UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the Fiscal Quarter Ended June 30, 2004

For the transition period from _____ to _________.

Commission file number: 0-27596

CONCEPTUS, INC.

1021 Howard Avenue
San Carlos, CA 94070
(Address of principal executive offices)

Registrant’s telephone number, including area code: (650) 628-4700

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for at least the past 90 days.

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

As of July 31, 2004, 25,568,280 shares of the registrant’s Common Stock were outstanding.

CONCEPTUS, INC.

FORM 10-Q for the Quarter Ended June 30, 2004

INDEX

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PART I: FINANCIAL INFORMATION

ITEM 1. Condensed Consolidated Financial Statements

Conceptus, Inc.

Condensed Consolidated Balance Sheets

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

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Conceptus, Inc.

Condensed Consolidated Statements of Operations

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

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Conceptus, Inc.

Condensed Consolidated Statements of Cash Flows

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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.

Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and pursuant to the instructions to Form 10-Q and Article 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, considered necessary for a fair presentation have been included.

     The condensed consolidated balance sheet at December 31, 2003 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. This financial data should be reviewed in conjunction with the audited consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. The results of operations for the three and six months ended June 30, 2004 may not necessarily be indicative of the operating results for the full 2004 fiscal year or any other future interim periods.

2.

Organization, Ownership and Business

In January 2004, the Company completed the sale of its wholly-owned French subsidiary for a nominal amount to an investor group comprised of the Company’s former French management team, and signed a long-term exclusive distribution agreement for Essure with the acquiring group for the European, Middle Eastern and African markets. The sale agreement includes a long-term call option that is intended to enable the Company to repurchase the French company at predetermined prices, depending upon the time periods, that are typical for a distribution company. The transaction did not have any material financial impact to the Company’s condensed consolidated financial statements.

3.

Summary of Significant Accounting Policies

The Company’s significant accounting policies are disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 that was filed with the Securities and Exchange Commission on March 15, 2004. The Company’s significant accounting policies have not materially changed since December 31, 2003.

4.

Inventories, net

     Inventories are stated at the lower of cost or market. Cost is based on actual costs computed on a first-in, first-out basis. The components of inventories consist of the following:

5.

Intangible Assets

Intangible assets as of June 30, 2004 are comprised of a technology license obtained as a result of the settlement of the patent litigation with Ovion, Inc. The license was acquired at a cost of $2.0 million in October 2003, which was paid in the Company’s common stock, and has an expected useful life of ten years from the date of settlement. The license fee is amortized based on the straight-line method over the useful life of ten years. Amortization expense of $50,000 and $100,000, respectively, has been classified on the Company’s condensed consolidated statement of operations for the three months and six months ended June 30, 2004 as cost of goods sold. Estimated future

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amortization expenses for each of the years ended December 31, 2004 through 2012 are $200,000 per year and $150,000 for the year ended December 31, 2013.

6.

Other Assets

Other assets as of June 30, 2004 are principally comprised of the $1.9 million carrying value of the $2.0 million cash payment that the Company made to Ovion, Inc. as part of the settlement of a patent litigation suit. The settlement agreement provided for the payment of a royalty to Ovion that will be equal to 3.25% of the cumulative net sales of Essure in excess of $75.0 million for a period of no longer than ten years. In accordance with the terms of the settlement agreement, the Company’s prepaid royalties will be fully amortized when cumulative net sales of Essure reach $136.5 million, thereby resulting in an effective royalty rate of 1.47%. The Company is amortizing the prepaid royalties to cost of goods sold over its net sales using this effective rate.

7.

Warranty

     The Company offers warranties on its product and records a liability for the estimated future costs associated with warranty claims, which is based upon historical experience and the Company’s estimate of the level of future costs. Warranty costs are reflected in the statement of operations as a cost of goods sold. A reconciliation of the changes in the Company’s warranty liability for the six months ended June 30, 2004 and 2003 follows (in thousands):

8.

Stock-based Compensation

     As permitted by SFAS No. 123, “Accounting for Stock-Based Compensation,” (SFAS No. 123), as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure — an amendment of FASB Statement No. 123,” the Company accounts for employee stock-based compensation in accordance with Accounting Principles Board Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its stock-based compensation plans.

