Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

For the transition period from                     to                 

Commission file number: 0-22427

HESKA CORPORATION

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (970) 493-7272

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  o   No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.  Yes  o   No  x

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes  o   No  x

The aggregate market value of voting common stock held by non-affiliates of the Registrant was approximately $60,480,577 as of June 30, 2008 based upon the closing price on the Nasdaq Capital Market reported for such date.  This calculation does not reflect a determination that certain persons are affiliates of the Registrant for any other purpose.

52,010,928 shares of the Registrant’s Common Stock, $.001 par value, were outstanding at March 13, 2009.

DOCUMENTS INCORPORATED BY REFERENCE

Items 10 (as to directors), 11, 12, 13 and 14 of Part III incorporate by reference information from the Registrant’s Proxy Statement to be filed with the Securities and Exchange Commission in connection with the solicitation of proxies for the Registrant’s 2009 Annual Meeting of Stockholders.

Table of Contents

TABLE OF CONTENTS

DRI-CHEM is a registered trademark of FUJIFILM Corporation.  i-STAT is a registered trademark of Abbott Laboratories.  SPOTCHEM is a trademark of Arkray, Inc.  TRI-HEART is a registered trademark of Schering-Plough Animal Health Corporation (“SPAH”) in the United States and is a trademark of Heska Corporation in other countries.  HESKA, ALLERCEPT, AVERT,  E.R.D.-HEALTHSCREEN, E-SCREEN, FELINE ULTRANASAL, HEMATRUE, SOLO STEP, THYROMED and VET/OX are registered trademarks and CBC-DIFF, G2 DIGITAL and VET/IV are registered trademarks of Heska Corporation in the United States and/or other countries.  This Form 10-K also refers to trademarks and trade names of other organizations.

i

Table of Contents

Statement Regarding Forward Looking Statements

This Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended.  For this purpose, any statements contained herein that are not statements of current or historical fact may be deemed to be forward-looking statements.  Without limiting the foregoing, words such as “anticipates,”  “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” variations of such words and similar expressions are intended to identify such forward-looking statements.  These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict.  Therefore, actual results could differ materially from those expressed or forecasted in any such forward-looking statements as a result of certain factors, including those set forth in “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business” and elsewhere in this Form 10-K.  Readers are cautioned not to place undue reliance on these forward-looking statements.

Although we believe that expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.  We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.  These forward-looking statements apply only as of the date of this Form 10-K or for statements incorporated by reference from the 2009 definitive proxy statement on Schedule 14A, as of the date of the Schedule 14A.

Internet Site

Our Internet address is www.heska.com.  Because we believe it provides useful information in a cost-effective manner to interested investors, via a link on our website our annual report on Form 10-K, 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 Securities Exchange Act of 1934 are publicly available free of charge and we believe are available as soon as reasonably practical after we electronically file such material with, or furnish it to, the Securities Exchange Commission.  Information contained on our website is not a part of this annual report on Form 10-K.

Where You Can Find Additional Information

You may review a copy of this annual report on Form 10-K, including exhibits and any schedule filed therewith, and obtain copies of such materials at prescribed rates, at the Securities and Exchange Commission’s Public Reference Room in Room 1580, 100 F Street, NE, Washington, D.C. 20549-0102.  You may obtain information on the operation of the Public Reference Room by calling the Securities and Exchange Commission at 1-800-SEC-0330.  The Securities and Exchange Commission maintains a website (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding registrants, such as Heska Corporation, that file electronically with the Securities and Exchange Commission.

PART I

Item 1.  Business.

We develop, manufacture, market, sell and support veterinary products.  Our core focus is on the canine and feline companion animal health markets where we strive to provide high value products.

1

Table of Contents

Our business is comprised of two reportable segments, Core Companion Animal Health and Other Vaccines, Pharmaceuticals and Products.  The Core Companion Animal Health segment (“CCA”) includes diagnostic instruments and supplies as well as single use diagnostic and other tests, vaccines and pharmaceuticals, primarily for canine and feline use.  These products are sold directly by us as well as through independent third-party distributors and other distribution relationships.  The Other Vaccines, Pharmaceuticals and Products segment (“OVP”) includes private label vaccine and pharmaceutical production, primarily for cattle but also for other animals including small mammals and fish.  All OVP products are sold by third parties under third party labels.

Our principal executive offices are located at 3760 Rocky Mountain Avenue, Loveland, Colorado 80538, our telephone number is (970) 493-7272 and our internet address is www.heska.com.  We originally incorporated in California in 1988, and we subsequently incorporated in Delaware in 1997.

Background

We were incorporated as Paravax, Inc. in 1988 and conducted research on vaccines to prevent infections by parasites.  In 1991, we moved our headquarters from California to northern Colorado in order to be located closer to the research facilities of the College of Veterinary Medicine and Biomedical Sciences of Colorado State University.  In 1995, we changed our name to Heska Corporation.  We completed our initial public offering in July 1997.  Between 1996 and 1998, we expanded our business, making several acquisitions and significantly increasing our sales and marketing activities.  During 1999 and 2000, we restructured and refocused our business, making several divestitures.  We continued to be a research and development-focused company, devoting substantial resources to the research and development of innovative products for the companion animal health market.  In 2001 and 2002, we took further steps to lower our expense base, largely in internal research and development but also in other areas, and to rationalize and further focus our business.  In the years since 2003, we have continued to concentrate our efforts on operating improvements, such as enhancing the effectiveness of our sales and marketing efforts and pursuing cost efficiencies, and seeking new product opportunities with third parties.

Core Companion Animal Health Segment

We presently sell a variety of companion animal health products and services, among the most significant of which are the following:

Veterinary Instruments

We offer a line of veterinary diagnostic and other instruments which are described below.  We also market and sell consumable supplies for these instruments. Our line of veterinary instruments includes the following:

·                  Handheld Blood Analysis.  The i-STAT 1 Handheld Clinical Analyzer, introduced in January 2007, is a handheld instrument that provides quick, easy analysis of critical electrolyte, blood gas, chemistry and basic hematology results with whole blood.  In addition, we continue to service and support the similar, less expensive original i-STAT Handheld Clinical Analyzer.  We are supplied new instruments and affiliated cartridges and supplies of these products under a contractual agreement with Abbott Point of Care Inc. (“APOC”), formerly known as i-STAT Corporation, a unit of Abbott Laboratories.

·                  Blood Chemistry.  The DRI-CHEM 4000 Veterinary Chemistry Analyzer, introduced in November 2007, is a robust system that uses dry slide technology for blood chemistry and electrolyte analysis and has the ability to run 22 tests at a time with a single blood sample.  Test slides are available as both pre-packaged panels as well as individual slides. The instrument has

2

Table of Contents

an additional feature allowing simple, fully automated sample dilution and results calculations. We are supplied this instrument and affiliated test slides and supplies under a contractual agreement with FUJIFILM Corporation (“FUJIFILM”).  In addition, we continue to service and support our previous chemistry instrument for which we are supplied affiliated test strips and supplies under a contractual agreement with Arkray Global Business, Inc. (“Arkray”).

·                  Hematology.  The HEMATRUE Veterinary Hematology Analyzer, introduced in July 2007, is an easy-to-use blood analyzer that measures such key parameters as white blood cell count, red blood cell count, platelet count and hemoglobin levels in animals.  In addition, we continue to service and support our previous hematology instrument, the HESKA CBC-DIFF Veterinary Hematology System.  We are supplied new instruments and affiliated reagents and supplies of these products under a contractual agreement with Boule Medical AB (“Boule”).

·                  IV Pumps.   The VET/IV 2.2 infusion pump is a compact, affordable IV pump that allows veterinarians to easily provide regulated infusion of fluids, drugs or nutritional products for their patients.

Point-of-Care Diagnostic and Other Tests

Heartworm Diagnostic Products.  Heartworm infections of dogs and cats are caused by the parasite Dirofilaria immitis.  This parasitic worm is transmitted in larval form to dogs and cats through the bite of an infected mosquito.  Larvae develop into adult worms that live in the pulmonary arteries and heart of the host, where they can cause serious cardiovascular, pulmonary, liver and kidney disease.  Our canine and feline heartworm diagnostic tests use monoclonal antibodies or a recombinant heartworm antigen, respectively, to detect heartworm antigens or antibodies circulating in the blood of an infected animal.

We currently market and sell heartworm diagnostic tests for both dogs and cats.  SOLO STEP CH for dogs and SOLO STEP FH for cats are available in point-of-care, single use formats that can be used by veterinarians on site.  We also offer SOLO STEP CH Batch Test Strips, a rapid and simple point-of-care antigen detection test for dogs that allows veterinarians in larger practices to run multiple samples at the same time.  We obtain SOLO STEP CH, SOLO STEP FH and SOLO STEP Batch Test Strips under a contractual agreement with Quidel Corporation (“Quidel”).

Early Renal Damage Detection Products.  Renal damage is a leading cause of death in both dogs and cats.  Several inflammatory, infectious or neoplastic diseases can damage an animal’s kidneys.  It is estimated that 70% to 80% of kidney function is already destroyed before veterinarians can detect renal damage using traditional tests.  Early detection is key to eliminate the causes and to mitigate the effects of kidney damage. Identification and treatment of the underlying cause of kidney damage can slow the progression of disease and add quality years to an animal’s life.

Our E.R.D.-HEALTHSCREEN Canine Urine Test and our E.R.D.-HEALTHSCREEN Feline Urine Test are rapid in-clinic immunoassay tests designed to detect microalbuminuria, the most sensitive indicator of renal damage.

Veterinary Diagnostic Laboratory Products and Services

Allergy Diagnostic Products and Services. Allergy is common in companion animals, and it has been estimated to affect approximately 10% to 15% of dogs.  Clinical symptoms of allergy are variable, but are often manifested as persistent and serious skin disease in dogs and cats.  Clinical management of allergic disease is problematic, as there are a large number of allergens that may give rise to these conditions.  Although skin testing is often regarded as the most accurate diagnostic procedure, such tests can be painful,

3

Table of Contents

subjective and inconvenient.  The effectiveness of the immunotherapy that is prescribed to treat allergic disease is inherently limited by inaccuracies in the diagnostic process.

Our ALLERCEPT Definitive Allergen Panels provide the most accurate determination of which we are aware of the specific allergens to which an animal, such as a dog, cat or horse, is reacting.  The panels use a highly specific recombinant version of the natural IgE receptor to test the serum of potentially allergic animals for IgE directed against a panel of known allergens.  A typical test panel consists primarily of various pollen, grass, mold, insect and mite allergens.  The test results serve as the basis for prescription ALLERCEPT Allergy Treatment Sets, discussed later in this document.

Outside of the United States, we sell kits to conduct blood testing using our ALLERCEPT Definitive Allergen Panels to third-party veterinary diagnostic laboratories.  We also sell products to screen for the presence of allergen-specific IgE to third party veterinary diagnostic laboratories outside of the United States — we sell kits to conduct preliminary blood testing using products based on our ALLERCEPT Definitive Allergen Panels as well as a similar test requiring less technical sophistication, our ALLERCEPT E-SCREEN Test.

We have veterinary diagnostic laboratories in Loveland, Colorado and Fribourg, Switzerland which both offer blood testing using our ALLERCEPT Definitive Allergen Panels.  In our Fribourg veterinary diagnostic laboratory, we also offer preliminary blood testing to screen for the presence of allergen-specific IgE using products based on our ALLERCEPT Definitive Allergen Panels.  Animals testing positive for allergen-specific IgE are candidates for further evaluation using our ALLERCEPT Definitive Allergen Panels.

Other Products and Services.  We sell ERD Reagent Packs used to detect microalbuminuria, the most sensitive indicator of renal damage, to Antech Diagnostics, the laboratory division of VCA Antech, Inc., for use in its veterinary diagnostic laboratories.

Our Loveland veterinary diagnostic laboratory currently also offers testing using our canine and feline heartworm, renal damage, immune status and flea bite allergy assays as well as other diagnostic services including polymerase chain reaction, or PCR, based tests for certain infectious diseases.  Our Loveland diagnostic laboratory is currently staffed by medical technologists experienced in animal disease and several additional technical staff.  We intend to continue to use our Loveland veterinary diagnostic laboratory both as a stand-alone service center for our customers and as an adjunct to our product development efforts.

Pharmaceuticals and Supplements

Heartworm Prevention.  We have an agreement with Schering-Plough Animal Health Corporation (“SPAH”), the worldwide animal health care business of Schering-Plough Corporation, granting SPAH the distribution and marketing rights in the United States for TRI-HEART Plus Chewable Tablets, our canine heartworm prevention product.  TRI-HEART Plus Chewable Tablets (ivermectin/pyrantel) are indicated for use as a monthly preventive treatment of canine heartworm infection and for treatment and control of ascarid and hookworm infections.  We manufacture TRI-HEART Plus Chewable Tablets at our Des Moines, Iowa production facility.

Nutritional Supplements.  We sell a novel fatty acid supplement, HESKA F.A. Granules.  The source of the fatty acids in this product, flaxseed oil, leads to high omega-3:omega-6 ratios of fatty acids.  Diets high in omega-3 fatty acids are believed to lead to lower levels of inflammatory mediators.  The HESKA F.A. Granules include vitamins and are formulated in a palatable flavor base that makes the product convenient and easy to administer.

Hypothyroid Treatment.  We sell a chewable thyroid supplement, THYROMED Chewable Tablets, for treatment of hypothyroidism in dogs.  Hypothyroidism is one of the most common endocrine disorders

4

Table of Contents

diagnosed in older dogs, treatment of which requires a daily hormone supplement for the lifetime of the animal.  THYROMED Chewable Tablets contain the active ingredient Levothyroxine Sodium, which is a clinically proven replacement for the naturally occurring hormone secreted by the thyroid gland.  The chewable formulation makes this daily supplement convenient and easy to administer.

