which provides the accounting requirements for retirement obligations associated with tangible long-lived assets. SFAS No. 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. SFAS No. 143 is effective for our 2003 fiscal year and we adopted this statement on January 1, 2003. The adoption of this statement did not have an impact on our financial statements.

In November 2002, the Emerging Issues Task Force (EITF) reached a consensus on EITF 00-21, “Revenue Arrangements with Multiple Deliverables” with respect to determining when and how to allocate revenue from sales with multiple deliverables. The EITF 00-21 consensus provides a framework for determining when and how to allocate revenue from sales with multiple deliverables based on a determination of whether the multiple deliverables qualify to be accounted for as separate units of accounting. The consensus is effective prospectively for arrangements entered into in fiscal periods beginning after June 15, 2003 and we adopted this consensus on July 1, 2003. The adoption of this consensus did not have a material impact on our financial statements.

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (FIN 46). Variable interest entities often are created for a single specified purpose, for example, to facilitate securitization, leasing, hedging, research and development, or other transactions or arrangements. Formerly “Consolidation of Certain Special Purpose Entities” in its draft form, this interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” defines what these variable interest entities are and provides guidelines on how to identity them and also on how an enterprise should assess its interests in a variable interest entity to decide whether to consolidate that entity. Generally, FIN 46 applies to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. On October 8, 2003, the FASB deferred the implementation date for the consolidation requirements of FIN 46 as it relates to variable interest entities that existed before February 1, 2003. For existing variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003, the provision of this interpretation will apply in financial statements issued for periods ending after December 15, 2003. FIN 46 also requires companies that expect to consolidate a variable interest entity they acquired before February 1, 2003 to disclose the entity’s nature, size, activities, and the company’s maximum exposure to loss in financial statements issued after January 31, 2003. Currently, we do not expect that the adoption of FIN 46 will have a material impact on our financial statements.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. SFAS No. 149 clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative and when a derivative contains a financing component that warrants special reporting in the statement of cash flows. SFAS No. 149 is generally effective for contracts entered into or modified after June 30, 2003. We do not believe that the adoption of SFAS No. 149 will have a material impact on our financial statements.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 changes the accounting for certain financial instruments that, under previous guidance, could be classified as equity or “mezzanine” equity, by now requiring those instruments to be classified as liabilities (or assets in some circumstances) in the balance sheet. This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. We do not believe that the adoption of SFAS No. 150 will have a material impact on our financial statements.

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

This quarterly report on Form 10-Q contains forward-looking statements. Forward-looking statements provide our current expectations or forecasts of future events. Forward-looking statements in this report include, without limitation:

•

information concerning possible or assumed future results of operations, trends in financial results and business plans, including those relating to earnings growth and revenue growth;

•

statements about the level of our costs and operating expenses relative to our revenue, and about the expected composition of our revenue;

•

statements about our future capital requirements and the sufficiency of our cash, cash equivalents, investments and available bank borrowings to meet these requirements;

•

other statements about our plans, objectives, expectations and intentions; and

•

other statements that are not historical facts.

Words such as “believe,” “anticipate,” “expect” and “intend” may identify forward-looking statements, but the absence of these words does not necessarily mean that a statement is not forward-looking. Forward-looking statements are subject to known and unknown risks and uncertainties, and are based on potentially inaccurate assumptions that could cause actual results to differ materially from those expected or implied by the forward-looking statements. You should not unduly rely on these forward-looking statements, which speak only as of the date of this report.

We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our future Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and Annual Reports on Form 10-K. Also note that we provide a cautionary discussion of risks, uncertainties and possibly inaccurate assumptions relevant to our business under the caption “Important Factors That May Affect Our Business, Our Results of Operations and Our Stock Price” in this report. These are risks that could cause our actual results to differ materially from those anticipated in our forward-looking statements or from our expected or historical results. Other factors besides the risks, uncertainties and possibly inaccurate assumptions described in this report could also affect actual results.

Overview

We are a leading provider of point-of-care, high performance, all-digital ultrasound imaging systems for use in a variety of clinical applications and settings. Our proprietary technologies have enabled us to design point-of-care diagnostic ultrasound systems that combine all-digital, high-resolution imaging with advanced features and capabilities traditionally found on cart-based ultrasound systems. We believe that the portability, high quality and cost-effectiveness of our products are expanding existing markets and will create new markets for ultrasound imaging by bringing ultrasound out of the imaging center to the point-of-care such as the patient’s bedside or the physician’s examining table.

The size and complexity of traditional ultrasound systems typically compel physicians to refer patients to a highly trained sonographer employed by an imaging center, such as a hospital’s radiology department. By providing ultrasound at the primary point-of-care, our easy-to-use systems can eliminate delays associated with the referral process and enable physicians to use ultrasound more frequently and in a wider variety of clinical settings. This increased accessibility creates the potential for enhanced patient care through earlier diagnosis of diseases and conditions.

We currently focus on six key market segments: radiology, obstetrics and gynecology, emergency medicine, surgery, cardiology and vascular medicine. Our current products include the TITAN^™ system and the 180PLUS system, for general ultrasound imaging, and the SonoHeart ELITE, specifically configured for cardiovascular applications. The iLook 25 imaging tool is designed to provide visual imaging for physicians and nurses while performing vascular access procedures and the iLook 15 imaging tool is designed to provide visual imaging of the chest and abdomen for physicians and nurses while performing other procedures and examinations. Our TITAN, SonoSite 180PLUS and SonoHeart ELITE products are used together with any of our transducers that are designed for specific clinical applications. Our iLook products each have a single transducer for specific clinical applications. We first shipped our newest product, the SonoSite TITAN, in June 2003.

We were formerly a division of ATL Ultrasound, Inc., or ATL. On April 6, 1998, we were spun-off as an independent, publicly-owned Washington corporation to further the development and commercialization of point-of-care, high performance, all-digital ultrasound imaging systems. ATL retained no ownership in us following the spin-off. We entered into a technology transfer and license agreement with ATL pursuant to which we took ownership of certain ultrasound technology developed as part of a government grant and also patent rights, which had been established or were being pursued for that technology. As part of this agreement, we also entered into a cross-license whereby we have the exclusive right to use certain ATL technology existing on April 6, 1998 or developed by ATL during the three-year period following April 6, 1998 in ultrasound systems weighing 15 pounds or less, and ATL has the exclusive right to use our technology existing on April 6, 1998 or developed by us during the same three-year period in ultrasound systems weighing more than 15 pounds. On April 6, 2003, this cross-license became nonexclusive and, except for the patented technology of each party, extends to all ultrasound systems regardless of weight. We sold our first products in September 1999.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to product returns, bad debts, inventories, investments, warranty obligations, service contracts, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. The results form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies require our more significant judgments and estimates used in the preparation of our consolidated financial statements:

Accounts receivable. We provide an allowance for doubtful accounts based upon specific customer risks and a general provision based upon historical trends. Losses can be difficult to anticipate. For example, in 2002, we wrote off approximately $400,000 of our Argentine receivables due to adverse economic conditions in Argentina. An increase in losses beyond those expected by management would reduce earnings when they become known.

