PART I - FINANCIAL INFORMATION

Item 1.

CLARIENT, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(in thousands, except share and per share amounts)

	March 31,			December 31,
	2006			2005
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	4,528		$	9,333
Restricted cash	232			—
Accounts receivable, net of allowance for doubtful accounts of $731 and $740 in 2006 and 2005, respectively (services group)	5,200			3,928
Accounts receivable, net of allowance for doubtful accounts of $150 and $207 in 2006 and 2005, (technology group)	523			858
Net investment in sales type leases	59			81
Inventories	1,211			1,088
Prepaid expenses and other current assets	833			754
Total current assets	12,586			16,042
Property and equipment, net of accumulated depreciation	9,988			8,007
Patents, net of accumulated amortization of $607 and $572 in 2006 and 2005, respectively	758			742
Net investment in sales type leases	183			188
Other	128			270
Total assets	$	23,643		$	25,249
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	2,810		$	3,122
Accrued payroll	1,174			1,109
Accrued expenses	1,313			1,341
Deferred revenue	994			1,233
Current maturities of long-term debt, including capital lease obligation	2,223			2,153
Total current liabilities	8,514			8,958
Long-term debt, including capital lease obligation	3,744			2,073
Deferred rent	3,001			1,756
Commitments and contingencies
Stockholders’ equity:
Common stock $0.01 par value, authorized 100,000,000 shares, issued and outstanding 66,813,227 and 66,912,762 in 2006 and 2005, respectively	668			669
Additional paid-in capital	132,461			132,388
Deferred compensation	—			(268		)
Accumulated deficit	(124,703		)	(120,285		)
Accumulated other comprehensive loss	(42		)	(42		)
Total stockholders’ equity	8,384			12,462
Total liabilities and stockholders’ equity	$	23,643		$	25,249

See accompanying notes to condensed consolidated financial statements.

CLARIENT, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Operations

(in thousands, except share and per share amounts)

(Unaudited)

	Three Months Ended March 31,
	2006			2005
Revenue:
Services group	$	5,515		$	1,887
Technology group	1,234			2,120
Total revenue	6,749			4,007
Cost of revenue:
Services group	3,265			1,833
Technology group	369			641
Total cost of revenue	3,634			2,474
Gross profit	3,115			1,533
Operating expenses:
Selling, general and administrative	4,003			3,029
Diagnostic services administration	2,168			1,423
Research and development	1,145			928
Total operating expenses	7,316			5,380
Loss from operations	(4,201		)	(3,847		)
Other expense	201			27
Loss before income taxes	(4,402		)	(3,874		)
Income taxes	16			—
Net loss attributable to common stock	$	(4,418	)	$	(3,874	)

Basic and diluted net loss per common share	$	(0.07	)	$	(0.08	)
Weighted average number of common shares outstanding	66,803,317			51,616,369

See accompanying notes to condensed consolidated financial statements.

CLARIENT, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(in thousands, except share and per share amounts)

(Unaudited)

	Three Months Ended March 31,
	2006			2005

Cash flows from operating activities:
Net loss	$	(4,418	)	$	(3,874	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization	776			786
Non-cash compensation charges	386			121
Gain on sale of assets	(301		)	—
Provision for bad debts	200			25
Reserve for excess and obsolete inventory	—			(67		)

Changes in operating assets and liabilities:
Accounts receivable, net (services group)	(1,529		)	(962		)
Accounts receivable, net (technology group)	392			155
Net investment in sales type leases	27			(615		)
Inventories	(123		)	108
Prepaid expenses and other assets	63			23
Accounts payable	(312		)	(626		)
Accrued payroll	65			231
Accrued expenses	(28		)	(408		)
Deferred revenue	(239		)	199
Deferred rent	1,245			—
Net cash used in operating activities	(3,796		)	(4,904		)

Cash flows from investing activities:
Additions to patents	(51		)	(6		)
Additions to restricted cash	(232		)	—
Additions to property and equipment	(2,731		)	(322		)
Proceeds from sale of assets	310			—
Net cash used in investing activities	(2,704		)	(328		)

Cash flows from financing activities:
Proceeds from exercise of stock options	18			60
Borrowings on long-term debt, including equipment lease obligation	2,936			442
Repayments on long-term debt, including capital lease obligation	(1,195		)	(495		)
Issuance of common stock	6			—
Offering costs	(70		)	—
Net cash provided by financing activities	1,695			7

Effect of exchange rate changes on cash and cash equivalents	—			5

Net decrease in cash and cash equivalents	(4,805		)	(5,220		)

Cash and cash equivalents at beginning of period	9,333			10,045

Cash and cash equivalents at end of period	$	4,528		$	4,825

See accompanying notes to condensed consolidated financial statements.

CLARIENT, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

(1) Interim Financial Statements

These interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in our annual report on Form 10-K for the fiscal year ended December 31, 2005 filed with the Securities and Exchange Commission.

The accompanying unaudited condensed consolidated financial statements reflect all adjustments, which, in the opinion of management, are necessary for a fair presentation of the financial position and the results of operations for the interim periods presented. All such adjustments are of a normal, recurring nature. Certain amounts have been reclassified to conform to the current period presentation. The results of operations for any interim period are not necessarily indicative of the results to be obtained for a full fiscal year.

(2) Equity-Based Compensation

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which was issued in December 2004. SFAS 123(R) revises SFAS No. 123, “Accounting for Stock Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and its related interpretations. SFAS 123(R) requires recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements over the period the employee is required to perform the services in exchange for the award. SFAS 123(R) also requires measurement of the cost of employee services received in exchange for an award. SFAS 123(R) also amends SFAS No. 95, “Statement of Cash Flows,” to require the excess tax benefits be reported as financing cash inflows, rather than as a reduction of taxes paid, which is included within operating cash flows. The Company adopted SFAS 123(R) using the modified prospective method. Accordingly, prior period amounts have not been restated. Under this application, the Company is required to record compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding at the date of adoption.

Prior to the adoption of SFAS 123(R), the Company recorded compensation expense related to the issuance of restricted stock grants to employees. The value of the restricted stock grant awards are determined on the date of grant and compensation expense is recognized on a straight-line basis over the vesting periods.

Stock-based compensation is as follows (in thousands):

	Three Months Ended March 31,
	2006		2005

Cost of revenue – services group	$	5	$	—
Cost of revenue – technology group	3		—
Stock-based compensation expense included in cost of revenue	8		—

Selling, general and administrative	290		104
Diagnostic services administration	71		17
Research and development	17		—
Stock-based compensation expense included in operating expense	378		121

Total stock-based compensation expense	$	386	$	121

SFAS 123(R) provides that income tax effects of share-based payments are recognized in the financial statements for those awards that will normally result in tax deduction under existing law. Under current U.S. federal tax law, the Company would receive a compensation expense deduction related to non-qualified stock options only when those options are exercised and vested shares are received. Accordingly, the financial statement recognition of compensation cost for non-qualified stock options creates a deductible temporary difference which results in a deferred tax asset and a corresponding deferred tax benefit in the income statement. The Company does not recognize a tax benefit for compensation expense related to incentive stock options unless the underlying shares are disposed in a disqualifying disposition.

The table below reflects pro forma information for the three months ended March 31, 2005 (in thousands except per-share amounts):

	2005
Consolidated net loss attributable to common stock:
As reported	$	(3,874	)
Stock-based employee compensation expense included in net loss as reported	121
Total stock-based employee compensation expense determined under fair-value based method for all awards	(465		)
Pro forma net loss	$	(4,218	)

Net loss per share — Basic and Diluted:
Net loss per share as reported	$	(0.08	)
Pro forma net loss per share	$	(0.08	)

(1) Net loss and net loss per share prior to January 1, 2006 did not include stock-based compensation expense for employee stock options under SFAS 123 because the Company did not adopt the recognition provisions of SFAS 123. Net loss and net loss per share prior to January 1, 2006 included compensation expense related to restricted stock grant awards.

(2) Stock-based compensation expense prior to January 1, 2006 is calculated based on the pro forma application of SFAS 123.

(3) Net loss and net loss per share prior to January 1, 2006 represents pro forma information based on SFAS 123.

The following assumptions were used to determine the fair value of stock options granted using the Black-Scholes option-pricing model:

	2006		2005
Dividend yield	0.0	%	0.0	%
Volatility	96	%	103	%
Average expected option life	5 years		4 years
Risk-free interest rate	4.64	%	4.10	%

(3) Net Loss Per Share

Basic and diluted loss per common share is calculated by dividing net loss by the weighted average common shares outstanding during the period. Stock options and warrants to purchase an aggregate of 12,512,796 and 10,493,261 shares of common stock were outstanding at March 31, 2006 and 2005, respectively. These stock options and warrants outstanding were not included in the computation of diluted earnings per share because the Company incurred a net loss in all periods presented and hence, the impact would be anti-dilutive.

(4) Patents

Patents are amortized over their respective estimated useful lives of ten years to their estimated residual values. The following table provides a summary of the Company’s technology related patents with definite useful lives recorded as of March 31, 2006 (in thousands):

Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount		Amortization Period in Years
$	1,365	$	(607	)	$	758	10

The following table summarizes the future estimated annual pretax amortization expense for these assets (in thousands):

Fiscal Year
Remainder of 2006	$	96
2007	131
2008	130
2009	115
2010 & thereafter	286
Total	$	758

(5) Net Investment in Sales-Type Leases

The Company derives a portion of its revenues under leasing arrangements. Such arrangements provide for monthly payments covering the system sale, maintenance and interest. These arrangements meet the criteria to be accounted for as sales-type leases pursuant to Statement of Financial Accounting Standards No. 13, “Accounting for Leases”. Accordingly, the system sale is recognized upon delivery of the system, provided all other revenue recognition criteria are met. Upon the recognition of revenue, an asset is established for the “investment in sales-type leases.” Maintenance revenue and interest income are recognized monthly over the lease term.

The following lists the components of the net investment in direct financing and sales-type leases as of March 31, 2006 (in thousands):

Total minimum lease payments to be received	$	338
Less: Amounts representing estimated maintenance costs including profit thereon, included in total minimum lease payments	45
Net minimum lease payments receivable	293
Less: Unearned maintenance income & interest	51
Net investment in sales-type leases	$	242

(6) Currency Translation

The financial position and results of operations of the Company’s foreign subsidiaries are determined using the local currency as the functional currency. Assets and liabilities of these subsidiaries are translated at the exchange rate in effect at each quarter-end. Income statement accounts are translated at the average rate of exchange prevailing during the period. The effects of currency translations are included in comprehensive loss.

(7) Comprehensive Loss

The total comprehensive loss is summarized as follows (in thousands):

	Three Months Ended March 31,
	2006			2005
Net loss	$	(4,418	)	$	(3,874	)
Foreign currency translation adjustment	—			5
Comprehensive loss	$	(4,418	)	$	(3,869	)

(8) Business Segments

The Company operates primarily in two business segments: 1) the Services Group delivers critical oncology testing services to community pathologists, biopharmaceutical companies and other researchers; and 2) the Technology Group is engaged in the development, manufacture and marketing of an automated cellular imaging system which is designed to assist physicians in making critical medical decisions. The segments are determined based on product and or services delivered to customer groups. The Company’s chief operating decision maker is the Chief Executive Officer and President. The chief operating decision maker allocates resources and assesses performance and other activities at the operating segment level.

Revenue, gross profit and identifiable assets for our operating segments are as follows (in thousands):

	Three Months Ended							Three Months Ended
	March 31, 2006							March 31, 2005
	Services Group		Technology Group		Total			Services Group		Technology Group		Total
Total revenues	$	5,515	$	1,234	$	6,749		$	1,887	$	2,120	$	4,007

Cost of revenue	3,265		369		3,634			1,833		641		2,474
Gross profit (loss)	$	2,250	$	865	3,115			$	54	$	1,479	1,533
Selling, general and administrative (including diagnostic services administration)					6,171							4,452
Research & development					1,145							928
Loss from operations					(4,201		)					(3,847		)
Other expense and income taxes					217							27
Net loss					$	(4,418	)					$	(3,874	)

	March 31, 2006						December 31, 2005
	Services Group		Technology Group		Total		Services Group		Technology Group		Total

Identifiable assets	$	18,653	$	4,990	$	23,643	$	21,806	$	3,443	$	25,249

(9) Recent Accounting Developments

Inventory Costs

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs”, (“SFAS 151”), an amendment of Accounting Research Bulletin No. 43, Inventory Pricing. SFAS 151 requires all companies to recognize a current-period charge for abnormal amounts of idle facility expense, freight, handling costs and wasted materials. The statement also requires that the allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. This new standard became effective for fiscal years beginning after June 15, 2005. The Company’s adoption of SFAS 151 as of January 1, 2006 had no material effect on its consolidated financial position, results of operations or cash flows.

Accounting Changes and Error Corrections

In June 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections-a replacement of APB No. 20 and FAS No. 3” (“SFAS 154”). SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle. SFAS 154 also provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The correction of an error in previously issued financial statements is not an accounting change. However, the reporting of an error correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retrospectively. Therefore, the reporting of a correction of an error by restating previously issued financial statements is also addressed by SFAS 154. SFAS 154 became effective in fiscal years beginning after December 15, 2005. The Company’s adoption of SFAS 154 as of January 1, 2006 had no impact on its financial position, results of operations or cash flows.

Amortization for Leasehold Improvements

In June 2005, the FASB’s Emerging Issues Task Force reached a consensus on Issue No. 05-6, “Determining the Amortization Period for Leasehold Improvements Purchased after Lease Inception or Acquired in a Business Combination” (EITF 05-6). This guidance requires that leasehold improvements acquired in a business combination or purchased subsequent to the inception of a lease be amortized over the shorter of the useful life of the assets or a term that includes required lease periods and renewals that are reasonably assured at the date of the business combination or purchase. This guidance was applicable only to leasehold improvements that are purchased or acquired in reporting periods beginning after June 29, 2005. The adoption of EITF 05-6 is not expected to have an impact on the Company’s consolidated financial position, results of operations or cash flows.