Vaccines and other Biologicals

Allergy Treatment.  Veterinarians who use our ALLERCEPT Definitive Allergen Panels often purchase ALLERCEPT Allergy Treatment Sets for those animals with positive test results.  These prescription immunotherapy treatment sets are formulated specifically for each allergic animal and contain only the allergens to which the animal has significant levels of IgE antibodies.  The prescription formulations are administered in a series of injections, with doses increasing over several months, to ameliorate the allergic condition of the animal.  Immunotherapy is generally continued for an extended time.  We offer canine, feline and equine immunotherapy treatment products.

Feline Respiratory Disease.  The use of injectable vaccines in cats has become controversial due to the frequency of injection site-associated side effects.  The most serious of these side effects are injection site sarcomas, tumors which, if untreated, are nearly always fatal.  While there is one competitive non-injectable two-way vaccine, all other competitive products are injectable formulations.

We sell the FELINE ULTRANASAL FVRCP Vaccine, a three-way modified live vaccine combination to prevent disease caused by the three most common respiratory viruses of cats:  calicivirus, rhinotracheitis virus and panleukopenia virus.  Our two-way modified live vaccine combination, FELINE ULTRANASAL FVRC, prevents disease caused by calicivirus and rhinotracheitis.  These vaccines are administered without needle injection by dropping the liquid preparation into the nostrils of cats.  Our vaccines avoid injection site side effects, and we believe they are very efficacious.

Other Vaccines, Pharmaceuticals and Products Segment

We have developed our own line of bovine vaccines that are licensed by the United States Department of Agriculture (“USDA”).   We have a long-term agreement with a distributor, Agri Laboratories, Ltd., (“AgriLabs”), for the marketing and sale of certain of these vaccines which are sold primarily under the Titanium® and MasterGuard® brands — registered trademarks of AgriLabs.  AgriLabs has rights to sell these bovine vaccines in the United States, Africa and Mexico into December 2013.  AgriLabs’ rights in these regions will be exclusive into December 2009.  We have the right to sell these bovine vaccines to any party of our choosing in other regions of the world. We also manufacture other bovine products not covered under the agreement with AgriLabs.

We manufacture biological and pharmaceutical products for a number of other animal health companies.  We manufacture products for animals including small mammals.  Our offerings range from providing complete turnkey services which include research, licensing, production, labeling and packaging of products to providing any one of these services as needed by our customers as well as validation support and distribution services.

Marketing, Sales and Customer Support

We estimate that there are approximately 46,000 veterinarians in the United States whose practices are devoted principally to small animal medicine.  Those veterinarians practice in approximately 20,000 clinics in the United States.  In 2008, our products were sold to approximately 14,500 such clinics in the United States.  Veterinarians may obtain our products directly from us or indirectly from others, such as independent third-party distributors.  All our Core Companion Animal Health products are predominately

5

Table of Contents

sold to or through veterinarians ultimately.  In many cases, veterinarians will markup their costs to the end user.  The acceptance of our products by veterinarians is critical to our success.

We currently market our Core Companion Animal Health products in the United States to veterinarians through an outside field organization, a telephone sales force, independent third-party distributors, as well as through trade shows and print advertising and through other distribution relationships, such as SPAH in the case of our heartworm preventive.  Our outside field organization currently consists of 38 individuals for activities in various parts of the United States.  Our inside sales force consists of 20 persons.

Our independent third-party distributors in the U.S. purchase and market our Core Companion Animal Health products utilizing their direct sales forces.  We currently have agreements with 16 regional distributors with approximately 676 field representatives.  We believe that one of our largest competitors, IDEXX Laboratories, Inc. (“IDEXX”), in effect prohibits its distributors from selling competitive products, including our diagnostic instruments and heartworm diagnostic tests.  As a result, 11 of these 16 regional distributors with approximately 135 field representatives carry our full distribution product line.  We believe the IDEXX restrictions limit our ability to engage national independent third party distributors to sell our full distribution line of products.

We have a staff dedicated to customer and product support in our Core Companion Animal Health segment including veterinarians, technical support specialists and service technicians.  Individuals from our product development group may also be used as a resource in responding to certain product inquiries.

Internationally, we market our Core Companion Animal Health products to veterinarians primarily through third-party veterinary diagnostic laboratories, independent third-party distributors and Novartis Agro K.K., Tokyo (“Novartis Japan”).  These entities typically provide customer support.  Novartis Japan exclusively markets and distributes SOLO STEP CH and our line of E.R.D. HEALTHSCREEN urine test products in Japan.

All OVP products are marketed and sold by third parties under third party labels.  AgriLabs currently has exclusive sales and marketing rights to certain of our bovine vaccines, which are sold primarily under the Titanium® and MasterGuard® labels, in the United States, Africa and Mexico.

We grant third parties rights to our intellectual property as well as our products, with our compensation often taking the form of royalties and/or milestone payments.  For example, we have an agreement with Nestlé Purina PetCare Company (“Purina”), a unit of Nestlé S.A., under which Purina pays royalties on certain pet food products it markets based on our patent-protected science.

Manufacturing

The majority of our product revenue is from proprietary products manufactured by third parties.  Third parties manufacture our veterinary instruments, including affiliated consumables and supplies, as well as other products including our heartworm point-of-care diagnostic tests, our allergy treatment products and our E.R.D.-HEALTHSCREEN Urine Tests.  Our handheld blood analysis instruments and affiliated supplies are manufactured under contract with APOC, our chemistry instruments and affiliated supplies are manufactured under contract with FUJIFILM, test strips and supplies affiliated with our previous chemistry instrument are manufactured under contract with Arkray and our hematology instruments and affiliated supplies are manufactured under contract with Boule.  Our immunotherapy treatment products are manufactured under contract with ALK-Abelló, Inc.  Our E.R.D. Reagent Packs and our E.R.D.- HEALTHSCREEN Urine Tests are manufactured under contract with Genzyme Diagnostics P.E.I., Inc., formerly known as Diagnostic Chemicals Limited.  Our heartworm point-of-care diagnostic tests are

6

Table of Contents

manufactured under a contract with Quidel.  We manufacture and supply Quidel with certain critical raw materials for our heartworm point-of-care tests.

Our facility in Des Moines, Iowa is a USDA, Food and Drug Administration (“FDA”), and Drug Enforcement Agency (“DEA”) licensed biological and pharmaceutical manufacturing facility.  This facility currently has the capacity to manufacture more than 50 million doses of vaccine each year.  We expect that we will manufacture most or all of our biological and pharmaceutical products at this facility, as well as most or all of our recombinant proteins and other proprietary reagents for our diagnostic tests.  We currently manufacture our canine heartworm prevention product, our FELINE ULTRANASAL Vaccines and all our OVP segment products at this facility.  Our OVP segment’s customers purchase products in both finished and bulk format, and we perform all phases of manufacturing, including growth of the active bacterial and viral agents, sterile filling, lyophilization and packaging at this facility.  We manufacture our various allergy diagnostic products at our Des Moines facility, our Loveland facility and our Fribourg facility.  We believe the raw materials for products we manufacture are available from several sources.

Product Development

We are committed to providing innovative products to address latent health needs of companion animals.  We may obtain such products from external sources, external collaboration or internal research and development.

We are committed to identifying external product opportunities and creating business and technical collaborations that lead to high value veterinary products.  We believe that our active participation in scientific networks and our reputation for investing in research enhances our ability to acquire external product opportunities.  We have collaborated, and intend to continue to do so, with a number of companies and universities.  Examples of such collaborations include:

·                  Quidel for the development of SOLO STEP CH Cassettes, SOLO STEP CH Batch Test Strips and SOLO STEP FH Cassettes;

·                  Boule for the development of veterinary applications for the HEMATRUE Veterinary Hematology Analyzer and associated reagents;

·                  FUJIFILM for the development of veterinary applications for the DRI-CHEM 4000 Veterinary Chemistry Analyzer and associated slides and supplies.

We are currently collaborating with FUJIFILM on a line extension of our chemistry instrument offering.  We expect to complete development and sell the resulting new instrument prior to year end.

Internal research and development is managed on a case-by-case basis.  We employ individuals with microbiology, immunology, genetics, biochemistry, molecular biology, parasitology as well as veterinary expertise and will form multidisciplinary product-associated teams as appropriate.  We incurred expenses of $3.5 million, $2.7 million and $2.0 million in the years ended December 31, 2006, 2007 and 2008, respectively, in support of our research and development activities.

Intellectual Property

We believe that patents, trademarks, copyrights and other proprietary rights are important to our business.  We also rely upon trade secrets, know-how, continuing technological innovations and licensing opportunities to develop and maintain our competitive position.  The proprietary technologies of our OVP segment are primarily protected through trade secret protection of, for example, our manufacturing processes in this area.

7

Table of Contents

We actively seek patent protection both in the United States and abroad.  Our issued and pending patent portfolios primarily relate to heartworm control, flea control, allergy, infectious disease vaccines, diagnostic and detection tests, immunomodulators, instrumentation, nutrition, pain control and vaccine delivery technologies.  As of December 31, 2008, we owned, co-owned or had rights to 176 issued U.S. patents and 35 pending U.S. patent applications expiring at various dates from February 2011 to August 2024.  Applications corresponding to pending U.S. applications have been or will be filed in other countries.  Our corresponding foreign patent portfolio as of December 31, 2008 included 80 issued patents and 35 pending applications in various foreign countries.

We have entered into a number of out-licensing agreements to realize additional value in certain of our intellectual property assets in fields outside of our core focus.  For example, in 1998 we obtained rights from ImmuLogic Pharmaceutical Corporation to an intellectual property portfolio including a number of major allergens and the genes that encode them for use in veterinary as well as human allergy applications.  In order to realize additional value from that portfolio, we granted licenses and options for licenses to several companies for the use of those allergens in the fields of diagnosis and treatment of human allergy.  In December 2006, we sold this intellectual property portfolio to Allergopharma Joachim Ganzer KG and obtained an exclusive license to veterinary rights for this intellectual property portfolio as part of the agreement.

We also have obtained exclusive and non-exclusive licenses for numerous other patents held by academic institutions and biotechnology and pharmaceutical companies.

Seasonality

We expect to experience less seasonality than we have in the past due to factors including increased instrument consumable revenue, which does not tend to be seasonal, and changes in the timing of certain product promotions. At this point, we do not anticipate a large seasonal effect on our consolidated financial results.

Government Regulation

Although the majority of our product revenue is from the sale of unregulated items, many of our products or products that we may develop are, or may be, subject to extensive regulation by governmental authorities in the United States, including the USDA and the FDA, and by similar agencies in other countries.  These regulations govern, among other things, the development, testing, manufacturing, labeling, storage, pre-market approval, advertising, promotion, sale and distribution of our products.  Satisfaction of these requirements can take several years to achieve and the time needed to satisfy them may vary substantially, based on the type, complexity and novelty of the product.  Any product that we develop must receive all relevant regulatory approval or clearances, if required, before it may be marketed in a particular country.  The following summarizes the major U.S. government agencies that regulate animal health products:

·                  USDA.  Vaccines and certain single use, point-of-care diagnostics are considered veterinary biologics and are therefore regulated by the Center for Veterinary Biologics, or CVB, of the USDA.  Industry data indicate that it takes approximately four years and $1.0 million to license a conventional vaccine for animals from basic research through licensing.  In contrast to vaccines, single use, point-of-care diagnostics can typically be licensed by the USDA in about two years, at considerably less cost.  However, vaccines or diagnostics that use innovative materials, such as those resulting from recombinant DNA technology, usually require additional time to license.  The USDA licensing process involves the submission of several data packages.  These packages include information on how the product will be manufactured, information on the efficacy and safety of the product in laboratory and target animal studies and information on performance of the product in field conditions.

8

Table of Contents

·                  FDA.  Pharmaceutical products, which typically include synthetic compounds, are approved and monitored by the Center for Veterinary Medicine of the FDA.  Industry data indicate that developing a new drug for animals requires approximately 11 years from commencement of research to market introduction and costs approximately $5.5 million.  Of this time, approximately three years is spent in animal studies and the regulatory review process.  However, unlike human drugs, neither preclinical studies nor a sequential phase system of studies are required.  Rather, for animal drugs, studies for safety and efficacy may be conducted immediately in the species for which the drug is intended.  Thus, there is no required phased evaluation of drug performance, and the Center for Veterinary Medicine will review data at appropriate times in the drug development process.  In addition, the time and cost for developing companion animal drugs may be significantly less than for drugs for livestock animals, as food safety issues relating to tissue residue levels are not applicable.

·                  EPA.  Products that are applied topically to animals or to premises to control external parasites are regulated by the Environmental Protection Agency, or EPA.

After we have received regulatory licensing or approval for our products, numerous regulatory requirements typically apply.  Among the conditions for certain regulatory approvals is the requirement that our manufacturing facilities or those of our third-party manufacturers conform to current Good Manufacturing Practices or other manufacturing regulations, which include requirements relating to quality control and quality assurance as well as maintenance of records and documentation.  The USDA, FDA and foreign regulatory authorities strictly enforce manufacturing regulatory requirements through periodic inspections and/or reports.

A number of our animal health products are not regulated.  For example, certain products such as our E.R.D.-HEALTHSCREEN Urine Tests and our ALLERCEPT panels, as well as other reference lab tests, are not regulated by either the USDA or FDA.  Similarly, none of our veterinary instruments requires regulatory approval to be marketed and sold in the United States.

We have pursued regulatory approval outside the United States based on market demographics of foreign countries.  For marketing outside the United States, we are subject to foreign regulatory requirements governing regulatory licensing and approval for many of our products.  Licensing and approval by comparable regulatory authorities of foreign countries must be obtained before we can market products in those countries.  Product licensing approval processes and requirements vary from country to country and the time required for such approvals may differ substantially from that required in the United States.  We cannot be certain that approval of any of our products in one country will result in approvals in any other country.  To date, we or our distributors have sought regulatory approval for certain of our products in Canada, which is governed by the Canadian Food Inspection Agency, or CFIA; in Japan, which is governed by the Japanese Ministry of Agriculture, Forestry and Fisheries, or MAFF; and in certain European and other Asian countries requiring such approval.