Revenue recognition. We recognize revenue on products and accessories when goods are shipped under an agreement with a customer, risk of loss and title have passed to the customer and collection of any resulting receivable is reasonably assured. For service contracts, revenue is recognized over the term of the contract. Revenue is recorded net of estimated returns. Sales discounts are recorded as a reduction in revenue.

In connection with sales to certain specific international customers, we sometimes conclude that full collection of the related accounts receivable is not reasonably assured due to extended payment terms or the financial condition of our customer and, consequently, we do not recognize revenue or cost of revenue at the time of title transfer. In instances where collection is not reasonably assured, revenue and cost of revenue are recorded when cash is received.

Valuation of inventories. Inventories are stated at the lower of cost or market on a first-in, first-out method. Included in our inventories balance are demonstration products used by our sales representatives and marketing department and items that have been shipped to customers for which revenue recognition requirements have not been met. Cost adjustments are recorded for obsolete material, earlier generation products and used product held either as saleable inventory or as demonstration product. The adjustments reduce their carrying values to amounts not lower than that which will result in approximately normal profit margins upon sale. Inventory items for which title has passed to customers are evaluated for recoverability based on the same process we use to evaluate collection of accounts receivable.

We make judgments regarding the carrying value of our inventory based on current market conditions. Market conditions may change depending upon competitive product introductions, consumer demand and reimbursement criteria in the medical community. If market conditions change or if the introduction of new products by us impacts the market for our previously released products, we may be required to write-down the cost of our inventory.

Warranty expense. We accrue estimated warranty expenses at the time of sale for costs expected to be incurred under our product warranties. This provision for warranty expenses is made based upon our historical experience and management’s judgment. We have limited history with some of our products. Any unexpected increase in defects would result in an increase in warranty expense and a reduction in earnings.

Results of Operations for the Three Months and Nine Months Ended September 30, 2003 and September 30, 2002

Revenue

Revenue increased to $20.2 million for the three months ended September 30, 2003, compared to $18.5 million for the three months ended September 30, 2002. Revenue increased to $57.5 million for the nine months ended September 30, 2003, compared to $47.9 million for the nine months ended September 30, 2002. The increase in both periods was primarily due to an increase in sales in the United States and Europe. The first shipments of TITAN occurred in June 2003 and accounted for approximately 30% of our revenue in the third quarter of 2003 and 19% of our revenue for the nine months ended September 30, 2003.

Total U.S. revenue increased to $13.6 million, or 67% of total revenue, for the three months ended September 30, 2003, compared to $11.1 million, or 60% of total revenue, for the three months ended September 30, 2002. Total U.S. revenue increased to $36.8 million, or 64% of total revenue, for the nine months ended September 30, 2003, compared to $27.8 million, or 58% of total revenue, for the nine months ended September 30, 2002. The increase in both periods was primarily due to initial sales of the TITAN system and increased military sales.

Revenue from Japan decreased to $253,000, or 1% of total revenue, for the three months ended September 30, 2003, compared to $1.9 million, or 10% of total revenue, for the three months ended September 30, 2002. Revenue from Japan decreased to $578,000, or 1% of total revenue, for the nine months ended September 30, 2003, compared to $5.0 million, or 10% of total revenue, for the nine months ended September 30, 2002. The decrease in both periods was primarily due to a decrease in orders from our distributor, Olympus. The Olympus organization has undergone significant organizational changes, which have affected its ability to provide sufficient sales and marketing focus on our products. As a result, we are working to establish additional distribution relationships in Japan.

Revenue from Europe, Africa and the Middle East increased to $4.7 million, or 23% of total revenue, for the three months ended September 30, 2003, compared to $3.7 million, or 20% of total revenue, for the three months ended September 30, 2002, due to an increase in revenue from direct sales in the United Kingdom, France and Germany. Changes in exchange rates accounted for approximately $330,000 of the increase in revenue. Revenue from Europe, Africa and the Middle East increased to $13.9 million, or 24% of total revenue, for the nine months ended September 30, 2003, compared to $9.6 million, or 20% of total revenue, for the nine months ended September 30, 2002, due to an increase in revenue from direct sales in the United Kingdom, France, Germany and Spain. Changes in exchange rates accounted for approximately $1.2 million of the increase in revenue. In Germany, recent health care reform introduced a Diagnosis Related Group (“DRG”) system that changes health care reimbursements from a “per day” reimbursement to a “per case” reimbursement. This change caused hospital administrators to delay capital equipment purchases as they evaluate the impact of the new system. Although revenue from Germany increased in both periods on a comparable basis, this delay has negatively impacted our sales expectations in Germany in 2003 and is expected to have a negative impact on our sales expectations for the balance of 2003.

Revenue from Canada, Australia, South and Latin America and Asia (excluding Japan) was $1.8 million, or 9% of total revenue, for the three months ended September 30, 2003, compared to $1.8 million, or 10% of total revenue, for the three months ended September 30, 2002. Revenue from Canada, Australia, South and Latin America and Asia (excluding Japan) increased to $6.3 million, or 11% of total revenue, for the nine months ended September 30, 2003, compared to $5.6 million, or 12% of total revenue, for the nine months ended September 30, 2002, primarily due to increased revenue from Australia, Argentina and India.

Gross margin

Gross margin increased to 63.5% for the three months ended September 30, 2003, compared to 59.5% for the three months ended September 30, 2002. Gross margin increased to 63.0% for the nine months ended September 30, 2003, compared to 58.6% for the nine months ended September 30, 2002. The increase in gross margin was primarily due to improved manufacturing efficiencies and increased average selling prices. The increased average selling prices resulted primarily from initial sales of the TITAN system, an increase in the percentage of direct sales compared with distributor sales, and for the nine month period, an increase in sales with advanced-feature configurations.

Operating expenses

Research and development expenses were $2.7 million for the three months ended September 30, 2003, compared to $2.9 million for the three months ended September 30, 2002. Research and development expenses were $8.4 million for the nine months ended September 30, 2003, compared to $9.2 million for the nine months ended September 30, 2002. Research and development expenses decreased in both periods primarily due to expenses incurred in 2002 associated with the development of the TITAN and the iLook products combined with a reduction in product development costs in the first three quarters of 2003 due to the completion of the TITAN system, which first shipped to customers in June 2003.

Sales and marketing expenses were $9.1 million for the three months ended September 30, 2003, compared to $9.3 million for the three months ended September 30, 2002. The decrease was primarily due to a decrease in marketing expenses as the third quarter of 2002 included significant marketing expenses related to the launch of our iLook products. Sales and marketing expenses were $27.6 million for the nine months ended September 30, 2003, compared to $23.4 million for the nine months ended September 30, 2002. The increase was primarily due to TITAN product launch expenses both in the U.S. and Europe, and an increase in compensation expense associated with the increase in revenue. In addition, expenses rose due to the increase, year over year, in the number of sales representatives in Europe and clinical application specialists in the U.S., and expenses associated with the reconfiguration of our U.S. sales territories in early 2003.

General and administrative expenses were $1.7 million for the three months ended September 30, 2003, compared to $1.6 million for the three months ended September 30, 2002. General and administrative expenses were $5.4 million for the nine months ended September 30, 2003, compared to $4.6 million for the nine months ended September 30, 2002. The increase in general and administrative expenses in both periods was primarily related to supporting our business growth and, additionally for the nine month period, due to expenses associated with medical reimbursement activities.

