Forward-Looking Statements

This Quarterly Report on Form 10-Q, including this Management's Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements that are based upon current expectations. These statements are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In some cases, you can identify forward-looking statements by terminology such as "may", "will", "should", "expect", "plan", "anticipate", "believe", "estimate", "intend", "potential" or "continue" or the negative of these terms or other comparable terminology. Forward-looking statements are based upon current expectations that involve risks and uncertainties. Our actual results and the timing of events could differ materially from those anticipated in our forward-looking statements as a result of many factors, including, but not limited to, the following: continued market acceptance of our methicillin resistant staphylococcus aureus ("MRSA") and other healthcare associated infection products; changes in the protocols, best practices or level of testing for MRSA and other healthcare associated infections; development and manufacturing problems; the need for additional intellectual property licenses for new tests and other products and the terms of such licenses; our ability to successfully sell additional products in the Clinical market; lengthy sales cycles in certain markets; the performance and market acceptance of our new products; our ability to obtain regulatory approvals and introduce new products into the Clinical market; the level of testing at existing clinical customer sites; the mix of products sold, which can affect gross margins; our reliance on distributors to market, sell and support our products; the occurrence of unforeseen expenditures, asset impairments, acquisitions or other transactions; our ability to integrate the businesses, technologies, operations and personnel of acquired companies; the scope and timing of actual United States Postal Service ("USPS") funding of the Biohazard Detection System ("BDS") in its current configuration; the rate of environmental testing using the BDS conducted by the USPS, which will affect the amount of consumable products sold; our success in increasing our direct sales; the impact of competitive products and pricing; our ability to manage geographically-dispersed operations; our ability to continue to realize manufacturing efficiencies, which are an important factor in improving gross margins; underlying market conditions worldwide; and the other risks set forth under "Risk Factors" and elsewhere in this report. We assume no obligation to update any of the forward-looking statements after the date of this report or to conform these forward-looking statements to actual results.

OVERVIEW

We are a broad-based molecular diagnostics company that develops, manufactures, and markets fully-integrated systems for testing in the Clinical, Industrial and Biothreat markets. Our systems enable rapid, sophisticated molecular testing for organisms and genetic-based diseases by automating otherwise complex manual laboratory procedures. Molecular testing involves a number of complicated and time-intensive steps, including sample preparation, DNA amplification and detection. Our easy-to-use systems integrate these steps and analyze complex biological samples in our proprietary test cartridges. We are currently the only company to have obtained Clinical Laboratory Improvement Amendments (CLIA) moderate complexity categorization for an amplified molecular test system and an associated specific infectious disease test on the market in the United States. Our efforts are currently focused on those applications where rapid molecular testing is particularly important, such as identifying infectious diseases and cancer in the Clinical market; food, agricultural and environmental testing in the Industrial market; and identifying bio-terrorism agents in the Biothreat market.

Our two principal systems are the GeneXpert and SmartCycler systems. The GeneXpert system integrates sample preparation in addition to DNA amplification and detection. The GeneXpert system is designed for a broad range of user types ranging from reference laboratories and hospital central laboratories to satellite testing locations, such as emergency departments and intensive care units within hospitals and doctors' offices. The SmartCycler system integrates DNA amplification and detection to allow rapid analysis of a sample.

The GeneXpert system represents a paradigm shift in the automation of molecular analysis, producing accurate results in a timely manner with minimal risk of contamination. Our GeneXpert system can provide rapid results with superior test specificity and sensitivity over comparable systems on the market today that are integrated but have open architectures.

We currently have available a broad and expanding menu of tests and reagents for use on our systems. Our reagents and tests are marketed along with our systems on a worldwide basis.

Sales Channels

Sales for products within our specific markets are conducted through both direct sales and indirect distribution channels worldwide. Clinical market sales in the United States and the United Kingdom are handled primarily on a direct basis, while sales in all other markets are handled primarily through indirect distribution. As international Clinical markets continue to develop, we expect to expand our direct sales efforts. Our marketing programs are managed on a direct basis.