9

Table of Contents

Core Companion Animal Health products previously discussed which have received regulatory approval in the United States and/or elsewhere are summarized below.

Competition

Our market is intensely competitive.  Our competitors include independent animal health companies and major pharmaceutical companies that have animal health divisions.  We also compete with independent, third-party distributors, including distributors who sell products under their own private labels.  In the point-of-care diagnostic testing market, our major competitors include IDEXX, Abaxis, Inc. and Synbiotics Corporation.  The products manufactured by our OVP segment for sale by third parties compete with similar products offered by a number of other companies, some of which have substantially greater financial, technical, research and other resources than us and may have more established marketing, sales, distribution and service organizations than our OVP segment’s customers.  Companies with a significant presence in the animal health market such as Bayer AG, CEVA Santé Animale, Merial Limited, Novartis AG, Pfizer Inc., Schering-Plough Corporation, Vétoquinol S.A., Virbac S.A. and Wyeth may be marketing or developing products that compete with our products or would compete with them if successfully developed.  These and other competitors and potential competitors may have substantially greater financial, technical, research and other resources and larger, more established marketing, sales, distribution and service organizations than we do.  Our competitors may offer broader product lines and have greater name recognition than we do.

Environmental Regulation

In connection with our product development activities and manufacturing of our biological, pharmaceutical and diagnostic and detection products, we are subject to federal, state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, handling and disposal of certain materials, biological specimens and wastes.  Although we believe that we have complied with these laws,

10

Table of Contents

regulations and policies in all material respects and have not been required to take any significant action to correct any noncompliance, we may be required to incur significant costs to comply with environmental and health and safety regulations in the future.  Although we believe that our safety procedures for handling and disposing of such materials comply with the standards prescribed by state and federal regulations, the risk of accidental contamination or injury from these materials cannot be eliminated.  In the event of such an accident, we could be held liable for any damages that result and any such liability could exceed our resources.

Employees

As of December 31, 2008, we and our subsidiaries employed 312 people, of whom 138 were focused in production and technical and logistical services, including instrumentation service, 108 in sales, marketing and customer support, 56 in general administrative services, such as accounting, and 10 in product development.  We believe that our ability to attract and retain skilled personnel is critical to our success.  None of our employees is covered by a collective bargaining agreement, and we believe our employee relations are good.

Executive Officers

Our executive officers and their ages as of March 16, 2009 are as follows:

Robert B. Grieve, Ph.D., one of our founders, currently serves as Chief Executive Officer and Chairman of the Board.  Dr. Grieve was named Chief Executive Officer effective January 1, 1999, Vice Chairman effective March 1992 and Chairman of the Board effective May 2000.  Dr. Grieve also served as Chief Scientific Officer from December 1994 to January 1999 and Vice President, Research and Development, from March 1992 to December 1994.  He has been a member of our Board of Directors since 1990.  He holds a Ph.D. degree from the University of Florida and M.S. and B.S. degrees from the University of Wyoming.

Michael J. McGinley, Ph.D. was appointed President and Chief Operating Officer effective January 1, 2009.  He previously served as Vice President, Global Operations from April through December 2008, Vice President, Operations and Technical Affairs and General Manager, Heska Des Moines from January 2002 to April 2008 and in other positions beginning in June 1997.  Prior to joining Heska, Dr. McGinley held positions with Bayer Animal Health and Fort Dodge Laboratories.  He holds Doctorate and M.S. degrees in Immunobiology from Iowa State University.

Jason A. Napolitano was appointed Executive Vice President and Chief Financial Officer in May 2002.  He was appointed our Secretary in February 2009.  He also served as our Secretary from May 2002 to December 2006.  Prior to joining us formally, he was a financial consultant.  From 1990 to 2001, Mr. Napolitano held various positions at Credit Suisse First Boston, an investment bank, including Vice President in health care investment banking and Director in mergers and acquisitions.  He holds a B.S. degree from Yale University.

11

Table of Contents

Michael A. Bent was appointed Vice President, Principal Accounting Officer and Controller in May 2002.  From September 1999 until April 2002, he was Corporate Controller.  From November 1993 until September 1999, Mr. Bent was Director, Accounting Operations at Coors Brewing Company.  Mr. Bent holds a B.S. in accounting from the University of Wyoming.  Mr. Bent is a CPA in Colorado and Wyoming.

G. Lynn Snodgrass was appointed Vice President, Sales in January 2007.  From January 2005 to December 2006, he was Senior Director, Sales for Heska Corporation.  He held various sales positions at Heska from August 1999 through December 2004.  Prior to joining Heska, he held various sales positions with Luitpold Pharmaceuticals, GPC Incorporated, Merck and Company and TV Fanfare, Inc.  Mr. Snodgrass holds a B.S. in Biomedical Science from Texas A&M University.

Item 1A.  Risk Factors

Our future operating results may vary substantially from period to period due to a number of factors, many of which are beyond our control.  The following discussion highlights some of these factors and the possible impact of these factors on future results of operations.  The risks and uncertainties described below are not the only ones we face.  Additional risks or uncertainties not presently known to us or that we deem to be currently immaterial also may impair our business operations.  If any of the following factors actually occur, our business, financial condition or results of operations could be harmed.  In that case, the price of our common stock could decline and you could experience losses on your investment.

We rely substantially on third-party suppliers.  The loss of products or delays in product availability from one or more third-party supplier could substantially harm our business.

To be successful, we must contract for the supply of, or manufacture ourselves, current and future products of appropriate quantity, quality and cost.  Such products must be available on a timely basis and be in compliance with any regulatory requirements.  Failure to do so could substantially harm our business.

We rely on third party suppliers to manufacture those products we do not manufacture ourselves.  Proprietary products provided by these suppliers represent a majority of our product revenue.  We currently rely on these suppliers for our veterinary instruments and consumable supplies for these instruments, for our point-of-care diagnostic and other tests, for the manufacture of our allergy immunotherapy treatment products as well as for the manufacture of other products.  Major suppliers who sell us proprietary products which are responsible for more than 5% of our trailing 12-month product revenue are APOC, Arkray, Boule, FUJIFILM and Quidel.  None of these suppliers sell us proprietary products which are responsible for more than 20% of our trailing 12-month product revenue, although the proprietary products of one is responsible for more than 15% of our revenue and one other is responsible for more than 10% of our revenue.  We often purchase products from our suppliers under agreements that are of limited duration or potentially can be terminated on an annual basis.  In the case of our veterinary diagnostic instruments, we are typically entitled to non-exclusive access to consumable supplies for a defined period upon expiration of exclusive rights, which could subject us to competitive pressures in the period of non-exclusive access.  For example, APOC has the right to cancel our agreement with notice to us and if APOC does so, we believe we have the contractual right to purchase consumable supplies from APOC for six months and sell consumable supplies for at least nine months following such notice on a non-exclusive basis.  Although we believe we have arrangements to ensure supply of our other major product offerings in the marketplace through at least the end of 2009, there can be no assurance that our suppliers will meet their obligations under any agreements we may have in place with them or that we will be able to compel them to do so.  Risks of relying on suppliers include:

·                  The loss of product rights upon expiration or termination of an existing agreement.  Unless we are able to find an alternate supply of a similar product, we would not be able to continue to offer our customers the same breadth of products and our sales and operating results would likely suffer.  In the case of an instrument supplier, we could also potentially suffer the loss of sales of consumable supplies, which would be significant in cases where we have built a significant installed base, further harming our sales prospects and opportunities.  Even if we were able to

12

Table of Contents

find an alternate supply for a product to which we lost rights, we would likely face increased competition from the product whose rights we lost being marketed by a third party or the former supplier and it may take us additional time and expense to gain the necessary approvals and launch an alternative product.

·                  Loss of exclusivity.  In the case of our veterinary diagnostic instruments, if we are entitled to non-exclusive access to consumable supplies for a defined period upon expiration of exclusive rights, we may face increased competition from a third party with similar non-exclusive access or our former supplier, which could cause us to lose customers and/or significantly decrease our margins and could significantly affect our financial results.  In addition, current agreements, or agreements we may negotiate in the future, with suppliers may require us to meet minimum annual sales levels to maintain our position as the exclusive distributor of these products.  We may not meet these minimum sales levels and maintain exclusivity over the distribution and sale of these products.  If we are not the exclusive distributor of these products, competition may increase significantly, reducing our revenues and/or decreasing our margins.

·                  High switching costs.  In our diagnostic instrument products we could face significant competition and lose all or some of the consumable revenues from the installed base of those instruments if we were to switch to a competitive instrument.  If we need to change to other commercial manufacturing contractors for certain of our regulated products, additional regulatory licenses or approvals must be obtained for these contractors prior to our use.  This would require new testing and compliance inspections prior to sale thus resulting in potential delays.  Any new manufacturer would have to be educated in, or develop substantially equivalent processes necessary for the production of our products.  We likely would have to train our sales force, distribution network employees and customer support organization on the new product and spend significant funds marketing the new product to our customer base.

·                  Inability to meet minimum obligations.  Current agreements, or agreements we may negotiate in the future, may commit us to certain minimum purchase or other spending obligations.  It is possible we will not be able to create the market demand to meet such obligations, which could create a drain on our financial resources and liquidity.  Some such agreements may require minimum purchases and/or sales to maintain product rights and we may be significantly harmed if we are unable to meet such requirements and lose product rights.

·                  The involuntary or voluntary discontinuation of a product line.  Unless we are able to find an alternate supply of a similar product in this or similar circumstances with any product, we would not be able to continue to offer our customers the same breadth of products and our sales would likely suffer.  Even if we are able to identify an alternate supply, it may take us additional time and expense to gain the necessary approvals and launch an alternative product, especially if the product is discontinued unexpectedly.  An example of such a situation arose in 2006 when Dolphin Medical Inc. (a majority-owned subsidiary of OSI Systems, Inc.) discontinued production of our VET/OX G2 DIGITAL Monitor as part of an agreement with Masimo Corporation to settle a patent dispute.

·                  Inconsistent or inadequate quality control.  We may not be able to control or adequately monitor the quality of products we receive from our suppliers.  Poor quality items could damage our reputation with our customers.

·                  Limited capacity or ability to scale capacity.  If market demand for our products increases suddenly, our current suppliers might not be able to fulfill our commercial needs, which would require us to seek new manufacturing arrangements and may result in substantial delays in meeting market demand.  If we consistently generate more demand for a product than a given

13

Table of Contents

supplier is capable of handling, it could lead to large backorders and potentially lost sales to competitive products that are readily available.  This could require us to seek or fund new sources of supply, which may be difficult to find unless it is under terms that are less advantageous.

·                  Regulatory risk.  Our manufacturing facility and those of some of our third party suppliers are subject to ongoing periodic unannounced inspection by regulatory authorities, including the FDA, USDA and other federal and state agencies for compliance with strictly enforced Good Manufacturing Practices, regulations and similar foreign standards, and we do not have control over our suppliers’ compliance with these regulations and standards.  Violations could potentially lead to interruptions in supply that could cause us to lose sales to readily available competitive products.

·                  Developmental delays.  We may experience delays in the scale-up quantities needed for product development that could delay regulatory submissions and commercialization of our products in development, causing us to miss key opportunities.

·                  Limited intellectual property rights.  We typically do not have intellectual property rights, or may have to share intellectual property rights, to the products themselves and any improvements to the manufacturing processes or new manufacturing processes for our products.

Potential problems with suppliers such as those discussed above could substantially decrease sales, lead to higher costs, and/or damage our reputation with our customers due to factors such as poor quality goods or delays in order fulfillment, resulting in our being unable to sell our products effectively and substantially harm our business.

We may be unable to successfully market and sell our products.

We may not successfully develop and maintain marketing and/or sales capabilities, and we may not be able to make arrangements with third parties to perform these activities on satisfactory terms.  If our marketing and sales strategy is unsuccessful, our ability to sell our products will be negatively impacted and our revenues will decrease.

We believe the recent worldwide economic weakness has had a negative effect on our business, and this may continue in the future.  This is particularly notable in the sale of new instruments, which is a capital expenditure many, if not most, veterinarians may choose to defer in times of perceived economic weakness.  Even if the overall economy begins to grow in the future, there may be a lag before veterinarians display confidence such growth will continue and return to historical capital expenditure purchasing patterns.  As the vast majority of cash flow to veterinarians ultimately is funded by pet owners without private insurance or government support, our business may be more susceptible to severe economic downturns than other health care businesses which rely less on individual consumers.

The market for companion animal healthcare products is highly fragmented.  Because our Core Companion Animal Health proprietary products are generally available only to veterinarians or by prescription and our medical instruments require technical training to operate, we predominately sell all our Core Companion Animal Health products to or through veterinarians ultimately.  The acceptance of our products by veterinarians is critical to our success.  Changes in our ability to obtain or maintain such acceptance or changes in veterinary medical practice could significantly decrease our anticipated sales.

We currently market and sell most of our Core Companion Animal Health products in the United States to veterinarians through an outside field organization of approximately 38 individuals, an inside sales force of approximately 20 individuals, approximately 11 independent third-party distributors who carry our full distribution product line and approximately 5 independent third-party distributors who carry portions of our

14

Table of Contents

distribution product line, as well as through trade shows and print advertising.  To be successful in these endeavors, we will have to effectively market our products and continue to develop and train our direct sales force as well as the sales personnel of our independent third-party distributors.

Independent third-party distributors may be effective in increasing sales of our products to veterinarians, although we would expect a corresponding lower gross margin as such distributors typically buy products from us at a discount to end user prices.  It is possible new or existing independent third-party distributors could cannibalize our direct sales efforts and lower our total gross margin.  For us to be effective when working with an independent third-party distributor, the distributor must agree to market and/or sell our products and we must provide proper economic incentives to the distributor as well as contend effectively for the distributor’s time and focus given other products the distributor may be carrying, potentially including those of our competitors.  If we fail to be effective with new or existing independent third-party distributors, our financial performance may suffer.  In addition, most of our independent third-party distributor agreements can be terminated on 60 days notice and we believe that IDEXX, one of our largest competitors, in effect prohibits its distributors from selling competitive products, including our diagnostic instruments and heartworm diagnostic tests.  We believe this restriction limits our ability to engage national independent third-party distributors to sell our full distribution line of products and has caused large distributors of our products in the past to no longer carry our instruments and heartworm diagnostic tests upon commencing distribution of the IDEXX product line.