Other income

Other income increased to $420,000 for the three months ended September 30, 2003, compared to $348,000 for the three months ended September 30, 2002. The increase was due to foreign currency transaction gains of approximately $157,000 in the third quarter of 2003. Other income increased to $1.1 million for the nine months ended September 30, 2003, compared to $451,000 for the nine months ended September 30, 2002. The increase was due to investment income on proceeds from the sale of 2,700,000 shares of common stock in May 2002 and foreign currency transaction gains of approximately $320,000 in the first nine months of 2003.

Liquidity and Capital Resources

Our cash and cash equivalents balance was $13.1 million as of September 30, 2003, compared to $26.4 million as of December 31, 2002. Cash and cash equivalents were primarily invested in money market accounts.

Operating activities used cash of $5.0 million for the nine months ended September 30, 2003 compared to $4.8 million for the nine months ended September 30, 2002. The increase in cash used in 2003 compared with 2002 was primarily due to a decrease in accounts payable due to the timing of payments, offset by a reduction in our net loss and a decrease in accounts receivable. As of September 30, 3003, we had a commitment to purchase approximately $3.4 million of integrated circuit chips (see “Concentration of credit and supply risk” above for further information).

Investing activities used cash of $10.8 million for the nine months ended September 30, 2003, compared to cash used of $33.4 million for the nine months ended September 30, 2002. The decrease in cash used in 2003 compared with 2002 was primarily due to a decrease in net purchases of investments.

We anticipate using cash to invest in high quality investment instruments during the remainder of 2003, the extent of which will be dependent upon the interest rate environment during the period and the timing of cash flows from our operations during the period.

Financing activities provided cash of $2.3 million for the nine months ended September 30, 2003, compared to $42.7 million for the nine months ended September 30, 2002. The main source of cash provided by financing activities in 2003 was the exercise of stock options totaling $2.4 million, compared to $0.2 million in 2002. The main source of cash provided by financing activities in 2002 was the sale of 2,700,000 shares of common stock in May 2002.

We anticipate that cash used in operations will decrease in 2003 compared to 2002 primarily due to anticipated decreases in our net loss. This decrease in cash used in operations will be dependent upon our ability to successfully sell our products, collect our receivables, control our inventories and manage our expenses.

We believe that our existing cash, cash equivalents and investment securities will be sufficient to fund our operations and capital expenditure requirements for at least the next 12 months. Nevertheless, we may experience an increased need for additional cash due to:

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any significant decline in our revenue or gross margins;

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any delay or inability to collect accounts receivable;

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any acquisition or strategic investment in another business;

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any significant increase in expenditures as a result of expansion of our sales and marketing infrastructure, our manufacturing capability, including commitments to purchase significant quantities of components, and our product development activities;

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any significant increase in our sales and marketing expenditures as a result of our introduction of new products or product upgrades; and

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any significant increase in expenditures related to the Neutrino patent infringement litigation.

Important Factors That May Affect Our Business, Our Results of Operations and Our Stock Price

If our products, including our new TITAN^™ modular ultrasound system, do not gain market acceptance, we will fail to generate sufficient revenue to maintain our business.

The market for point-of-care, high performance ultrasound systems is relatively new and largely undeveloped. We seek to sell our products to current users of ultrasound, as well as to physicians and other healthcare providers who do not currently use ultrasound. The success of our products depends on their acceptance by the medical community, patients and third-party payors as medically useful, safe and cost-effective.

In June 2003, we began shipping to customers our newest product, the SonoSite TITAN ultrasound system. Sales of TITAN accounted for approximately 30% of our revenue in the third quarter of 2003. The TITAN system has a modular design allowing both stationary and mobile usage and is based on the next generation of our proprietary ASIC, or application specific integrated circuit, technology. Along with the point-of-care market, we have positioned the TITAN system to compete in the traditional stationary ultrasound cart market.

Users of stationary ultrasound carts may not accept the TITAN system, which could discourage widespread new users and uses for the TITAN. Our new or existing customers may not accept the TITAN due to pricing and functionality differences. If demand for the TITAN differs from our projections, we may experience excess inventory levels or inventory shortages and may be unable to generate sufficient revenue to grow our business. If we are unable to gain market acceptance for our products generally, we will fail to generate sufficient revenue to maintain our business.

If we are unable to compete effectively, we will fail to generate sufficient revenue to maintain our business.

We currently face competition from companies that manufacture cart-based and portable ultrasound systems. The dominant competitors in this industry are GE Medical Systems, a unit of General Electric Company, Siemens AG and Philips Medical Systems, a unit of Koninklijke Philips Electronics, N.V. that owns two other competitors, Agilent Healthcare Solutions Group and ATL, our former parent company. These competitors are very large, global organizations and have the following advantages over us:

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greater financial and infrastructure resources;

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larger research and development staffs;

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greater experience in product manufacturing, marketing and distribution;

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greater brand name recognition; and

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long-standing relationships with many of our potential customers.

These manufacturers of cart-based and portable ultrasound systems could use their greater resources to increase and withstand competition through various means, including price and payment terms, product quality, market penetration, employee compensation, hospital systems integration and complementary services such as warranty protection, maintenance and product training. Existing product supply relationships between these companies and our potential customers could discourage widespread adoption of our products due to brand loyalty or preferred customer discounts. Competition from these companies for employees with experience in the primary point-of-care market could result in higher turnover of our employees. If we are unable to respond to competitive pressures from the cart-based and portable ultrasound markets, we could experience delayed or reduced market acceptance of our products, higher expenses and lower revenue.

In addition, as the market for point-of-care, high performance ultrasound systems develops, we expect competition to increase as potential and existing competitors enter the point-of-care market or modify their existing products to more closely approximate the combined portability, quality, performance and cost of our products. Our current competitors in the point-of-care market include GE Medical Systems, Agilent/Philips Medical Systems, Biosound Esaote, Inc., Medison America Inc., a subsidiary of Medison Company, Ltd., and Terason, a division of TeraTech Corporation. Other potential entrants to the point-of-care market include ZONARE Medical Systems, Inc. (formerly Novasonics, Inc.). These competitors may develop highly portable or point-of-care ultrasound systems that offer the same or greater reliability and quality, perform greater or more useful functions, or are more cost-effective than our products. Some of these competitors may also be able to use their marketing resources to gain a competitive advantage by more effectively building brand awareness of their products. If we are unable to compete effectively with new entrants to the point-of-care, high performance ultrasound market, we will be unable to generate sufficient revenue to maintain our business.

If our competitors develop and market medical imaging devices that render our products obsolete or noncompetitive, we will be unable to compete.

The life cycles of our products are difficult to estimate. Our products could become obsolete or unmarketable if:

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our competitors introduce ultrasound systems that are superior to ours;

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other products using new technologies emerge; or

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industry standards exceed our products’ capabilities.

If we fail to enhance our existing products or develop and market new products, our products will become obsolete and we will be unable to compete.

If healthcare reimbursement practices or reform restricts coverage available to our customers for the use of our products, we may experience limited market acceptance of our products.

