SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Mark One

OR

COMMISSION FILE NUMBER 000-22677

CHROMAVISION MEDICAL SYSTEMS, INC.

(949) 443-3355

NOT APPLICABLE

     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 x No o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

     Yes x No o

As of April 30, 2004 there were 51,423,709 shares outstanding of the Issuer’s Common Stock, $.01 par value.

CHROMAVISION MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

Table of Contents

PART I - FINANCIAL INFORMATION

     Item 1.

Condensed Consolidated Balance Sheets

See accompanying notes to condensed consolidated financial statements.

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CHROMAVISION MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Operations

     See accompanying notes to condensed consolidated financial statements.

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CHROMAVISION MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

     See accompanying notes to condensed consolidated financial statements.

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CHROMAVISION MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

(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, 2003 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.

Stock Options

     Pro forma information, which assumes the Company had accounted for stock options granted under the fair value method prescribed by SFAS No. 123, “Accounting for Stock-based Compensation,” is presented below. The per share weighted-average fair value of stock options granted was $1.87 for the three-month period ended March 31, 2004, and $0.88 for the three-month period ended March 31, 2003, respectively, as estimated using the Black-Scholes option-pricing model.

     For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting periods. The Company’s historical and pro forma net loss per share for the three-month periods ended March 31, 2004 and 2003, are as follows (in thousands, except per share data):

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

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(2) 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. In-the-money stock options and warrants to purchase an aggregate of 8,545,011 and 14,789 shares of common stock were outstanding at March 31, 2004 and 2003, 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.

(3) Currency Translation

     The financial position and results of operations of our 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.

(4) Comprehensive Loss

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

(5) Business Segments

     The Company currently operates primarily in one business segment 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 following table represents business segment information by geographic area (in thousands):

(a)

European operations represent business activities conducted primarily in Germany, Great Britain and France.

(6) Recent Accounting Developments

     The Company adopted the initial recognition and measurement provisions of FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN No. 45”), on January 1, 2003, which apply on a prospective basis to guarantees issued or modified after December 31, 2002. The Company adopted the disclosure provisions of FIN No. 45 during the quarter ended March 31, 2003. In the ordinary course of

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business, the Company is not subject to potential obligations under guarantees that fall within the scope of FIN No. 45 except for standard indemnification and warranty provisions that are contained within many of its customer product and service agreements. In addition, under previously existing accounting principles generally accepted in the United States of America, the Company continues to monitor the conditions that will trigger indemnifications and warranties to identify whether it is probable that a loss has occurred and will recognize any such losses under the guarantees and indemnification or warranty agreements and provisions when those losses are estimable.

     Indemnification and warranty provisions contained within the Company’s customer product and service agreements are generally consistent with those prevalent in the Company’s industry. The duration of the Company’s service warranties generally does not exceed one year following completion of its services. The Company has not incurred significant obligations under customer indemnification or warranty provisions and does not expect to incur significant obligations in the future. Accordingly, the Company does not maintain accruals for such potential indemnification obligations.

     In December 2003, the FASB issued FASB Interpretation No. 46 (as revised December 2003 “FIN 46R”), Consolidation of Variable Interest Entities (“VIEs”), which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46, Consolidation of Variable Interest Entities, which was issued in January 2003. The Company is required to apply FIN 46R to variable interests in VIEs created after December 31, 2003. For variable interests in VIEs created before January 1, 2004, the Interpretation will be applied beginning on January 1, 2004. For any VIEs that must be consolidated under FIN 46R that were created before January 1, 2004, the assets, liabilities, and noncontrolling interests of the VIE initially would be measured at their carrying amounts with any difference between the net amount added to the balance sheet and any previously recognized interest being recognized as the cumulative effect of an accounting change. If determining the carrying amounts is not practicable, fair value at the date FIN 46R first applies may be used to measure the assets, liabilities, and non-controlling interest of the VIE. Since the Company has no interest in any variable entity, the Company believes that the adoption of this interpretation will not have a material impact on its consolidated financial position or results of operations.