We operate in a highly competitive industry, which could render our products obsolete or substantially limit the volume of products that we sell.  This would limit our ability to compete and maintain sustained profitability.

The market in which we compete is intensely competitive.  Our competitors include independent animal health companies and major pharmaceutical companies that have animal health divisions.  We also compete with independent, third-party distributors, including distributors who sell products under their own private labels.  In the point-of-care diagnostic testing market, our major competitors include IDEXX, Abaxis, Inc. and Synbiotics Corporation.  The products manufactured by our OVP segment for sale by third parties compete with similar products offered by a number of other companies, some of which have substantially greater financial, technical, research and other resources than us and may have more established marketing, sales, distribution and service organizations than our OVP segment’s customers.  Competitors may have facilities with similar capabilities to our OVP segment, which they may operate and sell at a lower unit price to customers than our OVP segment does, which could cause us to lose customers.  Companies with a significant presence in the companion animal health market, such as Bayer AG, CEVA Santé Animale, Merial Limited (a company jointly owned by Merck & Co., Inc. and Sanofi-Aventis), Novartis AG, Pfizer Inc., Schering-Plough Corporation, Vétoquinol S.A., Virbac S.A. and Wyeth, may be marketing or developing products that compete with our products or would compete with them if developed.  These and other competitors and potential competitors may have substantially greater financial, technical, research and other resources and larger, more established marketing, sales and service organizations than we do.  Our competitors may offer broader product lines and have greater name recognition than we do.  Our competitors may develop or market technologies or products that are more effective or commercially attractive than our current or future products or that would render our technologies and products obsolete.  Further, additional competition could come from new entrants to the animal health care market.  Moreover, we may not have the financial resources, technical expertise or marketing, sales or support capabilities to compete successfully.  We believe that one of our largest competitors, IDEXX, in effect prohibits its distributors from selling competitive products, including our diagnostic instruments and heartworm diagnostic tests.  Another of our competitors, Abaxis, Inc. recently launched a canine heartworm diagnostic test competitive with ours.  If we fail to compete successfully, our ability to achieve sustained profitability will be limited and sustained profitability, or profitability at all, may not be possible.

15

Table of Contents

If the third parties to whom we granted substantial marketing rights for certain of our existing products or future products under development are not successful in marketing those products, then our sales and financial position may suffer.

Our agreements with our corporate marketing partners generally contain no or small minimum purchase requirements in order for them to maintain their exclusive or co-exclusive marketing rights.  We are party to an agreement with SPAH which grants distribution and marketing rights in the U.S. for our canine heartworm preventive product, TRI-HEART Plus Chewable Tablets.  AgriLabs has the exclusive right to sell certain of our bovine vaccines in the United States, Africa and Mexico.  Novartis Japan markets and distributes our SOLO STEP CH heartworm test and our E.R.D. Healthscreen urine test products in Japan under an exclusive arrangement.  One or more of these marketing partners may not devote sufficient resources to marketing our products.  For example, on March 9, 2009, Merck & Co., Inc. (“Merck”) and Schering-Plough Corporation (“SGP”) announced plans to merge.  SGP is the parent company of SPAH.  Merck owns 50% of Merial Limited, a company which sells a canine heartworm preventive competitive with ours.  If Merck and SGP are required to divest or cease operations related to our heartworm preventive in order to complete their merger, our sales could decline significantly and our business could be damaged.  Similarly, if SPAH personnel are distracted or experience turmoil as a result of the announced merger between Merck and SGP, our sales could decline significantly.  Furthermore, there may be nothing to prevent these partners from pursuing alternative technologies or products that may compete with our products in current or future agreements.  For example, we believe a unit of SPAH has obtained FDA approval for a canine heartworm preventive product with additional claims compared with our TRI-HEART Plus Chewable Tablets.  Should SPAH decide to emphasize sales and marketing efforts of this product rather than our TRI-HEART Plus Chewable Tablets or cancel our agreement regarding canine heartworm preventive distribution and marketing, our sales could decline significantly.  In the future, third-party marketing assistance may not be available on reasonable terms, if at all.  If any of these events occur, we may not be able to commercialize our products and our sales will decline.  In addition, both our agreement with AgriLabs requires us to potentially pay penalties if we are unable to supply product over an extended period of time.

We have historically not consistently generated positive cash flow from operations, may need additional capital and any required capital may not be available on reasonable terms or at all.

If our actual performance deviates from our operating plan, we may be required to raise additional capital in the future.  If necessary, we expect to raise these additional funds by the sale of equity securities or refinancing loans currently outstanding on assets with historical appraised values in excess of related debt.  There is no guarantee that additional capital will be available from these sources on reasonable terms, if at all, and certain of these sources may require approval by existing lenders.  The public markets may be unreceptive to equity financings and we may not be able to obtain additional private equity or debt financing.  Any equity financing would likely be dilutive to stockholders and additional debt financing, if available, may include restrictive covenants and increased interest rates that would limit our currently planned operations and strategies.  Additionally, funds we expect to be available under our existing revolving line of credit may not be available and other lenders could refuse to provide us with additional debt financing.  We believe the credit markets are particularly restrictive and difficult to obtain funding in versus recent history.  Furthermore, even if additional capital is available, it may not be of the magnitude required to meet our needs under these or other scenarios.  If additional funds are required and are not available, it would likely have a material adverse effect on our business, financial condition and our ability to continue as a going concern.

Our common stock is listed on the Nasdaq Capital Market and we may not be able to maintain that listing, which may make it more difficult for you to sell your shares.

Our common stock is listed on the Nasdaq Capital Market.  The Nasdaq has several quantitative and qualitative requirements companies must comply with to maintain this listing, including a $1.00 minimum bid price.  We are currently not in compliance with the $1.00 minimum bid price and we have received a communication from Nasdaq so advising us.  Nasdaq has announced a temporary suspension of minimum bid

16

Table of Contents

price enforcement until April 20, 2009, when the compliance process will be reinstated; we are to have 180 calendar days from April 20, 2009 to regain compliance with the minimum bid price requirement, which requires our stock to have a minimum closing bid price of $1.00 for at least 10 consecutive trading days.  If we fail to regain compliance with the minimum bid price requirement within 180 days, Nasdaq has informed us we will be eligible for an additional 180 calendar day compliance period if we satisfy the Nasdaq Capital Market initial listing criteria other than the minimum bid price requirement at that time.  There can be no assurance we will meet these criteria at that point, that Nasdaq will interpret these criteria in the same manner we do if we believe we meet the criteria, or that Nasdaq will not change such criteria to include requirements we do not meet in the future, any of which could cause us to fail to obtain the additional 180 day compliance period.  In addition, we may be delisted before April 20, 2009 if we fail to comply with certain other Nasdaq Capital Markets listing requirements.  If we are delisted from the Nasdaq Capital Market, our common stock may be considered a penny stock under the regulations of the SEC and would therefore be subject to rules that impose additional sales practice requirements on broker-dealers who sell our securities.  The additional burdens imposed upon broker-dealers may discourage broker-dealers from effecting transactions in our common stock, which could severely limit market liquidity of the common stock and your ability to sell our securities in the secondary market.  This lack of liquidity would also make it more difficult for us to raise capital in the future.

Many of our expenses are fixed and if factors beyond our control cause our revenue to fluctuate, this fluctuation could cause greater than expected losses, cash flow and liquidity shortfalls.

We believe that our future operating results will fluctuate on a quarterly basis due to a variety of factors which are generally beyond our control, including:

·                  supply of products from third-party suppliers or termination, cancellation or expiration of such relationships;

·                  the introduction of new products by our competitors or by us;

·                  competition and pricing pressures from competitive products;

·                  our ability to maintain relationships with independent third-party distributors;

·                  large customers failing to purchase at historical levels, including changes in independent third-party distributor purchasing patterns and inventory levels;

·                  fundamental shifts in market demand;

·                  manufacturing delays;

·                  shipment problems;

·                  information technology problems, which may prevent us from conducting our business effectively, or at all, and may also raise our costs;

·                  regulatory and other delays in product development;

·                  product recalls or other issues which may raise our costs;

·                  changes in our reputation and/or market acceptance of our current or new products; and

·                  changes in the mix of products sold.

We have high operating expenses, including those related to personnel.  Many of these expenses are fixed in the short term.  If any of the factors listed above cause our revenues to decline, our operating results could be substantially harmed.

17

Table of Contents

We often depend on third parties for products we intend to introduce in the future.  If our current relationships and collaborations are not successful, we may not be able to introduce the products we intend to in the future.

We are often dependent on third parties and collaborative partners to successfully and timely perform research and development activities to successfully develop new products.  For example, we jointly developed point-of-care diagnostic products with Quidel.  In other cases, we have discussed Heska marketing in the veterinary market an instrument being developed by a third party for use in the human health care market.  In the future, one or more of these third parties or collaborative partners may not complete research and development activities in a timely fashion, or at all.  Even if these third parties are successful in their research and development activities, we may not be able to come to an economic agreement with them.  If these third parties or collaborative partners fail to complete research and development activities, fail to complete them in a timely fashion, or if we are unable to negotiate economic agreements with such third parties or collaborative partners, our ability to introduce new products will be impacted negatively and our revenues may decline.  We are currently collaborating with FUJIFILM on a line extension of our chemistry instrument offering.  We expect to complete and sell the resulting new instrument prior to year end.  If FUJIFILM fails to complete the anticipated development activities in a timely fashion, we will not generate any sales of this new instrument prior to year end and our 2009 revenue will likely be lower than our current expectations as a result.

We may not be able to continue to achieve sustained profitability or increase profitability on a quarterly or annual basis.

Prior to 2005, we incurred net losses on an annual basis since our inception in 1988 and, as of December 31, 2008, we had an accumulated deficit of $174.0 million.  We have achieved only one quarter with income before income taxes greater than $1.5 million.  Accordingly, relatively small differences in our performance metrics may cause us to lose money in future periods.  Our ability to continue to be profitable in future periods will depend, in part, on our ability to increase sales in our Core Companion Animal Health segment, including maintaining and growing our installed base of instruments and related consumables, to maintain or increase gross margins and to limit the increase in our operating expenses to a reasonable level as well as avoid or effectively manage any unanticipated issues.  We may not be able to generate, sustain or increase profitability on a quarterly or annual basis.  If we cannot achieve or sustain profitability for an extended period, we may not be able to fund our expected cash needs, including the repayment of debt as it comes due, or continue our operations.

If we are unable to maintain various financial and other covenants required by our credit facility agreement we will be unable to borrow any funds under the agreement and fund our operations.

Under our credit and security agreement with Wells Fargo Bank, National Association (“Wells Fargo”) we are required to comply with various financial and non-financial covenants in order to borrow under the agreement.  The availability of borrowings under this agreement is essential to continue to fund our operations.  Among the financial covenants is a requirement to maintain minimum liquidity (cash plus excess borrowing base) of $1.5 million.  Additional requirements include covenants for minimum capital monthly and minimum net income quarterly.  Although we believe we will be able to maintain compliance with all these covenants and any covenants we may negotiate in the future, there can be no assurance thereof.  We have not always been able to maintain compliance with all covenants under our credit and security agreement in the past.  Although Wells Fargo granted us a waiver of non-compliance in each case, there can be no assurance we will be able to obtain similar waivers or other modifications if needed in the future on economic terms, if at all.

Failure to comply with any of the covenants, representations or warranties, or failure to modify them to allow future compliance, could result in our being in default and could cause all outstanding borrowings under our credit and security agreement to become immediately due and payable, or impact our ability to borrow under the agreement.  In addition, Wells Fargo has discretion in setting the advance rates which we may borrow against eligible assets.  We intend to rely on available borrowings under the credit and security agreement to fund our operations in the future.  If we are unable to borrow funds under this agreement, we will need to raise additional capital from other sources to continue our operations, which capital may not be available on acceptable terms, or at all.

Our future revenues depend on successful product development, commercialization and/or market acceptance, any of which can be slower than we expect or may not occur.

The product development and regulatory approval process for many of our potential products is extensive and may take substantially longer than we anticipate.  Research projects may fail.  New products that we may be developing for the veterinary marketplace may not perform up to our expectations.  Because we have limited resources to devote to product development and commercialization, any delay in the development of one product or reallocation of resources to product development efforts that prove unsuccessful may delay or jeopardize the development of other product candidates.  If we fail to successfully develop new products and bring them to market in a timely manner, our ability to generate additional revenue will decrease.

Even if we are successful in the development of a product or obtain rights to a product from a third-party supplier, we may experience delays in commercialization and/or market acceptance of the product.  For example, veterinarians may be slow to adopt a product or there may be delays in producing large volumes of a product.  The former is particularly likely where there is no comparable product available or historical use of such a product.  For example, while we believe our E.R.D.-HEALTHSCREEN urine tests for dogs and cats represent a significant scientific breakthrough in companion animal annual health examinations, these

18

Table of Contents

products have achieved significantly lower market acceptance than we anticipated.  The ultimate adoption of a new product by veterinarians, the rate of such adoption and the extent veterinarians choose to integrate such a product into their practice are all important factors in the economic success of one of our new products and are factors that we do not control to a large extent.  If our products do not achieve a significant level of market acceptance, demand for our products will not develop as expected and our revenues will be lower than we anticipate.

Our stock price has historically experienced high volatility, which may increase in the future, and which could affect our ability to raise capital in the future or make it difficult for investors to sell their shares.