Market acceptance of our products depends in part on the extent to which our customers receive reimbursement for the use of our products from governmental authorities such as Medicare, private health insurers and other third-party payors. Our customers generally have received reimbursement for ultrasound procedures performed using our products consistent with reimbursement criteria applicable to ultrasound procedures generally. The continuing efforts of governmental authorities, private health insurers and other third-party payors to contain or reduce the costs of healthcare through various means may, however, limit market acceptance of our products and, therefore, may affect our ability to market our current products, commercialize our potential products and become profitable. Reimbursement coverage, to the extent available, may not be adequate to enable us to achieve market acceptance of our products. In addition, we believe that third-party payors will attempt to reduce healthcare costs by limiting both coverage and level of reimbursement for new products cleared by the FDA or comparable foreign agencies. The efforts of government and third-party payors to contain or reduce the cost of healthcare could restrict physicians’ and other healthcare providers’ willingness to select our products and implement new ultrasound procedures, which could delay or reduce market acceptance of our products.

In the first half of 2003, six Medicare carriers adopted policies that precluded Part B Medicare reimbursement for ultrasound procedures conducted with hand-carried ultrasound units described as “lightweight ultrasound machines with Doppler capability.” The notices restricted coverage for devices that “allow only a limited view of structures.” These policies applied to Medicare reimbursement of health care providers in twenty-two states, including California and upstate New York.

In all states, these policies have been revised to allow payment for studies performed with hand-carried ultrasound units. The new policies, recognizing that many hand-carried ultrasound systems have functionality equal to that of cart-based ultrasound systems, define the requirements of medical necessity, completeness and documentation required of all ultrasound services, regardless of the equipment that is used to supply the service. In all states, there are no longer any billing restrictions in place for hand-carried ultrasound that do not also exist for cart-based ultrasound and that were not in place prior to the adoption of these original policies.

Additionally, there has been and will likely continue to be a number of federal and state proposals to implement government controls on pricing. The existence and adoption of these proposals could affect our ability to successfully market our current products and commercialize new products.

In Germany, recent health care reform introduced a Diagnosis Related Group (“DRG”) system that changes health care reimbursements from a “per day” reimbursement to a “per case” reimbursement. This change caused hospital administrators to delay capital equipment purchases as they evaluate the impact of the new system. Although revenue from Germany increased in 2003 compared to 2002, this delay has negatively impacted our sales expectations in Germany in 2003 and is expected to have a negative impact on our sales expectations for the balance of 2003. If similar changes in health care reimbursement are adopted in other countries, they could affect our ability to successfully market our products.

Changes in the health care industry may require us to decrease the selling price for our products or could result in a reduction in the size of the market for our products, each of which could have a negative impact on our financial performance.

Trends toward managed care, health care cost containment, and other changes in government and private sector initiatives in the United States and other countries in which we do business are placing increased emphasis on the delivery of more cost-effective medical therapies, which could adversely affect the sale and/or the prices of our products. For example:

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Major third-party payers of hospital and pre-hospital services, including Medicare, Medicaid and private health care insurers, have substantially revised their payment methodologies during the last few years which has resulted in stricter standards for reimbursement of hospital and pre-hospital charges for certain medical procedures;

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Numerous legislative proposals have been considered that would result in major reforms in the U.S. health care system that could have an adverse effect on our business;

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There has been a consolidation among health care facilities and purchasers of medical devices in the United States who prefer to limit the number of suppliers from whom they purchase medical products, and these entities may decide to stop purchasing our products or demand discounts on our prices;

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There is economic pressure to contain health care costs in international markets; and

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There are proposed and existing laws and regulations in domestic and international markets regulating pricing and profitability of companies in the health care industry.

These trends could lead to pressure to reduce prices for our products and could cause a decrease in the size of the market or a potential increase in competition that could adversely affect our levels of revenue and profitability of sales, which could have a material adverse effect on our business.

If traditional providers of ultrasound examinations discourage potential new users from adopting our products, we could experience limited demand for our products.

In traditional ultrasound practice, physicians and other healthcare providers typically refer patients to centralized locations where radiologists and other specialized personnel provide ultrasound examinations. Although our products are currently used by radiologists, our products also enable the delivery of ultrasound examinations at the primary point of care by the examining physician or healthcare provider. Radiologists and other ultrasound specialists have a professional and financial interest in maintaining traditional ultrasound practices. If these traditional providers of ultrasound examinations discourage other healthcare providers from adopting our products, we could experience limited demand for our products.

If the training and education necessary to conduct ultrasound examinations is not adequate or not readily available, this could discourage new users from adopting our products, which could affect demand for our products.

We seek to sell our products to customers already experienced in ultrasound procedures, as well as to physicians and other healthcare providers who do not currently use ultrasound imaging systems or administer ultrasound examinations. Although customers who are experienced in ultrasound procedures will need little, if any, specialized training to use our products, any new users of ultrasound will require training and education to properly administer ultrasound examinations. If these potential customers are unable or unwilling to be trained due to cost, time constraints, unavailability of courses or other reasons, we could experience limited demand for our products.

If our suppliers, including our single-source suppliers, fail to supply us with the components that we need to manufacture our products on a timely basis, we could experience production delays, cost increases and lost sales.

We depend on suppliers, including some single-source suppliers, to provide highly specialized parts, such as custom-designed integrated circuits, cable assemblies and transducer components. We also depend on single-source suppliers to provide other components, such as image displays, batteries, capacitors and cables. We do not maintain significant inventories of components, and may experience an interruption of supply if a supplier is unable or unwilling to meet our time, quantity and quality requirements. There are relatively few alternative sources of supply for some of these components. An increase in demand for some parts by other companies could also interrupt our supply of components. We have in the past experienced supply problems in timeliness and quality, but to date these problems have not resulted in lost sales or lower demand. Nevertheless, if we experience an interruption of supply or are required to switch suppliers, the manufacture and delivery of our products could be interrupted, our manufacturing costs could substantially increase and we could lose substantial amounts of product sales.

In March 2003, one of our component suppliers, Philips Semiconductor (“Philips”), informed us that, commencing in September 2003, it would discontinue production of our integrated circuit chips using 0.35-micron technology. We have designed and implemented a new chip using 0.2-micron technology that will continue to be produced by Philips to replace all but one of the discontinued chips. We expect to design and implement an additional new chip to replace the remaining 0.35-micron chip by early 2005. In the second quarter of 2003, we entered into a purchase commitment totaling approximately $3.6 million for supplies of 0.35-micron chips from Philips for our anticipated manufacturing needs until new chips have been incorporated in all of our products. We pay for these chips at the time deliveries are made to us. As of September 30, 2003, our remaining purchase commitment was approximately $3.4 million. On December 31, 2004, we are required to take possession of, and pay for, the balance of the undelivered chips. Demand for our products, however, may exceed our forecasts, in which case we would require additional 0.35-micron chips to manufacture additional products. Conversely, if demand for our products falls short of our forecasts, we may experience excess inventory of 0.35-micron chips. If our actual demand for these chips varies significantly from our forecasted demand, we may experience delays in manufacturing, lost sales, a write-down of inventory or a deterioration in gross margin.