(7) Stock Transactions

     On February 26, 2003, the Company issued 4,646,408 shares of Common Stock for an aggregate cash purchase price of $5.0 million ($1.0761 per share) in a private placement exempt from registration under Section 4 (2) of the Securities Act of 1933, as amended to Safeguard Delaware, Inc., a wholly-owned subsidiary of Safeguard Scientifics, Inc. We refer to Safeguard Scientifics, Inc. and its wholly-owned subsidiaries as “Safeguard”. As a result of the transaction, Safeguard’s percentage of beneficial ownership increased to approximately 62%. ChromaVision and Safeguard also entered into an agreement giving Safeguard certain rights to have the purchased shares registered under the Securities Act of 1933, as amended.

     On September 1, 2003, the Company issued 816,950 shares of restricted stock to employees with a value on the date of grant of $1,021,188 ($1.25 per share), which was recorded as deferred compensation. This restricted stock vests over a two-year period. Compensation expense is recognized on a straight-line basis over the vesting period and is reduced to the extent that a participant forfeits shares of restricted stock received prior to vesting. The deferred compensation charge is unaffected by future changes in the price of the common stock. Safeguard did not exercise its anti-dilution rights in conjunction with the restricted stock grant. As a result, Safeguard’s beneficial ownership decreased from approximately 62% to approximately 60%. These shares were issued following our delisting from the Nasdaq National Market without first being qualified under California state securities laws. As a result, the Company may have potential liability under California state securities laws to the individuals to whom the shares of restricted stock were issued. The Company may elect to conduct a rescission offer to such individuals to give them the election to rescind their restricted stock grant. Management is currently analyzing this matter and cannot, at this time, ascertain the extent of our potential liability, if any, although we do not believe that it would be material to the Company’s financial statements.

     On February 10, 2004, the Company completed a private placement exempt from registration under Section 4(2) of the Securities Act of 2,295,230 shares of common stock and a warrant to purchase shares of common stock to Safeguard for a purchase price of $5.0 million. The warrant issued to Safeguard is exercisable until March 1, 2008 and is currently exercisable to purchase 344,285 shares of common stock for an exercise price of $2.95 per share. As a result of this transaction, Safeguard’s percentage of beneficial ownership of our common stock increased from approximately 60% immediately preceding the transaction to approximately 63%. The Company also entered into a registration rights agreement giving Safeguard certain rights to have the purchased shares registered under the Securities Act of 1933, as amended.

     On March 25, 2004, the Company entered into a securities purchase agreement with a limited number of accredited investors pursuant to which we agreed to issue and the investors agreed to purchase 10,500,000 shares of common stock, together with warrants to purchase an additional 1,575,000 shares of common stock at an exercise price of $2.75 per share for an aggregate purchase price of $21.0 million (we refer to this financing as the “March 2004 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

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(4,200,000 shares of common stock and warrants to purchase 630,000 shares of common stock for aggregate gross proceeds of $8.4 million) were issued at an initial closing that occurred on March 31, 2004. The remaining shares and warrants to be issued in the transaction were issued at a subsequent closing which occurred on April 27, 2004. Safeguard was one of the purchasers in the March 2004 financing and acquired 3,750,000 shares (of which 1,500,000 shares were acquired at the initial closing) of common stock and warrants to purchase 562,500 shares of common stock (of which 225,000 were acquired at the initial closing) for an aggregate investment of $7.5 million. Following consummation of the subsequent closing of the financing Safeguard beneficially owned approximately 57.6% of our outstanding common stock.

     Each of the purchasers in the March 2004 financing was granted a preemptive right to purchase its pro-rata share of 49.9% of any new equity securities that we may issue on or prior to March 31, 2005. Safeguard had previously been granted preemptive rights, which it waived in connection with the March 2004 financing (except to the extent that it purchased securities in the March 2004 transaction). In connection with the March 2004 financing, the Company entered into a registration rights agreement with the purchasers in that financing.

     Due to its beneficial ownership of approximately 57.6% of our outstanding common stock, Safeguard has the power to elect all of the directors of our Company. The Company has given Safeguard contractual rights enabling it to exercise significant control over the Company.