(10) Stock Transactions

On November 8, 2005, the Company entered into a securities purchase agreement with a limited number of accredited investors pursuant to which the Company agreed to issue and the investors agreed to purchase 15,000,000 shares of common stock, together with warrants to purchase an additional 2,250,000 shares of common stock at an exercise price of $1.35 per share, for an aggregate purchase price of $15,000,000 (this financing is referred to as the “2005 financing”). The warrants issued in this transaction are exercisable for a period of four years after the date they were issued. This transaction was structured so that a portion of the common stock and warrants issued (8,900,000 shares of common stock and warrants to purchase 1,335,000 shares of common stock for aggregate gross proceeds of $8,900,000) were issued at an initial closing that occurred on November 9, 2005. The remaining shares and warrants were issued at a subsequent closing on December 14, 2005. Safeguard Scientifics, Inc. (“Safeguard”) was one of the purchasers in the 2005 financing and acquired 9,000,000 shares (of which 5,340,000 shares were acquired at the initial closing) of common stock and warrants to purchase 1,350,000 shares of common stock (of which 801,000 were acquired at the initial closing) for an aggregate investment of $9,000,000. Following consummation of the financing, Safeguard beneficially owned approximately 57% of the Company’s outstanding common stock. In connection with the 2005 financing, the Company entered into a registration rights agreement with the purchasers in that financing and the Company has registered the resale of shares issued in the 2005 financing with the Securities and Exchange Commission.

Due to its beneficial ownership of approximately 57% of the Company’s outstanding common stock, Safeguard has the power to elect all of the directors of the Company, although Safeguard has contractually agreed with the Company that a majority of the board of directors will consist of individuals not specifically designated by Safeguard. The Company has given Safeguard contractual rights enabling it to exercise significant control over the Company.

(11) Line of Credit

The Company currently has an $8.5 million revolving credit agreement, which expires on February 28, 2007 (the line of credit was increased from $5.5 million to $8.5 million in August 2005) and bears interest at the bank’s prime rate minus one-half percent. The borrowings under the line of credit are being used for working capital purposes and to provide a $3.0 million stand-by letter of credit to the landlord of our Aliso Viejo, California facility. The agreement also includes an annual credit facility fee of $27,500 and various restrictive covenants and requirements to maintain certain financial ratios. The Company paid Safeguard a commitment fee of $15,000 and issued to Safeguard a warrant to purchase 50,000 shares of common stock for an exercise price of $2.00 per share as additional consideration for Safeguard’s $3.0 million increase in the guarantee in August 2005. The Company is also obligated to pay Safeguard an amount equal to 0.5% of the amount guaranteed and 4.5% per annum of the daily-weighted average principal balance outstanding under the line of credit. The revolving credit agreement has only one financial covenant related to tangible net worth, which is required to be not less than $0.

(12) Equipment Financing

In August 2003, the Company entered into an agreement for an equipment financing line from General Electric Capital Corporation (“GE Capital”). The equipment financing line provided for $3.0 million in immediate financing resources and an additional $2.0 million as the Company achieves certain system placement objectives. The loan principal amortized ratably over the 33 month term. In September 2003, the Company borrowed $3.0 million at an interest rate of 8.16%. These borrowings under the equipment financing agreement were being used for working capital purposes and were secured by substantially all of the assets of the Company. The agreement also provided for various restrictive covenants, maintenance of certain financial ratios and a collateral monitoring fee of $5,000 per year. On March 1, 2006, the balance outstanding on the equipment financing line was paid in its entirety.

In June 2004, the Company entered into a master lease agreement with GE Capital for capital equipment financings of diagnostic services (laboratory) related equipment. The Company financed $2.6 million in 2004, $2.3 million in 2005 and $0.6 million in the three months ended March 31, 2006 of capital equipment under this arrangement, which were recorded as capital lease obligations. Each lease financing has a term of 36 months. The 2004 financings provides for an early purchase option by the Company after 30 months at 26.6% of the cost of the equipment. The 2005 and 2006 financings provides for an early purchase option by the Company after 24 months for a purchase price equal to 40.5% of the cost of the equipment.

The capital lease obligations as of March 31, 2006 are as follows (in thousands):

Fiscal Year:
Remainder of 2006	$	1,233
2007	1,651
2008	737
2009	158
Total	3,779
Less: current portion	1,665
Capital lease obligation, excluding current portion	$	2,114

(13) Borrowings on Equipment Subject to Operating Leases

On March 1, 2006, the Company entered into a Master Purchase Agreement with Med One Capital Inc. (“Med One”) pursuant to which Med One purchased certain ACIS® “cost per test” units for a gross amount of $2.3 million. Each unit purchased by Med One was in use by a customer at the time of the transaction. Med One also has the option to purchase additional units worth up to $1 million. Under the agreement, 10 percent of the purchase price is held in escrow and may be recoverable by Med One to the extent that any units returned to Med One prior to the expiration of the applicable equipment lease are not successfully remarketed. The escrow amount is classified as restricted cash. The proceeds from this financing are recorded as debt of which $0.6 million is classified as current and $1.6 million is classified as non-current at March 31, 2006. Amounts invoiced to customers for tests performed or the minimum monthly rental fee related to the units sold to Med One will be recorded as revenue and a portion of each fee will be recorded as interest expense and the remainder will reduce the amount recorded as debt. The Company will continue to record depreciation expense on the units sold to Med One which will be recorded to cost of revenues.

(14) Commitments and Contingencies

Operating Lease Commitment. The Company utilizes various operating leases for office space and equipment. The Company entered into a lease agreement dated as of July 20, 2005 for a mixed-use building with approximately 78,000 square feet in Aliso Viejo, California. The lease commenced on December 1, 2005 with an initial term of 10 years and an option to extend the lease term for up to two additional five-year periods. The initial annual base rent is approximately $500,000. As the Company occupies additional square footage, the annual base rent will be increased to approximately $1.0 million on June 1, 2006 and to approximately $1.4 million on December 1, 2008. The base rent is increased 3% annually effective on December 1 of each year beginning in 2006. The Company is also responsible for payments of common area operating expenses for the premises. The landlord has agreed to fund approximately $3.5 million of tenant improvements toward design and construction costs associated with the build-out of the facility of which the landlord has reimbursed the Company $2.4 million through March 31, 2006. Such costs will be capitalized as leasehold improvements and amortized over their estimated useful life, while the reimbursement will be recorded to deferred rent and recovered ratably over the term of the lease.

At March 31, 2006, future minimum lease payments for all operating leases are as follows (in thousands):

Fiscal year:
Remainder of 2006	$	742
2007	1,128
2008	1,178
2009	1,479
2010	1,503
Thereafter	7,812
	$	13,842

Construction Agreement. On October 26, 2005, the Company entered into a construction agreement with LCS Constructors, Inc. (LCS), a team of general contractors and construction managers dedicated to the planning, design, construction and facility support of laboratories and technical facilities, to build-out its newly-leased facility in Aliso Viejo, California. Under the terms of the agreement, LCS will provide or arrange for construction services, materials, equipment, permits and liability insurance for the construction of the facility. The project is expected to be completed in three phases, with a substantial completion date of December 31, 2005 for the first phase after which time the Company moved its laboratory facilities in January 2006 to the new location. The total amount paid for the first phase of the build-out pursuant to the contract was $3.6 million. Fees for the remaining two phases of the build-out will be included in amendments to this contract and are estimated to be approximately $2.2 million for the second phase and $350,000 for the third phase. Through March 31, 2006, the Company had incurred $1.0 million related to the second phase. The third phase anticipated completion date is as soon as practicable thereafter. Payments for all phases will be made in installments based on the percentage of completion. The final payment on each phase will be made after LCS has completed the applicable phase in its entirety, all corrective items have been completed and the architect prepares a final completion notice.

Distribution and Development Agreement with Dako. On July 18, 2005, the Company entered into a distribution agreement with Dako A/S (Dako), a Danish company that provides system solutions for cancer diagnostics and cell analysis worldwide. Under the terms of the agreement, Dako will distribute and market the Company’s ACIS® system and related software. The distribution arrangement is exclusive on a worldwide basis in research and clinical markets, and non-exclusive with respect to biotechnology and pharmaceutical companies (and their academic research partners). The agreement has a five-year initial term.

Dako has agreed to order a minimum of 40 ACIS® systems per contract year (15 in the first year), subject to certain adjustments. Revenue from systems sold under this agreement will be recognized when these ACIS® systems have been delivered and accepted by an end-user.

Dako has also agreed to invest research and development funds toward future ACIS® devices and related software, and such products would also be subject to the terms of the agreement. The Company will own all intellectual property created under the agreement that is related to image analysis and execution thereof, and Dako will own all intellectual property created under the agreement that is related to Dako’s specific implementation of the products or integration of the products with a product supplied by Dako. Such intellectual property will be cross-licensed from one party to the other. In the event the Company fails to supply ACIS® systems as set forth in the agreement, Dako will have the right and license to manufacture the ACIS® systems for that purpose for a reduced fee. Revenues received from research and development agreements are recognized over the contract performance period, starting with the contract’s commencement. The upfront payment is deferred and recognized on a straight-line basis over the estimated performance period. Milestone payments are recognized as revenue when they are due and payable, but not prior to the removal of any contingencies for each individual milestone.

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

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements that are based on current expectations, estimates, forecasts and projections about us, the industries in which we operate and other matters, as well as management’s beliefs and assumptions and other statements regarding matters that are not historical facts. These statements include, in particular, statements about our plans, strategies and prospects. For example, when we use words such as “projects,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “should,” “would,” “could,” “will,” “opportunity,” “potential” or “may,” variations of such words or other words that convey uncertainty of future events or outcomes, we are making forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Our forward-looking statements are subject to risks and uncertainties. Factors that might cause actual results to differ materially, include, but are not limited to, the Company’s ability to obtain additional financing on acceptable terms or at all, the Company’s ability to continue to develop and expand its services group business and its technology group business, the Company’s ability to successfully move and consolidate the Company’s laboratory and other operations into its new facility, the performance and acceptance of the Company’s instrument systems in the market place, the Company’s ability to expand and maintain a successful sales and marketing organization, continuation of favorable third party payer reimbursement for tests performed using the Company’s system and for other diagnostic tests, unanticipated expenses or liabilities or other adverse events affecting cash flow, uncertainty of success in developing any new software applications, the Company’s ability to successfully sell instruments under its distribution agreement with Dako A/S and to timely complete its next generation ACIS® device, failure to obtain Food and Drug Administration clearance or approval for particular applications, the Company’s ability to compete with other technologies and with emerging competitors in cell imaging and dependence on third parties for collaboration in developing new tests and in distributing the Company’s systems and tests performed on the system, and those risks which are discussed in “Risk Factors” below. Many of these factors are beyond our ability to predict or control. In addition, as a result of these and other factors, our past financial performance should not be relied on as an indication of future performance. All forward-looking statements attributable to us, or to persons acting on our behalf, are expressly qualified in their entirety by this cautionary statement. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In light of these risks and uncertainties, the forward-looking events and circumstances discussed in this report might not occur.

Results of Operations

Overview and Outlook

We are an advanced oncology diagnostics technology and services company. Our mission is to combine innovative technologies, meaningful test results and world-class expertise to improve outcomes of patients suffering from cancer. With the completion of the human genome project in the late 1990s, medical science has entered a new era of diagnostics that will move us closer than ever before to understanding the molecular causes for complex diseases, particularly cancer. As a result, the landscape of cancer management is undergoing significant change. There is now an escalating need for advanced oncology testing to provide physicians with necessary information on the cellular profile of a specific tumor, enabling them to select the most appropriate therapies.

In 2004 we began to leverage our core technologies and intellectual properties to commercialize a set of services to provide the community pathologist with the latest in cancer diagnostic technology. Anchored by our own proprietary image analysis technology and augmented by other emerging technologies, we are able to provide a complete assessment of the molecular cause and characteristics of cancer. Our Automated Cellular Imaging System (ACIS®) is a versatile automated microscope system that greatly improves the accuracy and reproducibility of digital cell imaging through its unique, patented technology. Our comprehensive laboratory services are focused on in-house pathology testing, using the ACIS® and other cutting-edge diagnostic technologies to assist physicians in cancer assessment.

In addition, we develop ACIS®-based tools for academic and biopharmaceutical company researchers, allowing them to perform cellular-level analyses much faster and with improved accuracy. A number of the top clinical laboratories, hospitals, university medical centers and biopharmaceutical companies in the U.S. and Europe have adopted our technology. By placing systems in key academic research centers and biopharmaceutical organizations, our systems can be established as a powerful standardization tool for the discovery and clinical trial process by aiding in target and patient selection for these emerging therapies. New tests will also drive higher demand for our specialized, high-end diagnostic services as a result of our expertise in related therapeutics.

We estimate that the market for advanced cancer diagnostic testing will increase from an estimated $1.5 billion today to over $2.5 billion by 2010. This increase is attributable to multiple factors including increasing incidences of cancer in an aging population, new therapies and expanded testing panels. Our previous concentration on image analysis systems limited us to participation in only the instrument systems portion of the market, which we estimate represented less than 10% of this market. Recent trends indicate treatment decisions are likely to involve the assessment of a complex panel of protein and gene based testing rather than a single test. Therefore, diagnostic and predictive testing for these therapies will likely become increasingly complex and there will be increased demand for sophisticated services to either interpret test results or assist pathologists in such interpretations. Our goal is to position ourselves to participate in a substantially greater portion of the cancer diagnostics market by serving the needs of the market from drug discovery through clinical practice with the services offered by our services and technology businesses.

The initial objective of our service strategy had been to support the expansion of the Access remote pathology program for community pathologists, a large customer segment. The focus of the development of the ACIS® technology platform has been to assist our customers in their diagnosis and assessment of cancer. We continue to explore numerous ways to leverage our relationship with our customers to better serve their needs and expand revenue opportunities. A logical extension of the remote pathology technical services has been the recent introduction of other esoteric tests and related professional diagnosis that support the oncology services marketplace. We provide a broad spectrum of other laboratory services, including:

• flow cytometry,

• molecular diagnostics including PCR (polymerase chain reaction),

• analysis of tumors of unknown origin, and

• expanded services for immunohistochemistry.

In July 2005, we entered into a distribution and development agreement with Dako A/S (Dako), a Danish company recognized as a worldwide leader in diagnostic pathology testing services. Under the agreement, Dako was appointed our exclusive distributor of the ACIS® system to the clinical marketplace, which includes local hospitals and pathology practices. Dako has agreed to fund new development milestones that, when achieved, will enhance and add new features to our ACIS® system. The Company believes that this program will improve the long-term prospects for the placement of systems in the U. S. and overseas.

