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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO

Commission file number 000-27212

Endocare, Inc.

Registrant’s telephone number, including area code:     (949) 450-5400

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

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

Common Stock, $.001 par value

Rights to Purchase Shares of Participating Preferred Stock

      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.

      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

      The aggregate market value of the Common Stock of the Registrant held by non-affiliates on March 15, 2002 was approximately 332,974,312 (based on the closing price for shares of the Registrant’s Common Stock as reported by the Nasdaq National Market for that date). Shares of Common Stock held by each officer, director and holder of 10% or more of the outstanding Common Stock have been excluded in that such persons may be deemed affiliates. Exclusion of shares held by any person should not be construed to indicate that such person possesses the power, direct or indirect, to direct or cause the direction of management or policies of the Registrant, or that such person is controlled by or under common control with the Registrant.

      There were 22,135,835 shares of the Registrant’s Common Stock issued and outstanding as of March 15, 2002.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the Company’s Proxy Statement for the Annual Meeting of Stockholders to be held on June 13, 2002, to be filed with the Commission pursuant to Regulation 14A, are incorporated by reference into Part III of this Annual Report on Form 10-K.

      Certain exhibits filed with the Company’s prior registration statements and Forms 10-K, 8-K and 10-Q are incorporated herein by reference into Part IV of this Annual Report on Form 10-K.

Table of Contents

ENDOCARE, INC.

FORM 10-K

TABLE OF CONTENTS

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PART I

      This Annual Report on Form 10-K may contain forward-looking statements that involve risks and uncertainties. Such statements typically include, but are not limited to, statements containing the words “believes,” “intends,” “anticipates,” “expects,” “estimates,” “should,” “planned” and words of similar import. Our actual results could differ materially from any such forward-looking statements as a result of risks and uncertainties, including those set forth below in “Risks Related to Our Business” and in other documents we file from time to time with the Securities and Exchange Commission, including our Quarterly Reports on Form 10-Q. Any such forward-looking statements reflect our management’s opinions only as of the date of this Annual Report on Form 10-K, and we undertake no obligation to revise or publicly release the results of any revisions to any such forward-looking statements. Readers should carefully review the risk factors set forth below in “Risks Related to Our Business” and in other documents we file from time to time with the Securities and Exchange Commission, including our Quarterly Reports on Form 10-Q.

      The Argon Advantage^TM, C3®, CryoBeam^TM, CryoSeed^TM, Cryocare®, Cryocare Surgical System^TM, CryoDisc^TM, Cryoguide^TM, Dura II^TM, EasyFlo^TM, Endocare®^TM, ErecAid®, Esteem®, FastTrac^TM, Horizon Prostatic Stent^TM, ProDynamic^TM, RigiScan®, SmartTemp^TM, SnapGauge^TM, StayErec^TMStepFree^TM, Targeted Ablation^TM, Targeted Ablation of the Prostate TAP®, Targeted Ablation Therapy TAT®, Targeted Cryoablation of the Prostate TCAP®, Targeted Cryoablation Therapy TCAT®, TEMPprobe^TM, ThermaStent^TM, and UroBreeze^TM are trademarks of Endocare, Inc. or its wholly-owned subsidiary, Timm Medical Technologies, Inc. This Annual Report on Form 10-K may also include trademarks and trade names owned by other parties, and all other trademarks and trade names mentioned in this Annual Report on Form 10-K are the property of their respective owners.

Overview

      We are a medical device company focused on developing, manufacturing and selling urological healthcare products with the potential to dramatically improve men’s health and quality of life. Our primary focus is on the diagnosis, treatment and monitoring of the two most common diseases of the prostate, prostate cancer and benign prostate hyperplasia, or BPH, which is a non-cancerous enlargement of the innermost part of the prostate. Our FDA-cleared Cryocare Surgical System occupies a leading position in the market for the cryosurgical treatment of prostate cancer. We are currently developing a urologic stent, the Horizon Prostatic Stent, designed to provide temporary and immediate relief for BPH patients. In February 2002, we expanded our urological product offerings by acquiring Timm Medical Technologies, Inc., or Timm Medical. Through this acquisition, we now own or have acquired marketing rights to an additional product used in the treatment of BPH, five products used in the diagnosis and treatment of erectile dysfunction, six products used in the diagnosis and management of urinary incontinence and one product used in the diagnosis of bladder cancer. This acquisition also increased our sales and marketing organization from 26 to approximately 80 people, including 55 field sales representatives. Our strategy is to increase sales of our current products through targeted sales and marketing efforts, to continue to develop and obtain regulatory approval for our Horizon Prostatic Stent and to develop and acquire additional products in urology that leverage our existing sales and marketing organization.

      Prostate Cancer: Our Cryocare Surgical System is a minimally invasive cryosurgical system for the targeted treatment of prostate cancer. In fiscal year 2001, we derived substantially all of our revenues from the sale of Cryocare Surgical System units and from recurring sales of disposable supplies used with the Cryocare Surgical System. We intend to increase sales by generating additional physician and patient awareness of the efficacy and advantages of our Cryocare Surgical System. The key elements of our Cryocare Surgical System include our patented real time temperature monitoring system, our Cryoguide computer-controlled ultrasound guidance and planning system and our disposable cryoprobes and guidewires. Careful monitoring of the temperature around the prostate and optimal positioning of the cryoprobes enables physicians to destroy cancer with relatively minimal risk to surrounding healthy tissue. We began selling our Cryocare Surgical System in July 1999 following Medicare’s initiation of national reimbursement coverage of cryosurgery for the

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      In addition to our Cryocare Surgical System, we have a right to market and sell to urology practices in the United States a proprietary prostate cancer test developed by Qualigen, Inc., the FastPack® System. The office-based FastPack System delivers accurate test results within 15 minutes. We also are developing a unique prostate biopsy tool, which we expect will allow physicians to more accurately locate and stage prostate tumors.

      Benign Prostate Hyperplasia: We are developing a proprietary urologic stent, the Horizon Prostatic Stent, to provide temporary and immediate relief for patients who undergo thermal therapies or other procedures to treat BPH. BPH is a non-cancerous enlargement of the innermost part of the prostate. Patients suffering from BPH often experience a frequent urge to urinate because of their inability to completely empty their bladder, a burning sensation or similar discomfort during urination and a general lack of control over initiating and ending urination. Our Horizon Prostatic Stent employs shape memory, a metallurgical property that causes the stent to enlarge and harden when heated and to shrink and soften when cooled. As a result of shape memory, our Horizon Prostatic Stent is soft and flexible during insertion, and then expands into the shape of a rigid tube when heated by the body. The stent can be removed easily by a physician by flushing cool water through the stent, which allows the stent to return to its pre-insertion relaxed state.

      We are exploring the use of our Horizon Prostatic Stent for the long-term relief of BPH without the need for thermal therapy or other treatment procedures in a subset of the patient population. We also are exploring the development of a stent, named the ThermaStent, that will deliver heat to destroy excess prostate tissue in patients with moderate to severe cases of BPH. We believe the potential advantage of the ThermaStent will be to provide patients with both immediate relief and a long-term cure for BPH in a one-step process.