(8) Line of Credit

     In February 2003, we entered into a $3.0 million revolving credit agreement with Comerica Bank-California (NYSE: CMA). This one year agreement was renewed for a second year to February 2005. The borrowings under the line of credit will be used for working capital purposes and will bear interest at Comerica’s prime rate plus one-half percent. The agreement also includes a one-time facility fee of $15,000, a fee of 0.25% on the unused balance of the line of credit, various restrictive covenants and requirements to maintain certain financial ratios. Borrowings under the line of credit are guaranteed by Safeguard in exchange for a one-time fee of $15,000 and an amount equal to 4.5% per annum of the daily-weighted average principal balance outstanding under the line of credit. The Company failed to satisfy certain financial covenants under the loan agreement as of the end of August 2003, and in October 2003 the lender waived these failures to satisfy the covenants and agreed to modify the covenants by amendment entered into on January 22, 2004. The amended agreement that began in February 2004 now has only one financial covenant related to tangible net worth, which must be greater than $1 through June 30, 2004 and greater than ($2,000,000) thereafter. As of March 31, 2004, the Company had no balance outstanding under the line of credit and was in compliance with the modified covenants. The Company believes it will remain in compliance with these modified covenants throughout the remaining term of the agreement.

(9) Equipment Financing

     In August 2003, the Company entered into a $3.0 million equipment financing agreement with GE Capital. The loan principal amortizes ratably over a 33-month term. The borrowings under the equipment financing agreement are being used for working capital purposes and bear interest at 600 basis points over the three year treasury constant maturities rates (2.16% at 9/19/03 or time of borrowing). The agreement also provides for an incremental $2.0 million of financing availability upon reaching certain system placement objectives, various restrictive covenants, maintenance of certain financial ratios and a collateral monitoring fee of $5,000 per year. In September 2003, the entire $3.0 million available under the financing agreement was borrowed with an interest rate of 8.16%. As of March 31, 2004, $2.6 million of debt remains outstanding with approximately $1.1 million of the debt classified as current and $1.5 million as long-term.

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

     Statements in this report describing our plans, goals, strategies, intentions, expectations and anticipated events are forward-looking statements. Important factors which could cause actual results to differ materially from those described in such forward-looking statements include the following: our ability to successfully implement our plans to begin offering cancer diagnostic laboratory services, biopharma services and in-sourcing of our Access remote pathology program, the performance and acceptance of our system and service offerings in the marketplace; changes in rates of third-party payer reimbursement for tests performed using our system; uncertainty of success in developing any new software applications; the outcome of any currently pending and any future litigation that involves us; any future success depends upon our ability to expand and maintain a successful sales and marketing organization; we may require additional financing for our business, and it is uncertain whether the financing will be available on favorable terms or at all; we may encounter unanticipated expenses, liabilities or other adverse events affecting cash flow; our ability to develop new tests and to distribute our systems and tests performed on the system depends on successful collaboration with third parties that we do not control; proper utilization of our system is dependent upon the quality of third party stains and reagents; we must successfully compete with other technologies and with emerging competitors in cell imaging many of which may have greater resources, market share, and brand recognition than us; an inadequate supply of biological samples could delay completion of clinical trials for new applications for our Automated Cellular Imaging System (“ACIS”); the clinical trials could fail to demonstrate the efficacy of the ACIS for new applications; new applications may not be successfully developed; the ability to commercialize new applications may be dependent on obtaining appropriate U.S. Food and Drug Administration (the “FDA”) and foreign regulatory approvals and clearances, which may not be obtained when anticipated or at all; our competitive position is dependent upon our ability to protect our patents and proprietary rights; manufacture of the ACIS is subject to FDA regulation and our ability to implement our strategy of providing decentralized ACIS analysis capabilities over the internet is dependent upon successful development of the related imaging technology and obtaining any required regulatory approvals. In addition, there is risk and uncertainty as to our expectation that our revenues may increase from the addition of new system placements, expanded sales of systems to research accounts and the roll-out of the Access remote pathology program in our laboratory facilities. Recent experience with respect to ACIS placements, new contracts for placements, revenues and results of operations may not be indicative of future results for the reasons set forth above.