Through our combined marketing and sales efforts with Dako, we are focused on the sale of the ACIS® system to clinical and research accounts, which include biopharmaceutical companies, biotechnology companies and academic medical centers. We believe that there are more than 1,000 such research organizations and an equal number of clinical organizations in the U.S. that are good candidates for ACIS®. An important driver of our success in the future will be our ability to develop new diagnostic tests on the ACIS® and duplicate the success and market penetration that has been achieved within the breast cancer testing markets. Working in collaboration with top-tier pharmaceutical companies, we are developing diagnostic tests and related assays that will target new cancer therapies to those patients most likely to benefit from their use.

An important component of our strategy is to continue to build and, when necessary, defend our intellectual property position. We file patent applications to protect technology, innovations and improvements that we consider important to the development of our business and we will consider acquisitions of businesses or intellectural property rights that will complement our existing business. We make investments in research and development and unique approaches to the application of new technologies.

Currently, we have 24 patent applications pending with the U.S. Patent and Trademark Office and 7 foreign patent applications pending. We have 23 issued patents in the U.S. and 11 foreign patents, all related to the system and method for cellular specimen grading performed by the ACIS® or related technologies. The patents for which we have received a final issuance have remaining legal lives that vary from 12 to 19 years. In all our patent applications we have endeavored to file claims which cover the underlying concepts of the unique features of the ACIS®, its associated processes and methodologies as well as our specific implementation of those processes and methodologies.

As a further protection against efforts to erode our proprietary position, we have systematically explored other designs, which could achieve results similar to the ACIS® and we have prepared patent applications on those alternate designs. Our research and development efforts have been further validated in the area of automated immunohistochemistry for which we have obtained five FDA 510(k) clearances over the past several years. These clearances help to validate the efficacy of our technology and to broaden the acceptance of our image analysis. It will be important for us to obtain FDA clearances for our portfolio of new diagnostic tests developed in our bioanalytical services development efforts.

Key indicators of our financial condition and operating performance

Our business is complex, and management is faced with several key challenges to reach profitability. We made the decision to provide in-house laboratory services in 2004 to give us an opportunity to capture a significant service-related revenue stream from the much broader and expanding cancer diagnostic testing marketplace. We have been experiencing double-digit growth since the inception of this business line indicating excellent execution of our sales plan and solid market acceptance of our service offerings. Consequently, management must manage the growth of this business, particularly related to billings, collections and business processes. We have yet to reach optimal financial metrics related to cash flow and operating margins due to our limited financial history in providing lab services.

We also face the challenged of effectively managing the transition from selling ACIS® systems directly to selling them through our distributor. We experienced a slower than expected start-up of the implementation of our distribution arrangement with Dako. The delayed ramp-up of this selling arrangement has resulted in our technology business experiencing a 42% decline in systems revenue from $2.1 million in the first quarter of 2005 to $1.2 million in the first quarter of 2006, and a corresponding decline in gross profit from $1.5 million to $0.9 million. We believe that the ramp-up of this relationship will improve in the remainder of the 2006 fiscal year, although we may not reach our sales goals for the full year.

Selling, general and administrative (SG&A) expenses, including diagnostic service administration, in the first quarter 2006 were 91% of total revenue, compared to 111% in the first quarter 2005. We expect an improving trend will continue as our revenues increase, offsetting our initial investments in: 1) selling expenses related to the ramp-up of our sales force responsible for our diagnostics services; 2) diagnostic services administration, particularly the costs of pathology services; 3) implementing the Dako distribution arrangement; 4) key business development initiatives focused on targeted cancer therapies in various stages of clinical study using our proprietary imaging technology; and 5) the build-out of our new state-of-the art laboratory facility in Aliso Viejo, California.

Finally, we are dependent on the use of both debt and equity financing to fund our operating losses in the near term and to sustain our growth pattern in the future. Management believes that our existing cash resources together with access to our financing sources described below, including the remaining $5.5 million available under our revolving line of credit with Comerica Bank and the $2.4 million of availability under our equipment lease line with GE Capital (which remains subject to GE Capital’s ongoing review of our financial condition at the time of each funding request), will be sufficient to satisfy the cash needs of our existing operations through the end of 2006. However, we may require additional debt or equity financing if we are unable to access one or more of these financing sources, if we enter into acquisition or other transactions requiring cash expenditures or if we encounter difficulties in executing our business plan.

Characteristics of our revenue and expenses

Services Group Billing. Revenues for our services group are derived primarily from billing insurers, pathologists and patients for the diagnostic services that we provide.

Third party billing. The majority of revenue currently generated by our services group is for patients that utilize insurance coverage from Medicare or other third party insurance companies. In these situations, we bill an insurer that pays a percentage of the amount billed based on several factors including the type of coverage (for example, HMO or PPO), whether the charges are considered to be in network or out of network, and the amount of any co-pays or deductibles that the patient may have at that time. The rates that are billed are typically a percentage of those amounts allowed by Medicare for the service provided as defined by Common Procedural Terminology (CPT) codes. The amounts that are paid to us are a function of the payers’ practice for paying claims of these types and whether we have specific agreements in place with the payers. We also have a Medicare provider number that allows us to bill and collect from Medicare.

Client (pathologist) billing. In some situations, we establish direct billing arrangements with our clients where we bill them for an agreed amount per test for the services provided and the client will then handle all billing directly with the private payers. The amounts that may be charged to our clients is determined in accordance with applicable state and federal laws and regulations.

Patient billing. Less than 10% of our billings are billed directly to patients. These billings can result from co-payment obligations, patient deductibles, circumstances where certain tests are not covered by insurance companies, and patients without any health insurance.

Technology Group Revenue. Revenues for our technology group are derived from fee-per-use, ACIS® sales and development revenue. We have been experiencing a shift in this revenue model since 2004 as we complete various financing arrangements with third-parties and strategic alliances with key distributors such as Dako.

Services Group Cost of Revenue and Gross Margin. Cost of revenue includes laboratory personnel, equipment, laboratory supplies and other direct costs such as shipping. Most of our cost of revenue structure is variable, except for staffing and related expenses which are semi-variable and depreciation which is mostly fixed.

Technology Group Cost of Revenue and Gross Margin. The cost of revenue primarily consists of cost for manufacturing the ACIS®, including the cost for direct material, labor, manufacturing overhead, and direct customer support. For fee-per-use revenue, the cost of the ACIS® is depreciated over three-years and for a system sale or sales-type lease the entire cost of the ACIS® system is recognized at the time of sale. Most of our cost of revenue structure is fixed, except for variable costs of materials and overhead related to ACIS® units sold.

Operating Expenses

Operating expenses include selling, general and administrative expenses; diagnostic services administration; and research and development. Expenses within this category primarily consist of the salaries, benefits and costs attributable to the support of our operations, such as: investments in information systems, expenses and office space costs for executive management, financial accounting, purchasing, administrative and human resources personnel, recruiting fees, legal, auditing and other professional services.

The majority of our current sales resources are dedicated to the growing diagnostic services business. Targeting community pathology practices and hospitals, the sales process for this business group is designed to understand the customer’s needs and develop appropriate solutions from our range of laboratory service options.

We also have a dedicated instrument systems sales organization. To ensure the success of our joint commercial efforts, this team is now solely focused on assisting the Dako sales team in targeting, selling and closing instrument placements in both the clinical and research markets as image analysis specialists.

Diagnostic services administration includes the costs of senior medical staff, senior operations personnel, collection costs, consultants and legal resources to facilitate implementation and support the operations of the diagnostic services segment. Collection costs are incurred from a third party billing and collection company that we have engaged to perform these services because of the high degree of technical complexity and knowledge required to effectively perform these operations. These costs are incurred as a percentage of amounts collected.

Critical Accounting Policies and Estimates

Our 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 U.S. generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and the disclosure of contingent assets and liabilities as of the dates of the balance sheets and revenues and expenses for the periods presented. Therefore, on an ongoing basis, we evaluate our estimates, including those provisions for bad debts and reserves.

Bad Debt

For estimated bad debts, we review on an individual account basis the age of the receivable, all circumstances surrounding the transaction that gave rise to the receivable and whether the customer continues to have the financial resources to pay the receivable as of the balance sheet date and prior to the issuance of the financial statements for the related period. This process is followed for both our instrument and laboratory accounts. However, we have outsourced the direct billing and collection of laboratory related receivables and we work closely with our outsourced billing partner to review the details of each laboratory related account.

Inventory, Long-Lived Assets and Accruals

For ACIS® inventory and work in progress, the respective reserve is based upon the expected future use of the ACIS® components and whether there are any lower of cost or market considerations.

We review our long-lived assets, such as fixed assets and intangibles, for impairment whenever events or changes indicate the carrying value may not be recoverable or that the useful lives are no longer appropriate. If we determine that the carrying value of the long-lived assets may not be recoverable, the asset is then written down to its estimated fair value based on a discounted cash flow basis. Included in long-lived assets are ACIS® units on lease to third parties under operating leases, which are recorded in property and equipment.

For other obligations where judgment is required, we review the circumstances surrounding the obligation and evaluate the facts and circumstances to determine an appropriate level of accrual for each obligation.

Revenue Recognition

Revenue for our diagnostic services is recognized at the time of completion of services at amounts equal to the contractual rates allowed from third parties, including Medicare, insurance companies, and to a small degree, private patients. These expected amounts are based both on Medicare allowable rates and our collection experience with other third party payers. Because of the requirements and nuances of billing for laboratory services, we generally invoice amounts that are greater than those allowable for payment. These differences are described as contractual discounts. As noted, however, it is only the expected payment from these parties which is net of these contractual discounts that is recorded as revenue.

Revenue for “fee-per-use” agreements is obtained through the billing information via modem, which accesses the ACIS® database. Revenue is recognized based on the greater of actual usage fees or the minimum monthly rental fee. Under this pricing model, we own or retain a substantial risk of ownership of most of the ACIS® instruments that are engaged in service and accordingly, all related depreciation and maintenance and service costs are expensed as incurred. For those instruments that are sold, we recognize and defer revenue using the residual method pursuant to the requirements of Statement of Position No. 97-2, “Software Revenue Recognition” (“SOP 97-2”), as amended by Statement of Position No. 98-9, “Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Arrangements.” At the outset of the arrangement with the customer, we defer revenue for the fair value of its undelivered elements (e.g., maintenance) and recognize revenue for the remainder of the arrangement fee attributable to the elements initially delivered in the arrangement (e.g., software license and related instrument) when the basic criteria in SOP 97-2 have been met. Maintenance revenue is recognized ratably over the term of the maintenance contract, which typically is a period of twelve months. We do not recognize revenue on sales of assets subject to an operating lease where we retain a substantial risk of ownership.

Revenue on system sales is recognized in accordance with Staff Accounting Bulletin No. 101, as amended by Staff Accounting Bulletin No. 104, when all criteria for revenue recognition have been met. Such criteria include, but are not limited to: existence of persuasive evidence of an arrangement; fixed and determinable product pricing; satisfaction of the terms of the arrangement including passing title and risk of loss to our customer upon shipment; and reasonable assurance of collection from our customer in accordance with the terms of the arrangement. For system sales delivered under the Dako distribution and development agreement, we recognize revenue when those ACIS® instruments have been delivered and accepted by an end-user customer.

Systems sold under a leasing arrangement are accounted for as sales-type leases pursuant to SFAS No. 13, “Accounting for Leases,” if applicable. We recognize the net effect of these transactions as a sale because of the bargain purchase option granted to the lessee.

Revenues from research and development agreements are recognized over the contract performance period, starting with the contract’s commencement. The upfront payment is deferred and recognized on a straight-line basis over the estimated performance period. Milestone payments are recognized as revenue when they are due and payable, but not prior to the removal of any contingencies for each individual milestone.

Three Months Ended March 31, 2006 Compared with Three Months Ended March 31, 2005

The following table presents our results of operations as percentages:

	Percentage of Revenues
	Three months ended March 31,
	2006		2005
Revenue:
Services group	81.7	%	47.1	%
Technology group	18.3		52.9
Total revenue	100.0		100.0

Cost of revenue:
Services group(as % of Services group revenue)	59.2		97.1
Technology group (as % of Technology group revenue)	29.9		30.2
Cost of revenue	53.8		61.7
Gross profit	46.2		38.3
Operating expenses:
Selling, general and administrative	59.3		75.6
Diagnostic service administration	32.1		35.5
Research and development	17.0		23.2
Total operating expenses	108.4		134.3
Loss from operations	(62.2	)	(96.0	)

Other expense	2.9		0.7
Provision for income taxes	0.3		0.0
Net loss	(65.4	)	(96.7	)

Revenue

Total revenue for the first quarter 2006 was $6.7 million compared to $4.0 million for the first quarter 2005, an increase of 68.4% or $2.7 million.

Services Group. Revenue from our services group increased 192% or $3.6 million from $1.9 million in the first quarter of 2005 to $5.5 million in the first quarter ended March 31, 2006. We provided diagnostic services for more than 14,400 patient cases, averaging $382 of revenue per case in the first quarter 2006 compared to 4,700 patient cases averaging $399 revenue per case for the first quarter 2005. The majority of tests performed in the first quarter of 2005 were related to breast cancer testing and substantially one primary CPT code. The mix of tests increased throughout 2005 and the first quarter of 2006 so that revenue derived from breast cancer testing in the first quarter 2006 was approximately one-half of the total services group revenue. The shift in our services mix has reduced the average revenue per test and may continue to decline in the future depending on the complexity of services associated with these new tests. However, we anticipate that diagnostic services revenues will increase throughout 2006 based on a more comprehensive suite of advanced cancer diagnostic tests available and the planned expansion of our sales force.

Technology Group. Revenue from our technology group in the first quarter 2006, including fee-per-use, system-sales and development revenue, was $1.2 million, compared to $2.1 million in the first quarter 2005, a decrease of approximately $0.9 million or 41.8%. The change is partially the result of a decrease in instrument systems revenue from $0.8 million for the first quarter 2005 to $0.4 million for the quarter ended March 31, 2006, resulting from our having sold four ACIS® systems in the first quarter of 2006 as compared to six ACIS® systems and four remote viewing stations in the first quarter of 2005. We expect technology services revenue to increase for the balance of 2006 as a result of the sale of systems through the Dako distribution agreement and development fees earned for the on-going development of a new generation of the ACIS® system.