The securities markets have experienced significant price and volume fluctuations and the market prices of securities of many microcap and smallcap companies have in the past been, and can in the future be expected to be, especially volatile.  During the past 12 months, our closing stock price has ranged from a low of $0.17 to a high of $1.60.  Fluctuations in the trading price or liquidity of our common stock may adversely affect our ability to raise capital through future equity financings.  Factors that may have a significant impact on the market price and marketability of our common stock include:

·      stock sales by large stockholders or by insiders;

·      changes in the outlook for our business, including any changes in our earnings guidance;

·      our quarterly operating results, including as compared to our revenue, earnings or other guidance and in comparison to historical results;

·      termination, cancellation or expiration of our third-party supplier relationships;

·      announcements of technological innovations or new products by our competitors or by us;

·      litigation;

19

Table of Contents

·      regulatory developments, including delays in product introductions;

·      developments or disputes concerning patents or proprietary rights;

·      availability of our revolving line of credit and compliance with debt covenants;

·      releases of reports by securities analysts;

·      changes in regulatory policies;

·      economic and other external factors; and

·      general market conditions.

In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted.  If a securities class action suit is filed against us, it is likely we would incur substantial legal fees and our management’s attention and resources would be diverted from operating our business in order to respond to the litigation.

The loss of significant customers could harm our operating results.

Sales to no single customer accounted for more than 10% of our consolidated revenue for the periods ended December 31, 2008, 2007 and 2006.  No single customer accounted for more than 10% of accounts receivable at December 31, 2008 or 2007.  The loss of significant customers who, for example, are historically large purchasers or who are considered leaders in their field could damage our business and financial results.

Obtaining and maintaining regulatory approvals in order to market our regulated products may be costly and delay the marketing and sales of our products.

Many of the products we develop, market or manufacture may subject us to extensive regulation by one or more of the USDA, the FDA, the EPA and foreign and other regulatory authorities.  These regulations govern, among other things, the development, testing, manufacturing, labeling, storage, pre-market approval, advertising, promotion and sale of some of our products.  Satisfaction of these requirements can take several years and time needed to satisfy them may vary substantially, based on the type, complexity and novelty of the product.

The effect of government regulation may be to delay or to prevent marketing of our products for a considerable period of time and to impose costly procedures upon our activities.  We have experienced in the past, and may experience in the future, difficulties that could delay or prevent us from obtaining the regulatory approval or license necessary to introduce or market our products.  Such delays in approval may cause us to forego a significant portion of a new product’s sales in its first year due to seasonality and advanced booking periods associated with certain products.  Regulatory approval of our products may also impose limitations on the indicated or intended uses for which our products may be marketed.

Among the conditions for certain regulatory approvals is the requirement that our facilities and/or the facilities of our third party manufacturers conform to current Good Manufacturing Practices and other requirements.  If any regulatory authority determines that our manufacturing facilities or those of our third party manufacturers do not conform to appropriate manufacturing requirements, we or the manufacturers of our products may be subject to sanctions, including, but not limited to, warning letters, manufacturing suspensions, product recalls or seizures, injunctions, refusal to permit products to be imported into or exported out of the United States, refusals of regulatory authorities to grant approval or to allow us to enter into government supply contracts, withdrawals of previously approved marketing applications, civil fines and criminal prosecutions.  In addition, certain of our agreements require us to pay penalties if we are unable to

20

Table of Contents

supply products, including for failure to maintain regulatory approvals.  Any of these events, alone or in unison, could damage our business.

Interpretation of existing legislation, regulations and rules or implementation of future legislation, regulations and rules could cause our costs to increase or could harm us in other ways.

The Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) has increased our required administrative actions and expenses as a public company.  The increase in general and administrative costs of complying with Sarbanes-Oxley will depend on how it is interpreted over time.  Of particular concern are the level of standards for internal control evaluation and reporting adopted under Section 404 of Sarbanes-Oxley.  If our regulators and/or auditors adopt or interpret more stringent standards than we anticipate, we and/or our auditors may be unable to conclude that our internal controls over financial reporting are designed and operating effectively, which could adversely affect investor confidence in our financial statements.  Even if we and our auditors are able to conclude that our internal controls over financial reporting are designed and operating effectively in such a circumstance, our general and administrative costs are likely to increase in such a circumstance.  In addition, actions by other entities, such as enhanced rules to maintain our listing on the Nasdaq Capital Market, could also increase our general and administrative costs or have other adverse effects on us, as could further legislative, regulatory or rule-making action or more stringent interpretations of existing legislation, regulations and rules.

We may face costly legal disputes, including related to our intellectual property or technology or that of our suppliers or collaborators.

We may face legal disputes related to our business.  Even if meritless, these disputes may require significant expenditures on our part and could entail a significant distraction to members of our management team or other key employees.  A legal dispute leading to an unfavorable ruling or settlement could have significant material adverse consequences on our business.

We may become subject to additional patent infringement claims and litigation in the United States or other countries or interference proceedings conducted in the United States Patent and Trademark Office, or USPTO, to determine the priority of inventions.  The defense and prosecution of intellectual property suits, USPTO interference proceedings and related legal and administrative proceedings are likely to be costly, time-consuming and distracting.  As is typical in our industry, from time to time we and our collaborators and suppliers have received, and may in the future receive, notices from third parties claiming infringement and invitations to take licenses under third party patents.  Any legal action against us or our collaborators or suppliers may require us or our collaborators or suppliers to obtain one or more licenses in order to market or manufacture affected products or services.  However, we or our collaborators or suppliers may not be able to obtain licenses for technology patented by others on commercially reasonable terms, or at all, may not be able to develop alternative approaches if unable to obtain licenses or current and future licenses may not be adequate, any of which could substantially harm our business.  An example of such a situation arose in 2006 when Dolphin Medical Inc. (a majority-owned subsidiary of OSI Systems, Inc.) discontinued production of our VET/OX G2 DIGITAL Monitor as part of an agreement with Masimo Corporation to settle a patent dispute.

We may also need to pursue litigation to enforce any patents issued to us or our collaborative partners, to protect trade secrets or know-how owned by us or our collaborative partners, or to determine the enforceability, scope and validity of the proprietary rights of others.  Any litigation or interference proceeding will likely result in substantial expense to us and significant diversion of the efforts of our technical and management personnel.  Any adverse determination in litigation or interference proceedings could subject us to significant liabilities to third parties.  Further, as a result of litigation or other proceedings, we may be required to seek licenses from third parties which may not be available on commercially reasonable terms, if at all.

21

Table of Contents

We depend on key personnel for our future success.  If we lose our key personnel or are unable to attract and retain additional personnel, we may be unable to achieve our goals.

Our future success is substantially dependent on the efforts of our senior management and other key personnel.  The loss of the services of members of our senior management or other key personnel may significantly delay or prevent the achievement of our business objectives.  Although we have an employment agreement with many of these individuals, all are at-will employees, which means that either the employee or Heska may terminate employment at any time without prior notice.  If we lose the services of, or fail to recruit, key personnel, the growth of our business could be substantially impaired.  We do not maintain key person life insurance for any of our senior management or key personnel.

Changes to financial accounting standards may affect our results of operations and cause us to change our business practices.

We prepare our financial statements in conformance with United States generally accepted accounting principles, or GAAP.  These accounting principles are established by and are subject to interpretation by the SEC, the Financial Accounting Standards Board, the American Institute of Certified Public Accountants, and others who interpret and create accounting policies.  A change in those policies can have a significant effect on our reported results and may affect our reporting of transactions completed before a change is made effective.  Such changes may adversely affect our reported financial results or the way we conduct our business.

We may face product returns and product liability litigation in excess of or not covered by our insurance coverage or indemnities and/or warranties from our suppliers.  If we become subject to product liability claims resulting from defects in our products, we may fail to achieve market acceptance of our products and our sales could substantially decline.

The testing, manufacturing and marketing of our current products as well as those currently under development entail an inherent risk of product liability claims and associated adverse publicity.  Following the introduction of a product, adverse side effects may be discovered.  Adverse publicity regarding such effects could affect sales of our other products for an indeterminate time period.  To date, we have not experienced any material product liability claims, but any claim arising in the future could substantially harm our business.  Potential product liability claims may exceed the amount of our insurance coverage or may be excluded from coverage under the terms of the policy.  We may not be able to continue to obtain adequate insurance at a reasonable cost, if at all.  In the event that we are held liable for a claim against which we are not indemnified or for damages exceeding the $10 million limit of our insurance coverage or which results in significant adverse publicity against us, we may lose revenue, be required to make substantial payments which could exceed our financial capacity and/or lose or fail to achieve market acceptance.

We may be held liable for the release of hazardous materials, which could result in extensive clean up costs or otherwise harm our business.

Certain of our products and development programs produced at our Des Moines, Iowa facility involve the controlled use of hazardous and biohazardous materials, including chemicals and infectious disease agents.  Although we believe that our safety procedures for handling and disposing of such materials comply with the standards prescribed by applicable local, state and federal regulations, we cannot eliminate the risk of accidental contamination or injury from these materials.  In the event of such an accident, we could be held liable for any fines, penalties, remediation costs or other damages that result.  Our liability for the release of hazardous materials could exceed our resources, which could lead to a shutdown of our operations, significant remediation costs and potential legal liability.  In addition, we may incur substantial costs to comply with environmental regulations if we choose to expand our manufacturing capacity.

22

Table of Contents

Item 1B.  Unresolved Staff Comments.

Not applicable.

Item 2.  Properties.

Our principal administrative and research and development activities are located in Loveland, Colorado.  We currently lease approximately 60,000 square feet at a facility in Loveland, Colorado under an 18-year lease agreement which expires in 2023.  Our principal production facility located in Des Moines, Iowa, consists of 168,000 square feet of buildings on 34 acres of land, which we own.  We also own a 175-acre farm used principally for testing products, located in Carlisle, Iowa.  Our European facility in Fribourg, Switzerland is leased under an agreement which expires in 2012.

Item 3.  Legal Proceedings.

None.

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

No matters were submitted to a vote of stockholders during the fourth quarter ended December 31, 2008.

23

Table of Contents

PART II

Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Our common stock is quoted on the Nasdaq Capital Market under the symbol “HSKA.”  The following table sets forth the high and low closing prices for our common stock as reported by the Nasdaq Capital Market for the periods indicated below:

As of March 13, 2009, there were approximately 293 holders of record of our common stock and approximately 2,559 beneficial stockholders.  We have never declared or paid cash dividends on our capital stock and do not anticipate paying any cash dividends in the near future.  In addition, we are restricted from paying dividends, other than dividends payable solely in stock, under the terms of our credit facility.  We currently intend to retain future earnings, if any, for the development of our business.

Equity Compensation Plan Information

The following table sets forth information about our common stock that may be issued upon exercise of options and rights under all of our equity compensation plans as of December 31, 2008, including the 1988 Stock Option Plan, the 1997 Stock Incentive Plan, the 2003 Stock Incentive Plan and the 1997 Employee Stock Purchase Plan.  Our stockholders have approved all of these plans.

24

Table of Contents

STOCK PRICE PERFORMANCE GRAPH

The following graph provides a comparison over the five-year period ended December 31, 2008 of the cumulative total stockholder return from a $100 investment in the Company’s common stock with the Center for Research in Securities Prices Total Return Index for Nasdaq Medical Devices, Instruments and Supplies, Manufacturers and Distributors Stocks (the “Nasdaq Medical Devices Index”), the CRSP Total Return Index for Nasdaq Pharmaceutical Stocks (the “Nasdaq Pharmaceutical Index”) and the CRSP Total Return Index for the Nasdaq Stock Market (U.S. and Foreign) (the “Nasdaq U.S. & Foreign Index”).

Comparison of Cumulative Total Return Among Heska Corporation,

 the Nasdaq Medical Devices Index, the Nasdaq Pharmaceutical Index and the Nasdaq U.S. and
Foreign Index

25

Table of Contents

Item 6.  Selected Consolidated Financial Data.

The following consolidated statement of operations and consolidated balance sheet data have been derived from our consolidated financial statements.  The information set forth below is not necessarily indicative of the results of future operations and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and related Notes included as Items 7 and 8 in this Form 10-K.

26

Table of Contents

Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Selected Consolidated Financial Data” and the Consolidated Financial Statements and related Notes included in Items 6 and 8 of this Form 10-K.

This discussion contains forward-looking statements that involve risks and uncertainties.  Such statements, which include statements concerning future revenue sources and concentration, gross profit margins, selling and marketing expenses, research and development expenses, general and administrative expenses, capital resources, additional financings or borrowings and additional losses, are subject to risks and uncertainties, including, but not limited to, those discussed below and elsewhere in this Form 10-K, particularly in Item 1A. “Risk Factors,” that could cause actual results to differ materially from those projected.  The forward-looking statements set forth in this Form 10-K are as of March 16, 2009, and we undertake no duty to update this information.

Overview

We develop, manufacture, market, sell and support veterinary products.  Our business is comprised of two reportable segments, Core Companion Animal Health, which represented 83% of 2008 product revenue, and Other Vaccines, Pharmaceuticals and Products which represented 17% of 2008 product revenue.

The Core Companion Animal Health segment (“CCA”) includes diagnostic and other instruments and supplies as well as single use diagnostic and other tests, pharmaceuticals and vaccines, primarily for canine and feline use.

Diagnostic and other instruments and supplies represented approximately 48% of our 2008 product revenue.  Many products in this area involve placing an instrument with a customer and generating future revenue from consumables, including items such as supplies and service, as that instrument is used.  Approximately 34% of our 2008 product revenue resulted from the sale of such consumables to an installed base of instruments and approximately 14% of our product revenue was from new hardware sales.  A loss of or disruption in supply of consumables we are selling to an installed base of instruments could substantially harm our business.  All products in this area are supplied by third parties, who typically own the product rights and supply the product to us under marketing and/or distribution agreements.  In many cases, we have collaborated with a third party to adapt a human instrument for veterinary use.  Major products in this area include our handheld blood analysis instrument, our chemistry instrument and our hematology instrument and their affiliated operating consumables.  Revenue from products in these three areas, including revenue from consumables, represented approximately 44% of our 2008 product revenue.