The Company granted 283,020 shares of restricted stock to its employees and directors during the six months ended June 30, 2004. The restricted stock shares have a purchase price of $0.003 per share and vest in equal installments over three years or cliff vest after three years with the potential of acceleration if certain company objectives are met. The Company is amortizing the total restricted stock expense of $2.3 million, calculated based on the fair market value of the stock on the date of the grant, over the vesting term of three years on a straight-line basis. Future restricted stock expense shall be $0.6 million, $0.8 million, $0.8 million and $0.1 million for the years 2004, 2005, 2006 and 2007, respectively. Of the total restricted stock expense of $2.3 million, $0.3 million is related to cost of sales, $0.3 million is related to research and development, and $1.7 million is related to selling, general and administrative expenses. For the six months ended June 30, 2004, $237,000 of restricted stock employee compensation expense is included in the net loss as reported and no restricted stock employee compensation expense is included in the net loss reported for the six months ended June 30, 2003.For the three months ended June 30, 2004, $168,000 of restricted stock employee compensation expense is included in the net loss as reported, and no restricted stock employee expense is included in the net loss reported for the three months ended June 30, 2003.

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     The following table provides a reconciliation of net loss to pro forma net loss as if the fair value method, pursuant to SFAS No. 123, had been applied to all employee awards (in thousands, except per share data):

To comply with pro forma reporting requirements of SFAS No. 123, compensation expense is also estimated for the fair value of the Company’s Employee Stock Purchase Plan (ESPP) rights, which are included in the pro forma totals above.

     Stock-based compensation arrangements to non-employees are accounted for in accordance with SFAS No. 123 and Emerging Issues Task Force Issue (EITF) No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” which requires that these equity instruments are recorded at their fair value on the measurement date. The measurement of stock-based compensation is subject to periodic adjustment as the underlying equity instruments vest. Stock-based compensation expense relating to non-employees was $217,000 and $214,000 for the six months ended June 30, 2004 and 2003, respectively. Stock-based compensation expense relating to non-employees was $81,000 and $215,000 for the three months ended June 30, 2004 and 2003, respectively.

9.

Computation of Net Loss Per Share

     Basic net loss per share is computed using the weighted-average number of common shares outstanding during each period. Diluted net loss per share is computed using the weighted-average number of common and potential dilutive shares outstanding during each period. Under the requirements for calculating basic net loss per share, the effect of potentially dilutive securities such as stock options, restricted stock grants, common stock shares subject to repurchase, warrants and convertible securities are excluded. Basic and diluted net loss per share is equivalent for all periods presented due to the Company’s net loss position.

     The total weighted average outstanding common shares used in determining net loss per share is as follows (in thousands):

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     The following numbers of shares represented by options and shares subject to repurchase were excluded from the computation of diluted net loss per share as their effect was antidilutive (in thousands):

10.

Comprehensive Loss

     The components of comprehensive loss for the three and six months ended June 30, 2004 and 2003 are as follows (in thousands).

Unrealized gains and losses on available-for-sale securities were immaterial for all periods presented.

11.

Stockholder’s Equity

     On February 25, 2004, the Company completed a private placement of approximately 3,000,000 shares of common stock at $8.50 per share. The net proceeds to the Company, after fees and other offering costs totaling $1,600,000, were approximately $23,900,000.

12.

Legal Proceedings

     From time to time the Company is involved in legal proceedings arising in the ordinary course of business. The Company believes there is no litigation pending that could have, individually or in the aggregate, a material adverse effect on its financial position, result of operations or cash flows.

13.

Recent Accounting Pronouncements

     At its November 2003 meeting, the EITF reached a consensus on disclosure guidance previously discussed under EITF 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The consensus provided for certain disclosure requirements that were effective for fiscal years ending after December 15, 2003. At its March 2004 meeting, the EITF reached a consensus on recognition and measurement guidance previously discussed under EITF 03-01. The consensus clarifies the meaning of other-than-temporary impairment and its application to investments classified as either available-for-sale or held-to-maturity under FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and investments accounted for under the cost method or the equity method. The recognition and measurement guidance for which the consensus was reached in the March 2004 meeting is to be applied to other-than-temporary impairment evaluations in reporting periods beginning after June 15, 2004. The adoption of the disclosure requirements has to date not had a material impact on the Company’s business, financial position, cash flows or result of operations.