Cost of Revenue and Gross Margin

For the first quarter 2006, our gross margin as a percentage of revenue was 46% compared to 38% for the first quarter 2005.

Services Group. Cost of revenue for the quarter ended March 31, 2006 was $3.3 million compared to $1.8 million for the first quarter of 2005. Our diagnostic services business commenced late in the second quarter of 2004 and, in the first quarter 2005, our costs as a percentage of revenue was relatively high due to the inclusion of costs incurred to support and launch our services group operations. These costs included laboratory personnel, equipment, laboratory supplies and other direct costs such as shipping. Gross margin for our services group for the first quarter 2006 was 41%, compared to 3% for the first quarter 2005. The increase in gross margin in the first quarter of 2006 is attributable to achieving economies of scale in our diagnostics laboratory operations. We anticipate similar gross margin results throughout 2006.

Technology Group. Cost of revenue was $0.4 million for the first quarter 2006 compared to $0.6 million for the first quarter 2005. The cost of revenue primarily consists of cost for manufacturing the ACIS®, including the cost for direct material, labor, manufacturing overhead, and direct customer support. For fee-per-use revenue, the cost of the ACIS® is depreciated over three-years and for a system sale or sales-type lease the entire cost of the ACIS® system is recognized at the time of sale. Gross margins for our technology group were 70% for both quarters ended March 31, 2006 and 2005 We expect that gross margins for the remainder of 2006 will be lower than those achieved in the quarter ended March 31, 2006, on an increased level of revenue. This anticipated decrease in gross margin is a result of our sale of systems through the Dako distribution arrangement, as the pricing terms reflect a reduction of certain expenses, including commissions, on sales to Dako which we would normally incur on our direct sales to end users.

Operating and Other Expenses

Selling, general and administrative expenses. SG&A expenses for the first quarter 2006 increased approximately $1.0 million, or 32%, to $4.0 million compared to $3.0 million for the comparable period in 2005. As a percent of revenues, these costs decreased from 76% in the first quarter 2005 to 59% in the first quarter 2006. The increase in expenses in the current quarter is primarily due to incremental increases in rent expense related to our new facility and to the implementation of Statement of Financial Accounting Standards No. 123(R). We anticipate that these costs may increase in the future with the addition of sales resources to support our projected increase in diagnostic services revenue.

Diagnostic services administration. These costs totaled $2.2 million for the first quarter 2006 which includes the costs of senior medical staff, senior operations personnel, collection costs, consultants and legal resources to facilitate implementation and support the operations of the diagnostic services segment. Our diagnostic services administration expenses were $0.7 million or 52% higher than the $1.4 million in the first quarter 2005. The increase is primarily due to higher collection costs on the 192% increase in services group revenue for the period. These costs are expected to continue to increase for the remaining three quarters of 2006, relative to the prior year, because of higher collection costs on an anticipated, continued increase in services group revenue. We currently outsource billing and collections to a third party and may consider directly providing these services in the future to improve cost controls and maintain the integrity of our customer relations.

Research and development expenses. Expenses for the three months ended March 31, 2006 increased by approximately $0.2 million or 23%, over the comparable period in 2005. This increase is primarily attributable to personnel and consultant additions to support the development activity under our distribution and development agreement with Dako. While development expenses are higher, we earn development fees under the terms of our distribution and development agreement with Dako which are recognized in revenue. These development activities, which are intended to produce features that could expand the volume of clinical tests supported by ACIS® and increase the utility of the ACIS® as a tool for researchers, are important to increasing clinical system test volume, expanding the number of clinical system placements, and increasing research systems sales.

Other expense and income taxes. These expenses for the three months ended March 31, 2006 totaled $0.2 million, compared to $27,000 for the comparable period in 2005, and consisted of approximately $0.2 million of interest expense and $16,000 of income tax expense, offset by approximately $51,000 of interest income. The interest expense is due to the borrowings under our financing facilities and the debt-guarantee fee charged by Safeguard Scientifics, Inc. (“Safeguard”), our majority stockholder. The $51,000 of interest income for the first quarter 2006 compares to $34,000 of interest income for the comparable period of 2005. The increase in interest income is primarily the result of higher cash balances in the first quarter 2006 compared to the first quarter 2005.

Our instrument systems business generates revenues from leases of the ACIS® system to certain customers (pursuant to which those customers pay us on a “fee-per-use” basis for each time the instrument is used to perform a test) and from sales of our ACIS® systems. Revenues from system leases are recognized over the lease term and revenues from system sales are recognized upon customer acceptance of the system. We do not anticipate leasing a significant number of new ACIS® systems on a going forward basis. Instead, we expect that sales of our ACIS® system to new customers will comprise the substantial majority of new system placements. These sales will include sales of systems pursuant to our distribution arrangement with Dako and direct sales by us in markets where our distribution arrangement with Dako is not exclusive. The rate of inventory purchases as it relates to ACIS® equipment purchases has been lower than prior periods due to the slower pace of system placements. However, as a result of our new distribution arrangement with Dako, we expect sales of systems to increase during the remainder of 2006 and that the rate of related inventory purchases will also increase. We also expect our research and development expenditures to increase with respect to development of a future ACIS® system. Future ACIS® system development expenses will be funded in part by Dako under the terms of our distribution and development arrangement.

We believe that we have substantially all of the laboratory equipment that is required to support our current operating activities. A substantial increase in diagnostic service activity in excess of our annual revenue plan may result in a requirement to make additional capital expenditures. We expect to fund any purchases of additional laboratory equipment from our 2006 equipment financing lease line.

We currently have an $8.5 million revolving credit agreement with Comerica, which expires on February 28, 2007. The borrowings under the line of credit are being used for working capital purposes and a $3.0 million stand-by letter of credit that was provided to the landlord of our new leased facility and bears interest at the bank’s prime rate minus 0.5% percent. The agreement also includes an annual facility fee of $27,500 and various restrictive covenants and requirements to maintain certain financial ratios. Borrowings under the line of credit are guaranteed by Safeguard in exchange for an annual fee of 0.5% of the amount guaranteed and an amount equal to 4.5% per annum of the daily-weighted average principal balance outstanding under the line of credit. The Company also issued a warrant to Safeguard to purchase 50,000 shares of common stock for an exercise price of $2.00 per share as additional consideration for Safeguard’s guarantee. The agreement has only one financial covenant related to tangible net worth, which is required to be not less that $0. Exclusive of the $3.0 million stand-by letter of credit, no amounts were outstanding under the line of credit at March 31, 2006.

In June 2004, the Company entered into a master lease agreement with GE Capital for capital equipment financings of diagnostic services (laboratory) related equipment. The Company financed $2.6 million in 2004, $2.3 million in 2005 and $0.6 million through March 31, 2006 of capital equipment under this arrangement, which were recorded as capital lease obligations. Each lease financing has a term of 36 months. At March 31, 2006, the company had $2.4 million available for additional 2006 equipment financings under the master lease agreement. The 2004 financings provides for an early purchase option by the Company after 30 months at 26.6% of the cost of the equipment. The 2005 and 2006 financings provides for an early purchase option by the Company after 24 months for a purchase price equal to 40.5% of the cost of the equipment.

On March 1, 2006, we entered into a Master Purchase Agreement with Med One pursuant to which Med One purchased ACIS® cost per test units that we previously leased to customers for a gross amount of $2.3 million. Med One also has the option to purchase additional units worth up to $1 million which we expect to complete in 2006. Under the agreement, 10 percent of the purchase price is held in escrow and may be recoverable by Med One to the extent that any units returned to Med One prior to the expiration of the applicable equipment lease are not successfully remarketed. The proceeds from this financing are recorded as debt. Amounts invoiced to customers for tests performed or the minimum monthly rental fee related to the units sold to Med One will be recorded as revenue and a portion of each fee will be recorded as interest expense and the remainder will reduce the amount recorded as debt. We will continue to record depreciation expense on the units sold to Med One which will be recorded to cost of revenues.

We believe that our existing cash resources together with access to our financing sources described above including the remaining $5.5 million available under our revolving line of credit with Comerica Bank and the $2.4 million of availability under our equipment lease line with GE Capital (which remains subject to GE Capital’s ongoing review of our financial condition at the time of each funding request) will be sufficient to satisfy the cash needs of our existing operations through the end of 2006. However, if we are unable to access one or more of these financing sources, or if we encounter difficulties in executing our business plan, we may require additional financing. Additionally, if we reach a decision to acquire or license complementary technology or acquire complementary businesses, we would require additional debt or equity financing, or would be required to monetize other assets. There can be no assurance that we will be able to obtain additional debt or equity financing when needed or on terms that are favorable to us and our stockholders. Furthermore, if additional funds are raised through an equity or convertible debt financing, our stockholders may experience significant dilution.

The following table summarizes our contractual obligations and commercial commitments at March 31, 2006, including our new facility lease and borrowings on equipment subject to operating leases. These commitments exclude any remaining amounts necessary to complete the build-out of our new facility and a $3.0 million standby letter of credit provided to the landlord under the lease agreement for our new facility.

	Payment due by period
	(in thousands)
Contractual Obligations	Total		Less than 1 Year		1-3 Years		4-5 Years		After 5 Years
Long-Term Debt Obligations	$	2,188	$	558	$	1,630	$	—	$	—
Capital Lease Obligations	3,779		1,665		2,114		—		—
Operating Leases	13,842		1,023		3,881		3,007		5,931
Total	$	19,809	$	3,246	$	7,625	$	3,007	$	5,931

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements that provide financing, liquidity, market or credit risk support or involve leasing, hedging or research and development services for our business or other similar arrangements that may expose us to liability that is not expressly reflected in the financial statements, except for facilities operating leases.

As of March 31, 2006, we did not have any relationships with unconsolidated entities or financial partnerships, often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such we are not subject to any material financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

New Accounting Standards

Several new accounting standards have been issued and adopted. None of these standards had a material impact on our financial position, results of operations, or liquidity. See Note 9 of the Notes to Condensed Consolidated Financial Statements.

Factors That May Affect Future Results

Before deciding to invest in us or to maintain or increase your investment, you should carefully consider the risks described below, in addition to the other information contained in this report and other reports we have filed with the Securities and Exchange Commission. The risks and uncertainties described below are not the only ones facing our Company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business operations. If any of these risks are realized, our business, financial condition or results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part of your investment.

We entered into a distribution and development agreement with Dako in July 2005 to support the marketing and sales of the ACIS® system to large hospitals, academic research centers and pathology groups. While we and Dako are making progress in both the distribution and development arrangements, we still face significant uncertainties, including our ability to meet specific development milestones that could negatively impact our delivery schedule for new generation products and the related impact on milestone payments for missing these deadlines, as well as those discussed above under “Liquidity and Capital Resources” and Part II, Item 1A “Risk Factors,” which include our ability to achieve market acceptance of the ACIS® and our ability to execute against our sales plan with Dako to sell instruments. We also face uncertainties with respect to our ability to ensure satisfactory reimbursement by Medicare and other third party insurance carriers, collectibility from private payors and our ability to execute on our business plan to provide additional laboratory and bioanalytical services.

Laboratory services provided for patients with the assistance of ACIS® technology are eligible for third party reimbursement using medical billing codes which apply to image analysis-based testing. These billing codes are known as Healthcare Common Procedure Coding System (HCPCS) codes, which include the CPT codes as the means by which Medicare and private insurers identify medical services that are provided to patients in the United States. CPT codes are established by an independent editorial panel convened by the American Medical Association (AMA). The reimbursement amounts, or relative values, associated with the CPT codes are established by the Centers for Medicare and Medicaid Services (CMS), under a process that involves recommendations from an independent Relative Value Update Committee also convened by the AMA, with advice from professional societies representing the various medical specialties.

A new CPT code appropriate for image analysis went into effect on January 1, 2004. The interim rates established for this code in 2004 were subsequently amended on January 1, 2005. Under the new code, the total Medicare reimbursement for ACIS®-based procedures performed in physician offices or independent laboratories is approximately $168 per test, reflecting a technical component of approximately $100 and a professional component of approximately $68. The technical component involves preparation of the patient sample and running the test on the ACIS®, while the professional component involves the physician’s reading and evaluation of the test results. The actual amount varies based upon a geographic factor index for each state and may be higher or lower than the amounts indicated above in particular cases based on one’s geographic location. In southern California, for example, where Clarient’s technical services are currently performed, the reimbursement amount for technical services is approximately $118 per slide.

We also face uncertainties with respect to our ability to complete development of additional tests for the ACIS®. In order to mitigate the risk that any one test will not be successfully developed, we maintain a pipeline of tests in a prioritized queue so that we can align development efforts according to priority if any one test is not successfully developed, or market feedback suggests that a test should be given a lower priority. In addition, the ACIS® is dependent upon the laboratory producing a quality stained slide for image analysis. Reagent and/or stain quality issues by stain manufacturers may impact the rate at which the ACIS® technology is adopted or new applications are added to existing placements.

Other Risks Related to Our Business

We have limited experience in providing laboratory and other services, which may cause us to experience difficulties that could delay or prevent the development, introduction and marketing of these services.

We began providing the technical component of reference laboratory services in-house beginning in April 2004 and we began to provide additional oncology-focused laboratory services that complement our image analysis and certified Access reference laboratory services in December 2004. The success and viability of these initiatives is dependent on a number of factors including:

• our ability to develop and provide services that we have provided only for a short time;

• adequate reimbursement;

• medical efficacy as demonstrated by clinical studies and governmental clearances;

• governmental clearances, governmental regulations and expansion of the menu of tests performed by ACIS® to bring greater economies of scale to our accounts operations; and

• our ability to obtain timely renewal of state and federal regulatory licenses.

We may not be successful in any of these areas, we may experience difficulties that could delay or prevent the successful development, introduction and marketing of these services, and we may not adequately meet the demands of the marketplace or achieve market acceptance. Our inability to accomplish any of these endeavors may have a material adverse effect on our business, operating results, cash flows and financial condition.

Our instrument business is highly dependent on the efforts of our distribution partners and on increased market penetration of the ACIS®, and it is uncertain whether the ACIS® will achieve that penetration.