Single use diagnostic and other tests, pharmaceuticals and vaccines and other products represented approximately 35% of our 2008 product revenue.  Since items in this area are single use by their nature, our aim is to build customer satisfaction and loyalty for each product, generate repeat annual sales from existing customers and expand our customer base in the future.  Products in this area are both supplied by third parties and provided by us.  Major products in this area include our heartworm diagnostic tests, our heartworm preventive, our allergy test kits, our allergy immunotherapy and our allergy diagnostic tests.  Combined revenue from heartworm-related products and allergy-related products represented approximately 32% of 2008 product revenue.

We consider the Core Companion Animal Health segment to be our core business and devote most of our management time and other resources to improving the prospects for this segment.  Maintaining a continuing, reliable and economic supply of products we currently obtain from third parties is critical to our success in this area.  Virtually all of our sales and marketing expenses are in the Core Companion Animal

27

Table of Contents

Health segment.  The majority of our research and development spending is dedicated to this segment, as well.

All our Core Companion Animal Health products predominately are sold to or through veterinarians ultimately.  In many cases, veterinarians will mark up their costs to the end user.  The acceptance of our products by veterinarians is critical to our success.  Core Companion Animal Health products are sold directly by us as well as through independent third-party distributors and other distribution relationships, such as our corporate agreement with SPAH and the sale of kits to conduct blood testing to third-party veterinary diagnostic laboratories.  Revenue from direct sales, independent third-party distributors and other distribution relationships represented approximately 51%, 29% and 20% of Core Companion Animal Health 2008 product revenue, respectively.

Independent third-party distributors may be effective in increasing sales of our products to veterinarians, although we would expect a corresponding lower gross margin as such distributors typically buy products from us at a discount to end user prices.  To be effective when working with an independent third-party distributor, the distributor must agree to market and/or sell our products and we must provide proper economic incentives to the distributor as well as contend effectively for the distributor’s time and focus given other products the distributor may be carrying, potentially including those of our competitors.  We believe that one of our largest competitors, IDEXX, in effect prohibits its distributors from selling competitive products, including our diagnostic instruments and heartworm diagnostic tests.  We believe the IDEXX restrictions limit our ability to engage national distributors to sell our full distribution line of products.

We intend to return to and sustain profitability through a combination of revenue growth, gross margin improvement and expense control.  Accordingly, we closely monitor product revenue growth trends in our Core Companion Animal Health segment.  Product revenue in this segment grew 2% in 2008 as compared to 2007 and has grown at a compounded annual growth rate of 16% since 1998, our first full year as a public company.

The Other Vaccines, Pharmaceuticals and Products segment (“OVP”) includes our 168,000 square foot USDA- and FDA-licensed production facility in Des Moines, Iowa.  We view this facility as a strategic asset which will allow us to control our cost of goods on any vaccines and pharmaceuticals that we may commercialize in the future.  We are increasingly integrating this facility with our operations elsewhere.  For example, virtually all our U.S. inventory is now stored at this facility and fulfillment logistics are managed there.  CCA segment products manufactured at this facility are transferred at cost and are not recorded as revenue for our OVP segment.  We view OVP reported revenue as revenue primarily to cover the overhead costs of the facility and to generate incremental cash flow to fund our Core Companion Animal Health segment.

Our OVP segment includes private label vaccine and pharmaceutical production, primarily for cattle but also for other animals such as small mammals.  All OVP products are sold by third parties under third party labels.

We have developed our own line of bovine vaccines that are licensed by the USDA.  We have a long-term agreement with a distributor, Agri Laboratories, Ltd., (“AgriLabs”), for the marketing and sale of certain of these vaccines which are sold primarily under the Titanium® and MasterGuard® brands which are registered trademarks of AgriLabs.  This agreement generates a significant portion of our OVP segment’s revenue.  AgriLabs has the exclusive right to sell the aforementioned bovine vaccines in the United States, Africa and Mexico until December 2009.  Our OVP segment also produces vaccines and pharmaceuticals for other third parties.

28

Table of Contents

Additionally, we generate non-product revenues from licensing of technology, royalties and sponsored research and development projects for third parties.  We perform these sponsored research and development projects for both companion animal and livestock product purposes.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations is based upon the consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”).  The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities as of the date of the financial statements, and the reported amounts of revenue and expense during the periods.  These estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances.  We have identified those critical accounting policies used in reporting our financial position and results of operations based upon a consideration of those accounting policies that involve the most complex or subjective decisions or assessment.  We consider the following to be our critical policies.

Revenue Recognition

We generate our revenue through the sale of products, licensing of technology product rights, royalties and sponsored research and development.  Our policy is to recognize revenue when the applicable revenue recognition criteria have been met, which generally include the following:

·                  Persuasive evidence of an arrangement exists;

·                  Delivery has occurred or services rendered;

·                  Price is fixed or determinable; and

·                  Collectibility is reasonably assured.

Revenue from the sale of products is recognized after both the goods are shipped to the customer and acceptance has been received, if required, with an appropriate provision for estimated returns and allowances.  We do not permit general returns of products sold.  Certain of our products have expiration dates.  Our policy is to exchange certain outdated, expired product with the same product.  We record an accrual for the estimated cost of replacing the expired product expected to be returned in the future, based on our historical experience, adjusted for any known factors that reasonably could be expected to change historical patterns, such as regulatory actions which allow us to extend the shelf life of our products.  Revenue from both direct sales to veterinarians and sales to independent third-party distributors are generally recognized when goods are shipped.  Our products are shipped complete and ready to use by the customer.  The terms of the customer arrangements generally pass title and risk of ownership to the customer at the time of shipment.  Certain customer arrangements provide for acceptance provisions.  Revenue for these arrangements is not recognized until the acceptance has been received or the acceptance period has lapsed.  We reduce our product revenue by the estimated cost of any rebates, allowances or similar programs, which are used as promotional programs.

Recording revenue from the sale of products involves the use of estimates and management judgment.  We must make a determination at the time of sale whether the customer has the ability to make payments in accordance with arrangements.  While we do utilize past payment history, and, to the extent available for new customers, public credit information in making our assessment, the determination of whether collectibility is reasonably assured is ultimately a judgment decision that must be made by management.  We must also make estimates regarding our future obligation relating to returns, rebates, allowances and similar other programs.

29

Table of Contents

License revenue under arrangements to sell or license product rights or technology rights is recognized as obligations under the agreement are satisfied, which generally occurs over a period of time.  Generally, licensing revenue is deferred and recognized over the estimated life of the related agreements, products, patents or technology.  Nonrefundable licensing fees, marketing rights and milestone payments received under contractual arrangements are deferred and recognized over the remaining contractual term using the straight-line method.  Revenue from licensing technology and product rights is reported in our research, development and other revenue line item.  An example of the former, i.e. licensing technology, is a patent we own under which we grant a third-party exclusive rights to the human healthcare market for the life of the patent in exchange for an upfront payment and royalty payments on sales of any product based on the patent.  The upfront payment will be amortized over the life of the patent and reported along with any affiliated royalty payments in our research, development and other revenue line item.  An example of the latter, i.e. product rights, is our July 2002 agreement to license Intervet Inc. certain rights to patents, trademarks and know-how for our Flu AVERT I.N. equine influenza vaccine, the world’s first intranasal influenza vaccine for horses.  As we had no further rights to manufacture, market or sell this vaccine without Intervet Inc.’s permission under this agreement, we are reporting the amortization of the upfront payment we received in this agreement along with any affiliated royalty payments in our research, development and other revenue line item.  The upfront payment is being amortized over the estimated life of the product.

Recording revenue from license arrangements involves the use of estimates.  The primary estimate made by management is determining the useful life of the related agreement, product, patent or technology.  We evaluate all of our licensing arrangements by estimating the useful life of either the product or the technology, the length of the agreement or the legal patent life and defer the revenue for recognition over the appropriate period.

Occasionally we enter into arrangements that include multiple elements.  Such arrangements may include the licensing of technology and manufacturing of product.  In these situations we must determine whether the various elements meet the criteria to be accounted for as separate elements.  If the elements cannot be separated, revenue is recognized once revenue recognition criteria for the entire arrangement have been met or over the period that our obligations to the customer are fulfilled, as appropriate.  If the elements are determined to be separable, the revenue is allocated to the separate elements based on relative fair value and recognized separately for each element when the applicable revenue recognition criteria have been met.  In accounting for these multiple element arrangements, we must make determinations about whether elements can be accounted for separately and make estimates regarding their relative fair values.

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts receivable based on client-specific allowances, as well as a general allowance.  Specific allowances are maintained for clients which are determined to have a high degree of collectibility risk based on such factors, among others, as: (i) the aging of the accounts receivable balance; (ii) the client’s past payment experience; (iii) a deterioration in the client’s financial condition, evidenced by weak financial condition and/or continued poor operating results, reduced credit ratings, and/or a bankruptcy filing.  In addition to the specific allowance, the Company maintains a general allowance for credit risk in its accounts receivable which is not covered by a specific allowance.  The general allowance is established based on such factors, among others, as: (i) the total balance of the outstanding accounts receivable, including considerations of the aging categories of those accounts receivable; (ii) past history of uncollectible accounts receivable write-offs; and (iii) the overall creditworthiness of the client base.  A considerable amount of judgment is required in assessing the realizability of accounts receivable.  Should any of the factors considered in determining the adequacy of the

30

Table of Contents

overall allowance change, an adjustment to the provision for doubtful accounts receivable may be necessary.

Inventories

Inventories are stated at the lower of cost or market, cost being determined on the first-in, first-out method.  Inventories are written down if the estimated net realizable value of an inventory item is less than its recorded value.  We review the carrying cost of our inventories by product each quarter to determine the adequacy of our reserves for obsolescence.  In accounting for inventories we must make estimates regarding the estimated net realizable value of our inventory.  This estimate is based, in part, on our forecasts of future sales and shelf life of product.

Capitalized Patent Costs

In the year ended December 31, 2006, we deferred and capitalized certain costs, including payments to third-party law firms for patent prosecution to expand the scope of our patents, related to the technology or patents underlying a variety of long-term licensing agreements.  We owned a portfolio of patents not then utilized in our product development or manufacture.  Several entities paid upfront licensing fees to utilize the technology supported by these patents in their own product development and commercialization efforts.  Because we believed that we had an obligation to protect the underlying patents, we deferred the revenue associated with these long-term agreements and the direct and incremental costs of prosecuting the patents that supported the agreements.  We use the term “patent prosecution” in this context in the narrow sense often used by intellectual property professionals — to describe activities where we seek to expand the scope of existing patents such as geographically, where we may look to expand patent protection into new countries, or for broader applications, such as for newly contemplated uses or expanded claim breadth coverage of the technology defined by those licensing our technology within existing geographies.  A situation where a third party has violated our intellectual property rights by using our patented technology without permission and we have filed a corresponding lawsuit would not meet this definition of “patent prosecution” and we would therefore expense the corresponding legal expenses as incurred.  In accordance with SFAS No. 95, paragraph 17(c), we classified patent prosecution expenditures which were capitalized as cash used for investing activities since, like a capital expenditure to improve a building or add a piece of equipment, the cost is a necessary investment into a productive asset to maintain our future revenue process.  No internal costs were capitalized.  These capitalized costs were amortized over the same period as the licensing revenue related to those patents was recognized.  Costs in excess of the amount of remaining related deferred licensing revenue were not capitalized, but expensed as incurred.  We capitalized approximately $292 thousand for the year ended December 31, 2006 and amortized approximately $334 thousand for the same period.  In December 2006, we sold all patents for which we had capitalized patent costs and, accordingly, we have no capitalized patent costs on our balance sheet as of December 31, 2008, 2007 and 2006.  We do not expect to capitalize any patent costs in the future.

31

Table of Contents

Deferred Tax Assets — Valuation Allowance

Our deferred tax assets, such as a net operating loss carryforward (“NOL”), are reduced by an offsetting valuation allowance based on judgmental assessment of available evidence if we are unable to conclude that it is more likely than not that some or all of the related deferred tax assets will be realized.  If we are able to conclude it is more likely than not that we will realize a future benefit from a deferred tax asset, we will reduce the related valuation allowance by an amount equal to the estimated quantity of income taxes we would pay in cash if we were not to utilize the deferred tax asset in the future.  The first time this occurs in a given jurisdiction, it will result in a net deferred tax asset on our balance sheet and an income tax benefit of equal magnitude in our statement of operations at the time we make the determination.  In future periods, we will then recognize as income tax expense the estimated quantity of income taxes we would have paid in cash had we not utilized the related deferred tax asset.  The corresponding journal entry will be a reduction of our deferred tax asset.  If there is a change regarding our tax position in the future, we will make a corresponding adjustment to the related valuation allowance.

Results of Operations

The following table summarizes our results of operations for the three most recent fiscal years:

32

Table of Contents

Revenue

Total revenue, which includes product revenue, research and development and other revenue, decreased 1% to $81.7 million in 2008 compared to $82.3 million in 2007.  Total revenue for 2007 increased 10% to $82.3 million from $75.1 million in 2006.  Product revenue decreased 1% to $80.3 million in 2008 compared to $80.8 million in 2007.  Product revenue increased 13% to $80.8 million in 2007 compared to $71.8 million in 2006.

Core Companion Animal Health segment product revenue increased 2% to $67.0 million in 2008 compared to $65.9 million in 2007.  Key factors in the increase were greater sales of our chemistry instrument, which was launched in November 2007, our instrument consumables and our heartworm diagnostic tests, somewhat offset by lower sales of our handheld blood analysis instruments and our heartworm preventive, both internationally and domestically.

2007 product revenue from our Core Companion Animal Health segment increased 10% to $65.9 million compared to $59.9 million in 2006.   Key factors in the increase were higher sales of our instrument consumables, our hematology instruments, our handheld blood analysis instruments, our IV pumps, international sales of our heartworm preventive, our microalbumin laboratory packs and our allergy diagnostic kits.