Results of Operations

Overview

     Our mission is to improve the quality and reduce the cost of patient care, and speed drug discovery. We develop, manufacture and market a versatile automated digital microscope system with the ability to detect, count and classify cells based on color, size and shape to assist pathologists in making critical medical decisions that can affect patient treatment. The ACIS^® (Automated Cellular Imaging System) combines an automated microscope with computer-based color imaging technology originally developed for the U.S. government’s “Star Wars” program.

     The FDA-cleared ACIS device is currently being used by pathologists and researchers to analyze specimens placed on slides and stained with color-producing, commercially available reagents. The system’s ability to overcome the limitations of the human eye (even when aided by a microscope) dramatically improves the observer’s ability to analyze cells and tissue. Peer-reviewed clinical data and publications have demonstrated that the ACIS digital microscope and proprietary software can considerably improve accuracy and consistency over other methods of laboratory testing. ChromaVision brings standardization, accuracy and reproducibility to anatomic pathology, an area of the laboratory focused on esoteric tests, which have traditionally been analyzed manually. In a multi-pathologist clinical study, observers improved their rates of correlation with an independent standard from a range of 42 to 92% scoring manually to 91 to 95% using ACIS. Even the most accurate pathologist scoring manually was able to achieve improved accuracy using ACIS.

     Recently, we have announced plans to broaden our service offering to now include the direct provision of Access technical services to our Access, remote pathology customers as well as to provide an array of complementary advanced cancer diagnostic services. All of these services will be provided in ChromaVision’s own laboratory facility that is currently being renovated for these purposes. We believe that we are qualified to provide this combination of services because of our proprietary image analysis technology and ability to develop companion diagnostic tests with biopharma companies in their introduction of new cancer therapeutics. In the future, we expect that contributions from these laboratory services will comprise a greater component of revenue.

     Safeguard Scientifics, Inc., a Pennsylvania corporation whose shares are listed on the New York Stock Exchange, owns beneficially approximately 57.6% of the outstanding shares of our Common Stock. We refer to Safeguard Scientifics, Inc. and its wholly-owned subsidiaries as “Safeguard”. As a result of this stock ownership, Safeguard has the ability to elect all of our directors and it also has significant contractual rights to control our business. See Note 7 of Notes to Condensed Consolidated Financial Statements.

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Critical Accounting Policies and Estimates

     Our discussion and analysis of our financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial reporting. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and 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 for ACIS in progress.

     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 respective period.

     For ACIS in progress, which is recorded in property plant and equipment, the respective reserve is based upon the expected future use of the ACIS components based upon proposed design changes, high value components that may be discontinued in the near future and whether there are any lower of cost or market considerations. 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.

     We place most of our instruments with users on a “fee-per-use” basis. We obtain 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 will own 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) when the basic criteria in SOP 97-2 have been met. Maintenance revenue is recognized ratably over the term of the maintenance contract, typically 12 months. Revenue on product sales is recognized upon acceptance by the customer subsequent to a testing and evaluation period.

Three Months Ended March 31, 2004 Compared with Three Months Ended March 31, 2003

     Revenue – Fee per use. Our focus has been on placing the ACIS under a lease arrangement in which the customer is charged monthly based on the number of tests performed, subject to a minimum monthly payment. We are now transitioning to directly provide laboratory services in our facilities. Revenue for the three months ended March 31, 2004 decreased approximately $1.1 million or 41.6% over the comparable period in 2003 due primarily to a decrease in the average monthly revenue for ACIS placements and the remote viewing stations. The average monthly revenue for ACIS placements and remote viewing stations was approximately $3,495 and $386, respectively in the first quarter of 2004 as compared to $5,040 and $2,303, respectively for the comparable period in 2003. The decline in the average monthly revenue is primarily due to pricing concessions offered to our customers in response to lower reimbursement levels from 2003 to 2004 (See discussion following under “Uncertainties to Future Operations). The decline in revenue per unit per month for Access customers, or those with remote viewing stations, declined more than that for ACIS customers because Access accounts only receive the professional component of reimbursement, which fell much more substantially than the decline in overall reimbursement. We anticipate that the average monthly system revenue will remain at approximately the levels experienced in the first quarter of 2004 and that most if not all of the negative impact from reimbursement has been reflected in current revenue figures. We renegotiated new contracts with approximately 90% of our accounts based on the new levels of reimbursement. We believe that we will substantially retain this group of customers and that the net decline of twenty-one billing systems that took place in the first quarter will not continue to any significant degree going forward. In February 2004, we gave notice of termination to our largest customer, US Labs, so that ChromaVision could provide technical services to our Access customers. Our existing contractual relationship with US Labs will end in July 2004. We intend to transition these customers to the new ChromaVision laboratory operation and expect to see new revenue from these services increasing over the next several quarters. Although, it is not known how many of the current Access customers will elect to transition from US Labs to ChromaVision, we believe that most will continue to use ChromaVision’s FDA approved, proprietary technology.