      Through our acquisition of Timm Medical, we obtained rights to distribute to urologists in North America a non-surgical, office-based thermal therapy for BPH developed by ArgoMed, Inc., the Thermoflex® System. The Thermoflex System utilizes a proprietary catheter and console to deliver heated water to destroy excess prostate tissue and reopen the urethra’s path through the prostate. The distribution agreement with ArgoMed may be terminated by either party without cause after June 30, 2002.

      Erectile Dysfunction: With our acquisition of Timm Medical, we now market five products used in the diagnosis and treatment of erectile dysfunction. Our two diagnostic tools include the RigiScan Monitor and the SnapGauge. The RigiScan Monitor is an ambulatory device that measures the frequency, rigidity and duration of both nocturnal and provocative erections. The SnapGauge is a disposable, single-use diagnostic device used to confirm maximum rigidity achieved during nocturnal erections.

      We also offer a leading line of vacuum therapy systems and a prosthetic device for the treatment of erectile dysfunction. Our vacuum therapy systems include the Esteem, the StayErec and the ErecAid Systems. The Dura II Penile Prosthesis is a positionable, concealable penile prosthesis which consists of two cylinders that are surgically implanted to impart penile rigidity.

      Urinary Incontinence: With the acquisition of Timm Medical, we now offer six products used in the diagnosis and management of urinary incontinence in both men and women. Our diagnostic products consist of the ProDynamic Monitor, the UroBreeze Urodynamics Monitor and the EasyFlo Uroflowmetry System. These monitoring systems measure bladder, abdominal and urethral pressures to help physicians determine the cause of urinary incontinence and track the progress of treatments. We also offer a line of disposable products, such as catheters and tubing kits, for use with these monitors. We also have exclusive North American distribution rights to the urodynamic products, including the Andromeda Ellipse Monitor, developed by Andromeda Medizinische Systeme, Gmbh of Munich, Germany.

      We also offer two proprietary, non-invasive products for the management of urinary incontinence. Our patented C3 device is used to control mild to moderate male incontinence through an external cuff that compresses and occludes the urethra. Our StepFree System is a pelvic muscle-toning program using vaginal weights to improve female bladder control. In addition to these diagnosis and management products, Timm

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      Bladder Cancer: As part of our acquisition of Timm Medical, we obtained exclusive distribution rights to urologists in the United States to a bladder cancer detection test developed by Matritech, Inc., the NMP22^TM POC Test. The NMP22 POC Test will allow urologists to test their patients for bladder cancer in their office. The FDA is currently reviewing Matritech’s 510(k) application for the NMP22 POC Test.

      Additional Cryosurgical Markets: We believe our proprietary cryosurgical technologies have broad applications across a number of surgical markets, including the treatment of tumors in the kidney, lung, breast, liver and bones, as well as the treatment of cardiac arrhythmias. In October 1999, we formed a strategic alliance with Sanarus Medical, Inc. to commercialize our proprietary cryosurgical technology for the treatment of breast cancer, benign breast tumors and gynecological diseases. We received FDA clearance in October 2001 for the use of our cryosurgical system for the treatment of benign breast tumors. Sanarus intends to market this product as the Visica^TMTreatment System. In September 2001, we formed a strategic alliance with CryoCath Technologies Inc. to market, sell and distribute our proprietary cryosurgical technology for the treatment of cardiac arrhythmias. In February 2002, we received FDA clearance for use of our cryosurgical technologies for the treatment of cardiac arrhythmias. CryoCath intends to market this product as the SurgiFrost^TM System. In addition to these two strategic alliances, we intend to continue to enhance and leverage our cryosurgical technology platform by partnering with third parties who can effectively develop, distribute or otherwise commercialize our technology in clinical areas outside of urology.

      We were incorporated under the laws of the State of Delaware in May 1994. We maintain our executive offices at 201 Technology, Irvine, California 92618, and our telephone number at that address is (949) 450-5400. Financial information regarding our financial condition and results of operations can be found in a separate section of this Annual Report on Form 10-K, beginning on page F-1.

Prostate Cancer

      The prostate is a walnut size gland surrounding the male urethra, located below the bladder and adjacent to the rectum. Prostate cancer is a malignant tumor that begins most often in the periphery of the gland and, like other forms of cancer, may spread beyond the prostate to other parts of the body. If left untreated, prostate cancer can metastasize to the lung or bone, resulting in death.

      The incidence of prostate cancer has risen steadily since 1980 to become the second most common cause of cancer-related deaths among men. Prostate cancer is most prominent in North America and northwestern Europe and less common in Asia, Africa, Central America, and South America. The American Cancer Society estimates there will be about 189,000 new cases of prostate cancer diagnosed and an estimated 30,200 deaths associated with the disease in the United States during 2002. Prostate cancer incidence and mortality increase with age. Prostate cancer is found most often in men who are over the age of 50. According to the American Cancer Society, more than 70% of men diagnosed with prostate cancer are over the age of 65. In addition to age, other risk factors are linked to prostate cancer, such as genetics and diet.

      The dramatic increase in prostate cancer cases has led to heightened awareness of the disease, which has led to increased rates of testing and improved diagnostic methods. The American Cancer Society recommends that men without symptoms, risk factors and a life expectancy of at least ten years should begin regular annual medical exams at the age of 50, and believes that the physicians should offer as a part of the exam, the prostate-specific antigen, or PSA, blood test and a digital rectal examination in which the physician places a gloved finger into the rectum and examines the prostate for lumps. The PSA blood test determines the amount of prostate specific antigen present in the blood. PSA is found in a protein secreted by the prostate, and elevated levels of PSA can be associated with either prostatitis, a non-cancerous inflammatory condition, or a proliferation of cancer cells in the prostate. Transrectal ultrasound tests and biopsies are typically performed on patients with elevated PSA readings to confirm the existence of cancer.

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      Over 85% of prostate cancer patients are eligible for our cryosurgical treatment. The U.S. market for prostate cancer treatment for newly diagnosed patients is estimated to be approximately $1.3 billion in 2001 and is expected to grow to $2 billion by 2006. We believe the market for secondary cryosurgical treatment of patients with recurring prostate cancer is significant.

      Therapeutic alternatives for patients with prostate cancer have been both limited and unattractive. Current treatment options include radical surgery, radiation therapy, hormone or other ancillary therapies, “watchful waiting” and cryotherapy. These options are evaluated using a number of criteria, including the patient’s age, physical condition and stage of the disease. Due to the slow progression of the disease, however, the decision for treatment typically is based upon the severity of the condition and the resulting quality of life.

      Radical prostatectomy has been used for over 30 years and is most often the therapy of choice due to the surgeon’s high degree of confidence in surgically removing the cancerous tissue, particularly for patients having more advanced stages of the disease. The procedure is dependent on the skill of the surgeon and is often associated with relatively high rates of impotence and incontinence and can result in operative mortality.