Revenues

Currently, we derive our revenues primarily from the sales of our two systems and associated reagents and disposables in the Clinical, Industrial, and Biothreat markets, and to a lesser extent from contract and government sponsored research.

Research and Development

The objective of our research and development programs is to develop high-value test applications for the GeneXpert and/or SmartCycler systems for the Clinical, Biothreat, and Industrial testing markets. We focus our research efforts on four main areas: a) systems engineering efforts to extend the multiplexing capabilities of our systems and to develop new low and high throughput systems,
b) chemistry research in our Bothell, Washington facility to develop innovative and proprietary methods to design and synthesize oligonucleotide primers, probes, and dyes to optimize the speed, performance and ease-of-use of our assays, c) assay development efforts to design, optimize, and produce specific tests that leverage the systems and chemistry we have developed, and d) target discovery research to identify novel micro RNA targets to be used in the development of future assays. Our development efforts focus primarily on the development of clinical diagnostic products that encompass many of the new technologies that are developed with our research programs.

CRITICAL ACCOUNTING POLICIES, ESTIMATES AND ASSUMPTIONS

Except as discussed below, management believes that there have been no significant changes during the nine months ended September 30, 2008 to the items that we disclosed as our critical accounting policies and estimates in Management's Discussion and Analysis of Financial Condition and Results of Operation in our 2007 Annual Report on Form 10-K filed with the Securities and Exchange Commission. For a description of those critical accounting policies, please refer to our 2007 Annual Report on Form 10-K.

Our investments at cost of $25.0 million at September 30, 2008 consisted of auction rate securities. Auction rate securities are securities that are structured with short-term interest rate reset dates of generally less than 90 days but with contractual maturities that can be well in excess of ten years. Since March 2008, all of our auction rate securities failed at auction. Our auction rate securities consist of investments that are backed by pools of student loans, which are principally guaranteed by the Federal Family Educational Loan Program ("FFELP"), or insured. We believe that the credit quality of these securities is high based on these guarantees and insurance. We determine the fair market values of our financial instruments based on the fair value hierarchy established in SFAS 157, which requires an entity to maximize the use of observable inputs (Level 1 and Level 2 inputs) and minimize the use of unobservable inputs (Level 3 inputs) when measuring fair value. Given the current failures in the auction markets to provide quoted market prices of the securities, as well as the lack of any correlation of these instruments to other observable market data, we valued these securities using a discounted cash flow methodology with the most significant inputs categorized as Level 3. Significant inputs that went into the model were the credit quality of the issuer, the percentage and the types of guarantees, the timing and probability of the auction succeeding or the security being called and discount factors. We also considered various factors in determining whether to recognize an other-than-temporary impairment charge in the condensed consolidated statement of operations, including the duration of time and the severity to which the fair value has been less than our amortized cost basis, any adverse changes in the investees' financial condition and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated maturity or recovery in market value. At September 30, 2008, the value of our auction rate securities was $21.0 million, all of which have failed to settle at auction since March 2008. After careful consideration of the various factors involved in the valuation of our auction rate securities, as of September 30, 2008 we have recorded cumulative unrealized losses of $4.0 million, which are included in accumulated other comprehensive loss in the condensed consolidated balance sheet. Changes in the assumptions of our model based on the dynamic market conditions could have a significant impact on the valuation of these securities, which may lead us in the future to take an impairment charge for these securities. While we presently do not intend to liquidate these investments, in the event that we did liquidate these investments prior to their scheduled maturities and there were no changes in market interest rates, we could be required to recognize a realized loss on those investments when we liquidate. Furthermore, if this situation were to persist despite our ability to hold such investments until maturity or recovery, we may be required to record an impairment charge at a future date, which would adversely affect our reported results of operations in such period. In October 2008, UBS, the fund manager with which we hold our auction rate securities, announced a comprehensive settlement arrangement for its clients holding auction rate securities. Under the proposal, UBS will issue auction rate securities rights to us. These rights will enable us to sell the auction rate securities held in our accounts with UBS to UBS at par value during a two year period beginning in June 2010. In exchange, we would be required to release UBS from claims we have for damages related to the securities other than consequential damages, and grant UBS the right to sell or otherwise dispose of our auction rate securities on our behalf (so long as we are paid the par value of the securities upon any disposition). We have until November 14, 2008 to accept this offer from UBS. If we participate in the program, we would also be eligible to receive no net cost loans for up to 75% of the market value of our auction rate securities. No settlement has been reached as of September 30 2008.