Increased market acceptance of the ACIS® depends on a number of variables, including, but not limited to, the following:

• the ability of the ACIS® to perform as expected;

• acceptance by patients, physicians, third party payers and laboratories of the ACIS® to run the tests performed using it;

• our ability to develop a significant number of tests performed with the ACIS®;

• the amount of reimbursement by third party payers for a test performed using the ACIS®;

• our ability to expand our diagnostic laboratory service initiative;

• the effectiveness of our marketing, distribution and pricing strategy;

• availability of alternative and competing diagnostic products; and

• scientific studies and other publicity concerning ACIS® or competitive products.

The future commercial success of our products will depend primarily on convincing research, reference and clinical laboratories to evaluate and offer these products as research tools for scientists and clinical investigators and as diagnostic products to physicians, laboratory professionals and other medical practitioner and convincing physicians, laboratory professionals and other medical practitioners to order tests for their patients involving our technologies. To accomplish this, we will need to convince oncologists, pathologists and other members of the medical and biotechnology communities of the benefits of our products. Additionally, if ongoing or future clinical trials result in unfavorable or inconsistent results, these products may not achieve market acceptance. Even if the efficacy of our future products and services are established, physicians may elect not to use them for a number of reasons. These reasons might include the training required for their use or unfavorable reimbursement from health care payers.

We have entered into and intend to continue to enter into corporate collaborations for the development of new applications, clinical collaborations with respect to tests using the ACIS® and strategic alliances for the distribution of the ACIS® and our other products, including products we may develop in the future. In July 2005, we entered into a distribution and development agreement with Dako, which is exclusive in research and clinical markets and non-exclusive with respect to biotechnology and pharmaceutical companies (and their academic research partners). We therefore depend upon the success of Dako to distribute our ACIS® products and perform their responsibilities under our collaborative arrangements. The transition from selling ACIS® systems directly to selling them through Dako has been challenging. We experienced a slower than expected start-up of the implementation of our distribution arrangement with Dako. The delayed ramp-up of this selling arrangement has resulted in our technology business experiencing a 42% decline in systems revenue from $2.1 million in the first quarter of 2005 to $1.2 million in the first quarter of 2006, and a corresponding decline in gross profit from $1.5 million to $0.9 million. We believe that the ramp-up of this relationship will improve in the 2006 fiscal year, although we may not reach our sales goals for the full year. If our arrangement with Dako is not successful, the marketability of our products and services may be limited and our technology could become underfunded and obsolete relative to new, emerging technologies of companies that have greater financial resources. We cannot assure you that we will be able to enter into additional arrangements that may be necessary in order to develop and commercialize our products, or that we will realize any of the contemplated benefits from existing or new arrangements.

We have a history of operating losses, and our future profitability is uncertain.

We have incurred operating losses in every year since inception, and our accumulated deficit as of March 31, 2006 was $125 million. Those operating losses are principally associated with the research and development of our ACIS® technology, the start-up and early operations of our diagnostics laboratory business, the conducting of clinical trials, preparation of regulatory clearance filings, the development of Dako’s sales and marketing organization to commercialize the ACIS® and the capital investments we have made relating to our recently launched diagnostic services business. Although leasing and sales of the ACIS® have been encouraging since we introduced our new business strategy in the third quarter of 2004 and we have recently begun to provide a wide array of laboratory services, we may not be able to achieve profitable operations at any time in the future.

Because our operating expenses are likely to increase in the near term, we will need to generate significant additional revenue to achieve profitability. We expect to continue to incur losses as a result of the expansion of the laboratory services, ongoing research and development expenses, as well as increased sales expenses. We are unable to predict when we will become profitable, and we may never become profitable. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. If we are unable to achieve and then maintain profitability, the market value of our common stock will decline.

We are in the process of relocating our business and will be required to make significant expenditures in connection therewith.

We recently relocated our diagnostic services laboratory to a new facility in Aliso Viejo, California. We currently lease our corporate headquarters and manufacturing facility on a month-to-month basis, and we intend to move our corporate headquarters and manufacturing facility to the Aliso Viejo facility during the second quarter of 2006. The recent relocation of our diagnostic services laboratory and the move of our corporate headquarters and manufacturing facility to the Aliso Viejo facility could create risk of business interruption and will require substantial capital investment. There is no guarantee that we will be able to successfully complete this move to a new facility.

We may require additional financing for, among other things , for funding our operating losses, planned expansion of our laboratory operations, capital expenditures and other costs related to the move to a new facility, acquisition transactions and expenses associated with our anticipated increase in placements of our ACIS® systems and it is uncertain whether such financing will be available on favorable terms, if at all.

Our present and future funding requirements will also depend on certain other external factors, including, among other things:

• the level of research and development investment required to maintain and improve our technology position;

• costs of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights;

• our need or decision to acquire or license complementary technologies or acquire complementary businesses;

• competing technological and market developments; and

• changes in regulatory policies or laws that affect our operations.

We do not know whether additional financing will be available on commercially acceptable terms when needed. If adequate funds are not available or are not available on commercially acceptable terms, we might be required to delay, scale back or eliminate some or all of our development activities, new business initiatives, clinical studies or regulatory activities or to license to third parties the right to commercialize products or technologies that we would otherwise seek to commercialize ourselves. If additional funds are raised through an equity or convertible debt financing, our stockholders may experience significant dilution.

Our strategy for the development and commercialization of the ACIS® platform contemplates collaborations with third parties, making us dependent on their success.

We do not have the ability to independently conduct the clinical trials required to obtain regulatory clearances for our applications, but rely on third-party expert clinical investigators and clinical research organizations to perform these functions. If we cannot locate and enter into favorable agreements with acceptable third parties, or if these third parties do not successfully carry out their contractual obligations, meet expected deadlines or follow regulatory requirements, including clinical laboratory, manufacturing and good clinical practice guidelines, then we may be the subject of an enforcement action by the FDA or other regulatory bodies, and may be unable to obtain clearances for our products or to commercialize them on a timely basis, if at all.

Our ability to engage in certain business transactions may be limited by the restrictive covenants of our debt financing agreements.

Our existing financing agreements with Comerica Bank-California contain financial covenants requiring us to meet financial ratios and financial condition tests, as well as covenants restricting our ability to:

• incur additional debt;

• pay dividends or make other distributions or payments on capital stock;

• make investments;

• incur or permit to exist liens;

• enter into transactions with affiliates;

• change business, legal name or state of incorporation;

• guarantee the debt of other entities, including joint ventures;

• merge or consolidate or otherwise combine with another company; and

• transfer or sell our assets.

These covenants could adversely affect our ability to finance our future operations or capital needs and pursue available business opportunities, including acquisitions. A breach of any of these covenants could result in a default in respect of the related indebtedness. If a default occurs, the relevant lenders could elect to declare the indebtedness, together with accrued interest and other fees, to be immediately due and payable and proceed against any collateral securing that indebtedness. We believe that we are currently in compliance with the covenants in our financing agreements.

We have limited commercial manufacturing capacity and may encounter difficulties as we undertake to manufacture our system in increasing quantities.

We may encounter significant delays and incur significant unexpected costs in scaling-up our manufacturing operations. In addition, we may encounter delays and difficulties in hiring and training the workforce necessary to manufacture the ACIS® in the increasing quantities required for us to achieve profitability. The failure to scale-up manufacturing operations successfully, in a timely and cost-effective manner, could have a material adverse effect on our revenues and income. We believe that we have adequate manufacturing capacity to meet anticipated demand for 2006. However, in order to meet demand thereafter, we will have to expand our manufacturing processes and manpower or rely on third-party manufacturers. We might encounter difficulties in expanding our manufacturing processes and hiring qualified personnel or in developing relationships with third-party manufacturers. If we are unable to overcome these difficulties our ability to meet product demand could be impaired or delayed.

We may not successfully manage our growth, which may result in delays or unanticipated difficulties in implementing our business plan.

Our success will depend upon the expansion of our operations and the effective management of our growth. We expect to experience growth in the scope of our operations and services and the number of our employees. If we grow significantly, such growth will place a significant strain on management and on administrative, operational and financial resources. To manage any growth, we would need to expand our facilities, augment our operational, financial and management systems, internal controls and infrastructure and hire and train additional qualified personnel. Our future success is heavily dependent upon growth and acceptance of our future products and services. If we are unable to scale our business appropriately or otherwise adapt to anticipated growth and new product introduction, our business, operating results, cash flows and financial condition may be harmed.

The medical imaging technology market is characterized by rapid technological change, frequent new product introductions and evolving industry standards, and we may encounter difficulties keeping pace with changes in this market.

The introduction of diagnostic tests embodying new technologies and the emergence of new industry standards can render existing tests obsolete and unmarketable in short periods of time. We expect competitors to introduce new products and services and enhancements to existing products and services. The life cycles of tests using the ACIS®, and of the ACIS® itself, are difficult to estimate. Our future success will depend upon our ability to enhance our current tests, to develop new tests, and to enhance and continue to develop the hardware and software included in the ACIS®, in a manner that keeps pace with emerging industry standards and achieves market acceptance. Our inability to accomplish any of these endeavors will have a material adverse effect on our business, operating results, cash flows and financial condition.

We face substantial existing competition and potential new competition from others pursuing technologies for imaging systems.

We compete in a highly competitive industry. ACIS® was first released in 1997 for use in research as an imaging system for the detection of rare cellular events. The primary application was for the detection of cells which contained a marker used to distinguish possible cancerous cells in bone marrow. At that time, the most significant competition to the ACIS® for this application was use of manual microscopes and certain other cell-based techniques. These other techniques include polymerase chain reaction (PCR), a technique used in clinical labs to detect DNA sequences, and flow cytometry, a technique used to analyze biological material through the detection of the light-absorbing or fluorescing properties of cells. A natural progression for Clarient and the ACIS® was to penetrate the manually intensive slide-based cancer testing market, with an initial focus on the breast cancer market. Companies such as Dako, Ventana and BioGenex have greater cancer-testing market share and stronger medical laboratory relationships than we do. They also have two of the critical system components needed to drive standardization—reagents and staining automation. In July 2005, we entered into a distribution and development agreement with Dako relating to our ACIS® system, which is exclusive in research and clinical markets and non-exclusive with respect to biotechnology and pharmaceutical companies (and their academic research partners). Other imaging companies such as TriPath and Applied Imaging are currently expanding into this market. Advancements in alternative cancer diagnostic tests and the development of new protein-based therapies will bring increased competition to this market segment, and such competition could adversely affect our operating results, cash flows and financial condition.

The clinical laboratory business is intensely competitive both in terms of price and service. This industry is dominated by several national independent laboratories, but includes many smaller niche and regional independent laboratories as well. Large commercial enterprises, including Quest and LabCorp, have substantially greater financial resources and may have larger research and development programs and more sales and marketing channels than we do, enabling them to potentially develop and market competing products and services. These enterprises may also be able to achieve greater economies of scale or establish contracts with payer groups on more favorable terms. Smaller niche laboratories compete with us based on their reputation for offering a narrow test menu. Academic and regional medical institutions generally lack the advantages of the larger commercial laboratories but still compete with us on a limited basis. Pricing of laboratory testing services is one of the significant factors often used by health care providers in selecting a laboratory. As a result of the clinical laboratory industry undergoing significant consolidation, larger clinical laboratory providers are able to increase cost efficiencies afforded by large-scale automated testing. This consolidation results in greater price competition. We may be unable to increase cost efficiencies sufficiently, if at all, and as a result, our operating results, cash flows and our financial position could be negatively impacted by such price competition.

Competition in the pharmaceutical and biotechnology industries, and the medical devices and diagnostic products segments in particular, is intense and has been accentuated by the rapid pace of technological development. Our competitors in this area include large diagnostics and life sciences companies. Most of these entities have substantially greater research and development capabilities and financial, scientific, manufacturing, marketing, sales and service resources than we do. Some of them also have more experience than we do in research and development, clinical trials, regulatory matters, manufacturing, marketing and sales.

Because of their experience and greater research and development capabilities, our competitors might succeed in developing and commercializing technologies or products earlier and obtaining regulatory approvals and clearances from the FDA more rapidly than we can. Our competitors also might develop more effective technologies or products that are more predictive, more highly automated or more cost-effective, and that may render our technologies or products obsolete or non-competitive.

We rely significantly on third-party manufacturers who may fail to supply us with components necessary to our products and services on a timely basis.

We rely currently and intend to continue to rely significantly in the future on third-party manufacturers to produce all of the components used in our ACIS® device and for future instrument systems that we may develop. We are dependent on these third-party manufacturers to perform their obligations in a timely and effective manner and in compliance with FDA and other regulatory requirements.

To date, we have generally not experienced difficulties in obtaining components from our manufacturers and, in cases where a particular manufacturer was unable to provide us with a necessary component, we have been able to locate suitable secondary sources. However, if the suppliers we rely on in the manufacturing of our products were unable to supply us with necessary components and we were unable to locate acceptable secondary sources, we might be unable to satisfy product demand, which would negatively impact our business. In addition, if any of these components are no longer available in the marketplace, we will be forced to further develop our technologies to incorporate alternate components. If we incorporate new components or raw materials into our products we might need to seek and obtain additional approvals or clearances from the FDA or foreign regulatory agencies, which could delay the commercialization of these products.

Failure in our information technology systems could disrupt our operations.

Our success will depend, in part, on the continued and uninterrupted performance of our information technology systems. Information systems are used extensively in virtually all aspects of our business, including laboratory testing, billing, customer service, logistics and management of medical data. Our success depends, in part, on the continued and uninterrupted performance of our information technology systems.

Our computer systems are vulnerable to damage from a variety of sources, including telecommunications failures, malicious human acts and natural disasters. Moreover, despite reasonable security measures we have implemented, some of our information technology systems are potentially vulnerable to physical or electronic break-ins, computer viruses and similar disruptive problems, in part because we conduct business on the Internet and because some of these systems are located at third party web hosting providers and we cannot control the maintenance and operation of the data centers. Despite the precautions we have taken, unanticipated problems affecting our systems could cause interruptions in our information technology systems, leading to lost revenue, deterioration of customer confidence, or significant business disruption. Our business, financial condition, results of operations, or cash flows could be materially and adversely affected by any problem that interrupts or delays our operations.