     Revenue — System sales. Revenue for the three months ended March 31, 2004 increased approximately $187,000 or 101.6% over the comparable period in 2003 due primarily to an increase in the number of units sold. Three systems were sold during the first quarter of 2004 as compared to one during the comparable period in 2003. System sales contributed 19.2% of total revenue for the first quarter of 2004 as compared to 6.5% for the comparable period in 2003. Revenue from system sales can fluctuate significantly principally due to the infrequent and limited number of system sales. We have placed a greater emphasis on selling ACIS systems to research and biopharma accounts and anticipate that system sale revenue will become a larger component of total revenue in the future. These efforts will be facilitated by an increase in sales staff for these purposes and greater development of ACIS system features most attractive to this customer segment.

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     Cost of revenue. Cost of revenue for the three months ended March 31, 2004 increased approximately $67,000, or 7.8% over the comparable period in 2003, due primarily to the increase in system placements. Cost of revenue primarily consists of cost for manufacturing the ACIS, which includes the cost for direct material, labor costs and manufacturing overhead. For fee-per-use revenue the cost of the ACIS is depreciated over a three-year time period and for a system sale the entire cost of the ACIS system is recognized at the time of sale. The gross margin, as a percentage of total revenue for the three months ended March 31, 2004 was 52.1% as compared to 69.9% for the comparable period in 2003. The gross margin decrease is primarily due to the lower revenue per unit for ACIS and Access, remote viewing systems.

     Selling, general and administrative expenses. Expenses for the three months ended March 31, 2004 increased approximately $0.2 million, or 6.6% over the comparable period in 2003. The increase for the three-month period includes combined severance, bonus and stock option expense of $0.2 million and Safeguard’s combined charges for interim CEO management and corporate governance consultants of $0.1 million. These charges were offset, in part, by lower headcount from our third quarter 2003 workforce reduction and lower costs of depreciation and travel costs. Included in selling, general and administrative expenses are new general and administrative start-up costs for 2004 related to the previously announced introduction of new oncology services. These costs, which approximated $600,000, of which approximately $200,000 was capitalized to property, plant and equipment, in the first quarter of 2004, are initially directed at the development of ChromaVision’s in-house Access technical services capability. These costs will continue to be an increasing component of total costs in future periods.

     Research and development expenses. Expenses for the three months ended March 31, 2004 decreased by approximately $0.1 million or 9.3%, over the comparable period in 2003. The decrease for the three-month period is due to the reduction in personnel costs as a result of the third quarter 2003 workforce reduction. We believe that sufficient resources exist currently to support the development of new features for the clinical and research markets. These new development activities, which are intended to produce features that could expand the volume of clinical tests supported by ACIS and increase the attractiveness of the ACIS as a tool for researchers, are important to increasing clinical system test volume, expanding the count of clinical system placements, and increasing research system sales.

     Other income(expense). Other expense for the three months ended March 31, 2004 totaled $61,000, compared to $8,000 of other income for the comparable period of 2003, and consisted of approximately $71,000 of interest expense offset by approximately $11,000 on interest income. The interest expense is due to the borrowings under our $3.0 million equipment financing agreement, which began in September 2003. No borrowings under the equipment financing agreement, or any other credit facility, existed during the first quarter of 2003. The $11,000 of interest income for the first quarter of 2004 compares to $8,000 of interest income for the comparable period of 2003. The increase in interest income is primarily the result of higher cash balances in the first quarter of 2004 compared to the first quarter of 2003.