Other Vaccines, Pharmaceuticals and Products segment (“OVP”) product revenue decreased 11% to $13.3 million in 2008 compared to $14.9 million in 2007.  The largest factor in the decrease was approximately $1.6 million in revenue (the “United Revenue”) recognized in 2007 upon receipt of a payment for product previously shipped and “take or pay” minimums for 2005 and 2006 which previously had not been paid as part of a now settled dispute with United Vaccines, Inc. (“UV”), a former customer.  As UV had ceased operations, we did not generate any corresponding revenue from UV in 2008, nor do we expect to generate any revenue from UV in the future.  This decrease was somewhat offset by an increase in sales of bovine vaccines under our contract with AgriLabs.

2007 product revenue from OVP increased 25% to $14.9 million compared to $11.9 million in 2006.  Key factors in the increase were greater sales of fish vaccines, the United Revenue and an increase in sales of bovine vaccines under our contract with AgriLabs.  Decreases in sales of our bulk bovine biologicals and our equine influenza vaccine somewhat offset increased sales in other areas.  We licensed Intervet Inc. exclusive rights to our equine influenza vaccine in July 2002, and our last shipment of this product prior to Intervet Inc. producing the product themselves occurred in the third quarter of 2006.

Revenue from research and development and other revenue decreased by 13% to $1.3 million in 2008 from $1.5 million in 2007.  The primary factor in the decrease was $250 thousand in revenue recognized from a service contract in 2007, with no corresponding revenue recognized in 2008 as the service contract was completed in 2007.  The service contract was related to a worldwide patent portfolio covering a number of major allergens and the genes that encode them (the “Allergopharma Portfolio”) and was with the buyer of the Allergopharma Portfolio, which we sold in December 2006.

Revenue from research and development and other revenue decreased by 53% to $1.5 million in 2007 from $3.2 million in 2006.  The decrease is primarily due to revenue from the acceleration of approximately $1.5 million in previously deferred licensing fees recognized upon completion of the sale of the Allergopharma Portfolio in December 2006, with no corresponding revenue recognized in 2007.

We expect total revenue to decline slightly when compared to 2008.

33

Table of Contents

Cost of Revenue

Cost of revenue consists of two components: 1) cost of products sold and 2) cost of research, development and other revenue, both of which correspond to their respective revenue categories.  Cost of revenue totaled $52.8 million for the twelve months ended December 31, 2008, a 7% increase as compared to $49.1 million for the corresponding period in 2007.  Gross profit decreased 13% to $28.8 million for 2008 as compared to $33.2 million in 2007.  Gross Margin, i.e. gross profit divided by total revenue, decreased to 35.3% for 2008 as compared to 40.3% in 2007.  Cost of revenue totaled $49.1 million for 2007, an 11% increase as compared to $44.4 million for 2006.  Gross profit increased 8% to $33.2 million for 2007 as compared to $30.6 million in 2006.  Gross Margin decreased to 40.3% for 2007 as compared to 40.8% in 2006.

Cost of products sold increased 7% to $52.5 million in the twelve months ended December 31, 2008 from $48.9 million in 2007.  Gross profit on product revenue decreased 13% to $27.9 million for 2008 from $31.9 million in the prior year.  Product Gross Margin, i.e. gross profit on product revenue divided by product revenue, decreased to 34.7% in 2008 as compared to 39.5% in 2007.  The largest factor in the decrease was recognition of the United Revenue in 2007 for which the affiliated Cost of products sold had been recognized in prior periods and for which no corresponding revenue or gross profit was recognized in 2008.  In addition, product mix and increased reserves taken against inventory we expect to expire prior to sale, primarily related to consumables for our new chemistry instrument and our handheld diagnostic instruments, were factors in the decrease.  Cost of products sold increased 14% to $48.9 million in 2007 as compared to $43.0 million in 2006.  Gross profit on product revenue increased 11% to $31.9 million for 2007 from $28.8 million in 2006.  Product Gross Margin decreased to 39.5% in 2007 as compared to 40.1% in 2006.  Product mix was a key factor in the decrease, including sales of our diagnostic instruments, which represented a larger share of overall sales than in 2006.  Our diagnostic instruments tend to be relatively lower margin sales and certain instruments experienced lower gross margins in 2007 than in 2006 due to aggressive sales and marketing programs in 2007.  This was somewhat offset by recognition of the United Revenue for which the affiliated cost of products sold had been recognized in prior periods.

Cost of research, development and other revenue increased 21% to $331 thousand in the twelve months ended December 31, 2008 as compared to $274 thousand in 2007.  Gross profit on research, development and other revenue decreased 21% to $1.0 million for 2008 from $1.3 million in 2007.  Other Gross Margin, i.e. gross profit on research, development and other revenue divided by research, development and other revenue, decreased to 75.0% for 2008 as compared to 82.1% in 2007. A factor in the decline was lower margins on sponsored research and development revenue.  Cost of research, development and other revenue decreased 81% to $274 thousand in 2007 as compared to $1.4 million in 2006.  Gross profit on research, development and other revenue decreased 32% to $1.3 million for the twelve months ended December 31, 2007 from $1.8 million in 2006.  Other Gross Margin increased to 82.1% for 2007 as compared to 56.4% in 2006.  The primary reason for the increase in gross margin was revenue related to the Allergopharma Portfolio from deferred licensing fees for which a corresponding capitalized patent cost was amortized, which occurred in 2006, but not in 2007.  This was somewhat offset by the acceleration of certain previously deferred upfront licensing fees which were recognized in 2006 due to the sale of the Allergopharma Portfolio in December 2006.

We expect Gross Margin to be flat or down slightly for 2009 as compared to 2008.

Operating Expenses

Selling and marketing expenses increased by 10% to $17.6 million in 2008 compared to $16.1 million in 2007.  Key factors in the change were an increase in personnel and increased expenditures on market research.  Selling and marketing expenses increased by 12% to $16.1 million in 2007 as compared to $14.4 million in 2006.  A key factor in the increase was cost related to new product launches.

34

Table of Contents

Research and development expenses decreased by $728 thousand to $2.0 million in 2008 from $2.7 million in 2007.  A key factor in the change was less space at our corporate headquarters being used for research and development activities.  In late 2007, we implemented a plan to move and expand space for certain activities within our corporate headquarters, which reduced the space dedicated to research and development activities.  Research and development expenses decreased by $804 thousand to $2.7 million in 2007 from $3.5 million in 2006.  A factor in the decline was a decrease in accrued expenses related to our Management Incentive Program (“MIP”) recognized in 2007 as compared to 2006.

General and administrative expenses were $8.9 million in 2008, a slight decrease as compared to 2007.  A factor in the decline was no MIP payouts were earned in 2008 while there was some corresponding MIP payout earned in 2007.  General and administrative expenses decreased by 10% to $8.9 million in 2007 from $9.9 million in 2006.  Key factors in the decline were lower incentive compensation, including compensation related to our MIP, in 2007 as compared to 2006, and lower legal fees, primarily related to our litigation with UV in 2006.

In 2008, we recorded restructuring expenses of approximately $785 thousand, consisting of approximately $621 thousand related primarily to personnel severance and other costs for certain individuals affected by our restructuring in December 2008 and $164 thousand related to inventory of discontinued products, including a monitoring product the manufacturer has informed us it no longer intends to support.  We recorded no restructuring expenses in 2007 or 2006.

Other operating expenses of approximately $232 thousand in 2008 relate to an asset impairment charge related to certain rental instruments we own.  In 2007, we recognized a gain of approximately $47 thousand on the sale of certain patents we held net of costs on this line.  In 2006, we recognized a gain of approximately $155 thousand on the sale of the Allergopharma Portfolio on this line.  The gain is equal to the sales price less the net book value of the Allergopharma Portfolio, which included all of our unamortized capitalized patent costs.

We expect 2009 operating expenses will be lower than in 2008, primarily as a result of our restructuring at the end of 2008.

Interest and Other Expense, Net

Interest and other expense, net was $640 thousand in 2008, as compared to $588 thousand in 2007 and $1.0 million in 2006.  This line item includes interest expense, interest income and foreign currency gains and losses.  The largest factor in the increase in 2008 as compared to 2007 was greater borrowings under our revolving line of credit with Wells Fargo, somewhat offset by lower market interest rates.  The largest factor in the decrease from 2006 to 2007 was lower borrowings under our credit and security agreement with Wells Fargo along with the fact that we repaid $500 thousand in subordinated debt in May 2007.  Another factor was lower interest rate spreads to Prime on our borrowings with Wells Fargo resulting from our achievement of negotiated milestones.

We expect interest and other expense, net to decrease in 2009 as compared to 2008 based on lower market interest rates and lower average borrowings, somewhat offset by an increase in our interest rate spread.

Income Tax Expense (Benefit)

In general, income tax expense (or benefit) can be broken into two categories: current and deferred.  Valuation allowance adjustments and net operating loss usage have been components of deferred income tax expense (benefit) in all years presented.

35

Table of Contents

Current income tax expense generally consists of taxes payable on tax returns for a given year.  These primarily relate to domestic federal alternative minimum tax payments required, although state taxes are also included in this category.  We have typically not had to pay much in cash taxes when we have generated taxable income due to our NOL in Switzerland and in the United States.

A valuation allowance adjustment is due to a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years.  Based on the profitable operating performance of our subsidiary in Switzerland, in the fourth quarter of 2005 we concluded that our NOL in Switzerland was realizable on a more-likely-than-not basis.  We reduced the related valuation allowance in the fourth quarter of 2005.  This resulted in a net deferred tax asset equal to the estimated quantity of income taxes we would have recognized in our future statements of operations as income tax expense that we would not have to actually pay in cash assuming our estimate of our NOL usage in Switzerland was exactly correct.

We subsequently obtained agreements from the tax authorities in the canton of Fribourg (the “Tax Agreements”) regarding the determination of our taxable income which reduced our taxable income in Switzerland in 2005 and 2006 from previous estimates for financial reporting purposes and we expected to reduce our taxable income, and thus our tax obligation, in future years as compared to prior expectations.  Given our corresponding lower income expectations in Switzerland, we no longer believed we would utilize all of our NOL in Switzerland before it was scheduled to expire at the end of 2008.  Accordingly, we reduced our net deferred tax asset related to this NOL via an increase in the related valuation allowance which is reported as a valuation allowance adjustment income tax expense of $69 thousand in the fourth quarter of 2006.  We did not generate sufficient taxable income in 2008 to fully utilize our Swiss net deferred tax asset, which expired at the end of 2008, and made an associated reduction in the deferred tax asset and recorded a corresponding income tax expense journal entry of $10 thousand in the fourth quarter of 2008.

Net operating loss usage represents the tax we would have paid had we not had an NOL in a given jurisdiction, but did not pay.  We had net operating loss usage in Switzerland of $32 thousand, $17 thousand and $79 thousand in 2008, 2007 and 2006, respectively.  The amount decreased from 2006 to 2007 due to the Tax Agreements.  The amount increased from 2007 to 2008 due to the expiration of a “tax holiday” from canton, municipal and church income taxes in the canton of Fribourg in August 2007.

In the fourth quarter of 2007, based on the Company’s profitable domestic operating performance, we concluded that a portion of our domestic deferred tax assets, which primarily consist of our domestic NOL, was realizable on a more-likely-than-not basis and the related valuation allowance was, resulting in an income tax benefit of $30 million, reported as a valuation allowance adjustment income tax benefit.  This resulted in a net deferred tax asset of $30 million for our domestic deferred tax assets.

In 2008, domestic deferred income tax benefits related to our loss before income taxes was the primary reason we recorded a $471 thousand income tax benefit.  In 2007, the $30 million valuation allowance adjustment related to our domestic NOL discussed above was the primary reason for the $29.9 million income tax benefit recorded.  In 2006, deferred tax expenses discussed above related to our Swiss subsidiary were the primary components of $206 thousand in income tax expense.

In 2009, we expect current income tax expense as compared to an income tax benefit in 2008 as we expect to generate income before income taxes as opposed to the loss before income taxes we experienced in 2008.

36

Table of Contents

or benefit in 2009 and expect to record valuation allowance adjustment income tax expense or benefit infrequently, if at all, in future years.

Net Income (Loss)

Our 2008 net loss was $850 thousand as compared to net income of $34.8 million in 2007 and $1.8 million in 2006.  The decline in 2008 as compared to 2007 was due to the large valuation allowance adjustment related to our domestic NOL recognized in 2007, but not 2008.  Lower total revenue, lower Gross Margin and higher operating expenses for 2008 as compared to 2007 also contributed to the change.  A large valuation allowance income tax benefit was the primary reason for the increase from 2006 to 2007, although increased revenue also contributed to the improvement.

In 2009, we expect to generate net income as opposed to the net loss we reported in 2008, primarily as a result of lower operating expenses.

Liquidity, Capital Resources and Financial Condition

We have incurred net cumulative negative cash flow from operations since inception in 1988.  For the year ended December 31, 2008, we had total revenue of $81.7 million and net loss of $850 thousand.  In 2008, net cash provided by operations was $1.7 million.  At December 31, 2008, we had $4.7 million of cash and cash equivalents, working capital of $9.1 million, $11.0 million of outstanding borrowings under our revolving line of credit, discussed below, and $1.2 million of other debt and capital leases.

Net cash flows from operating activities provided cash of $1.7 million in 2008 as compared to using cash of $1.7 million in 2007 and providing cash of $1.1 million in 2006.  The major factors in the improvement in 2008 versus 2007 were a $7.4 million improvement in cash provided by inventory as we lowered our inventory levels at year end 2008 compared to year end 2007, a $1.9 million improvement in cash provided by accrued liabilities and other related items primarily due to a relatively large cash payout for our 2006 MIP in early 2007, a $1.2 million improvement in cash provided by accounts receivable primarily due to lower fourth quarter sales and $1.1 million greater depreciation and amortization primarily related to full versus partial year depreciation on rental instruments we capitalized in 2007.  This was somewhat offset by a $35.7 million decrease in net income, partially mitigated by a $29.4 million decrease in deferred tax benefit primarily due to the $30 million valuation allowance adjustment related to our domestic NOL recorded in 2007, as well as a $2.6 million increase in cash used for accounts payable which primarily relates to lower inventory received but not paid for at year end 2008 as compared to 2007.  The major factors in the use of cash in 2007 as compared to providing cash of $1.1 million in 2006 were an increase in cash used for inventories of $5.4 million due primarily to the non-cash transfer of inventory to property and equipment related to 2007 rental programs on certain of our diagnostic instruments as well as greater overall inventory levels, decreases in cash provided from accrued liabilities and other related items of $3.7 million primarily due to decreases in accrued management incentive plan payouts, somewhat offset by a $33.0 million improvement in our net income which was mostly offset by a corresponding deferred tax benefit change of $30.1 million, a $2.5 million improvement in cash provided by accounts receivable resulting from a lower days outstanding accounts receivable balance and a $1.2 million improvement in cash provided by accounts payable related to increased spending.