If a catastrophe were to strike our facility, we would be unable to operate our business competitively.

We currently assemble, test and release our ACIS® device at our facility located in San Juan Capistrano, California and we provide diagnostic services from our new laboratory facility in Aliso Viejo, California. We do not have alternative production plans in place or alternative facilities available at this time. If there are unforeseen shutdowns to our facility, we will be unable to satisfy customer orders on a timely basis.

Our facilities may be affected by catastrophes such as fires, earthquakes or sustained interruptions in electrical service. Earthquakes are of particular significance to us because all of our clinical laboratory facilities are located in Southern California, an earthquake-prone area. In the event our existing facilities or equipment are affected by man-made or natural disasters, we may be unable to process our customers’ samples in a timely manner and unable to operate our business in a commercially competitive manner.

Our ability to maintain our competitive position depends on our ability to attract and retain highly qualified managerial, technical and sales and marketing personnel.

We believe that our continued success depends to a significant extent upon the efforts and abilities of our executive officers and our scientific and technical personnel, including the following individuals:

• Ronald A. Andrews, our President and Chief Executive Officer;

• Heather Creran, our Executive Vice President and Chief Operating Officer—Diagnostic Services;

• Ken Bloom, M.D., our Chief Medical Director;

• Karen Garza, our Vice President of Marketing and Strategic Initiatives;

• Jose de la Torre-Bueno, Ph.D., our Vice President and Chief Technology Officer;

• David J. Daly, our Vice President of Sales; and

• James Cureton, our Vice President of Instrument Systems.

We do not maintain key-person life insurance on any of our officers, scientific and technical personnel or other employees. The loss of any of our executive officers or senior managers could have a material adverse effect on our business, operating results, cash flows and financial condition.

Our Chief Financial Officer resigned on February 3, 2006. We have engaged a professional search firm to begin recruitment of a new Chief Financial Officer and have hired John A. Roberts to serve as our Acting Chief Financial Officer on an interim basis.

Furthermore, our anticipated growth and expansion will require the addition of highly skilled technical, management, financial, sales and marketing personnel. In particular, we may encounter difficulties in attracting a sufficient number of qualified California licensed laboratory scientists. Competition for personnel is intense, and our failure to hire and retain talented personnel or the loss of one or more key employees could have a material adverse effect on our business. Many members of our current senior management group have been recruited and hired over the past 18 months. These individuals may not be able to fulfill their responsibilities adequately and may not remain with us.

The reimbursement rate for ACIS®-based services has changed significantly over the past several years and further changes may result in an adverse effect on our revenues and results of operations.

The majority of the sales of our products in the U.S. and other markets will depend, in large part, on the availability of adequate reimbursement to users of these products from government insurance plans, including Medicare and Medicaid in the U.S., managed care organizations, private insurance plans and other third-party payers. The continued success of the ACIS® depends upon its ability to replace or augment existing procedures that are covered and otherwise eligible for payments and covered by the medical insurance industry.

We are not able to fully assess or predict the full impact of future changes in reimbursement levels on our business at this time, nor whether Medicare will review the medical necessity and appropriateness of amounts that have been paid in prior years, although it is likely that reductions in reimbursement levels will impact our pricing, profitability and the demand for testing.

Our net revenue will be diminished if payers do not adequately cover or reimburse our services.

There has been and will continue to be significant efforts by both federal and state agencies to reduce costs in government healthcare programs and otherwise implement government control of healthcare costs. In addition, increasing emphasis on managed care in the U.S. may continue to put pressure on the pricing of healthcare services. Uncertainty exists as to the coverage and reimbursement status of new applications or services. Third party payers, including governmental payers such as Medicare and private payers, are scrutinizing new medical products and services and may not cover or may limit coverage and the level of reimbursement for our services. Third party insurance coverage may not be available to patients for any of our existing assays or assays we discover and develop. However, a substantial portion of the testing for which we bill our hospital and laboratory clients is ultimately paid by third party payers. Any pricing pressure exerted by these third party payers on our customers may, in turn, be exerted by our customers on us. If government and other third party payers do not provide adequate coverage and reimbursement for our assays, our operating results, cash flows or financial condition may decline.

Managed care organizations are using capitated payment contracts in an attempt to shift payment risks which may negatively impact our operating margins.

Managed care providers typically contract with a limited number of clinical laboratories and then designate the laboratory or laboratories to be used for tests ordered by participating physicians. The majority of managed care testing is negotiated on a fee-for-service basis at a discount. Such discounts have historically resulted in price erosion and we expect that they could negatively impact our operating margins as we continue to offer laboratory services to managed care organizations.

Third party billing is extremely complicated and will result in significant additional costs to us.

Billing for laboratory services is extremely complicated. The customer refers the tests; the payer is the party that pays for the tests, and the two are not always the same. Depending on the billing arrangement and applicable law, we need to bill various payers, such as patients, insurance companies, Medicare, Medicaid, doctors and employer groups, all of which have different billing requirements. Additionally, our billing relationships require us to undertake internal audits to evaluate compliance with applicable laws and regulations as well as internal compliance policies and procedures. Insurance companies also impose routine external audits to evaluate payments made. This adds further complexity to the billing process.

Among many other factors complicating billing are:

• pricing differences between our fee schedules and the reimbursement rates of the payers;

• disputes with payers as to which party is responsible for payment; and

• disparity in coverage and information requirements among various carriers.

We incur significant additional costs as a result of our participation in the Medicare and Medicaid programs, as billing and reimbursement for clinical laboratory testing are subject to considerable and complex federal and state regulations. The additional costs we expect to incur include those related to: (1) complexity added to our billing processes; (2) training and education of our employees and customers; (3) implementing compliance procedures and oversight; (4) collections and legal costs; and (5) costs associated with, among other factors, challenging coverage and payment denials and providing patients with information regarding claims processing and services, such as advanced beneficiary notices.

We may acquire other businesses, products or technologies in order to remain competitive in our market and our business could be adversely affected as a result of any of these future acquisitions.

We may make acquisitions of complementary businesses, products or technologies. If we identify any additional appropriate acquisition candidates, we may not be successful in negotiating acceptable terms of the acquisition, financing the acquisition, or integrating the acquired business, products or technologies into our existing business and operations. Further, completing an acquisition and integrating an acquired business will significantly divert management time and resources. The diversion of management attention and any difficulties encountered in the transition and integration process could harm our business. If we consummate any significant acquisitions using stock or other securities as consideration, our shareholders’ equity could be significantly diluted. If we make any significant acquisitions using cash consideration, we may be required to use a substantial portion of our available cash. Acquisition financing may not be available on favorable terms, if at all. In addition, we may be required to amortize significant amounts of other intangible assets in connection with future acquisitions, which would harm our operating results, cash flows and financial condition.

Risks Related to Litigation and Intellectual Property

Product liability claims could subject us to significant monetary damage.

The manufacture and sale of the ACIS® and similar products entails an inherent risk of product liability arising from an inaccurate, or allegedly inaccurate, test or diagnosis. We currently maintain numerous insurance policies, including a $2,000,000 general liability policy, a $5,000,000 technology-based errors and omissions policy and a $10,000,000 umbrella liability policy (which excludes technology based errors and omissions). These policies have deductible ranges from $5,000 to $25,000 and contain customary exclusions (including certain exclusions for medical malpractice and asbestos). Although we have not experienced any material losses to date, we cannot assure you that we will be able to maintain or acquire adequate product liability insurance in the future. Any product liability claim against us could have a material adverse effect on our reputation and operating results, cash flows and financial condition.

Clinicians or patients using our products or services may sue us and our insurance may not sufficiently cover all claims brought against us, which will increase our expenses.

The development, marketing, sale and performance of healthcare services expose us to the risk of litigation, including professional negligence. Damages assessed in connection with, and the costs of defending, any legal action could be substantial. We currently maintain numerous insurance policies, including a $3,000,000 professional liability insurance policy ($2,000,000 per incident). This policy has a deductible of $10,000 and contains customary exclusions (including exclusions relating to asbestos and biological contaminants). However, we may be faced with litigation claims which exceed our insurance coverage or are not covered under any of our insurance policies. In addition, litigation could have a material adverse effect on our business if it impacts our existing and potential customer relationships, creates adverse public relations, diverts management resources from the operation of the business or hampers our ability to perform assays or otherwise conduct our business.

If we use biological and hazardous materials in a manner that causes injury, we could be liable for damages.

Our research and development and clinical pathology activities sometimes involve the controlled use of potentially harmful biological materials, hazardous materials, chemicals and various radioactive compounds. We cannot completely eliminate the risk of accidental contamination or injury to third parties from the use, storage, handling or disposal of these materials. We currently maintain numerous insurance policies, including a $2,000,000 general liability policy and a $10,000,000 umbrella liability policy (which excludes technology-based errors and omissions). These policies have deductible ranges from $5,000 to $25,000 and contain customary exclusions (including certain exclusions relating to asbestos and medical malpractice). However, in the event of contamination or injury, we could be held liable for any resulting damages, and any liability could exceed our resources or any applicable insurance coverage we may have. Additionally, we are subject on an ongoing basis to federal, state and local laws and regulations governing the use, storage, handling and disposal of these materials and specified waste products. The cost of compliance with these laws and regulations is significant and could negatively affect our operations, cash flows and financial condition if these costs increase substantially.

Any breakdown in the protection of our proprietary technology, or any determination that our proprietary technology infringes on the rights of others, could materially affect our business.

Our commercial success will depend in part on our ability to protect and maintain our proprietary technology and to obtain and enforce patents on our technology. We rely primarily on a combination of copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect our proprietary rights. However, obtaining, defending and enforcing our patents and other intellectual property rights involve complex legal and factual questions. We cannot assure you that we will be able to obtain, defend or enforce our patent rights covering our technologies in the U.S. or in foreign countries, or be able to effectively maintain our technologies as unpatented trade secrets or otherwise obtain meaningful protection for our proprietary technology. Moreover, we cannot assure you that third parties will not infringe, design around, or improve upon our proprietary technology or rights.

The healthcare industry has been the subject of extensive litigation regarding patents and other proprietary rights and if we are unable to protect our patents and proprietary rights, through litigation or otherwise, our reputation and competitiveness in the marketplace could be materially damaged.

We may initiate litigation to attempt to stop the infringement of our patent claims or to attempt to force an unauthorized user of our trade secrets to compensate us for the infringement or unauthorized use. Patent and trade secret litigation is complex and often difficult and expensive, and would consume the time of our management and other significant resources. If the outcome of litigation is adverse to us, third parties may be able to use our technologies without payments to us. Moreover, some of our competitors may be better able to sustain the costs of litigation because they have substantially greater resources. Because of these factors relating to litigation, we may be unable to prevent misappropriation of our patent and other proprietary rights effectively.

If the use of our technologies conflicts with the intellectual property rights of third-parties, we may incur substantial liabilities and we may be unable to commercialize products based on these technologies in a profitable manner, if at all.

Our competitors or others may have or acquire patent rights that they could enforce against us. If they do so, we may be required to alter our technologies, pay licensing fees or cease activities. If our technologies conflict with patent rights of others, third parties could bring legal action against us or our licensees, suppliers, customers or collaborators, claiming damages and seeking to enjoin manufacturing and marketing of the affected products. If these legal actions are successful, in addition to any potential liability for damages, we might have to obtain a royalty or licensing arrangement in order to continue to manufacture or market the affected products. A required license or royalty under the related patent or other intellectual property may not be available on acceptable terms, if at all.

We may be unaware of issued patents that our technologies infringe. Because patent applications can take many years to issue, there may be currently pending applications, unknown to us, that may later result in issued patents upon which our technologies may infringe. There could also be existing patents of which we are unaware upon which our technologies may infringe. In addition, if third parties file patent applications or obtain patents claiming technology also claimed by us in pending applications, we may have to participate in interference proceedings in the U.S. Patent and Trademark Office to determine priority of invention. If third parties file oppositions in foreign countries, we may also have to participate in opposition proceedings in foreign tribunals to defend the patentability of the filed foreign patent applications. We may have to participate in interference proceedings involving our issued patents or our pending applications.

If a third party claims that we infringe upon its proprietary rights, any of the following may occur:

• we may become involved in time-consuming and expensive litigation, even if the claim is without merit;

• we may become liable for substantial damages for past infringement, including possible treble damages for allegations of willful infringement, if a court decides that our technologies infringe upon a competitor’s patent;

• a court may prohibit us from selling or licensing our product without a license from the patent holder, which may not be available on commercially acceptable terms, if at all, or which may require us to pay substantial royalties or grant cross licenses to our patents; and

• we may have to redesign our product so that it does not infringe upon others’ patent rights, which may not be possible or could require substantial funds or time.

If any of these events occurs, our business, results of operation, cash flows and financial condition will suffer and the market price of our common stock will likely decline.

Risks Related to Regulation of Our Industry

FDA regulations and those of other regulatory agencies can cause significant uncertainty, delay and expense in introducing new applications for the ACIS® and present a continuing risk to our ability to offer applications.

As a medical device, our ACIS® product is subject to extensive and frequently changing federal, state and local governmental regulation in the U.S. and in other countries. The FDA pursuant to its authority under the Food, Drug and Cosmetic Act, regulates virtually all aspects of the development, testing, manufacture, labeling, storage, record keeping, distribution, sale, marketing, advertising and promotion and importing and exporting of medical devices. Failure to comply with applicable governmental requirements can result in fines, recall or seizure of products, total or partial suspension of production, withdrawal of existing product approvals or clearances, refusal to approve or clear new applications or notices and criminal prosecution. In addition, changes in existing laws or regulations, or new laws or regulations, may delay or prevent us from marketing our products or cause us to reduce our pricing.

If we are not able to obtain all of the regulatory approvals and clearances required to commercialize our products, our business would be significantly harmed.

The ACIS® and other medical devices we develop require clearance or approval by the FDA before they can be commercially distributed in the U.S. and may require similar approvals by foreign regulatory authorities before distribution in foreign jurisdictions. Regulatory clearance or approval of applications for the ACIS® or other products we may develop, including the related software, may be denied or may include significant limitations on the indicated uses for which it may be marketed. The FDA actively enforces the prohibition on marketing products that have not been approved or cleared and also imposes and enforces strict regulations regarding the validation and quality of manufacturing, which are enforced through periodic inspection of manufacturing facilities. Foreign countries have comparable regulations.