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

     The following discussion of our financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes thereto included in Part I-Item 1 of this quarterly report. In addition, the following discussion contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. We wish to alert readers that the risk factors set forth in our Annual Report on Form 10-K for the year ended December 31, 2003, as well as other factors, including those set forth in the following discussion and under “Risk Factors” below, could in the future affect, and in the past have affected, our actual results and could cause our results for future periods to differ materially from those expressed or implied in any forward-looking statements made by us.

Overview

     We develop, manufacture and market Essure^®, an innovative and proprietary non-incisional permanent birth control device for women that was approved for marketing in the United States in November 2002 by the United States Food and Drug Administration (FDA). Essure is a soft and flexible micro-insert delivered into a woman’s fallopian tubes designed to provide permanent birth control by causing a benign tissue in-growth that blocks the fallopian tubes. A successfully placed Essure micro-insert prohibits the egg from traveling through the fallopian tubes and therefore prevents fertilization.

     The Essure Procedure

     The Essure placement procedure is typically performed as an outpatient procedure and is intended to be a less invasive and a less costly alternative to tubal ligation, the leading form of birth control in the United States and worldwide. Laparoscopic tubal ligation and tubal ligation by laparotomy typically involve abdominal incisions and/or punctures, general or regional anesthesia, four to ten days of normal recovery time and the risks associated with an incisional procedure. The Essure placement procedure does not require cutting or penetrating the abdomen, which lowers the likelihood of post-operative pain due to the incisions/punctures, and is typically performed in an outpatient setting without general or regional anesthesia. In the Pivotal trial of Essure, the total procedure time averaged 35 minutes, with an average of 13 minutes of hysteroscopic time to place the Essure micro-insert. A patient is typically discharged approximately 45 minutes after the Essure placement procedure. No overnight hospital stay is required. Furthermore, Essure is effective without drugs or hormones. There is a three-month waiting period after the procedure during which the woman must use another form of birth control while tissue in-growth occurs. At 90 days following the procedure, the patient completes a follow-up examination called a hysterosalpingogram (HSG), which can determine whether the device was placed successfully and whether the fallopian tubes are occluded.

     We believe that Essure is also an attractive alternative to tubal ligation for physicians, hospitals and payors. Essure is a less invasive permanent birth control option for physicians to offer to their patients; hospitals are able to utilize their facilities more cost effectively with the Essure placement procedure compared with tubal ligation, and payors are experiencing cost reductions resulting from the elimination of overhead and procedural costs related to anesthesia and post-operative hospital stays associated with tubal ligations. In addition, payors may also benefit from the reduction of unplanned pregnancies associated with non-permanent methods of birth control used by patients who have chosen to avoid the drawbacks of traditional permanent birth control methods but who may elect to use Essure.

     Published reports estimate that 700,000 tubal ligation procedures are performed each year in the United States and 13 million procedures worldwide. We intend to tap into this market and establish the Essure procedure as the standard of care for permanent birth control.

     Essure is currently being marketed in multiple countries. In November 2002 we received approval from the FDA to market Essure in the United States. In 2001, we were given approval to affix the CE Mark to Essure, indicating that Essure is certified for sale throughout the European Union, subject to compliance with local regulations such as registration with health ministries and/or particular requirements regarding labeling or distribution. In 1999, Essure was listed with Australia’s Therapeutic Goods Administration, which allows us to

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market and sell Essure in Australia. In Canada, we received clearance from Health Canada to market Essure in Canada in November 2001. We also have distributors in Singapore, Indonesia, Morocco, Turkey and New Zealand.

     Effectiveness of Essure

     Based on clinical trial data filed with the FDA in November 2003, Essure has been demonstrated to be 99.8% effective at three years of follow-up. In June 2004, the FDA approved new labeling claims that extended the labeled effectiveness rate to 99.8% at three years of follow-up, from two years previously.

     Penetration

     As of June 30, 2004, Conceptus has trained or is in the process of training 1,233 physicians on the Essure procedure. Doctors are required to be preceptored for between 3 and 5 cases by a certified trainer before they can perform procedures independently. This represents an increase of 264 physicians over the number of physicians at March 31, 2004 and 441 over the number of physicians at December 31, 2003. The level of sales for Essure, particularly in this early period of adoption, is highly dependent on the number of physicians trained to perform the procedure.