Net cash flows from investing activities used cash of $554 thousand in 2008 as compared to using cash of $2.3 million in 2007 and providing cash of $159 thousand in 2006.  Expenditures for property and equipment totaled approximately $554 thousand, $2.4 million and $1.2 million in 2008, 2007 and 2006, respectively.  The cash used in 2008 was entirely for purchases of property and equipment, which decreased from $1.8 million as compared to 2007.  A factor in the decrease was the launch of three major instruments in 2007 for which we capitalized demonstration and other units, with no corresponding instrument launches in 2008.  The cash used in 2007 was entirely for purchases of property and equipment, which increased from 2006 due to the purchases of demonstration units for the three new diagnostic instruments we launched in 2007 and increased purchases related to our Des Moines manufacturing operations in 2007 as compared to 2006.  In 2006, the sale of certain intellectual property generated cash, after related costs, of approximately

37

Table of Contents

$1.6 million which was slightly larger than approximately $1.5 million in capital expenditures and capitalized patent costs.

Net cash flows from financing activities used cash of $2.0 million in 2008 as compared to providing $4.2 million in 2007 and using $1.4 million in 2006.  In 2008 we used cash to reduce our borrowings under our line of credit by $1.6 million and repay principal on term debt of $776 thousand which was partially offset by proceeds from the issuance of common stock upon option exercises and in our Employee Stock Purchase Plan totaling $372 thousand.  In 2007, we increased our line of credit borrowings by $4.6 million and received $851 thousand from the issuance of common stock upon option exercises and in our Employee Stock Purchase Plan.  These cash inflows were somewhat offset by the repayment of principal on term debt of $1.3 million.  In 2006, we reduced our line of credit borrowings by $1.4 million and repaid principal on term debt of $763 thousand which was somewhat offset by $766 thousand in proceeds from the issuance of common stock upon option exercises and in our Employee Stock Purchase Plan.  Proceeds from the issuance of common stock decreased in 2008 as compared to 2007 and 2006 primarily due to lower proceeds from option exercises.  We repaid approximately $500 thousand more term debt in 2007 than in 2008 and 2006 because a $500 thousand term loan from a customer matured and was repaid in 2007.

At December 31, 2008, we had a $15.0 million asset-based revolving line of credit with Wells Fargo which has a maturity date of June 30, 2011.  At December 31, 2008, $11.0 million was outstanding under this line of credit.  Our ability to borrow under this line of credit varies based upon available cash, eligible accounts receivable and eligible inventory.  On December 31, 2008, interest was charged at a stated rate of prime plus 2.50% and was payable monthly.  We are required to comply with various financial and non-financial covenants, and we have made various representations and warranties.  Among the financial covenants is a requirement to maintain a minimum liquidity (cash plus excess borrowing base) of $1.5 million.  Additional requirements include covenants for minimum capital monthly and minimum net income quarterly.  Failure to comply with any of the covenants, representations or warranties could result in our being in default on the loan and could cause all outstanding amounts payable to Wells Fargo, including those discussed below, to become immediately due and payable or impact our ability to borrow under the agreement.  We were in compliance with all financial covenants as of December 31, 2008.  At December 31, 2008, our remaining available borrowing capacity based upon eligible accounts receivable and eligible inventory under our revolving line of credit was approximately $448 thousand.

At December 31, 2008, we also had outstanding obligations for long-term debt and capital leases totaling approximately $1.2 million primarily related to three term loans with Wells Fargo.  One term loan is secured by real estate in Iowa and had an outstanding balance at December 31, 2008 of approximately $269 thousand due in monthly installments of $17,658 plus interest.  The term loan had a stated interest rate of prime plus 2.50% on December 31, 2008 and is to be paid in full in April 2010.  The other two term loans are secured by machinery and equipment at our Des Moines, Iowa and Loveland, Colorado locations (the “Equipment Notes”).  Principal payments on the Equipment Notes of $46,296 plus interest are due monthly.  The Equipment Notes had a stated interest rate of prime plus 2.50% on December 31, 2008 and are to be paid in full in August 2010.  Our capital lease obligations totaled approximately $2 thousand at December 31, 2008.

At December 31, 2008, we had deferred revenue and other long term liabilities, net of current portion, of approximately $5.3 million.  Included in this total is approximately $3.8 million of deferred revenue related to up-front fees that have been received for certain product rights and technology rights out-licensed.  These deferred amounts are being recognized on a straight-line basis over the remaining lives of the agreements, products, patents or technology.

Our primary short-term need for capital, which is subject to change, is to fund our operations, which consist of continued sales and marketing, general and administrative and research and development efforts, working capital associated with increased product sales and capital expenditures relating to maintaining and

38

Table of Contents

developing our manufacturing operations.  Our future liquidity and capital requirements will depend on numerous factors, including the extent to which our marketing and selling efforts, as well as those of third parties who market, sell and distribute our products, are successful in increasing our revenue, the extent to which currently planned products and/or technologies under development are successfully developed and achieve market acceptance, changes required by us by regulatory bodies to maintain our operations and other factors.

Our financial plan for 2009 indicates that our available cash and cash equivalents, together with cash from operations and borrowings expected to be available under our revolving line of credit, will be sufficient to fund our operations through 2009 and into 2010.  Our financial plan for 2009 expects that we will have positive cash flow from operations.  However, our actual results may differ from this plan, and we may be required to consider alternative strategies, such as further reductions in our personnel costs.  We may be required to raise additional capital in the future.  If necessary, we expect to raise these additional funds through the sale of equity securities or refinancing loans currently outstanding on assets with historical appraised values significantly in excess of related debt.  There is no guarantee that additional capital will be available from these sources on acceptable terms, if at all, and certain of these sources may require approval by existing lenders.  If we cannot raise the additional funds through these options on acceptable terms or with the necessary timing, management could also reduce discretionary spending to decrease our cash burn rate through actions such as delaying or canceling budgeted research activities or marketing plans.  These actions would likely extend the then available cash and cash equivalents, and then available borrowings to some degree.  See “Risk Factors” in Item 1A of this Form 10-K for a discussion of some of the factors that affect our capital raising alternatives.

A summary of our contractual obligations at December 31, 2008 is shown below:

In addition to those agreements considered above where our contractual obligation is fixed, we are party to commercial agreements which may require us to make milestone payments under certain circumstances.  All milestone obligations which we believe are likely to be triggered but are not yet paid are included in “Unconditional Purchase Obligations” in the table above.  We do not believe other potential milestone obligations, some of which we consider to be of remote likelihood of ever being triggered, will have a material impact on our liquidity, capital resources or financial condition in the foreseeable future.

Net Operating Loss Carryforwards

As of December 31, 2008, we had a net domestic operating loss carryforward, or NOL, of approximately $166.4 million, a domestic alternative minimum tax credit of approximately $129 thousand and a domestic research and development tax credit carryforward of approximately $312 thousand.  Our NOL is scheduled to expire in various years beginning in 2010 and ending in 2028, with the majority scheduled to expire in 2018 or later.  The NOL and tax credit carryforwards are subject to alternative minimum tax limitations and to examination by the tax authorities.  In addition, we had a “change of ownership” as defined under the provisions of Section 382 of the Internal Revenue Code of 1986, as amended (an “Ownership Change”).  We believe the latest Ownership Change occurred at the time of our initial public offering in July 1997.

39

Table of Contents

We do not believe this Ownership Change will place a significant restriction on our ability to utilize our NOLs in the future.

Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board issued Statement of Financial Standards No. 157, “Fair Value Measurements” (“SFAS 157”).  SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with accounting principles generally accepted in the Untied States, and expands disclosures about fair value measurements.  This statement does not require any new fair value measurements; rather, it applies under other accounting pronouncements that require or permit fair value measurements.  The provisions of SFAS 157 are effective for fiscal years beginning after November 15, 2007 (beginning in 2008 for calendar year-end entities).  In February 2008, FSP 157-2 was issued which delayed application of SFAS No. 157 for non-recurring nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until fiscal years beginning after November 15, 2008, and interim periods within those fiscal years (beginning in 2009 for calendar year-end entities).  The adoption of the provisions of FSP 157-2 for non-recurring nonfinancial assets and nonfinancial liabilities will impact how those balances are measured, for example in the case of assessing impairment.  The adoption of SFAS No. 157 related to non-recurring, non-financial fair value measurements is not expected to have a material impact on the Company’s results of operations or financial position.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS No. 141(R)”).  Under SFAS No. 141(R), an entity is required to recognize the assets acquired, liabilities assumed, contractual contingencies and contingent consideration at their fair value on the acquisition date.  It further requires that acquisition-related costs are recognized separately from the acquisition and expensed as incurred, restructuring costs generally be expensed in periods subsequent to the acquisition date, and changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period impact income tax expense.  The adoption of SFAS No.141(R) will change the accounting treatment for business combinations on a prospective basis beginning in 2009 for calendar year-end entities.  The effects are presumed to be material to the accounting for future business acquisitions, if any, and will also increase future income statement volatility upon consummation of future business acquisitions.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51” (“SFAS No. 160”).  SFAS No. 160 changes the accounting and reporting for minority interests, which will be recharacterized as non-controlling interests and classified as a component of equity.  SFAS No. 160 is effective for business combinations with an acquisition date beginning in the first quarter of fiscal year 2009.  The adoption of SFAS No. 160 is not expected to have an impact on the Company’s consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161, “Disclosure about Derivative Instruments and Hedging Activities, an amendment of SFAS No. 133”, (“SFAS 161”).  SFAS No. 161 changes the disclosure requirements for derivative instruments and hedging activities.  Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under Statement 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows.  SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008 (beginning in 2009 for calendar year-end entities) with early application encouraged.  The adoption of SFAS No. 161 is not expected to have a material impact on the Company’s results of operations or financial position.

40

Table of Contents

Item 7A.  Quantitative and Qualitative Disclosures about Market Risk.

Market risk represents the risk of loss that may impact the financial position, results of operations or cash flows due to adverse changes in financial and commodity market prices and rates.  We are exposed to market risk in the areas of changes in United States and foreign interest rates and changes in foreign currency exchange rates as measured against the United States dollar.  These exposures are directly related to our normal operating and funding activities.

Interest Rate Risk

The interest payable on certain of our lines of credit and other borrowings is variable based on the United States prime rate and, therefore, is affected by changes in market interest rates.  At December 31, 2008, approximately $12.2 million was outstanding on these lines of credit and other borrowings with a weighted average interest rate of 5.75%.  We also had approximately $4.7 million of cash and cash equivalents at December 31, 2008, the majority of which was invested in liquid interest bearing accounts.  We had no interest rate hedge transactions in place on December 31, 2008.  We completed an interest rate risk sensitivity analysis based on the above and an assumed one-percentage point increase/decrease in interest rates.  If market rates increase/decrease by one percentage point, we would experience an increase/decrease in annual interest expense of approximately $75 thousand based on our outstanding balances as of December 31, 2008.

Foreign Currency Risk

Our investment in foreign assets consists primarily of our investment in our European subsidiary.  Foreign currency risk may impact our results of operations.  In cases where we purchase inventory in one currency and sell corresponding products in another, our gross margin percentage is typically at risk based on foreign currency exchange rates.  In addition, in cases where we may be generating operating income in foreign currencies, the magnitude of such operating income when translated into U.S. dollars will be at risk based on foreign currency exchange rates.  Our agreements with suppliers and customers vary significantly in regard to the existence and extent of currency adjustment and other currency risk sharing provisions.  We had no foreign currency hedge transactions in place on December 31, 2008.

We have a wholly-owned subsidiary in Switzerland which uses the Swiss Franc as its functional currency.  We purchase inventory in foreign currencies, primarily Japanese Yen and Euros, and sell corresponding products in U.S. dollars.  We also sell products in foreign currencies, primarily Japanese Yen and Euros, where our inventory costs are in U.S. dollars.  Based on our 2008 results of operations, if foreign currency exchange rates were to strengthen/weaken by 25% against the dollar, we would expect a resulting pre-tax loss/gain of approximately $900 thousand.

41

Table of Contents

Item 8.  Financial Statements and Supplementary Data.

HESKA CORPORATION

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

42

Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders

Heska Corporation:

We have audited the accompanying consolidated balance sheets of Heska Corporation and its subsidiaries as of December 31, 2007 and 2008, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2008.  In connection with our audit of these consolidated financial statements, we also have audited the financial statement schedule of valuation and qualifying accounts for the years ended December 31, 2006, 2007 and 2008.  We also have audited the Company’s internal control over financial reporting based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO Criteria”).  The Company’s management is responsible for these financial statements and schedule, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying management’s report.  Our responsibility is to express an opinion on these financial statements and the effectiveness of the Company’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects.  Our audit of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation.  Our audit of internal control included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances.  We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.  A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heska Corporation and its subsidiaries as of December 31, 2007 and 2008, and the results of their operations and their cash flows for each of the three years in the period ended

43

Table of Contents

December 31, 2008 in conformity with accounting principles generally accepted in the United States of America.  Also, in our opinion, the related consolidated financial statement schedule of valuation and qualifying accounts, for the years ended December 31, 2006, 2007 and 2008, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.  Also in our opinion, Heska Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008 based on the COSO Criteria.

Denver, Colorado

March 16, 2009

44

Table of Contents

HESKA CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except per share amounts)