Uncertainties as to Future Operations

     The year 2000 was our first full year of commercial activity during which we focused primarily on marketing and sales of the ACIS system as our menu of capabilities performed with the ACIS expanded and gained commercial acceptance. While we have made significant progress, we still face significant uncertainties, including those discussed below under “Risk Factors” and “Liquidity and Capital Resources,” which include our ability to achieve market acceptance of the ACIS, our ability to ensure satisfactory reimbursement by Medicare and other third party insurance carriers under new billing codes which have been established for image analysis-based testing effective as of January 1, 2004 and our ability to execute on our business plan to begin providing additional 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 Common Procedural Terminology, or 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.

     Effective April 1, 2003, the CMS instituted a National Correct Coding Initiative (NCCI) edit. The NCCI edit significantly reduced from April 1, 2003 to December 31, 2003 the amount of reimbursement previously paid by Medicare for services involving automated image analysis by limiting the codes that would be accepted for reimbursement for ACIS-based services. The CMS edit applied directly only to Medicare patients. We estimate that 25 to 35% of ACIS-based services are performed for Medicare beneficiaries. We believe that, before the edit, the majority of our customers were being reimbursed approximately $200 per test. Under the NCCI interim edit (effective until December 31, 2003) customers were reimbursed about $85 per test for Medicare patients. During this time, the edit was adopted to a limited degree by other third-party payers.

     A new CPT code for image analysis went into effect on January 1, 2004. Under the new code, the total Medicare reimbursement for ACIS-based procedures performed in physician offices or independent laboratories is approximately $140 per

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test, reflecting a technical component of approximately $85 and a professional component of approximately $55. 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.

     The adoption of a new CPT code appropriate for image analysis reflects the expanding role of image analysis in pathology and the need for appropriate reimbursement to enable use of this technology by healthcare providers to benefit patients. Potentially, the new CPT code could help to streamline reimbursement for ACIS users by allowing them to code more specifically for image analysis-based services in claims billed to third party payers. The 2004 valuations of the new code are considered interim valuations and are open for comment to influence further adjustments in 2005. ChromaVision will continue working with relevant medical societies and other appropriate constituents to obtain appropriate reimbursement amounts by all payers for providers of image analysis- based services. The goal is to have the amount paid by Medicare and other payers for image analysis-based services accurately reflect the technology costs, the benefit that image analysis brings to patients, and its positive impact on healthcare economics.

     The reduction of reimbursement resulting from the NCCI edit and the 2004 interim valuations for ACIS-based procedures will not only reduce revenue for current ACIS customers, but also may result in system returns or cancellations by current customers and may also negatively impact future placements of ACIS. ChromaVision is in the process of determining the ultimate impact of this code on our customers and our business. In addition, because of the increase in the technical component to reimbursement, ChromaVision is required to enter into new contracts with the hospitals that often prepare the slides for analysis. Hospitals typically have longer buying cycles and a more extensive contract evaluation process then the pathology practitioner which may delay the implementation of these contracts. At the same time, ChromaVision’s current pathologist customers, for whom professional service reimbursement has been reduced from approximately $150 to $55 per test, will require more significant rate reductions. The creation of these “split billing” agreements, where ChromaVision will seek fees from both a hospital and pathology practice, have the potential to be difficult to implement and could cause delays in coming to a rate agreement.

     Due to the change in reimbursement effective January 1, 2004, our sales representatives have focused considerable efforts, during the first quarter of 2004, on renegotiating many of the fee-per-use contracts. As a result, we have experienced a reduction in system placements and fee-per-use revenue during the first quarter of 2004, as compared with previous quarters in 2003. Approximately 90% of our contracts have been renegotiated as of March 31, 2004. New sales efforts will now be substantially focused on system placement expansion and continued support of our existing base of installations.

     We face risks that our ACIS and remote Access viewing systems may become obsolete or their market value may decline below their manufacturing cost. These risks have increased due to the recent slowdown in system placements and increase in system returns. Some of these risks are mitigated by the depreciation of these systems as they become engaged in service and our ability to upgrade these systems, at a relatively low cost, to meet new application demands.