      Radiation therapy for prostate cancer includes both external radiation beam and interstitial radioactive seed therapies. External beam radiation therapy emerged as one of the first alternatives to radical prostatectomy; however, studies have shown that the success rate of this procedure is not comparable to that of radical prostatectomy. Interstitial radioactive seed therapy, also referred to as brachytherapy, is the permanent placement of radioactive seeds in the prostate. Brachytherapy has been shown to be most effective for localized tumors caught in the early stage of disease development.

      Ancillary therapies, primarily consisting of hormone therapy and chemotherapy, are used to slow the growth of cancer and reduce tumor size, but are generally not intended to be curative. Ancillary therapies are often used during advanced stages of the disease to extend life and to relieve symptoms. Side effects of hormonal drug therapy include increased development of breasts, impotence and decreased libido. In addition, many hormone pharmaceuticals artificially lower PSA levels in patients, which can interfere with the staging of the disease and monitoring its progress. Side effects of chemotherapy include nausea, hair loss and fatigue. Drug therapy and chemotherapy require long-term, repeated administration of medication on an outpatient basis.

      “Watchful waiting” is recommended by some physicians in some circumstances based upon the severity and growth rate of the disease, as well as the age and life expectancy of the patient. The aim of watchful waiting is to monitor the patient, treat some of the attendant symptoms and determine when more active intervention is required. Watchful waiting has gained popularity among those patients refusing treatment due to side effects associated with radical prostatectomy. Watchful waiting requires periodic physician visits and PSA monitoring.

      Cryosurgery, freezing tissue to destroy tumor cells, was first developed in the 1960’s. During this period, the use of “cold probes,” or cryoprobes, was explored as a method to kill prostate tissue without resorting to radical surgery. Although effective in killing cancer cells, the inability to control the amount of tissue frozen during the procedure prevented broad use and development of cryotherapy for prostate cancer. These initial negative experiences with cryosurgery continue to contribute to a lack of widespread acceptance of the procedure today.

      In the late 1980’s, progress in ultrasound imaging allowed for a revival in the use of cryosurgery. Using ultrasound, the cryoprobe may be guided to the targeted tissue from outside the body through a small incision. The physician activates the cryoprobe and uses ultrasound to monitor the growth of ice in the prostate as it is occurring. When the ice encompasses the entire prostate, the probe is turned off. This feedback mechanism of watching the therapy as it is administered allows the physician more precise control during application. Published studies suggest that cryosurgery may be able to deliver disease free rates comparable to radical

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      We have developed our proprietary Cryocare Surgical System, a next-generation cryosurgery system, to allow urologists to treat prostate cancer in a minimally invasive manner. We designed the Cryocare Surgical System to freeze tissue much faster and with more control than previous cryosurgical systems.

      The Cryocare Surgical System incorporates enhanced control mechanisms to minimize the risk of unintended damage to tissue surrounding the prostate. The argon gas-based cryoprobes stop freezing instantly. Use of six to eight temperature probes selectively placed in the prostate near the rectal tissue, sphincter muscles, which control continence, and neurovascular bundles, which control potency, enables the physician to monitor temperatures of tissue adjacent to the prostate in real time.

      The majority of our cryosurgical procedures to date have been performed in medium to high risk patients. In these procedures, the urologist intentionally ablates the neurovascular bundles to prevent the recurrence of cancer, typically resulting in impotence. We are attempting to develop a nerve sparing procedure for lower risk patients through a combination of early detection and improved surgical techniques.

      Our Cryoguide, a software controlled ultrasound planning and mapping system sold as an accessory to the Cryocare Surgical System, is a significant advancement in targeted cryoablation of the prostate. The Cryoguide control unit consists of a computer console and display screen designed to be compatible with standard ultrasound equipment. The Cryoguide allows physicians to visualize the prostate in three dimensions and uses a grid system to facilitate the precise placement of our cryoprobes in the optimal position in the prostate. Our Cryoguide incorporates a visualization and planning process allowing the surgeon to simulate cryoablation of the prostate. This simulation allows validation of the positioning of the cryoprobes prior to initiating treatment and tailoring the iceball formation for individual patients, improving patient outcomes. The Cryoguide creates a standardized repeatable procedure and decreases procedural time.

      We are continually evaluating and implementing technology that will refine and improve the Cryocare Surgical System. Our proprietary cryoprobes are engineered to produce consistently sculpted ice conforming to the unique anatomy of the prostate. Our efficient argon gas-based system delivers lethal ice in a controllable and repeatable fashion. We also developed a percutaneous access device, named FastTrac, which allows a simplified one-step insertion of our cryoprobes to significantly reduce procedure time.

      The Cryocare Surgical System has been cleared for marketing by the FDA. We commercially launched the Cryocare Surgical System in July 1999 following the initiation of national Medicare coverage for cryosurgical procedures as a primary treatment alternative for localized prostate cancer. Through direct sales and our placement program, we have installed Cryocare Surgical Systems primarily in North America, with over 2,500 patients treated to date. Effective July 1, 2001, the Healthcare Financing Administration, now the Centers for Medicaid and Medicare Services, or CMS, approved national Medicare coverage for secondary cryosurgical treatment of prostate cancer patients who have failed radiation therapy.

      Cryosurgery is the first minimally invasive procedure that urologists can perform themselves. With radiation therapies, urologists must refer the patient for treatment to a radiation oncologist. Cryosurgery offers the urologist both the opportunity to maintain continuity of patient care and to generate additional revenue.

      Our Cryocare Surgical System provides the following significant clinical advantages relative to other principal treatment options for prostate cancer:

	•	Effective for a broad range of low to high risk prostate cancer patients. In low risk cases, the success of cryosurgery, including our Cryocare Surgical System, is comparable to radiation therapy. In medium to high risk cases, results of cryotherapy appear to be superior to brachytherapy and are comparable to radiation therapy.

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	•	High quality of life following treatment. Our minimally invasive procedure offers patients short recovery periods and we believe may result in a lower incidence of certain side effects, including incontinence.
	•	Treatment of patients who have failed radiation therapy. Patients who have failed radiation therapy have limited options. Cryosurgery is a potentially curative treatment option that can be used to treat these patients effectively with fewer side effects than surgery.
	•	Treatment can be performed more than once. Unlike radiation therapy, cryosurgery can be repeated if the cancer recurs.

     Diagnosis and Monitoring of Prostate Cancer

      Heightened awareness of prostate cancer has led to increased rates of testing and improved diagnostic and monitoring methods. To this end, we acquired a right to market and sell to urology practices in the United States the FastPack System, a proprietary, PSA test developed by Qualigen, Inc. The FastPack System delivers accurate results within 15 minutes in the urologist’s office. The FastPack System consists of the FastPack Analyzer and the FastPack, a disposable, single-use test pack. The FastPack Analyzer is fully automated and features one-button operation. The FastPack is a multi-chambered plastic pouch that contains all of the chemical reagents needed for a single test. To perform the test, the physician inserts a sample of the patient’s blood in the FastPack and places the pack in the FastPack Analyzer, which automatically completes the test. Qualigen has received FDA clearance for the FastPack System. We also are developing a unique prostate biopsy tool, which we expect will allow physicians to more accurately locate and stage prostate tumors.