RESULTS OF OPERATIONS

Comparison of the Three and Nine Months Ended September 30, 2008 and 2007

Revenues



                                       Three Months Ended September 30,            Nine Months Ended September 30,
                                       2008           2007        % Change          2008           2007       % Change
                                      (Amounts in thousands)                      (Amounts in thousands)
Revenues:
System sales                        $    13,961    $    15,911         (12 )%   $     40,708    $    32,142         27 %
Reagent and disposable sales             28,432         18,105          57 %          82,558         47,525         74 %

Total product sales                      42,393         34,016          25 %         123,266         79,667         55 %
Other revenue                             2,522          2,313           9 %           8,532          9,379         (9 )%

Total revenues                      $    44,915    $    36,329          24 %    $    131,798    $    89,046         48 %

We operate in three market areas: Clinical, Industrial and Biothreat. The following table illustrates product sales in the three market areas as a percentage of total product sales:

                                    Three Months Ended          Nine Months Ended
                                       September 30,              September 30,
                                    2008           2007        2008          2007
                                           (As a % of total product sales)
       Product sales by market:
       Core Clinical                    66 %           48 %        55 %          35 %
       Clinical Partner                  4 %           13 %        11 %          14 %

       Total clinical                   70 %           61 %        66 %          49 %
       Biothreat                        20 %           26 %        25 %          37 %
       Industrial                       10 %           13 %         9 %          14 %

       Total product sales             100 %          100 %       100 %         100 %

Within the Clinical market, we have core clinical sales to laboratories and hospitals and non-core clinical sales to partners. Non-core clinical partner sales include sales of our SmartCycler System to Becton Dickinson as well as OEM sales of selected tests to Roche. The increase in product sales of 25% to $42.4 million for the third quarter of 2008 from $34.0 million for the third quarter of 2007 was driven by an increase of 47% in North America, primarily due to an increase of approximately $10.2 million of our Xpert MRSA disposable tests to approximately $14 million. The increase in product sales of 55% to $123.3 million for the nine months ended September 30, 2008 from $79.7 million for the same period in 2007 was driven by increases of 94% in North America, excluding sales to the USPS, and 63% in Europe, primarily due to an increase in overall GeneXpert system sales in the Core Clinical market and Xpert MRSA disposable test sales. The increase in system sales was primarily driven by a 51% increase in GeneXpert System sales for the Core Clinical market for healthcare associated infections. The increase in reagent and disposable sales was primarily due to sales of approximately $33.0 million of our Xpert MRSA disposable tests, as compared to approximately $4 million for the nine months ended September 30, 2007. We expect our Core Clinical product sales to continue to increase during the remainder of 2008 with the continued expansion of the healthcare associated infections market and we expect that our Clinical Partner product sales will continue to decrease during the remainder of 2008 due to our contract with Becton Dickinson expiring in November 2008 and the cancellation by Roche of certain contracted purchases. We also expect our Biothreat sales to decrease during the remainder of 2008 as we expect the USPS to purchase contractually minimum levels of product.

The following table provides a breakdown of our product sales by geographic regions:

                                          Three Months Ended          Nine Months Ended
                                             September 30,              September 30,
                                          2008           2007        2008          2007
                                                 (As a % of total product sales)
 Product Sales by Geographic Regions:
 North America                                85 %           81 %        79 %          80 %
 International                                15 %           19 %        21 %          20 %

 Total product sales                         100 %          100 %       100 %         100 %

The change in product sales by geographic regions for the three months ended September 30, 2008 compared to the same period in 2007 was primarily due to an increase in Xpert MRSA disposable test sales, predominately in North America, offset by a decrease in International Clinical Partner sales of selected tests to Roche. The change in product sales by geographic regions for the nine months ended September 30, 2008 compared to the same period in 2007 was primarily due to slower Biothreat growth in North America compared to overall Clinical growth.