     Reimbursement of Essure

     Market acceptance of Essure also depends in part upon the availability of reimbursement within prevailing healthcare payment systems. We believe that physician advocacy of our product will be required to continue to obtain reimbursement. As of June 30, 2004, we received positive reimbursement decisions for Essure from private insurers covering a total of 148 million covered lives, which represents 71% of all the insured, non-Medicare population of the United States. We intend to continue our effort to educate payors of the cost-effectiveness of our product, and to further establish programs to help physicians to navigate reimbursement issues.

     In the first six months of 2004, we received several positive responses from government and private agencies, which we believe will help us to speed up the acceptance of Essure by doctors and patients.

     In March 2004, the American Medical Association accepted our application for a category I CPT code, which will be effective January 1, 2005, subject to the completion of the AMA application process. Category I codes are reserved for those procedures that have demonstrated clinical efficacy, widespread use and have FDA approval. By having a CPT code specific to the Essure procedure, it is expected that coding for reimbursement will become considerably easier for doctors and facilities and that there will be fewer incidents of doctors being reimbursed incorrectly or having claims denied inadvertently. We expect that the new code, once the process to establish it at all private payers that have given a favorable coverage decision is complete, will significantly ease the burden on a physician’s office in obtaining reimbursement for Essure, and accelerate the coverage of Essure by private insurance companies and Medicaid. This process is expected to take up to six months following the January 1, 2005 effectivity date of the CPT code.

     In March 2004, the Committee for Medicare and Medicaid Services (CMS) established a temporary Healthcare Common Procedure Coding System (HCPCS) code for separate payment of the Essure device when used in an office setting or outpatient/ambulatory surgery center for both private payers and Medicaid. The temporary HCPCS code became effective on April 1, 2004. CMS issues temporary codes while permanent codes are being established, a process that typically takes six to twelve months. CMS issues permanent HCPCS codes for use in procedures that may be covered by Medicare and Medicaid. Private insurance companies use the CMS issued codes and payment levels as a baseline for establishing their own coverage systems and levels. We believe the CMS reimbursement code helps create an avenue for reimbursement of Essure when performed in the physician’s office and surgery centers.

     In early March 2004, Planned Parenthood Federation of America (Planned Parenthood) approved Essure for use in qualifying Planned Parenthood affiliates across the United States. Planned Parenthood has nearly 900 clinics under 123 Planned Parenthood affiliates that serve nearly five million people per year. Planned Parenthood tested the Essure procedure in clinics in Oregon and Pennsylvania, evaluating the ability of a typical clinic to successfully offer the procedure. Standards for the use of Essure in Planned Parenthood affiliates were then developed along with guidelines for the introduction of the procedure into Planned Parenthood clinic settings. We

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believe that Planned Parenthood conducted a thorough evaluation that demonstrated that Essure could safely and effectively be offered in a clinical setting. We believe that their approval is of vital importance to our goal of making sure all women have access to Essure, including those who do not have private insurance coverage.

     Utilization of Essure

     Essure is a novel product in the contraception market, which is dominated by procedures that are well established among physicians and patients and are routinely taught to new physicians. As a result, we believe that recommendations and endorsements by physicians will be essential for market acceptance of our product. Physicians are traditionally slow to adopt new products and treatment practices, partly because of perceived liability risks. Our biggest challenge is to speed up the adoption process to make the Essure procedure the standard of care for permanent birth control. The following discussion summarizes our program in the United States to increase adoption of the Essure procedure.

     Utilization, which is the average number of procedures performed per physician, increased this quarter for the first time since the commercial launch of the product in the U.S. to 0.9 from an average of 0.8 in the first quarter of 2004, for those physicians that are certified to perform the Essure procedure. This increase is directly attributable to our tactical reimbursement efforts aimed at educating the physician and office staff regarding payer procedures following a declined claim, including appeals and petitioning procedures. Typically a newly covered product will go through a period where claims are either inadvertently declined or are paid at the incorrect amount. In either instance, the physician is reluctant to perform additional procedures until payment has been secured for earlier cases, causing the decline in utilization for Essure. Our tactical reimbursement focus is intended to give the physician and his/her staff the tools to ensure that claims will ultimately be paid and thereby encourages the physician to continue performing the Essure procedure despite reimbursement issues. We expect to complete our program in our top 100 accounts by the end of August 2004, and will then pursue the next group of 100 accounts. This tactical reimbursement program will be in place for the foreseeable future and is expected to be able to reach 100 accounts every 45 to 60 days.