If our suppliers or we fail to comply with U.S. and foreign governmental regulations applicable to our products and manufacturing practices, we could experience product introduction delays, production delays, cost increases and lost sales.

Our products, our manufacturing activities and the manufacturing activities of our third-party medical device manufacturers are subject to extensive regulation by a number of governmental agencies, including the FDA and comparable international agencies. Our third-party manufacturers and we are or will be required to:

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obtain prior clearance or approval from these agencies before we can market and sell our products;

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undergo rigorous inspections by domestic and international agencies; and

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

The manufacture and sale of our products are subject to extensive regulation by numerous governmental authorities, principally the FDA, as well as several other state and foreign agencies. The FDA requires that all medical devices introduced to the market be preceded either by pre-market notification clearance under Section 510(k) of the Federal Food, Drug & Cosmetic Act, or an approved pre-market approval application, or PMA. By granting 510(k) clearance, the FDA indicates agreement with an applicant’s determination that the product for which clearance has been sought is substantially equivalent to medical devices that were on the market prior to 1976 or have subsequently received clearance. The process of obtaining 510(k) clearance typically takes approximately two to three months. To date, we have not been required to file any PMAs and all of our products have received 510(k) clearance. In addition, foreign regulatory agencies also require similar pre-market clearance or registration before our products can be marketed or offered for sale in their countries. Any delays, or failures, in obtaining such clearances may result in lost sales.

In addition, the FDA requires us and our key medical device suppliers to demonstrate and maintain compliance with the FDA’s Quality System Regulation, or QSR, which covers the methods and documentation of the design, testing, production, control, quality assurance, labeling, packaging, shipping and servicing of our products. The FDA enforces the QSR through periodic inspections; the FDA inspected our manufacturing facility in September 2003. In addition, the British Standards Institution has performed several management systems assessments of our manufacturing processes. These inspections resulted in observations to which we submitted responses, and we believe these responses have been accepted by those agencies. Any failure to take corrective action in response to a QSR inspection could force a shutdown of our manufacturing operations, and a recall of, or field action relating to, our products. Also, in August 2001, the FDA classified as a class II field action a May 2000 software upgrade we issued to correct an error in an algorithm contained in one of our products. In September 2000, we provided purchasers of our products with a software upgrade to correct this error, and at the FDA’s request, we recently sent letters to these purchasers again to provide them with a final opportunity to upgrade the software at no charge. We expect that when this action is completed, we will receive final written closure from the FDA on this matter.

Compliance with the regulations of these agencies, including the Environmental Protection Agency and the Occupational Safety and Health Administration, may require us to incur substantial costs and may delay or prevent the introduction of new or improved products. Although to date these actions by regulatory bodies have not required us to incur substantial costs or delay product shipments, we expect to experience further inspections and incur additional costs as a result of governmental regulation. If we fail to comply with the laws and regulations pertaining to our business, we may be subject to fines, sanctions, including the temporary or permanent suspension of operations, product field actions, criminal prosecution and marketing restrictions. Our third-party medical device manufacturers may also be subject to the same sanctions if they fail to comply with the laws and regulations, and, as a result, may fail to supply us with components required to manufacture our products.

Our reliance on a single manufacturing facility may impair our ability to respond to natural disasters or other unforeseen catastrophic events.

Our sole manufacturing facility is located in a single building in Bothell, Washington. Despite precautions taken by us, a natural disaster such as an earthquake or other unanticipated catastrophic events at this building could significantly impair our ability to manufacture our products and operate our business. Our facility and certain manufacturing equipment would be difficult to replace and could require substantial replacement lead-time. Such catastrophic events may also destroy any inventory of product or components. While we carry insurance for natural disasters and business interruption, the occurrence of such an event could result in losses that exceed the amount of our insurance coverage, which would impair our financial results.

We have a history of losses, we expect future losses and we may never achieve sustained profitability.

With the exception of the fiscal quarter ended December 31, 2002, we have incurred net losses in each quarter since we commenced operations. As of September 30, 2003, we had an accumulated deficit of approximately $89.7 million. Although we incurred a loss in the fiscal quarter and nine months ended September 30, 2003, we expect to achieve one or more profitable quarters within the next several quarters. Even if we do achieve one or more profitable quarters, however, we may be unable to sustain or increase future profitability on a quarterly or annual basis. Additionally, our losses may increase if we cannot increase or sustain our revenue. With the exception of the fiscal quarter ended December 31, 2002, our revenue from product sales has been insufficient to cover our expenses. We expect that our operating expenses will increase in the foreseeable future as we expand our sales and marketing infrastructure, our administrative support and possibly our product development activities. Our expansion efforts, to be successful, may require more funding than we currently anticipate. Accordingly, we will need to generate significant additional revenue in the future before we will be able to sustain or increase profitability. If we cannot generate such revenue, we may never be profitable. If we fail to achieve sustained profitability, the market price for our common stock will likely fall.

A failure to manage our growth could impair our ability to achieve our business objectives.

We have experienced rapid growth since our inception as a stand-alone company. Our revenue increased from $32.0 million in 2000 to $45.7 million in 2001 and $73.0 million in 2002. We expect continued significant growth as we continue to develop, manufacture, market and sell our products. Our growth could strain our existing management, operational and financial resources. In order to manage our growth effectively, we will need to expand our manufacturing and quality assurance staff, our sales staff and our manufacturing capabilities. In addition, we will need to improve the productivity and efficiency of our existing operational, financial and management resources and information systems. We may be unable to hire and retain the personnel necessary to operate and expand our business. We also may be unable to increase the productivity and efficiency of our existing resources. If we fail to timely improve or augment our existing resources in response to our growth, we may be unable to effectively manage our business and achieve our objectives.

Our foreign distributors may be unwilling or unable to devote sufficient resources to market and sell our products, which could delay or reduce market acceptance and sales of our products outside the United States.

We currently depend on foreign distributors to help promote market acceptance and demand for our products in countries in which we do not have a direct sales force. For example, sales to our distributor in Japan, Olympus, represented 10% of our revenue in 2002, but only 1% of our revenue in the nine months ended September 30, 2003. Foreign distributors that are in the business of distributing other medical products may not devote the resources and support required within these countries to generate awareness of our products and grow or maintain product sales. If these distributors are unwilling or unable to market and sell our products, we could experience delayed or reduced market acceptance and sales of our products outside the United States.

In Japan, we have not achieved revenue growth the past two fiscal years. In late 2002, we examined the market for our product and confirmed a significant market opportunity that was not being realized by Olympus and their dealer network. In an effort to develop this market opportunity, we have been working on securing additional distribution relationships in Japan. The Olympus organization has undergone significant organizational changes, which have affected its ability to provide sufficient sales and marketing focus on our products. We have also begun the process of obtaining product licenses in SonoSite’s name, which will enable us to work with distributors in Japan other than Olympus. As a result, this transition has resulted in a significant reduction in revenue from Japan in fiscal 2003 compared with fiscal 2002.

Our lack of customer purchase commitments and our limited order backlog make it difficult to predict sales and plan manufacturing requirements, which can lead to lower revenue, higher expenses and reduced margins.