No single country outside of the United States represented more than 10% of our total revenues in any period presented.

Other revenue of $2.5 million in the three months ended September 30, 2008 increased 9% from $2.3 million for the same period in 2007, primarily due to increases in the programs for the National Institutes of Health and the Foundation for Innovative New Diagnostics, partially offset by a decrease in revenue associated with the termination of the Centers for Disease Control and Prevention program in the third quarter of 2007. Other revenue of $8.5 million for the nine months ended September 30, 2008 decreased 9% from $9.4 million for the same period in 2007, primarily due to the termination of the Centers for Disease Control program in the third quarter of 2007, which had higher program revenues in the nine months ended September 30, 2007 than in the same period of 2008. We expect that our quarterly other revenue will decrease during the remainder of 2008 as certain of our collaboration projects reach transition levels in their lifecycles.

Costs and Operating Expenses



                                                Three Months Ended                           Nine Months Ended
                                                   September 30,                               September 30,
                                          2008            2007       % Change          2008           2007      % Change
                                         (Amounts in thousands)                      (Amounts in thousands)
Costs and operating expenses:
Cost of product sales                 $     23,623    $     19,966         18 %    $      69,479    $  47,722         46 %
Collaboration profit sharing                 2,460           2,729        (10 )%           8,970        8,957          0 %
Research and development                    11,611           8,371         39 %           32,473       22,732         43 %
Sales and marketing                          7,871           6,411         23 %           22,246       15,971         39 %
General and administrative                   5,517           4,445         24 %           15,782       12,418         27 %

Total costs and operating expenses    $     51,082    $     41,922         22 %    $     148,950    $ 107,800         38 %

Cost of Product Sales

Cost of product sales consists of raw materials, direct labor and stock-based compensation expense, manufacturing overhead, facility costs and warranty costs. Cost of product sales also includes royalties on product sales and amortization of intangible assets related to technology licenses and intangibles acquired in the purchase of Sangtec. As a result of the increased product sales discussed above, cost of product sales increased 18% to $23.6 million for the third quarter of 2008 compared to $20.0 million for the third quarter of 2007 and increased 46% to $69.5 million from $47.7 million for the first nine months of 2008 and 2007, respectively. Our product gross margin percentage was 44% for the third quarter of 2008 compared to 41% for the third quarter of 2007 and 44% for the nine months ended September 30, 2008 as compared to 40% for the same period in 2007. The increase in product gross margin percentage in the three and nine months ended September 30, 2008 versus the same period in 2007 was primarily due to a shift in product mix to higher margin products, such as clinical reagents, and increased manufacturing efficiencies resulting from automation of our manufacturing processes and increased volumes. For the nine months ended September 30, 2008, these increases were partially offset by costs associated with a production issue related to a GeneXpert cartridge part during the second quarter of 2008.

Collaboration Profit Sharing

Collaboration profit sharing represents the amount that we pay to Applied Biosystems Group under our collaboration agreement to develop reagents for use in the USPS BDS program. Under the agreement, computed gross margin on anthrax cartridge sales are shared equally between the two parties. The collaboration profit sharing expense was $2.5 million and $2.7 million for the third quarter of 2008 and 2007, respectively, and $9.0 million for each of the nine months ended September 30, 2008 and 2007. The slight decrease in collaboration profit sharing for the third quarter of 2008 as compared to the third quarter of 2007 was the result of decreased anthrax cartridge sales under the USPS BDS program, and this expense will remain proportional to the sales of anthrax cartridges under the USPS BDS program, which we expect will decrease during the remainder of 2008.