     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 if any one test is not successfully developed, or market feedback suggests that a test should be given a lower priority, we can align development efforts according to priority. In addition, the ACIS system 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 uncertainties affecting our business include our ability to implement our new business initiatives, including transitioning from our primary imaging provider to providing our laboratory services in-house and to collaborate successfully with other companies, universities and research centers to develop, initiate and complete clinical trials of new applications for the ACIS and obtain governmental approvals for the applications. Although we have recently hired many individuals with experience in operating and building out laboratory services, we do not have an historical or demonstrated competency in reference laboratory service provision and may, therefore, have a difficult time in transitioning new customers to its new laboratory services operation. Lack of success in these efforts could have a material adverse effect on the future results of our operation and our ability to generate sufficient cash flow to fund operations.

Liquidity and Capital Resources

     At March 31, 2004, we had approximately $12.0 million of cash and cash equivalents. On April 27, 2004, we consummated the final closing of our March 2004 financing by private placement which resulted in additional net proceeds of approximately $12.0 million. Cash used in operating activities was $1.2 million in the first quarter of 2004 due primarily to our net loss of $3.3 million offset by non-cash charges of $0.7 million for depreciation and $0.2 million for stock and other compensation. Cash used in investing activities of $1.2 million consisted of capital expenditures related primarily to the manufacture of the ACIS systems placed with customers in the first quarter of 2004 and expenditures for new laboratory equipment in support of our expanded laboratory and biopharma services. The rate of capital expenditures, as it relates to ACIS

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and ACCESS equipment purchases for the remainder of 2004, is expected to be relatively lower than prior years, particularly in the first half of the year, due to the reduced backlog of signed contracts for new system placements at the end of 2003. Slow contract signings in the second half of 2003 and the first quarter of 2004 were due primarily to the reduction in Medicare reimbursement amounts for ACIS testing and a focus on renegotiating current fee-per-use contracts, as previously discussed above. Contract signings and related placements of new systems and sales of systems to the research markets are expected to increase in the second half of 2004. We believe that contract signings for new laboratory services, both those related to Access technical services as well as those for broader cancer diagnostic services, will also increase in the second half of 2004 as we build out and establish these service capabilities at that time. In addition, because of a management decision in the third quarter of 2003 to terminate agreements with low performing accounts and a limited number of customer cancellations, we have an increase in the supply of returned equipment that is available for placement with new accounts in the future. We believe that we will be able to place this supply of returned equipment with new customers.

     Our business plan also anticipates placing ACIS and ACCESS instruments with users and charging a fee-per-use for each time the instrument is used to perform a test or to alternatively to sell these systems to research customers. The manufacture of these instruments will require a significant outlay of cash, subject to the near term supply of returned equipment noted above, for which revenues will be recognized over the lease term. We intend to fund these expenditures with our current cash resources, with the funds available under our $3.0 million revolving line of credit, and with new equipment financing specifically directed towards our new laboratory equipment acquisitions. While we believe that these resources will be adequate to support the entirety of our business expansion needs, both for new system placements as well as for the broader build out of the laboratory facilities, we intend to increase our mix of system sales to per use contracts to generate more cash. The majority of these sales will be to research accounts. We also intend a “modified” sale transaction with clinical customers that will include a combination of up front purchase cost and long term per-use license fees for future test volumes. This latter approach is one that best fits our smaller ACIS accounts, those with lower test volumes, and that improves the overall economics for these customers.

     Cash provided from financing activities during the first quarter of 2004 was $12.7 million primarily due to the completion of a $5.0 million private placement of our common stock with Safeguard in February 2004 and the initial $7.9 million, net of $0.5 million offering costs, portion of a $21.0 million private placement of our common stock to a limited number of accredited investors in March 2004. Both of these financing transactions are described below. In addition, we paid down approximately $0.2 million of the outstanding GE equipment financing.