We do not generally have volume purchase commitments with our customers, who typically order products on a purchase order basis. In limited circumstances, customer orders may be cancelled, changed or delayed on short notice. Lack of significant order backlog or a significant recurring revenue stream makes it difficult for us to forecast future sales with certainty. Varying sales cycles with our customers make it difficult to accurately forecast component and product requirements. These factors expose us to a number of risks:

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If we overestimate our requirements, we may be obligated to purchase more components or third-party products than is required;

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If we underestimate our requirements, our third-party manufacturers and suppliers may have an inadequate product or product component inventory, which could interrupt manufacturing of our products and result in delays in shipments and revenue;

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We may also experience shortages of product components from time to time, which also could delay the manufacturing of our products; and

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Over or under production can lead to higher expenses, lower than anticipated revenue, and reduced margins.

Our creation, maintenance and expansion of direct sales and distribution operations will require a significant investment of our financial and management resources and may fail to generate a substantial increase in sales.

We have historically relied on third-party distributors to sell our products in Europe and Asia. In 2001, we commenced operations in the United Kingdom and France, and in 2002, we commenced operations in Germany and Spain to sell our products directly in each of those countries. In 2003, we entered into a joint venture with a partner in China to sell our products there. We recently hired a vice president for international sales and, as a result, we expect our foreign direct sales operations to grow. Establishing, maintaining and expanding these operations will require us to:

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substantially increase our costs of operations;

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temporarily divert existing management resources;

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establish an efficient and self-reliant local infrastructure;

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attract, hire and train qualified local sales and administrative personnel;

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comply with additional local regulatory requirements; and

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expand our information, financial, distribution and control systems to manage expanded global operations.

Our movement into Europe and Asia has required, and will continue to require, substantial financial and management resources. The costs of this expansion are unpredictable, difficult to control and may exceed budgeted amounts. We have experienced some operating challenges with our European operations. In Germany, recent health care reform caused hospital administrators to delay capital equipment purchases as they evaluate the impact of the new system. Although revenue from Germany increased in 2003 compared to 2002, this delay has negatively impacted our sales expectations in Germany in 2003 and is expected to have a negative impact on our sales expectations for the balance of 2003. In France and Spain, we have experienced challenges related to the performance of certain sales representatives. Despite our expenditures and efforts, we may not generate a substantial increase in European or Asian revenue, which would impair our operating results.

Our foreign revenue is subject to currency fluctuation and other risks associated with doing business outside the United States.

The percentage of our revenue originating outside the United States equaled 42% in fiscal 2002 and 36% in the nine months ended September 30, 2003. Of this foreign revenue, approximately 25% originated in Japan in fiscal 2002 and 3% in the nine months ended September 30, 2003. Our revenue from international sales may be adversely affected by any of the following risks:

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currency rate fluctuations;

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adverse political or economic conditions;

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reduced protection for intellectual property rights;

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longer receivables collection periods and greater difficulty in receivables collection;

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localizing products for foreign markets; and

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compliance with export laws, including license requirements, trade restrictions and tariff increases.

As of September 30, 2003, 43% of our outstanding accounts receivable balance was from international customers. We regularly review our receivable positions in foreign countries for any indication that collection may be at risk. For example, due to economic events in Argentina, including the decision to allow the Argentine peso to float against the U.S. dollar, we wrote off $400,000 of our Argentine receivables in 2002, for which we had already established an allowance.

Our efforts to integrate the business and technology of any future acquisition, even if successful, may result in significant costs or create significant disruptions that outweigh the benefits of any such acquisition.

As part of our business strategy, we may acquire other companies, products or technologies. We may fail in our attempt to successfully integrate into our business the operations, technology, products, customers, suppliers and personnel of any such acquired business or technology. Even if integration is successful, any such acquisition may include costs for:

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integration of operations, including combining teams and processes in various functional areas;

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integration of new technology into our products;

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fees and expenses of professionals involved in completing the integration process; and

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potential existing liabilities of any future acquisition target.

Additionally, our efforts to consummate an acquisition or to successfully integrate any such acquisition could place a significant burden on our management and internal resources, disrupting our business. If we fail in our attempts to integrate any acquired business or technology, or if the costs and burdens of such acquisition or integration outweigh the benefits of such acquisition, our financial resources or financial results could be impaired.

The loss of any principal member of our management team or product development staff, on whom we rely heavily, could impair our ability to compete.

Our success depends heavily on our ability to retain the services of the principal members of our management team and product development staff. Competition among medical device companies for qualified employees is intense. We may fail to retain these key employees, and we may fail to attract qualified replacements if they do leave. We do not maintain key-person insurance on any of our employees. We do not have employment agreements with any of our employees, except in certain countries outside the United States. The loss of any of our key employees could significantly delay or prevent the achievement of our product development or business objectives.

If we are unable to protect and enforce our intellectual property rights, we may be unable to compete effectively.

Much of our value arises out of our proprietary technology and intellectual property for the design, manufacture and use of point-of-care ultrasound imaging systems. Our success and ability to compete effectively depend on our ability to protect our proprietary information. We rely on patent, copyright, trade secret and trademark laws to protect our proprietary technology and limit the ability of others to compete with us using the same or similar technology.

We currently hold 16 patents relating to our technology. A number of other patents are pending in the United States and in foreign jurisdictions. Additionally, we have a license from our former parent, ATL, to use certain ATL technology and ATL technological developments in our point-of-care products. This license was exclusive through April 5, 2003, and became nonexclusive after that date. We also enter into confidentiality or license agreements with our employees, consultants and corporate partners, and generally control access to, and the distribution of, our product designs, documentation and other proprietary information, as well as the designs, documentation and other information that we license from others.

Our efforts afford only limited protection and may not adequately protect our rights to the extent necessary to sustain any competitive advantage we may have. Despite our efforts to protect our intellectual property, we may experience:

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unauthorized use of our technology by competitors;

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independent development of the same or similar technology by a competitor, coupled with a lack of enforceable patents on our part;

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failure of our pending patent applications to result in issued patents;

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successful interference actions to our patents, successful patent infringement lawsuits or successful oppositions to our patents and patent applications;

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unauthorized disclosure or use of our proprietary information by former employees or affiliates; and

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failure by our commercial partners to comply with their obligations to share technology or use our technology in a limited manner.

Policing unauthorized use of our intellectual property will be difficult and may be cost-prohibitive. We may fail to prevent misappropriation of our technology, particularly in countries where the laws may not protect our proprietary rights to the same extent as do the laws of the United States. If we cannot prevent other companies from using our proprietary technology or if our patents are found invalid or otherwise unenforceable, we may be unable to compete effectively against other manufacturers of ultrasound systems, which could decrease our market share.

Existing or potential intellectual property claims and litigation may divert our resources and subject us to significant liability for damages, substantial litigation expense and the loss of our proprietary rights.

In order to protect or enforce our patent rights, we may initiate patent litigation. In addition, others may initiate patent litigation against us. We may become subject to interference proceedings conducted in patent and trademark offices to determine the priority of inventions. There are numerous issued and pending patents in the ultrasound field. The validity and breadth of medical technology patents may involve complex legal and factual questions for which important legal principles may remain unresolved. In addition, because patent applications can take many years to result in issued patents and are maintained in confidence by the U.S. Patent and Trademark Office while pending, there may be currently pending applications of which we are unaware, which may later result in issued patents that our products may infringe. There could also be existing patents of which we are not aware that one or more of our products may infringe. Litigation may be necessary to:

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assert or defend against claims of infringement;

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enforce our issued and licensed patents;

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protect our trade secrets or know-how; or

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determine the enforceability, scope and validity of the proprietary rights of others.