Research and Development Expenses

Research and development expenses consist of salaries and employee-related expenses, which include stock-based compensation, clinical trials, research and development materials, facility costs and depreciation. Research and development expenses increased 39% to $11.6 million for the third quarter of 2008 from $8.4 million for the third quarter of 2007. The increase in research and development expenses of $3.2 million is primarily due to a $0.9 million increase in salaries and employee-related expenses, inclusive of a $0.2 million increase in stock-based compensation. Other increases included a $0.6 million increase in clinical trial costs, a $0.7 million increase in supplies used in research activities and a $0.3 million increase in contractor costs. Research and development expenses increased 43% to $32.5 million for the nine months ended September 30, 2008 from $22.7 million for the same period of 2007. The increase in research and development expenses of $9.7 million is primarily due to a $3.5 million increase in salaries and employee-related expenses, inclusive of a $1.2 million increase of stock-based compensation. Other increases included a $1.7 million increase in clinical trial costs, a $1.5 million increase in supplies used in research activities, a $0.4 million increase in contractor costs and a $0.3 million increase in lab supplies. We expect that our research and development expenses will remain relatively flat as a percentage of total revenues during the remainder of 2008.

Sales and Marketing Expenses

Sales and marketing expenses consist primarily of salaries and employee-related expenses, which include commissions and stock-based compensation, travel, facility-related costs and marketing and promotion expenses. Sales and marketing expenses increased 23% to $7.9 million for the third quarter of 2008 from $6.4 million for the third quarter of 2007. The increase of $1.5 million included a $0.5 million increase in salaries and employee-related expenses, inclusive of a $0.2 million increase in stock-based compensation, a $0.5 million increase in trade-show and travel-related expenses and a $0.1 million increase in contractor costs. Sales and marketing expenses increased 39% to $22.2 million for the nine months ended September 30, 2008 from $16.0 million for the same period of 2007. The increase of $6.2 million included a $4.0 million increase in salaries and employee-related expenses, inclusive of a $1.2 million increase in stock-based compensation, a $1.2 million increase in trade-show and travel-related expenses, a $0.2 million increase in advertising expense and a $0.2 million increase in contractor costs. These increases reflect the increase in sales and marketing headcount and expanded efforts in the Clinical market, including Europe. We expect our sales and marketing expenses to increase during the remainder of 2008 as a result of the continuing expansion of our direct sales force in the UK and our marketing team both in the United States and Europe, and as we continue to expand our efforts in the Clinical market, with particular emphasis on pursuing the market opportunities for our Xpert MRSA test and other healthcare associated infections products, but we believe these expenses will remain relatively constant as a percentage of total revenues as compared to the first nine months of fiscal 2008.

General and Administrative Expenses

General and administrative expenses consist primarily of salaries and employee-related expenses, which include stock-based compensation, travel, facility, legal, accounting and other professional fees. General and administrative expenses increased 24% to $5.5 million for the third quarter of 2008 from $4.4 million for the third quarter of 2007. The increase of $1.1 million is primarily due to a $0.9 million increase in salaries and employee-related expenses, inclusive of a $0.3 million increase in stock-based compensation expense, which reflects an increase in headcount. In addition, legal, accounting, and other professional expenses increased $0.2 million in the third quarter of 2008 as compared to the same period of 2007. General and administrative expenses increased 27% to $15.8 million for the nine months ended September 30, 2008 from $12.4 million for the same period of 2007. The increase of $3.4 million is primarily due to a $1.9 million increase in salaries and employee-related expenses, inclusive of a $0.9 million increase in stock-based compensation expense, which reflects an increase in headcount. In addition, legal, accounting, and other professional expenses increased $0.8 million in the first nine months of the year in 2008 as compared to the same period of 2007. We expect our general and administrative expenses to remain relatively flat as a percentage of total revenues during the remainder of 2008.

Other Income (Expense), Net



                                               Three Months Ended                             Nine Months Ended
                                                 September 30,                                  September 30,
                                         2008             2007      % Change         2008              2007         % Change
                                      (Amounts in thousands)                         (Amounts in thousands)
Other income (expense), net:
Interest income                     $          241       $  621          (61 )%   $     1,039       $     2,175          (52 )%
. . .