Benign Prostate Hyperplasia

     Market Background

      BPH, which affects a significant number of adult men, is a non-cancerous enlargement of the innermost part of the prostate. BPH frequently results in a gradual squeezing of the part of the urethra which runs through the prostate. This causes patients to experience a frequent urge to urinate because of the incomplete emptying of the bladder and a burning sensation or similar discomfort during urination. The obstruction of urinary flow can also lead to a general lack of control over urination, including difficulty initiating urination when desired as well as difficulty preventing urinary flow because of the residual volume of urine in the bladder, a condition known as urinary incontinence. BPH symptoms may disturb sleep by causing the BPH sufferer to awaken frequently to urinate. Although symptoms occasionally stabilize or diminish without intervention, they generally become more severe over the course of the disease. Left untreated, the obstruction caused by BPH can lead to acute urinary retention, the complete inability to urinate, serious urinary tract infections and, in severe cases, permanent bladder and kidney damage.

      Most males will eventually suffer from BPH. In the United States, the incidence of BPH for men in their fifties is approximately 50% and rises to approximately 80% by the age of 80. The general aging of the United States population, as well as increasing life expectancies, is anticipated to contribute to the continued growth in the number of BPH sufferers. It is estimated that approximately 12 to 25 million men worldwide suffer from the symptoms of BPH.

      Patients diagnosed with BPH generally have four options for treatment: “watchful waiting,” drug therapy, surgical intervention and new, less-invasive thermal therapies. Treatment is generally reserved for patients with intolerable symptoms or those with significant potential symptoms if treatment were withheld. A large number of patients delay discussing their symptoms or elect “watchful waiting” to see if the condition remains tolerable. We believe the development of less invasive procedures for treatment of BPH could result in a substantial increase in the number of BPH patients who elect to receive interventional therapy.

      Drugs therapies involve drugs designed to shrink the prostate by inhibiting or slowing the growth of prostate cells. Other drugs are designed to relax the muscles in the prostate and bladder neck to relieve

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      Transurethral resection of the prostate, or TURP, is the most common surgical procedure and involves the removal of the prostate’s innermost core in order to reduce pressure on the urethra. TURP is performed by introducing an electrosurgical cutting loop through a cystoscope into the urethra and “chipping out” both the prostatic urethra and surrounding prostate tissue up to the surgical capsule, thereby completely clearing the obstruction. The average TURP procedure requires a hospital stay of approximately four days.

      Other technologies developed or under development are non-surgical, catheter-based therapies that use thermal energy to preferentially heat diseased areas of the prostate to a temperature sufficient to cause tissue death. Thermal energy forms being utilized include microwave, radio frequency, ultrasound energy and heated water. The procedures are typically performed in an outpatient setting under local anesthesia.

     Our Stent Technology for BPH

      We are developing a proprietary urologic stent, the Horizon Prostatic Stent, to provide temporary and immediate relief for patients who undergo thermal therapy or other procedures to treat BPH. Our Horizon Prostatic Stent is made of nitinol, a titanium metal alloy that employs a metallurgical property named shape memory. This shape memory property causes the Horizon Prostatic Stent to be soft and flexible in its relaxed state, allowing a physician to introduce and position the device in a relatively pain-free manner using a catheter. When the device is heated naturally by the body after insertion, the device expands and hardens into the shape of a rigid tube, or stent. A catheter is inserted using a local anesthetic and positioned in the prostatic urethra under direct vision. After approximately 30 days, a physician can remove the stent by flushing cool water through the working channel of a cystoscope, causing the stent to return to its pre-insertion relaxed state. The design of the Horizon Prostatic Stent allows physicians to insert and remove the device in an outpatient setting under local anesthesia. We have received a CE Mark for the Horizon Prostatic Stent, and have begun to market the Horizon Prostatic Stent through our European distributors.

      The FDA has determined that our Horizon Prostatic Stent requires premarket approval, or PMA, prior to commercialization in the United States. We have completed a feasibility study for the Horizon Prostatic Stent, and received approval from the FDA to commence a pivotal study, which is the final study before we submit our PMA application. We divided our PMA application into three modules. We filed the first PMA module, manufacturing, with the FDA in December 2001, and the second PMA module, pre-clinical testing, in February 2002. Although the process is uncertain, we anticipate filing the last PMA module during 2002. Nevertheless, the PMA process generally takes between one and three years from completion of an application or even longer. In addition, achieving a completed application is a process that may take numerous clinical trials and require filing of amendments over time. Therefore, our Horizon Prostatic Stent may not be commercially available for a number of years.

      We are exploring the use of our Horizon Prostatic Stent for the long-term relief of BPH without the need for thermal therapies or other treatment procedures in a subset of the patient population. We also are exploring the development of a stent, the ThermaStent, that physicians can use to deliver heat to destroy excess prostate tissue in patients with moderate to severe BPH. We believe the potential advantage of the ThermaStent will be to provide patients with both immediate relief and a long-term cure for BPH in a one-step process.

     Thermal Therapy for BPH

      Through our acquisition of Timm Medical, we obtained rights to distribute to urologists in North America a non-surgical, office-based thermal therapy for BPH developed by ArgoMed, Inc., the Thermoflex System. The Thermoflex System utilizes a proprietary disposable catheter and console to deliver heated water to destroy excess prostate tissue and reopen the urethra’s path through the prostate. Because the Thermoflex System is based on heated water, it is less expensive to manufacture than other thermal therapy systems. In addition, the conductive heat used in the Thermoflex System is easier to control than radiant heat used by other thermal therapies, which should allow better treatment results. Most patients do not require general

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Erectile Dysfunction

     Market Background

      Erectile dysfunction, or impotence, is the inability to achieve or maintain an erection firm enough, or for a sufficient amount of time, for sexual intercourse. Worldwide sales for erectile dysfunction products are estimated at $1.2 billion annually. Approximately 30 million men in the United States suffer from erectile dysfunction, primarily those over the age of 40. A variety of physical and psychological conditions can cause erectile dysfunction, including diabetes, high blood pressure, high cholesterol, nervous system disorders, complications from surgery, medication, alcoholism, spinal cord injuries, depression and other psychological conditions. Erectile dysfunction is most often caused by physical problems, rather than psychological problems.

      Men suffering from erectile dysfunction generally have five treatment options: drug therapy, vacuum systems, needle injection therapy, urethral suppositories and penile implants. Historically, it is estimated that fewer than 10% of men afflicted with erectile dysfunction sought treatment for their condition. The introduction and advertising of Viagra by Pfizer Inc. in 1998, however, significantly increased the population of patients seeking treatment. This trend is expected to continue during the next five years as patients become increasingly comfortable in seeking treatment. Although the success of Viagra has had a positive impact on the diagnosis and treatment of patients suffering from erectile dysfunction, a significant number of patients do not respond to Viagra, experience side effects or are not proper candidates for Viagra or other drug therapies. We believe that these patients will turn to alternative treatments for erectile dysfunction, including vacuum systems and penile implants.