     On July 27, 2004, we announced that the FDA had approved labeling changes allowing concomitant use of Essure with Johnson & Johnson’s GYNECARE THERMACHOICE* Uterine Balloon Therapy system. THERMACHOICE is a device allowing the physician to perform endometrial ablation to correct the condition of menorrhagia (excessive uterine bleeding). We had signed in October 2003 a co-promotion agreement with the GYNECARE division that will permit the GYNECARE sales force to market Essure. We believe this agreement will provide us with the ability to substantially increase awareness, gaining market presence and credibility, accelerating our ability to train doctors, as well as expand our market opportunity by driving adoption among a group of physicians not previously targeted by our marketing programs. The success of the joint marketing campaign will depend upon the effectiveness of our GYNECARE sales force training programs, market demand for Essure in conjunction with the THERMACHOICE treatment and the efforts and commitment of GYNECARE to this new program. We cannot be certain how successful this program will be, if at all.

     As a condition of FDA approval, Conceptus and GYNECARE agreed to provide the FDA with investigational data from a prospective study of 50 women to assess whether the THERMACHOICE endometrial ablation procedure causes intrauterine scarring and/or adhesions that could prevent or interfere with an effective HSG at three-months post-Essure placement. In addition, the study will also assess tubal occlusion three months after concomitant Essure/THERMACHOICE procedures. The study is to be conducted at no fewer than three investigational sites and is expected to be completed within nine months following study approval. A final report should be submitted to the FDA within three months of completion of the study. Information provided in this report will be used to assess the effectiveness of concomitant Essure/THERMACHOICE procedures. Data presented in this report may be used to develop additional statements for inclusion in Essure labeling.

     In addition, we are expanding our sales territories and channels of distribution that will also impact penetration and utilization. With the addition of two national account managers and three sales territories, we will have increased our sales coverage by 25%, from 19, as of March 31, 2004, to 24 direct sales representatives. We are pursuing relationships with regional distributors of women’s gynecology products.

     In late July 2004 we announced that we initiated an extensive direct to consumer advertising campaign in the Chicago, Illinois metropolitan area that would commence in August 2004 and that would extend for 6 months

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and involve radio, direct mail and print media (magazine) advertisements aimed at increasing consumer awareness. Depending on the success of this marketing effort, we will be evaluating additional major metropolitan markets in which to conduct a similar advertising campaign in 2005. This program is directly responsible for the forecasted increase in selling, general and administration expense during the remaining six months of 2004.

We have experienced significant operating losses since inception and, as of June 30, 2004, had an accumulated deficit of $170.6 million. We expect our operating losses to continue at least through 2004 as we continue to expend substantial resources in the selling and marketing of Essure in the United States. Due to the unpredictable nature of these activities, we do not know whether we will achieve or sustain profitability in the future.

     We maintain websites located at www.conceptus.com and www.essure.com. We make available free of charge on or through our website, our annual report on Form 10-K, our quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Information contained on our website is not incorporated by reference into and does not form a part of this Form 10-Q.

Results of Operations — Three and Six Months Ended June 30, 2004 and 2003

     Net Sales

     Net sales were $2.8 million for the three months ended June 30, 2004 as compared to $2.0 million for the three months ended June 30, 2003, an increase of $0.8 million, or 36%, and $2.4 million for the three months ended March 31, 2004. Net sales for the six months ended June 30, 2004 were $5.2 million as compared to $3.2 million for the six months ended June 30, 2004. The increase of $2.0 million, or 61%, in net sales for the first six months of 2004 is due to increased sales of Essure in the United States. After we received FDA approval to market Essure in the United States in November of 2002, we launched an aggressive marketing campaign to increase awareness of Essure among physicians and patients while at the same time increase our customer base by establishing physicians training programs. The net sales increase is a direct result of our continuous effort to market and sell Essure in the United States.