     In February 2003, we entered into a $3.0 million revolving credit agreement with Comerica Bank-California (NYSE: CMA). This one-year agreement was renewed for a second year to February 2005. The borrowings under the line of credit will be used for working capital purposes and will bear interest at Comerica’s prime rate plus one-half percent. The agreement also includes a one-time facility fee of $15,000, a fee of 0.25% on the unused balance of the line of credit, various restrictive covenants and requirements to maintain certain financial ratios. Borrowings under the line of credit are guaranteed by Safeguard in exchange for a one-time fee of $15,000 and an amount equal to 4.5% per annum of the daily-weighted average principal balance outstanding under the line of credit. We failed to satisfy certain financial covenants related to tangible net worth under the loan agreement as of the end of August 2003, and in October 2003 the lender waived these failures to satisfy the covenants and agreed to modify the covenants. The amended agreement that began in February 2004 now has only one financial covenant related to tangible net worth, which must be greater than $1 through June 30, 2004 and greater than $(2,000,000) thereafter. We were in compliance with the revised covenants at March 31, 2004 and management believes that it will remain in compliance throughout the remaining term of the agreement. As of March 31, 2004, $3.0 million was available under the line of credit.

     In August 2003, we entered into a $3.0 million equipment financing agreement with GE Capital. The loan principal amortizes ratably over a 33-month term. The borrowings under the equipment financing agreement are being used for working capital purposes and bear interest at 600 basis points over the three year treasury constant maturities rates (2.16% at 9/19/03 or time of borrowing). The agreement also provides for an incremental $2.0 million of financing availability upon reaching certain system placement objectives, various restrictive covenants, maintenance of certain financial ratios and a collateral monitoring fee of $5,000 per year. In September 2003, the entire $3.0 million available under the financing agreement was borrowed with an interest rate of 8.16%. As of March 31, 2004, $2.6 million of debt remains outstanding with approximately $1.1 million of the debt classified as current and $1.5 million as long-term.

     Borrowings under the equipment financing agreement with GE Capital are secured by substantially all of our assets. The agreement with GE Capital incorporates some of the restrictive covenants and certain other requirements of the Comerica revolving credit agreement, including any subsequent amendments granted by Comerica with respect to the incorporated covenants. The agreement with GE Capital also includes a provision whereby a material adverse change to our financial condition could be considered an event of default. We believe, however, that based on current operations, committed borrowings, the $5.0 million received from the private placement with Safeguard Delaware, Inc. in February 2004 and the $21.0 million equity financing in March 2004, that we will remain in compliance with its debt covenants over the next twelve months and that it is not probable that GE Capital will exercise the material adverse change clause as an event of default.

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     On February 10, 2004, we completed a private placement of 2,295,230 shares of common stock and a warrant to purchase shares of common stock to Safeguard for a purchase price of $5.0 million. The warrant issued to Safeguard, which is exercisable until March 1, 2008, as amended, is currently exercisable to purchase 344,285 shares of common stock for an exercise price of $2.95 per share. In connection with this private placement transaction, we entered into a registration rights agreement giving Safeguard certain rights to have the purchased shares registered under the Securities Act of 1933, as amended.

     On March 25, 2004, we entered into a securities purchase agreement with a limited number of accredited investors pursuant to which we agreed to issue and the investors agreed to purchase 10,500,000 shares of common stock for an aggregate purchase price of $21.0 million or $2.00 per share, together with warrants to purchase an additional 1,575,000 shares of common stock at an exercise price of $2.75 per share for an aggregate purchase price of $21.0 million (we refer to this financing as the “March 2004 financing”). The warrants issued in this transaction are exercisable for a period of four years after the date they are issued. We structured this transaction so that a portion of the common stock and warrants issued (4,200,000 shares of common stock and warrants to purchase 630,000 shares of common stock for aggregate gross proceeds of $8.4 million) were issued at an initial closing that occurred on March 31, 2004. The remaining shares and warrants to be issued in the transaction were issued at a subsequent closing which occurred on April 27, 2004. Safeguard was one of the purchasers in the March 2004 financing and acquired 3,750,000 shares of common stock and warrants to purchase 562,500 shares of common stock for an aggregate investment of $7.5 million. Each of the purchasers in the March 2004 financing was granted a preemptive right to purchase its pro rata share of 49.9% of any new equity securities that we may issue on or prior to March 31, 2005. Safeguard had previously been granted preemptive rights, which it waived in connection with the March 2004 financing,