     Our Erectile Dysfunction Offerings

      Through our acquisition of Timm Medical, we now have an erectile dysfunction product line consisting of diagnostic and treatment products.

     Diagnostic Products

      We now market a leading line of diagnostic tools for erectile dysfunction, including the RigiScan Monitor and the SnapGauge. The RigiScan Monitor is an ambulatory diagnostic tool used to measure the frequency, rigidity and duration of both nocturnal and provocative erections. The RigiScan Monitor allows a physician to review a patient’s nocturnal erection session, reaction to visual erectile stimuli and reaction to drug therapies. The SnapGauge is a disposable diagnostic device used to confirm maximum rigidity achieved during nocturnal erections. Both of these products provide a non-threatening, non-invasive, cost-effective method for a physician to measure the severity of a patient’s erectile dysfunction.

     Treatment Products

      We also offer a leading line of vacuum therapy systems and a penile implant for the treatment of erectile dysfunction. Even with the success of drug therapies, these product lines continue to appeal to a growing patient population. Target patient populations include individuals who have not responded to or have conditions contraindicated for existing drug therapies, patients who are not eligible for third-party reimbursement under their present healthcare plans and those patients concerned with the side-effects of drug therapies.

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      We hold a leading market position in vacuum therapy systems. We offer a full line of products, including the Esteem, StayErec and ErecAid Systems. Vacuum therapy involves the use of a mechanical system that creates a vacuum around the penis, causing the erectile bodies to fill with blood. A constriction ring is then placed around the base of the penis to impede blood drainage and maintain the erection. These systems are over 90% effective and represent a low cost treatment for erectile dysfunction. We are reviewing various revenue opportunities in this market, including the development and distribution of new accessories for our existing vacuum therapy systems.

      In addition to our vacuum therapy systems, we offer a penile implant, the Dura II Penile Prosthesis, which consists of two cylinders that are surgically implanted to impart penile rigidity. The Dura II has a patented, segmented design making positioning quick and easy while providing satisfactory rigidity and excellent concealment. The one-piece construction of the Dura II simplifies the implantation procedure. Patients generally receive the Dura II under local anesthesia on an outpatient basis.

Urinary Incontinence

     Market Background

      Urinary incontinence is the inability to control the release of urine from the body. Incontinence represents one of the largest underserved urology markets. Urinary incontinence afflicts approximately 11 million women and two million men in the United States. A wide range of factors can cause incontinence, including weakened pelvic muscles, tumors or other cancers, surgery, obesity, drugs and neurological damage. Childbirth and menopause are additional causes of incontinence in women. Patients with mild incontinence attempt to manage their incontinence condition through the use of diapers and absorbent pads, behavioral therapy, pelvic muscle strengthening, urethral inserts and clamps or, for men, a catheter and a urinary drainage bag. Patients with moderate to severe incontinence typically find management of their incontinence unacceptable and attempt to treat their incontinence with injectable bulking materials or surgical solutions, including bladder neck slings and artificial urinary sphincters.

     Our Urinary Incontinence Offerings

      Through our acquisition of Timm Medical, we now have a urinary incontinence product line consisting of diagnostic equipment and management products for both men and women. In addition to these diagnostic and management products, Timm Medical was developing, and we intend to continue to develop, additional products for the treatment of incontinence in men and women.

     Diagnostic Products

      Our diagnostic products consist of our UroBreeze Urodynamics Monitor, the ProDynamic Monitor and the EasyFlo Uroflowmetry System. These monitoring systems measure bladder, abdominal and urethral pressures to help physicians determine the cause of urinary incontinence and track the progress of treatments. The UroBreeze Urodynamics Monitor is a lightweight, portable urodynamic monitor that provides up to five channels of testing information. The ProDynamic Monitor is a larger urodynamic monitor that provides up to seven channels of testing information, and is typically sold to hospitals and large physician offices. The EasyFlo Uroflowmetry System is a lower cost ambulatory monitor used in the evaluation of urine flow. We also offer a line of disposable products, such as catheters and tubing kits, for use with these monitors. Our incontinence diagnostic equipment line enjoys a strong industry reputation, rooted in a 25-year history of reliability, advanced functionality and innovation.

      We also have exclusive North American distribution rights to the urodynamic products, including the Andromeda Ellipse Monitor, developed by Andromeda Medizinische Systeme, Gmbh of Munich, Germany. The Andromeda Ellipse Monitor is a sophisticated urodynamic monitor that provides up to eight channels of testing information, and includes video urodynamic capabilities.

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     Management Products

      We offer two management products for urinary incontinence that are non-invasive and represent either a bridge towards a permanent treatment for incontinence or restore continence utilizing natural methods. Our patented C3 device is used to control mild to moderate male incontinence through an external cuff that compresses and occludes the urethra. The C3 offers men a comfortable, hygienic and discrete method of controlling their incontinence condition. Each device can be used for up to 10 days. Our patented StepFree System is a pelvic muscle-toning program for improving female bladder control. The StepFree System consists of a series of vaginal weights designed to facilitate the proper performance of a woman’s pelvic muscles, which play an important role in urinary control. The StepFree System is a home-based program designed to be a part of a woman’s normal routine and provides demonstrable progress through graduated weight goals and benchmarks.

Bladder Cancer

     Market Background

      According to the American Cancer Society, there will be about 56,500 new cases of bladder cancer diagnosed in the United States in 2002, and an estimated 12,600 deaths. Bladder cancer is four times more prevalent in men than women, and typically occurs in patients over the age of 55. With average Medicare costs in excess of $58,000 per patient, bladder cancer is the most expensive form of cancer to treat. Early detection of bladder cancer is a key factor in improved survival. For patients diagnosed with localized disease, the five-year relative survival rate is 94%. For patients whose cancer is regional or distant, the five-year survival rates drop to 48% and 6%, respectively. Only 74% of bladder cancers are currently detected in the early stage according to the American Cancer Society.

      Current standard diagnostic techniques include cystoscopy and urine cytology. Cystoscopy is a procedure performed in a physician’s office under local anesthesia in which a fiber optic tube is inserted into the bladder through the urethra. Urine cytology is a laboratory test where a microscope is used to analyze abnormal bladder cells that may be shed into the urine. Urine cytology has a very low sensitivity for diagnosing bladder cancer, typically about 30%, with inconclusive results being common.

     Our Bladder Cancer Offering

      As part of our recent acquisition of Timm Medical, we obtained exclusive distribution rights to urologists in the United States to a bladder cancer detection test developed by Matritech, Inc., the NMP22 POC Test. The NMP22 POC Test will allow doctors to test their patients for bladder cancer in their office. The test is performed on a single voided urine sample, and is twice as sensitive as urine cytology. The FDA is currently reviewing a 510(k) application for the NMP22 POC Test. Matritech previously received FDA approval for a lab-based version of the NMP22 POC Test.