     We expect net sales to increase on a quarterly basis for the remainder of fiscal 2004 and have put in place sales, marketing and reimbursement programs to help us to reach our sales goal. However, as we have noted elsewhere in this Form 10-Q, our expected sales growth is dependant on market acceptance of Essure and third party reimbursement for the procedure, which involves factors that are outside of our control.

     For the three months ended June 30, 2004, net sales to one distributor accounted for 11% of our total consolidated net sales. For the three months ended June 30, 2003, no single customer accounted for more than 10% of net sales. For the six months ending June 30, 2004, one distributor accounted for 12% of our net sales. For the same period in 2003, one distributor accounted for 10% of our net sales. Accounts receivable from one distributor accounted for 22% of our total net accounts receivables outstanding as of June 30, 2004. At June 30, 2003, accounts receivable from one distributor were 21%,of our total net accounts receivables outstanding.

     Net product sales by geographic region as a percentage of net sales for the three and six months ended June 30, 2004 and 2003 are as follows:

     Net sales are attributed to region based on the shipping location of the external customers.

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     Gross Profit

     Cost of goods sold for the three months ended June 30, 2004 were $1.7 million as compared to $1.8 million for the three months ended June 30, 2003. The decrease of $0.1 million, or 5%, is primarily due to cost efficiencies from higher production volume. Gross profit margin also improved from 11% in the first quarter of 2004 to 39% in the second quarter of 2004, which represents improved costs in our manufacturing processes as a result of our manufacturing outsourcing effort. For the six months ending June 30, 2004, cost of goods sold was $3.8 million, compared to $2.9 million for the same period last year, for an increase of $0.9 million, or 30%. Gross profit margin for the first six months increased from 9% in 2003 to 26% in 2004. We have reduced per unit production cost by increasing production volume without increasing fixed cost. In April 2004, we received FDA approval to begin manufacturing at UTI Venusa, Ltd, in Ciudad Juarez, Mexico. We have transitioned generally all manufacturing activities to our third party subcontractor in Mexico and maintain only limited production capability in San Carlos for research and development of new manufacturing processes. We expect this change will result in significant further decreases in manufacturing costs in future periods and we expect our gross profit margin to continue to improve into the mid to upper 60% range by the third quarter of 2004. Cost of goods sold for the three and six months ended June 30, 2003 represented the costs of early stage product introduction and limited production volumes.

     Operating Expenses

     Research and development expenses, which includes expenditures related to product development, clinical research and regulatory affairs, decreased to $0.9 million for the three months ended June 30, 2004 from $1.7 million for the three months ended June 30, 2003. The decline of $0.8 million, or 45%, reflects the reduction in clinical research and regulatory affairs expenses in primarily compensation ($0.5 million) and consulting and outside services ($0.1 million). For the six months ended June 30, 2004, research and development expenses decreased $1.1 million, or 33%, to $2.2 million from $3.3 million in same period of 2003. The reduction in spending reflects the decline of clinical research and regulatory affairs activities after FDA approval of Essure in November 2002. We expect research and development expenses for the remaining quarters of fiscal 2004 to trend up slightly from the level of the second quarter of fiscal 2004 to a level of between $1.0 and $1.1 million.

     Selling, general and administrative spending for the three months ended June 30, 2004 was $6.5 million as compared to $9.3 million for the three months ended June 30, 2003. The decrease of $2.8 million, or 30%, is primarily a result of reduced spending in training and marketing expenses. For the six months ended June 30, 2004, selling, general and administrative expenses were $12.7 million, which represents a decrease of $6.3 million, or 33%, from $18.9 million for the six months ending June 30, 2003. In early 2003, we had focused on group training of physicians to attain an aggressive training goal within a relatively short period of time. As a result, we successfully reached our goal of training more than 700 doctors in 2003. Our current goal is to help our trained physicians to build their practices so that they can increase the number of procedures performed, which is benefited by one on one training. The decrease in marketing spending is primarily due to the reduction in spending related to the initial cost of building our marketing infrastructure such as concept design, development of videos, marketing brochures and other marketing medias. In addition to the marketing and training expense reductions, we also decreased spending as a result of the spin-off of our former French subsidiary in January 2004. These decreases were partially offset by increased general and administrative expenses for Sarbanes-Oxley implementation. In order to focus our