We may become involved in the defense and prosecution, if necessary, of intellectual property suits, patent interferences, opposition proceedings and other administrative proceedings. For example, on July 24, 2001, Neutrino Development Corporation filed a complaint against us in U.S. District Court, Southern District of Texas, Houston Division, alleging infringement of U.S. Patent 6,221,021, or the ‘021 patent, by SonoSite as a result of our use, sale and manufacture of the SonoSite 180, SonoSite 180 PLUS, SonoHeart and SonoHeart PLUS devices. The complaint asserts claims for preliminary and permanent injunctive relief enjoining all alleged acts of infringement, compensatory and enhanced damages, attorney’s fees and costs, and pre- and post-judgment interest. On August 14, 2001, we filed an answer asserting affirmative defenses of non-infringement and patent invalidity, and included a counterclaim seeking a declaratory judgment of non-infringement and invalidity regarding Neutrino’s patent. On October 4, 2001, the court denied a request by Neutrino for preliminary injunctive relief to prevent us from manufacturing and selling our products pending the ultimate disposition of the litigation. On February 20, 2002, in what is known as a “Markman” hearing, the parties presented their arguments regarding the proper construction of Neutrino’s patent claims.

Our involvement in intellectual property claims and litigation could:

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divert existing management, scientific and financial resources;

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subject us to significant liabilities;

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allow our competitors to market competitive products without obtaining a license from us;

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cause product shipment delays and lost sales;

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require us to enter into royalty or licensing agreements, which may not be available on terms acceptable to us, if at all; or

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force us to modify or discontinue selling our products, or to develop new products.

The termination or other loss of our license to use certain ATL technology would significantly impair our ability to manufacture, market and sell our products.

We license certain technology from ATL that is incorporated into our single technology platform, and we use this ATL technology in all of our point-of-care ultrasound imaging systems. Virtually all of our revenue is attributable to products incorporating this ATL technology.

ATL may terminate our license in the event of an uncured material default by us in our obligations under the license agreement. Although many key aspects of our technology platform—including the high level of miniaturization that allows us to manufacture our systems—are independently owned by us under the terms of our spin-off from ATL, the termination or other loss of our license to use ATL technology would significantly impair our ability to manufacture, market and sell our products. If this happens, we may be unable to generate sufficient revenue to maintain our business.

Product liability and other claims and product field actions could increase our costs, delay or reduce our sales and damage our reputation, which could significantly impair our financial condition.

Our business exposes us to the risk of product liability, malpractice or warranty claims inherent in the sale and support of medical device products, including those based on claims that the use or failure of one of our products resulted in a misdiagnosis or harm to a patient. Such claims may damage our reputation by raising questions about our products’ safety and efficacy, and could interfere with our efforts to market our products. Although to date we have not been involved in any medical malpractice or product liability litigation, we may incur significant liability if such litigation were to occur. We may also face adverse publicity resulting from product field actions or regulatory proceedings brought against us. Although we currently maintain liability insurance in amounts we believe are commercially reasonable, any product liability we incur may exceed our insurance coverage. Liability insurance is expensive and may cease to be available on acceptable terms, if at all. A product liability or other claim or product field action not covered by our insurance or exceeding our coverage could significantly impair our financial condition. In addition, a product field action or a liability claim against us could significantly harm our reputation and make it more difficult to obtain the funding and commercial relationships necessary to maintain our business.

If our stock price continues to be volatile, your shares may decline in value.

The market price for our common stock, as well as for securities of emerging growth companies generally, has been volatile in the past and is likely to continue to be volatile. You may be unable to resell your shares at or above the price you paid due to a number of factors, many of which are beyond our control, including:

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the difference between quarterly operating results and those expected by investors or securities analysts;

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changes in earnings estimates by analysts;

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the loss of significant orders;

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announcements of technological innovations or new products by our competitors;

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changes in the structure of healthcare financing and payment systems;

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general conditions in the medical industry or global economy;

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a lack of liquidity in the market for our stock; and

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a significant sale or sales of our common stock by one or more of our shareholders.

Our future capital-raising activities or acquisition of businesses or assets could involve the issuance of equity securities, which would dilute your investment and could result in a decline in the trading price of our common stock.

To meet our long-term funding requirements, we may sell securities in the public or private equity markets if and when conditions are favorable, even if we do not have an immediate need for additional capital at that time. For example, in May 2002, we raised net proceeds of $42.6 million through the sale of 2,700,000 shares of our common stock. Furthermore, we may enter into financing transactions at prices that represent a substantial discount to market price. In addition, we may issue a significant amount of our securities in connection with our purchase of, or strategic investment in, other businesses or assets. Raising funds or paying for acquisitions through the issuance of equity securities will dilute the ownership of our existing shareholders. A negative reaction by investors and securities analysts to any sale or issuance of our equity securities could result in a decline in the trading price of our common stock.

The concentrated ownership of our common stock could delay or prevent a change of control, which could cause a decline in the market price of our common stock.

As of September 30, 2003, our executive officers, directors and affiliated entities together beneficially owned approximately 5.6% of the outstanding shares of our common stock. Based on currently available information, seven other shareholders owned in the aggregate approximately 49.1% of the outstanding shares of our common stock. Among these shareholders, the State of Wisconsin Investment Board, or SWIB, owned approximately 13.3% of the outstanding shares of our common stock and WM Advisors owned approximately 9.4%. As a result, these shareholders or any other concentrated owner may be able to exert significant influence over all matters requiring shareholder approval, including the election of directors, matters relating to the attraction and retention of employees, such as stock option plans, and approval of significant corporate transactions that could include certain matters relating to future financing arrangements and unsolicited tender offers. This concentration of ownership may delay, deter or prevent a third party from acquiring control over us at a premium over the then-current market price of our common stock, which could result in a decline in our stock price.

Our restated articles of incorporation, our bylaws, Washington law and some of our agreements contain provisions that could discourage a takeover and prevent shareholders from receiving a premium for their shares.

There are provisions in our restated articles of incorporation, our bylaws and Washington law that make it more difficult for a third party to obtain control of us, even if doing so would be beneficial to our shareholders.

Additionally, our acquisition may be made more difficult or expensive by the following:

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change of control provisions in our license agreement with ATL, which require us to pay ATL $75 million if, at any time between April 6, 2003 and April 6, 2006, any single person or entity engaged in the medical diagnostic imaging business, other than through the sale or manufacture of our products, obtains, directly or indirectly, voting control of a majority of our common stock or the power to elect our entire board of directors;

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acceleration provisions in benefit plans and change-in-control agreements with our employees; and

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our shareholder rights plan, which is designed to dilute a hostile acquiror’s interest so that the acquisition becomes prohibitively expensive. Under our rights plan, each of our shareholders has one share purchase right for each share of common stock held, with each right having an exercise price approximating our board of directors’ estimate of the long-term value of one share of our common stock. The rights are triggered if an acquiror acquires, or successfully makes a tender offer for, 20% or more of our outstanding common stock. In such event, each shareholder other than the acquiror would have the right to purchase, at the exercise price, a number of newly issued shares of our capital stock at a 50% discount. If the acquiror were to acquire 50% or more of our assets or earning power, each shareholder would have the right to purchase, at the exercise price, a number of shares of acquiror’s stock at a 50% discount. Our board of directors may redeem the rights at a nominal cost at any time before a person acquires 20% or more of our outstanding common stock, which allows board-approved transactions to proceed. In addition, our board of directors may exchange all or part of the rights (other than rights held by the acquiror) for such number of shares of our common stock equal in value to the exercise price. Such an exchange produces the desired dilution without actually requiring our shareholders to purchase shares.

If we incur a tax liability in connection with our spin-off from ATL, we would be required to pay a potentially significant expense, which would diminish our financial resources.

Our spin-off was treated by ATL as a tax-free spin-off under Section 355 of the Internal Revenue Code of 1986. If ATL were to recognize taxable gain from the spin-off, the Internal Revenue Service, or IRS, could impose that liability on any member of the ATL consolidated group as constituted prior to the spin-off, including us. Generally, the IRS may assert that our spin-off from ATL is a taxable transaction until the expiration of the statute of limitations applicable to ATL with respect to the spin-off transaction. The expiration of the statute of limitations with respect to the spin-off transaction depends upon the actions and tax filings of ATL and the special rules applicable to spin-offs in general, which special rules could result in the extension of the general statute of limitations for an indefinite period of time. In the event of a tax liability, ATL has agreed to cover 85% of any such liability, unless the tax is imposed due to our actions solely or by ATL solely, in which case, we have agreed with ATL that the party who is solely at fault shall bear all of the tax liability. We are unaware of any actions that would result in a tax liability to us under the indemnity agreement regarding the spin-off transaction. We are aware that ATL was acquired in a transaction subsequent to the spin-off transaction, which could potentially result in the spin-off being treated as a taxable transaction, but which resulting tax liability in our view would be the sole responsibility of ATL pursuant to our agreement with ATL. ATL may refuse, however, to indemnify us for a tax liability arising out of the spin-off transaction or may argue that it did not cause the tax liability to be imposed. In such event, we may incur a significant expense for all or a portion of the taxes related to the spin-off.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest rate risk

We are exposed to market risk relating to changes in interest rates, which could adversely affect the value of our investments in marketable securities.

As of September 30, 2003, our portfolio consisted of $34.2 million of interest-bearing debt securities with maturities of less than one year and $14.3 million of interest-bearing debt securities with maturities of more than one year. Our intent is to hold these securities until maturity, but we have classified them as available-for-sale in the event of unanticipated cash needs. The interest bearing securities are subject to interest rate risk and will fall in value if market interest rates increase. We believe that the impact on the fair market value of our securities and related earnings for the remainder of 2003 from a hypothetical 10% increase in market interest rates would not have a material impact on the investment portfolio.

Foreign currency risk

Except for sales transacted by our wholly-owned subsidiaries, we transact all our sales in U.S. dollars, or USDs; therefore, the obligations of many of our international customers are in USDs. Our exposure to risk from fluctuations in foreign currencies relates primarily to the strengthening of the USD against the local currency of our international customers, which may impact our ability to collect amounts owed by our international customers.

As of September 30, 2003, 43% of our outstanding accounts receivable balance was from international customers, of which 46%, or approximately $3.9 million was denominated in a currency other than USDs. Total sales for the nine months ended September 30, 2003 denominated in a currency other than USDs were approximately $9.9 million, or 17% of total consolidated revenue. The British pound and the Euro represented the majority of financial transactions executed in a currency not denominated in USDs. A change in exchange rates compared to the USD of 10% would not have a significant impact on our statement of financial position or results of operations. Historically, the impact on us of changes in exchange rates compared to the USD has been insignificant. We regularly review our receivable positions in foreign countries for any indication that collection may be at risk. In addition, we utilize letters of credit where they are warranted in order to mitigate our collection risk. As of September 30, 2003, we did not have any foreign currency hedging contracts.

Item 4. Controls and Procedures

Evaluation of disclosure controls and procedures

The term “disclosure controls and procedures” is defined in Rules 13a-14(c) and 15d-14(c) of the Exchange Act. These rules refer to the controls and other procedures of a company that are designed to ensure that the information required to be disclosed by a company in the reports that it files under the Exchange Act is recorded, processed, summarized and reported within required time periods. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our Exchange Act reports is accumulated and communicated to management, including our principal executive officer and our chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

Our chief executive officer and our chief financial officer have evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2003, and they have concluded that our disclosure controls and procedures were effective.

Changes in internal controls

There were no significant changes in SonoSite’s internal controls over financial reporting or, to SonoSite’s knowledge, in other factors that could significantly affect SonoSite’s disclosure controls and procedures during the quarter ended September 30, 2003.

PART II: OTHER INFORMATION

Item 1. Legal Proceedings

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

None.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

Exhibit No.		Description

4.4(A)		Amendment to Rights Agreement, dated as of August 25, 2003, by and between SonoSite, Inc. and EquiServe Trust Company, N.A., the successor in interest to First Chicago Trust Company
31.1		Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1		Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350 (Section 906 of the Sarbanes-Oxley Act of 2002)
32.2		Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350 (Section 906 of the Sarbanes-Oxley Act of 2002)

(A) Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed on August 26, 2003 (SEC File No. 000-23791).

(b) Reports on Form 8-K

On July 31, 2003, we filed a Current Report on Form 8-K, dated July 31, 2003, (a) furnishing under Item 12 thereof the results of our operations for the quarter ended June 30, 2003 and (b) filing as exhibits under Item 7 thereof the related press release dated July 31, 2003.

On August 26, 2003, we filed a Current Report on Form 8-K, dated August 25, 2003, (a) reporting under Item 5 thereof that our Rights Agreement was amended and (b) filing as an exhibit under Item 7 thereof a copy of the Amendment to Rights Agreement.

On September 5, 2003 we filed a Current Report on Form 8-K, dated September 4, 2003, reporting under Item 5 thereof a decision interpreting certain terms used in the patent that is the subject of litigation between Neutrino Development Corporation and SonoSite, Inc.

SIGNATURE

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

	SONOSITE, INC. (Registrant)

Dated: November 11, 2003	By:	/s/ MICHAEL J. SCHUH

		Michael J. Schuh Vice President-Finance, Chief Financial Officer and Treasurer (Authorized Officer and Principal Financial Officer)

INDEX TO EXHIBITS

Exhibit No.		Description

4.4(A)		Amendment to Rights Agreement, dated as of August 25, 2003, by and between SonoSite, Inc. and EquiServe Trust Company, N.A., the successor in interest to First Chicago Trust Company

31.1		Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350 (Section 906 of the Sarbanes-Oxley Act of 2002)

32.2		Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350 (Section 906 of the Sarbanes-Oxley Act of 2002)

(A) Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed on August 26, 2003 (SEC File No. 000-23791).