Strategy

      Our goal is to become a leading medical device company in the area of urology, and to apply our proprietary cryosurgical technology across horizontal markets. Key elements of our strategy are to:

	•	Maximize the Market Opportunity for Our Cryocare Surgical System in the Treatment of Prostate Cancer. Since our inception we have focused considerable resources on establishing our Cryocare Surgical System as a primary treatment option for prostate cancer. We intend to continue to dedicate significant effort to:

	•	educate physicians and patients regarding the advantages of our Cryocare Surgical System;
	•	demonstrate the safety and efficacy of cryosurgery as a primary treatment for prostate cancer;
	•	demonstrate the safety and efficacy of cryosurgery as a secondary treatment in treating patients that have failed radiation therapy;

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	•	maximize reimbursement for cryosurgery;
	•	market the product to physicians and hospitals through our direct sales force;
	•	provide physician training; and
	•	improve our Cryocare Surgical System so that it is easier to use.

	•	Leverage our Acquisition of Timm Medical. Through our acquisition of Timm Medical, we acquired or obtained marketing rights for an additional product used in the treatment of BPH, five products used in the diagnosis and treatment of erectile dysfunction, six products used in the diagnosis and management of urinary incontinence and one product used in the diagnosis of bladder cancer. We also increased our sales and marketing organization from 26 people to approximately 80 people, including 55 field sales representatives. The sales force we acquired from Timm Medical is the only urology-focused sales force that is accredited by the Certification Board of Urology Nurses and Associates, or CBUNA, a certification process that includes extensive ongoing training by physicians and industry professionals. We intend to use this targeted sales force to aggressively market our Cryocare Surgical System and other urological products to the approximately 8,000 urologists in the United States.
	•	Develop New and Innovative Medical Products. We believe that our stent technology represents a potentially significant advance for treating the symptoms of BPH. We are developing this technology in three ways:

	•	We plan to conduct a pivotal trial of our Horizon Prostatic Stent for temporary use, in combination with other therapies and alone.
	•	We plan to conduct a clinical study of our Horizon Prostatic Stent for long-term use, without the need for any other therapy.
	•	We plan to conduct preclinical studies of our ThermaStent device as a primary treatment that offers both a long-term cure and immediate relief for BPH.

	We are also developing our prostate biopsy product, our cardiac arrhythmia product and other horizontal applications of our proprietary cryosurgical technology. In addition, Timm Medical was developing, and we intend to continue to develop, additional products for the treatment of incontinence in men and women.

	•	Leverage our Cryosurgery Technology Platform. We intend to continue applying our proprietary cryosurgical technologies to surgical markets outside urology. We believe our cryosurgical technologies have broad applications across a number of surgical markets. We believe that these markets can be more cost effectively accessed through partners rather than through developing our own infrastructure. We formed a strategic alliance with Sanarus Medical, Inc. to develop our cryosurgical technology for the treatment of breast cancer, benign breast tumors and gynecological diseases. We also formed a strategic alliance with CryoCath Technologies Inc. to market our cryosurgical technology for the treatment of cardiac arrhythmia. We intend to continue to collaborate with well known medical device companies to develop and market non-urology applications.
	•	Continue to Acquire Complementary Urological Products and Technologies. In addition to our acquisition of Timm Medical, we intend to continue to acquire or license complementary products and technologies in the urology market. We believe we are well suited to identify, evaluate and attract these opportunities because of our focus in this market. By acquiring complementary urological products, we believe we will be able to leverage our urology sales force and product development expertise.

Strategic Alliances

      We use collaborative marketing arrangements and distribution alliances to market our Cryocare Surgical System. We also have entered into collaborative agreements providing us with the right to distribute products of others and to realize value in the application of our proprietary cryosurgical technology in non-urology applications.

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     Distribution Arrangement for Our Cryocare Surgical System

      U.S. Therapies, LLC: On June 30, 2001, we issued 213,010 shares of our common stock with a fair market value of $2,837,293 as consideration for a membership interest in the form of Class A Units of U.S. Therapies, LLC equal to approximately 9% of the total issued and outstanding Class A Units of U.S. Therapies and approximately 5% of the Class A Units on a fully-diluted basis. U.S. Therapies is a national urology group representing more than 150 urologists across the nation. We simultaneously entered into a distribution agreement with U.S. Medical Devices, Ltd., a subsidiary of U.S. Therapies, under which U.S. Medical Devices received exclusive sales rights to our Cryocare Surgical System and associated disposable products in 16 states. U.S. Medical Devices also has the exclusive right to distribute the Cryocare Surgical System to HealthTronics Surgical Services, Inc. (Nasdaq: HTRN) and its affiliates, a company that provides urologic and orthopedic services to patients in 35 states through physician partnerships. We have recorded net sales of $685,000 and $4,105,000 to U.S. Medical Devices for the three months and the 12 months ended December 31, 2001, respectively. These net sales constitute approximately 13% and approximately 26% of our revenues for the three and 12 months ended December 31, 2001, respectively.

     Distribution Arrangements for Additional Cryosurgical Markets

      Sanarus Medical, Inc.: In October 1999, we entered into a strategic alliance with Sanarus Medical, Inc. to commercialize our proprietary cryosurgical technology for the treatment of breast cancer, benign breast tumors and gynecological diseases. Sanarus is a private company focused on developing minimally-invasive solutions for total breast care management. The terms of the related agreements included a 5% equity investment by us in Sanarus totaling $300,000. We also received a warrant to acquire approximately 79% of Sanarus’ common stock at that time in consideration for entering into a manufacturing, supply and license agreement. In July 2001, Sanarus completed an equity financing. This financing along with other financings by Sanarus reduced our current ownership interest to 2% and our potential maximum ownership percentage in Sanarus to approximately 22% on a fully-diluted basis. We received FDA clearance in October 2001 for the use of our cryosurgical system for the treatment of benign breast tumors. Sanarus intends to market this product as the Visica Treatment System.

      CryoCath Technologies, Inc.: In September 2001, we entered into a five-year exclusive market access and supply agreement with CryoCath Technologies, Inc., a public company on the Toronto Stock Exchange focused on developing minimally invasive, catheter-based cryotherapy products to treat cardiovascular disease. Under this agreement, CryoCath obtained an exclusive, worldwide right to market, sell and distribute our cryosurgical technologies for the targeted treatment of cardiac arrhythmias. The agreement requires CryoCath to pay license fees and to make minimum product purchases. We are obligated under the agreement to undertake product development projects, maintain regulatory approval for the products in the United States and Europe and indemnify CryoCath in the event of some third party claims. We have the right to reduce CryoCath’s rights to a non-exclusive license if CryoCath fails to meet certain minimum purchase requirements. In February 2002, we received FDA clearance for use of our cryosurgical technologies for the treatment of cardiac arrhythmias. CryoCath intends to market the system as the Surgifrost System.