In most cases, the development and commercialization of additional diagnostic applications in the U.S. will require either pre-market notification, or 510(k) clearance, or pre-market approval (PMA) from the FDA prior to marketing. The 510(k) clearance pathway usually takes from two to twelve months from submission, but can take longer. The pre-market approval pathway is much more costly, lengthy, uncertain and generally takes from one to two years or longer from submission. We do not know whether we will be able to obtain the clearances or approvals required to commercialize these products. In addition, modifications and enhancements to a medical device also require a new FDA clearance or approval if they could significantly affect its safety or effectiveness or would constitute a major change in the device’s intended use, design or manufacture. The FDA requires every manufacturer to make this determination in the first instance, but the FDA may review any manufacturer’s decision. If the FDA requires us to seek clearance or approval for modification of a previously cleared product for which we have concluded that new clearances or approvals are unnecessary, we may be required to cease marketing or to recall the modified product until we obtain clearance or approval, and we may be subject to significant regulatory fines or penalties.

In the case of a PMA and/or a 510(k), there is no assurance that the agency will agree with the submission and/or clear or approve the product. FDA may reject a 510(k) submission and require that a company file a PMA instead. Determination by FDA that any of our devices or certain applications of ours are subject to the PMA process could have a material adverse effect on our business, results of operations and financial condition. Nonetheless, a business benefit can accrue where FDA approves a PMA because holding a PMA may, in some instances, provide a competitive advantage. A change or modification of a medical device that has already received FDA clearance or approval can result in the need to submit further filings to the agency.

Applications submitted for FDA clearance or approval will be subject to substantial restrictions, including, among other things, restrictions on the indications for which we may market these products, which could result in lower revenues. The marketing claims we will be permitted to make in labeling or advertising regarding our cancer diagnostic products, if cleared or approved by the FDA, will be limited to those specified in any clearance or approval. In addition, we are subject to inspection and marketing surveillance by the FDA to determine our compliance with regulatory requirements. Finally, we are subject to medical device reporting regulations that require us to report to the FDA or similar governmental bodies in other countries if our products cause or contribute to a death or serious injury or malfunction in a way that would be reasonably likely to contribute to death or serious injury if the malfunction were to recur. If the FDA finds that we have failed to comply with these requirements, it can institute a wide variety of enforcement actions, ranging from a public warning letter to more severe sanctions, including:

• fines, injunctions and civil penalties;

• recall or seizure of our products;

• operating restrictions, partial suspension or total shutdown of production;

• denial of requests for 510(k) clearances or pre-market approvals of product candidates;

• withdrawal of 510(k) clearances or pre-market approvals already granted; and

• criminal prosecution.

Any of these enforcement actions could affect our ability to commercially distribute our products in the U.S. and may also harm our ability to conduct the clinical trials necessary to support the marketing, clearance or approval of additional applications.

We cannot predict the extent of future FDA regulation of our in-house diagnostic laboratory services.

Neither the FDA nor any other governmental agency currently fully regulates the in-house diagnostic laboratory services that we market to physicians, laboratory professionals and other medical practitioners. These tests are commonly referred to as “home brews.” FDA maintains that it has the authority to regulate “home brews” under the Federal Food, Drug, and Cosmetic Act as medical devices, however, as a matter of enforcement discretion, but has decided not to exercise its authority. FDA is currently assessing the feasibility of applying additional regulatory controls over in-house diagnostic laboratory testing. We cannot predict the extent of future FDA regulation and there can be no assurance that the FDA will not require in-house diagnostic laboratory testing to receive premarketing clearance, or premarket approval prior to marketing. Additional FDA regulatory controls over our in-house diagnostic laboratory services could add substantial additional costs to our operations, and may delay or prevent our ability to commercially distribute our services in the U.S.

Our medical devices, facilities and products are subject to significant quality control oversight and regulations, and our failure to comply with these could result in penalties or enforcement proceedings.

Manufacturers of medical devices are subject to federal and state regulation regarding validation and the quality of manufacturing facilities, including FDA’s Quality System Regulation, or QSR, which covers, among other things, the design, testing production processes, controls, quality assurance, labeling, packaging, storing and shipping of medical devices. The FDA periodically inspects facilities to ascertain compliance with these and other requirements. Our failure to comply with these quality system regulations could result in, among other things, warning letters, fines, injunctions, seizures, civil or criminal penalties or enforcement proceedings, including the recall of a product or a “cease distribution” order requiring us to stop placing our products in service or selling, any one of which could materially adversely affect our business, results of operations and financial condition. Similar results would occur if we were to violate foreign regulations.

Our operations are subject to strict laws prohibiting fraudulent billing and other abuse, and our failure to comply with such laws could result in substantial penalties.

Of particular importance to our operations are federal and state laws prohibiting fraudulent billing and providing for the recovery of non-fraudulent overpayments, as a large number of laboratories have been forced by the federal and state governments, as well as by private payers, to enter into substantial settlements under these laws. In particular, if an entity is determined to have violated the federal False Claims Act, it may be required to pay up to three times the actual damages sustained by the government, plus civil penalties of between $5,500 to $11,000 for each separate false claim. There are many potential bases for liability under the federal False Claims Act. Liability arises, primarily, when an entity knowingly submits, or causes another to submit, a false claim for reimbursement to the federal government. Submitting a claim with reckless disregard or deliberate ignorance of its truth or falsity could result in substantial civil liability. A trend affecting the healthcare industry is the increased use of the federal False Claims Act and, in particular, actions under the False Claims Act’s “whistleblower” or “qui tam” provisions. Those provisions allow a private individual to bring actions on behalf of the government alleging that the defendant has submitted a fraudulent claim for payment to the federal government. The government must decide whether to intervene in the lawsuit and to become the primary prosecutor. If it declines to do so, the individual may choose to pursue the case alone, although the government must be kept apprised of the progress of the lawsuit. Whether or not the federal government intervenes in the case, it will receive the majority of any recovery. In recent years, the number of suits brought against healthcare providers by private individuals has increased dramatically. In addition, various states have enacted laws modeled after the federal False Claims Act.

Government investigations of clinical laboratories have been ongoing for a number of years and are expected to continue in the future. Written “corporate compliance” programs to actively monitor compliance with fraud laws and other regulatory requirements are recommended by the Department of Health and Human Services’ Office of the Inspector General and we have a program following the guidelines in place.

Our laboratory services are subject to extensive federal and state regulation, and our failure to comply with such regulations could result in penalties or suspension of Medicare payments and/or loss of our licenses, certificates or accreditation.

The clinical laboratory testing industry is subject to extensive regulation, and many of these statutes and regulations have not been interpreted by the courts. The CLIA and implementing regulations established quality standards for all laboratory testing to ensure the accuracy, reliability and timeliness of patient test results regardless of where the test was performed. Laboratories covered under CLIA are those which perform laboratory testing on specimens derived from humans for the purpose of providing information for the diagnosis, prevention, treatment of disease and other factors. The Centers for Medicare and Medicaid Services is charged with the implementation of CLIA, including registration, surveys, enforcement and approvals of the use of private accreditation agencies. For certification under CLIA, laboratories such as ours must meet various requirements, including requirements relating to quality assurance, quality control and personnel standards. Since we perform patient testing from all states, our laboratory is also subject to strict regulation by California, New York and various other states. State laws require that laboratory personnel meet certain qualifications, specify certain quality controls or require maintenance of certain records, and are required to possess state regulatory licenses to offer the professional and technical components of laboratory services. If we are unable to maintain our existing state regulatory licenses in a timely manner or if we are unable to secure new state regulatory licenses for new locations, our ability to provide laboratory services could be compromised. Our failure to comply with CLIA, state or other applicable requirements could result in various penalties, including restrictions on tests which the laboratory may perform, substantial civil monetary penalties, imposition of specific corrective action plans, suspension of Medicare payments and/or loss of licensure, certification or accreditation. Such penalties could result in our being unable to continue performing laboratory testing. Compliance with such standards is verified by periodic inspections and requires participation in proficiency testing programs.

We are subject to significant environmental, health and safety regulation.

We are subject to licensing and regulation under federal, state and local laws and regulations relating to the protection of the environment and human health and safety, including laws and regulations relating to the handling, transportation and disposal of medical specimens, infectious and hazardous waste and radioactive materials as well as to the safety and health of laboratory employees. In addition, the federal Occupational Safety and Health Administration has established extensive requirements relating to workplace safety for health care employers, including clinical laboratories, whose workers may be exposed to blood-borne pathogens such as HIV and the hepatitis B virus. These regulations, among other things, require work practice controls, protective clothing and equipment, training, medical follow-up, vaccinations and other measures designed to minimize exposure to, and transmission of, blood-borne pathogens. In addition, the federally-enacted Needlestick Safety and Prevention Act requires, among other things, that we include in our safety programs the evaluation and use of engineering controls such as safety needles if found to be effective at reducing the risk of needlestick injuries in the workplace.

We are subject to federal and state laws governing the financial relationship among healthcare providers, including Medicare and Medicaid laws, and our failure to comply with these laws could result in significant penalties and other adverse consequences.

Existing federal laws governing Medicare and Medicaid and other similar state laws impose a variety of broadly described restrictions on financial relationships among healthcare providers, including clinical laboratories. These laws include the federal anti-kickback law which prohibits individuals or entities, including clinical laboratories, from, among other things, making any payments or furnishing other benefits intended to induce or influence the referral of patients for tests billed to Medicare, Medicaid or certain other federally funded programs. Several courts have interpreted the statute’s intent requirement to mean that if any one purpose of an arrangement involving remuneration is to induce referrals of federal healthcare covered business, the statute has been violated. Penalties for violations include criminal penalties and civil sanctions such as fines, imprisonment and possible exclusion from Medicare, Medicaid and other federal healthcare programs. In addition, some kickback allegations have been claimed to violate the federal False Claims Act (discussed above). In addition, many states have adopted laws similar to the federal anti-kickback law. Some of these state prohibitions apply to referral of patients for healthcare items or services reimbursed by any source, not only the Medicare and Medicaid programs. Many of the federal and state anti-fraud statutes and regulations, including their application to joint ventures and collaborative agreements, are vague or indefinite and have not been interpreted by the courts.

In addition, these laws also include self-referral prohibitions which prevent us from accepting referrals from physicians who have non-exempt ownership or compensation relationships with us as well as anti-markup and direct billing rules that may apply to our relationships with our customers. Specifically, the federal anti-”self-referral” law, commonly known as the “Stark” Law, prohibits, with certain exceptions, Medicare payments for laboratory tests referred by physicians who have, personally or through a family member, an investment interest in, or a compensation arrangement with, the testing laboratory. A person who engages in a scheme to circumvent the Stark Law’s prohibitions may be fined up to $100,000 for each such arrangement or scheme. In addition, anyone who presents or causes to be presented a claim to the Medicare program in violation of the Stark Law is subject to monetary penalties of up to $15,000 per claim submitted, an assessment of several times the amount claimed, and possible exclusion from participation in federal healthcare programs. In addition, claims submitted in violation of the Stark Law may be alleged to be subject to liability under the federal False Claims Act and its whistleblower provisions.

Several states in which we operate have enacted legislation that prohibits physician self-referral arrangements and/or requires physicians to disclose any financial interest they may have with a healthcare provider to their patients when referring patients to that provider. Some of these statutes cover all patients and are not limited to Medicare or Medicaid beneficiaries. Possible sanctions for violating state physician self-referral laws vary, but may include loss of license and civil and criminal sanctions. State laws vary from jurisdiction to jurisdiction and, in a few states, are more restrictive than the federal Stark Law. Some states have indicated they will interpret their own self-referral statutes the same way that the U.S. Centers for Medicare and Medicaid Services (CMS) interprets the Stark Law, but it is possible the states will interpret their own laws differently in the future. The laws of many states prohibit physicians from sharing professional fees with non-physicians and prohibit non-physician entities, such as us, from practicing medicine and from employing physicians to practice medicine.

If we do not comply with existing or additional regulations, or if we incur penalties, it could increase our expenses, prevent us from increasing net revenue, or hinder our ability to conduct our business. In addition, changes in existing regulations or new regulations may delay or prevent us from marketing our products or cause us to reduce our pricing.

Our business is subject to stringent laws and regulations governing the privacy, security and transmission of medical information, and our failure to comply could subject us to criminal penalties and civil sanctions.

The use and disclosure of patient medical information is subject to substantial regulation by federal, state, and foreign governments. For example, the Health Insurance Portability and Accountability Act of 1996, known as HIPAA, was enacted among other things, to establish uniform standards governing the conduct of certain electronic health care transactions and to protect the security and privacy of individually identifiable health information maintained or transmitted by health care providers, health plans and health care clearinghouses. We are currently required to comply with three standards under HIPAA. We must comply with the Standards for Electronic Transactions, which establish standards for common health care transactions, such as claims information, plan eligibility, payment information and the use of electronic signatures; unique identifiers for providers, employers, health plans and individuals; security; privacy; and enforcement. We were required to comply with these Standards by October 16, 2003. We also must comply with the Standards for Privacy of Individually Identifiable Information, which restrict our use and disclosure of certain individually identifiable health information. We were required to comply with the Privacy Standards by April 14, 2003. The Security Standards required us to implement certain security measures to safeguard certain electronic health information by April 20, 2005. In addition, CMS has published a final rule, which will require us to adopt a Unique Health Identifier for use in filing and processing health care claims and other transactions by May 23, 2007. While the government intended this legislation to reduce administrative expenses and burdens for the health care industry, our compliance with this law may entail significant and costly changes for us. If we fail to comply with these standards, we could be subject to criminal penalties and civil sanctions.

The Standards for Privacy of Individually Identifiable Information establish a “floor” and do not supersede state laws that are more stringent. Therefore, we are required to comply with both federal privacy regulations and varying state privacy laws. In addition, for health care data transfers from other countries relating to citizens of those countries, we must comply with the laws of those other countries.

Federal law and the laws of many states generally specify who may practice medicine and limit the scope of relationships between medical practitioners and other parties.