     Distribution Arrangements for Third Party Products

      Qualigen, Inc.: In June 2001, we signed an original equipment manufacturer agreement with Qualigen, Inc., a private company focused on developing advanced blood testing systems for point-of-care use. Under this agreement, we obtained the right to distribute Qualigen’s 15-minute total prostate specific antigen test, the FastPack System, as part of a urology diagnostic workstation we are developing. The agreement has a term of five years and includes one year of exclusivity with the option of four one-year extensions of exclusivity based upon minimum purchase commitments. In September 2001, we expanded our relationship with Qualigen by entering into a five-year distribution agreement. Under the distribution agreement, we obtained the non-exclusive right to market the Fastpack System as a stand-alone product directly to urology practices. After the expiration of the initial five-year term, the distribution agreement automatically renews for successive one-year terms until terminated by one of the parties. Either party may terminate the distribution agreement without cause on 90 days written notice to the other party. In the event that Qualigen terminates

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      ArgoMed, Inc.: Through our acquisition of Timm Medical, we obtained rights to distribute to urologists in North America a non-surgical, office-based thermal therapy for BPH developed by ArgoMed, Inc., the Thermoflex System. ArgoMed is a private company focused on developing and marketing minimally invasive thermal therapy technologies to treat BPH and other urologic disorders. The Thermoflex System utilizes a proprietary catheter and console to deliver heated water to destroy excess prostate tissue and reopen the urethra’s path through the prostate. The distribution agreement establishes minimum purchase requirements. The initial term of the distribution agreement expires in May 2005, but automatically renews for successive one-year terms until terminated by one of the parties. In addition, either party may terminate the distribution agreement without cause after June 30, 2002.

      Matritech, Inc.: As part of our recent acquisition of Timm Medical, we obtained exclusive distribution rights to a bladder cancer detection test, the NMP22 POC Test. The NMP22 POC Test was developed by Matritech, Inc., a public company focused on the development of proteomics-based diagnostic products for the early detection of cancer. Under the distribution agreement, Matritech must use best efforts to obtain FDA clearance for the NMP22 POC Test. The agreement terminates six years after Matritech receives FDA clearance for the test. After the expiration of the six-year term, the agreement automatically renews for successive one-year terms until terminated by one of the parties. Either party may terminate the agreement if Matritech fails to obtain FDA clearance for the test. As part of the agreement, Timm Medical made, and we will be required to make future, marketing payments to Matritech upon completion of certain milestones. In addition, Timm Medical was required to purchase $150,000 in the common stock of Matritech, which stock may not be sold until January 2003 without Matritech’s prior consent. The distribution agreement also establishes minimum purchase requirements.

Products

      We are marketing, developing or have commercial rights to distribute the following products:

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Patents and Intellectual Property

      We have rights to nine issued patents relating to our cryosurgical technology, including rights to four in-licensed patents. These patents relate to our cryoprobe technology for creating the freeze zone and precisely controlling the shape of the freeze zone produced by the cryoprobes. Additionally, our patents relate to our computer guided system for assisting surgeons in properly placing cryoprobes in a patient, a computer controlled cryosurgery apparatus and method, and a cryosurgical integrated control and monitoring system. We also have several patents pending. We have rights to 11 patents relating to our stent product line, including

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      Our policy is to secure and protect intellectual property rights relating to our technology through patenting inventions and licensing others when necessary. While we believe that the protection of patents and licenses is important to our business, we also rely on trade secrets, know-how and continuing technological innovation to maintain our competitive position. Given our technology and patent portfolio, we do not consider the operation of our business to be materially dependent upon any one patent, group of patents or single technological innovation.

      Our policy is to sell our products under trademarks and to secure trademark protection in the United States and worldwide where possible. We believe the protection of our trademarks is important to our business.

      No assurance can be given that our processes or products will not infringe patents or other intellectual property rights of others or that any license required would be made available under any such patents or intellectual property rights, on terms acceptable to us or at all. From time to time, we have received correspondence alleging infringement of intellectual property rights of third parties. No assurance can be given that any relevant claims of third parties would not be upheld as valid and enforceable, and therefore we could be prevented from practicing the subject matter claimed or would be required to obtain licenses from the owners of any such intellectual property rights to avoid infringement.

      In December 2000, we settled a patent lawsuit against Cryomedical Sciences, Inc. and in March 2001, we settled two patent lawsuits against Israel-based Galil Medical, Ltd. and its U.S. affiliate, Galil Medical (USA), Inc. The lawsuits against Cryomedical Sciences and Galil concerned the infringement of our patent for an integrated cryosurgical system. The settlements resulted in cross-licensing agreements between Galil and Endocare and Cryomedical Sciences and Endocare.

      We seek to preserve the confidentiality of our technology by entering into confidentiality agreements with our employees, consultants, customers and key vendors and by other means. No assurance can be given, however, that these measures will prevent the unauthorized disclosure or use of such technology.

Research Strategy

      Our research goal is to develop innovative urological healthcare technologies which dramatically improve patient outcomes. Our primary focus is on the diagnosis, treatment and management of prostate disease. To that end, we plan to develop innovations which improve the speed and efficacy of our Cryocare Surgical System. We also will conduct research and development of a number of complementary products focusing on diagnosis and treatment of prostate disease with an emphasis on our stents for the treatment of BPH. In addition, Timm Medical was developing, and we intend to continue to develop, product enhancements to existing urological product offerings and new product offerings for the treatment of incontinence in men and women. We also are constantly evaluating horizontal applications that may allow us to apply our cryosurgical technologies. Once new applications have been identified, we will develop cryosurgical systems and cryoprobes tailored to that application.

      We spent approximately $2.6 million, $3.2 million and $3.5 million for the years ended 1999, 2000 and 2001, respectively, on research and development activities. In fiscal year 2001, Timm Medical spent approximately $1.3 million on research and development activities.

Sales and Marketing

      We sell our products primarily to physicians and hospitals and have both domestic and international customers. Net sales to U.S. Medical Devices, Ltd. constituted 26% of our net revenues for the year ended December 31, 2001, and the loss of U.S. Medical Devices as a distributor would have a material adverse effect on our net revenues. None of our other customers account for in excess of 10% of our net revenues.

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      We currently sell our products domestically through our direct sales force which, as of December 31, 2001, consisted of 26 people, including a senior vice president of sales and marketing, vice president of marketing, seven regional sales managers and two clinical application specialists. With our acquisition of Timm Medical, our sales and marketing force has increased to 80 people, including 55 field sales representatives. We intend to continue to expand our direct sales force and enhance our direct sales capabilities by hiring additional sales and marketing personnel. Our strategy is to focus marketing and sales efforts and generating physician access to and awareness of our Cryocare Surgical System and other urological product offerings. We also intend to create patient demand by providing education on the benefits of cryosurgical therapy and our other urological product offerings versus alternative treatment options. We also have plans to expand our marketing initiatives to programs targeted directly at prostate disease patients.

      We also distribute our Cryocare Surgical System through affiliates of national urological groups. These marketing partners sell our systems directly to urology groups and indirectly to multiple urology groups through sales to limited liability companies or other entities in which such groups have an equity interest. We also distribute our cryosurgical systems through the operators of mobile lythotripsy systems for the treatment of kidney stones.

      Internationally, our products are sold primarily through independent distributors in Germany, China, Brazil, Australia, the United Kingdom, Turkey, Greece, Korea, Japan and Taiwan. Our international sales represented approximately 12%, 16% and 7% of our consolidated revenue in 1999, 2000 and 2001, respectively.

Reimbursement

      We sell our Cryocare System and related disposable guidewires and cryoprobes to hospitals and other entities that provide services to hospitals. Most procedures involving the Cryocare Surgical System are performed in hospitals on an inpatient basis. While occasional patients pay for cryosurgical procedures, virtually all patients depend upon third party payors, including Medicare, Medicaid, Tricare and other federal healthcare programs, as well as private insurers to pay for their procedures. Accordingly, our revenue is dependent upon third party reimbursement.

      Reimbursement for cryosurgical procedures using our products as a primary treatment alternative for localized prostate cancer began July 1999. Effective July 2001, Medicare coverage was approved for secondary cryosurgical treatment of prostate cancer patients who have failed radiation therapy.

      When Medicare reimbursed services are provided on an inpatient basis, the hospital is reimbursed under the Medicare prospective payment system, based on the applicable diagnosis related group, or DRG. A single payment covers all facility services.

      Outpatient reimbursement for cryosurgical procedures for Medicare beneficiaries is in accordance with the newly effective Hospital Outpatient Prospective Payment System, or HOPPS. Under HOPPS, reimbursement is made on a per procedure basis. The physician is paid a professional fee and the hospital receives payment for the technical portion of the fee. The hospital’s technical fee includes the per procedure share of the cost for any depreciable equipment, such as our Cryocare Surgical System unit, and the provision of disposable devices, such as our guidewires and cryoprobes.

      Medicare makes additional payments to hospitals when certain qualifying new medical devices are used to perform a procedure or service on a program beneficiary on an outpatient basis. Generally speaking, the additional payment amount for qualifying medical devices is the amount by which a hospital’s charges for a device used in an outpatient service, adjusted to cost, exceed the portion of the otherwise applicable hospital outpatient department fee schedule amount determined by the Secretary of the U.S. Department of Health and Human Services to be associated with the device. As a result, these “pass-through” payments help to compensate hospitals for the additional costs of utilizing new technology in treating Medicare beneficiaries. Our guidewires and cryoprobes are currently paid on a pass-through basis.

      Two statutory expenditure control mechanisms, however, limit overall program payments that can be made on a pass-through basis for qualifying medical devices, and, as such, also limit actual item-specific payments to hospitals using qualifying devices. The more significant among these two mechanisms caps the

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      Items qualifying for pass-through payment continue to be eligible for at least two, but not more than three years. After a temporary payment period expires for an item, its cost is packaged with the relative procedure code or medical visit and assigned to the APC group that is clinically related and comparable in resources used. At such time, the APC groupings, weights and payments are updated to include costs associated with former pass-through items. We have no assurance that once pass-through status for our guidewires and cryoprobes ends and CMS sets an all inclusive technical fee for cryosurgery, total reimbursement will remain at current levels. If overall Medicare reimbursement to hospitals is reduced, it is likely that we would have to reduce our charges to hospitals for the equipment and devices. This could have a material adverse effect on our revenues.

      We are in discussions currently with CMS to ensure that correct data is utilized when CMS incorporates the pass-through payments for our guidewires and cryoprobes into the technical fee paid to the hospital for the cryosurgery procedure. We have been asked by CMS to submit data demonstrating the hospital’s costs to perform cryosurgery on an outpatient basis. To date, no resolution has been reached regarding the final technical payment to the hospital.

      The items we acquired through our acquisition of Timm Medical also are reimbursed by Medicare and other federal healthcare programs, as well as private insurers. Timm Medical provides certain items pursuant to physicians’ orders directly to patients, and bills the patient or payor. Consequently, Timm Medical’s business, unlike the other elements of Endocare’s business, involves dealing directly with Medicare and other payors, and would be directly impacted by any changes in either coverage policies or reimbursement amounts adopted by Medicare or other payors. An initial reimbursement rate for the Thermoflex System was established in January 2002.

      Future devices and technology that we develop would have to be approved by Medicare after we obtain FDA approval or clearance. The Medicare approval process is lengthy and there is no assurance that Medicare approval would be granted. Each private insurer makes its own determination whether to cover a device or procedure and sets its own reimbursement rate. It is unlikely that a private insurer would provide coverage if Medicare refused to do so.

Backlog

      As of December 31, 2001, we maintained minimal backlog. Our policy is to carry enough inventory to be able to ship most orders within a few days of receipt of order. Historically, most of our orders have been for shipment within 30 days of the placement of the order. Therefore, we rely on orders placed during a given period for sales during that period. Backlog information as of the end of a particular period is not necessarily indicative of future levels of our revenue.

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Manufacturing

      We manufacture our Cryocare Surgical System and related disposables internally at our facilities in Irvine, California. Our existing Irvine manufacturing facility was subject to an FDA audit in September 1999, and the FDA did not find any deviations from its QSR requirements. In addition, we have obtained from the California Department of Health Services a license to manufacture medical devices, subject to periodic inspections and other regulation by that agency. We have received ISO 9001 certification indicating compliance of our existing Irvine manufacturing facility with European standards for quality assurance and manufacturing process control.

      We recently moved our executive offices to a new facility in Irvine, California, and plan to transfer our manufacturing activities to this new facility in April 2002. This new facility has not yet been inspected by the FDA or the California Department of Health Services.

      The erectile dysfunction and urinary incontinence products we acquired through our acquisition of Timm Medical are manufactured in Eden Prairie, Minnesota. The Eden Prairie facility is equipped and registered to produce FDA Class I, II, and III medical devices and has received ISO 9001, EN 46001 and CE mark certifications. This facility also maintains controlled environment rooms for production of implantable products.

Government Regulation

      Governmental regulation in the United States and other countries is a significant factor affecting the research and development, manufacture and marketing of our products. In the United States, the FDA has broad authority under the Federal Food, Drug and Cosmetic Act, the FDC Act, to regulate the distribution, manufacture and sale of medical devices. Foreign sales of medical devices are subject to foreign governmental regulation and restrictions which vary from country to country.

      Medical devices intended for human use in the United States are classified into one of three categories, depending upon the degree of regulatory control to which they will be subject. Such devices are classified by regulation into either class I general controls, class II special standards or class III pre-market approval depending upon the level of regulatory control required to provide reasonable assurance of the safety and effectiveness of the device.

      Most Class I devices are exempt from premarket notification or approval. Class II devices are subject to the premarket notification requirements under Section 510(k) of the FDC Act. For a 510(k) to be cleared by the FDA, the manufacturer must demonstrate to the FDA that a device is substantially equivalent to another