Under such laws, we are prohibited from practicing medicine or exercising control over the provision of medical services and may only do so through a professional corporation designed for this purpose. In order to comply with such laws, all medical services are provided by or under the supervision of Clarient Pathology Associates, Inc. (the P.C.). We refer to the P.C. and us collectively throughout this report as “we”, “us”, and “our”, except in this paragraph. The P.C. is organized so that all physician services are offered by the physicians who are employed by the P.C. Clarient does not employ practicing physicians as practitioners, exert control over their decisions regarding medical care, or represent to the public that Clarient offers medical services. Clarient has entered into an Administrative Services Agreement with the P.C. pursuant to which Clarient performs all non-medical management of the P.C. and has exclusive authority over all aspects of the business of the P.C. (other than those directly related to the provision of patient medical services or as otherwise prohibited by state law). The non-medical management provided by Clarient includes, among other functions, treasury and capital planning, financial reporting and accounting, pricing decisions, patient acceptance policies, setting office hours, contracting with third party payers, and all administrative services. Clarient provides all of the resources (systems, procedures, and staffing) or contract with third party billing services to bill third party payers or patients. Clarient also provides or outsources all of the resources for cash collection and management of accounts receivables, including custody of the lockbox where cash receipts are deposited. From the cash receipts, Clarient pays all physician salaries and operating costs of the center and of Clarient. Compensation guidelines for the licensed medical professionals at the P.C. are set by Clarient, and Clarient has established guidelines for selecting, hiring, and terminating the licensed medical professionals. Where applicable, Clarient also negotiates and execute substantially all of the provider contracts with third party payers. Clarient will not loan or otherwise advance funds to the P.C. for any purpose.

Clarient believes that the services Clarient provides and will provide in the future to the P.C. does not constitute the practice of medicine under applicable laws. Because of the unique structure of the relationships described above, many aspects of our business operations have not been the subject of state or federal regulatory interpretation. We have no assurance that a review of our business by the courts or regulatory authorities will not result in a determination that could adversely affect our operations or that the health care regulatory environment will not change so as to restrict our existing operations or future expansion.

Risks Related to Our Common Stock

We have never paid cash dividends on our common stock and do not anticipate paying dividends on our common stock, which may cause you to rely on capital appreciation for a return on your investment.

We currently intend to retain future earnings for use in our business and do not anticipate paying cash dividends on our common stock in the foreseeable future. Any payment of cash dividends will also depend on our financial condition, results of operations, capital requirements and other factors and will be at the discretion of our board of directors. Accordingly, you will have to rely on capital appreciation, if any, to earn a return on your investment in our common stock.

If we raise additional funds you may suffer dilution or subordination and we may grant rights in our technology or products to third parties.

If we raise additional funds by issuing equity securities, further dilution to our stockholders could result, and new investors could have rights superior to those of holders of the shares of our common stock. Any equity securities issued also may provide for rights, preferences or privileges senior to those of holders of our common stock. If we raise additional funds by issuing debt securities, these debt securities would have rights, preferences and privileges senior to those of holders of our common stock, and the terms of the debt securities issued could impose significant restrictions on our operations. If we raise additional funds through collaborations and licensing arrangements, we might be required to relinquish significant rights to our technologies or products, or grant licenses on terms that are not favorable to us. If adequate funds are not available, we may have to delay or may be unable to continue to develop our products.

Our stock price is likely to continue to be volatile, which could result in substantial losses for investors.

The market price of our common stock has in the past been, and in the future is likely to be, highly volatile. These fluctuations could result in substantial losses for investors. Our stock price may fluctuate for a number of reasons including, but not limited to:

• media reports and publications and announcements about cancer or diagnostic products or treatments or new innovations;

• developments in or disputes regarding patent or other proprietary rights;

• announcements regarding clinical trials or other technological or competitive developments by us and our competitors;

• loss of a significant customer or group purchasing organization contract;

• the hiring and retention of key personnel;

• announcements concerning our competitors or the biotechnology industry in general;

• regulatory developments regarding us or our competitors;

• changes in reimbursement policies concerning our products or competitors’ products;

• changes in the current structure of the healthcare financing and payment systems;

• stock market price and volume fluctuations, which have particularly affected the market prices for medical products and high technology companies and which have often been unrelated to the operating performance of such companies; and

• general economic, political and market conditions.

In addition, stock markets have from time to time experienced extreme price and volume fluctuations. The market prices for medical device and laboratory service affected by these market fluctuations and such effects have often been unrelated to the operating performance of such companies. These broad market fluctuations may cause a decline in the market price of our common stock.

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

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

Future sales of shares by existing stockholders could result in a decline in the market price of the stock.

Some of our current stockholders hold a substantial number of shares which they are currently able to sell in the public market, or which they will be able to sell under registration statements that have already been declared effective by the Securities and Exchange Commission, and our employees hold options to purchase a significant number of shares and/or have been issued shares of restricted stock that are covered by registration statements on Form S-8. If our common stockholders sell substantial amounts of common stock in the public market, or the market perceives that such sales may occur, the market price of our common stock could fall. Safeguard Scientifics, Inc., which owns a majority of our outstanding common stock, has rights, subject to some conditions, to require us to file registration statements covering shares owned by them that are not already covered by existing registration statements and to include Safeguard’s shares in registration statements that we may file for ourselves or other stockholders. Furthermore, if we were to include in a Company-initiated registration statement shares held by Safeguard pursuant to the exercise of its registrations rights, the sale of those shares could impair our ability to raise needed capital by depressing the price at which we could sell our common stock.

We are controlled by a single existing stockholder, whose interests may differ from other stockholders’ interests and may adversely affect the trading price of our common stock.

Safeguard Scientifics, Inc. beneficially owns a majority of the outstanding shares of our common stock. As a result, Safeguard Scientifics, Inc. will have significant influence in determining the outcome of any corporate transaction or other matter submitted to the stockholders for approval, including mergers, consolidations and the sale of all or substantially all of our assets. In addition, Safeguard Scientifics, Inc. has the ability to elect all of our directors (although Safeguard has contractually agreed with us that our board of directors will consist of a majority of directors not specifically designated by Safeguard) and Safeguard could dictate the management of our business and affairs. The interests of Safeguard may differ from other stockholders’ interests. In addition, this concentration of ownership may delay, prevent, or deter a change in control and could deprive other stockholders of an opportunity to receive a premium for their common stock as part of a sale of our business. This significant concentration of share ownership may adversely affect the trading price of our common stock because investors often perceive disadvantages in owning stock in companies with controlling stockholders.

We have adopted a stockholder rights plan and other arrangements which could inhibit a change in control and prevent a stockholder from receiving a favorable price for his or her shares.

Our board of directors has adopted a stockholders’ rights plan providing for discounted purchase rights to its stockholders upon specified acquisitions of our common stock. The exercise of these rights is intended to inhibit specific changes of control of our company.

In addition, Section 203 of the Delaware General Corporation Law limits business combination transactions with 15% stockholders that have not been approved by our board of directors. These provisions and others could make it difficult for a third party to acquire us, or for members of our board of directors to be replaced, even if doing so would be beneficial to our stockholders. Because our board of directors is responsible for appointing the members of our management team, these provisions could in turn affect any attempt to replace the current management team. If a change of control or change in management is delayed or prevented, you may lose an opportunity to realize a premium on your shares of common stock or the market price of our common stock could decline.

Our shares of common stock currently trade on the Nasdaq Capital Market which results in a number of legal and other consequences that may negatively affect our business and the liquidity and price of our common stock.

Effective August 15, 2003, a Nasdaq Qualifications Panel terminated our Nasdaq National Market Listing and transferred our securities to the Nasdaq Capital Market. With our securities listed on the Nasdaq Capital Market, we face a variety of legal and other consequences that may negatively affect our business including, without limitation, the following:

• future issuances of our securities may require time-consuming and costly registration statements and qualifications because state securities law exemptions available to us are more limited;

• securities analysts may not initiate coverage of Clarient; and

• we may lose current or potential investors.

In addition, we are required to satisfy various listing maintenance standards for our common stock to be quoted on the Nasdaq Capital Market. If we fail to meet such standards, our common stock would likely be delisted from the Nasdaq Capital Market and trade on the over-the-counter bulletin board, commonly referred to as the “pink sheets.” This alternative is generally considered to be a less efficient market and would seriously impair the liquidity of our common stock and limit our potential to raise future capital through the sale of our common stock, which could materially harm our business, results of operations, cash flows and financial position.

Recently enacted and proposed changes in securities laws and regulations will increase our costs.

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

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Historically, we have invested excess cash in short-term debt securities that are intended to be held to maturity. These short-term investments typically have various maturity dates which do not exceed one year. We had no short-term investments as of March 31, 2006.

Two of the main risks associated with these investments are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of debt securities. Fluctuations in interest rates would not have a material effect on our financial statements because of the short-term nature of the securities in which we invest and our intention to hold the securities to maturity. Credit risk refers to the possibility that the issuer of the debt securities will not be able to make principal and interest payments. We have limited the investments to investment grade or comparable securities and have not experienced any losses on our investments to date due to credit risk.

Changes in foreign exchange rates, and in particular a strengthening of the U.S. dollar, may negatively affect our consolidated sales and gross margins as expressed in U.S. dollars. To date, we have not entered into any foreign exchange contracts to hedge our exposure to foreign exchange rate fluctuations. However, as our international operations grow, we may enter into such arrangements in the future. Effective January 1, 2002, our foreign sales were denominated in U.S. dollars or Euros. Foreign currency-denominated sales have not been significant.

Item 4. Controls and Procedures

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

As required by SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to provide reasonable assurance that we would meet our disclosure obligations.

Our services group business is an increasingly significant component of our operations. As a result, in the ordinary course, we have reviewed and continue to review our system of internal control over financial reporting for the laboratory operations, and we have implemented changes based on our ongoing review that are designed to improve and increase the efficiency of our internal controls while maintaining an effective control environment. For example, during the first quarter of 2006, we continued evaluating the automation of various processes relating to our laboratory services to replace certain processes that are currently conducted manually. Except for the foregoing, there has been no change in our internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to affect, our internal control over financial reporting.

PART II – OTHER INFORMATION

Item 1A. Risk Factors

Except as set forth below, there have been no material changes in our risk factors from the information set forth above under the heading “Factors that may Affect Future Results” and in our Annual Report on Form 10-K for the year ended December 31, 2005.

Increased market acceptance of the ACIS® depends on a number of variables, including, but not limited to, the following:

• the ability of the ACIS® to perform as expected;

• acceptance by patients, physicians, third party payers and laboratories of the ACIS® to run the tests performed using it;

• our ability to develop a significant number of tests performed with the ACIS®;

• the amount of reimbursement by third party payers for a test performed using the ACIS®;

• our ability to expand our diagnostic laboratory service initiative;

• the effectiveness of our marketing, distribution and pricing strategy;

• availability of alternative and competing diagnostic products; and

• scientific studies and other publicity concerning ACIS® or competitive products.

We may require additional financing for, among other things, funding our operating losses, planned expansion of our laboratory operations, capital expenditures and other costs related to the move to a new

facility, acquisition transactions and expenses associated with our anticipated increase in placements of our ACIS® systems and it is uncertain whether such financing will be available on favorable terms, if at all.

Our present and future funding requirements will also depend on certain other external factors, including, among other things:

• the level of research and development investment required to maintain and improve our technology position;

• costs of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights;

• our need or decision to acquire or license complementary technologies or acquire complementary businesses;

• competing technological and market developments; and

• changes in regulatory policies or laws that affect our operations.

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005, which could materially affect our business, financial condition and future results. The risks described in this report and in our Annual Report on Form 10-K are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

Mark One

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

For The Quarterly Period Ended March 31, 2006

OR

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

DELAWARE		75-2649072
(State or other jurisdiction of incorporation		(IRS Employer Identification Number)
or organization)

33171 PASEO CERVEZA
SAN JUAN CAPISTRANO, CA		92675-4824
(Address of principal executive offices)		(Zip code)

PART I FINANCIAL INFORMATION

Item 1		Financial Statements

		Condensed Consolidated Balance Sheets as of March 31, 2006 (unaudited) and December 31, 2005

		Condensed Consolidated Statements of Operations (unaudited) for the three months ended March 31, 2006 and 2005

		Condensed Consolidated Statements of Cash Flows (unaudited) for the three months ended March 31, 2006 and 2005

		Notes to Condensed Consolidated Financial Statements

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

Item 3		Quantitative and Qualitative Disclosures About Market Risk

Item 4		Controls and Procedures

PART II OTHER INFORMATION

Item 1A		Risk Factors

Item 6		Exhibits

SIGNATURES

Exhibit Number		Description

31.1		Certifications pursuant to Exchange Act Rule 13a-14(a) or Rule 15d-14(a) for Ronald A. Andrews. (*)
31.2		Certifications pursuant to Exchange Act Rule 13a-14(a) or Rule 15d-14(a) for John A. Roberts. (*)
32.1		Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 for Ronald A. Andrews. (*)
32.2		Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 for John A. Roberts. (*)

	CLARIENT, INC.

DATE: MAY 5, 2006	BY:	/s/ Ronald A. Andrews
		Ronald A. Andrews
		President and Chief Executive Officer

DATE: MAY 5, 2006	BY:	/s/ John A. Roberts
		John A. Roberts
		Acting Chief Financial Officer

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

Mark One

ý

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

For The Quarterly Period Ended March 31, 2006

OR

o

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

For the Transition Period from to

Commission File Number 000-22677

CLARIENT, INC.

(Exact name of registrant as specified in its charter)

DELAWARE

75-2649072

(State or other jurisdiction of incorporation

(IRS Employer Identification Number)

or organization)

33171 PASEO CERVEZA

SAN JUAN CAPISTRANO, CA

92675-4824

(Address of principal executive offices)

(Zip code)

(888) 443-3310

(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, and (2) has been subject to such filing requirements for the past 90 days.

Yes ý No o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. (See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.)

Large Accelerated Filer o

Accelerated Filer o

Non-Accelerated Filer ý

As of April 28, 2006, 66,864,383 shares of the Registrant’s common stock were outstanding.

SIGNATURES

PART I - FINANCIAL INFORMATION

Item 1.

Condensed Consolidated Statements of Cash Flows

(2) Equity-Based Compensation

(9) Recent Accounting Developments

(10) Stock Transactions

Overview and Outlook

Critical Accounting Policies and Estimates

Item 1A. Risk Factors

SIGNATURES

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION