MEDSTONE INTERNATIONAL INC/ - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-K

(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2001

OR

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from _____________ to ______________

Commission File Number 0-16752

MEDSTONE INTERNATIONAL, INC.
(Exact name of registrant as specified in its charter)

Delaware 66-0439440
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

100 Columbia, Suite 100, Aliso Viejo, California 92656
(Address of principal executive offices) (Zip code)

Registrant's telephone number, including area code: (949) 448-7700

Securities Registered Pursuant to Section 12(b) of the Act: None

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock, $.004 par value
(Title of Class)

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
-- --

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 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-K. [_]

The number of shares of the Common Stock of the registrant outstanding as
of March 4, 2002 was 3,946,220. The number of shares of voting and non-voting
Common Stock held by non-affiliates on such date was 3,846,912 with an
approximate aggregate market value of $16,541,722.

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TABLE OF CONTENTS

Page
Item Number and Caption Number
----------------------- ------

PART I

Item 1. Business ................................................. 1
Item 2. Properties ............................................... 10
Item 3. Legal Proceedings ........................................ 10
Item 4. Submission of Matters to a Vote of Security Holders ...... 11

PART II

Item 5. Market for Registrant's Common Equity
and Related Stockholder Matters ......................... 12
Item 6. Selected Financial Data .................................. 13
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations ..................... 14
Item 7A. Quantitative and Qualitative Disclosures About
Market Risk ............................................. 20
Item 8. Financial Statements and Supplementary Data .............. 20
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure ..................... 20

PART III

Item 10. Directors and Executive Officers of the Registrant ....... 21
Item 11. Executive Compensation ................................... 24
Item 12. Security Ownership of Certain Beneficial
Owners and Management ................................... 29
Item 13. Certain Relationships and Investments .................... 31

PART IV

Item 14. Exhibits, Financial Statement Schedules,
and Reports on Form 8-K ................................. 33

-I-

PART I

Item 1. BUSINESS

Introduction

Medstone International, Inc., (the "Company" or "Medstone"), a Delaware
corporation formed in October 1984, manufactures, markets and maintains
lithotripters. The Company sells its lithotripters and related supplies, and
also makes them available for use by health care providers on a fee-for-service
in both fixed and mobile settings. Medstone currently offers its lithotripsy
products and services both in the United States and internationally. Medstone
has expanded its product offerings to include several other durable medical
equipment products marketed to the urology market. The Company's consolidated
revenues during fiscal 2001 came primarily from Medstone's lithotripsy business.

Subsidiary Businesses and Spin-outs to Shareholders

One continuing element of the Company's strategic plan is the incubation,
financing and staffing of new medical businesses subsidiaries. If and when such
a new business proves viable, the Company may determine to spin-out most of the
subsidiary's shares, creating a separate publicly-held company as dividends to
the Company's stockholders.

The Company's first spin out was Cardiac Science, Inc. ("Cardiac Science")
(trade symbol: DFIB), which occurred in 1991. Cardiac Science designs,
manufactures and sells a line of external defibrillation devices for the
hospital cardiac care market. During 2001, the Company sold its remaining
holdings of Cardiac Science. (See Item 13. "Certain Relationships and
Investments" and Note 9. "Related Party Transactions" in the Notes to
Consolidated Financial Statements.)

In early 1996, the Company spun off two additional subsidiaries, Endocare,
Inc. ("Endocare") (trade symbol: ENDO) and Urogen Corp. ("Urogen") (trade
symbol: UROG), to the Company's stockholders of record at December 29, 1995.
Endocare manufactures equipment and devices to treat urologic soft tissue
diseases. Urogen is a development stage biotechnology company currently
developing gene therapy products for the treatment of hemophilia A and prostate
cancer. During 2001, Urogen changed its name to Genstar Therapeutics Corp.
("Genstar") (trade symbol:GNT). At March 4, 2002, when the market price of the
Genstar stock was $1.62 per share, the Company held 95,000 shares of Genstar
with a market value of approximately $153,900. (See Note 9. "Related Party
Transactions" in the Notes to Consolidated Financial Statements.)

In June 1996 the Company purchased, for $1.35 million cash, a 60% interest
in Northern Nevada Lithotripsy Associates, LLC ("Northern Nevada"), an operator
of lithotripsy services. In March 1997, the Company purchased, for $2.3 million
cash, a 60% interest in Southern Idaho Lithotripsy Associates, LLC ("Southern
Idaho"), another operator of lithotripsy services. At March 2002, the Company
continued to own a majority interest in each of these companies. These
companies' revenues are derived from invoicing patients or insurers. (See Note
3. "Acquisitions and Investments in Joint Ventures" in the Notes to Consolidated
Financial Statements.)

United Physicians Resources, Inc. ("UPR") was incorporated as a
majority-owned subsidiary of the Company in June 1996, to expand the Company's
service orientation to the urologist practitioners. UPR provides billing,
practice management and consulting services as an additional service line once
the initial physician relationship has been established. At March 2002, the
Company continued to own a majority interest in UPR. UPR purchased the
operations of Integrated Healthcare Systems, Inc. in July 1996 for $30,000.

1

In September 1998, the Company was party to the formation of k.Biotech, an
Indian biotechnology company. k.Biotech is a development stage enterprise which
has purchased license agreements for four compounds developed by the
International Centre of Genetic Engineering and Biotechnology of the United
Nations ("ICGEB"). The four licensed ICGEB compounds, Hepatitis B Vaccine,
Interferon, Erythropoietin and GCSF, may be marketed in ICGEG member countries,
primarily in lower Asia and Africa. The Hepatitis B Vaccine is currently in
clinical trials in India, and k. Biotech is currently evaluating various funding
options to be able to continue to the next step in its business plan. The
Company has invested a total of $325,000 in k.Biotech, giving the Company then a
21% ownership share. During 2001, the Company evaluated the financial position
and business prospects of k. Biotech and recognized losses and created an
investment reserve against its investment equal to the $325,000 investment,
effectively reducing the carrying value to $0. (See Item 13. "Certain
Relationships and Investments" and Note 3. "Acquisitions and Investments in
Joint Ventures" and Note 9. "Related Party Transactions" in the Notes to
Consolidated Financial Statements.)

In April 1999, a wholly-owned subsidiary of the Company, Medstone
International, Ltd. ("Ltd"), purchased certain assets of Creos Ltd., a former
supplier of the Company, from its liquidator for $165,000 in cash. Upon
purchase, the subsidiary, located in Fife, Scotland, commenced manufacturing
operations. (See Note 3. "Acquisitions and Investments in Joint Ventures" in the
Notes to Consolidated Financial Statements.)

In October 1999, Medstone International Ltd. purchased all outstanding
shares of Zenith Medical Systems, Ltd. ("Zenith"), a distributor of durable
medical equipment located in Manchester, England, for $870,000 in cash less
$284,000 of acquired cash, for a net cost of $586,000. (See Note 3.
"Acquisitions and Investments in Joint Ventures" in the Notes to Consolidated
Financial Statements.)

In April 2000, the Company purchased common stock representing a 46%
interest in Medicredit.com, Inc. ("MediCredit") for $1 million in cash.
MediCredit, a California based company, funds and services loans to physicians
to finance elective surgeries in the cosmetic and cash paying sector of
healthcare. Along with the cash investment in MediCredit, the Company agreed to
a subordinated line of credit of up to $2 million at prime rate. At March 4,
2002, the net carrying value of the credit line was $0. The outstanding balance
of $2 million has a $2 million reserve, recognized in 2001, due to the Company's
review of the collectability of the note. The Company's 46% ownership interest
has a current carrying value of $0 due to the recognition of a valuation reserve
of $953,011, recorded in 2001, due to the Company's review of the viability and
equity balance of Medicredit as of December 31, 2001. (See Item 13. "Certain
Relationships and Investments" and Note 9. "Related Party Transactions" in the
Notes to Consolidated Financial Statements.)

In September 2001, the Company purchased, for $1 million cash common stock
representing a 25% ownership position in Arcoma AB ("Arcoma"), a Swedish
designer and manufacturer of medical imaging tables/devices. Arcoma is a
supplier to the Company for several tables that the Company currently markets.
(See Item 13. "Certain Relationships and Investments" and Note 9. "Related Party
Transactions" in the Notes to Consolidated Financial Statements.)

Products

Lithotripsy Equipment
- ---------------------

The Medstone STS and STS-T(C) lithotripter systems (the "Systems") are
presently being used to treat kidney stones, without invasive surgery, in the
U.S. and foreign locations. The Company received a pre-market approval ("PMA")
for the STS System from the U.S. Food and Drug Administration ("FDA") in 1988
authorizing commercial use of the device for treating patients with kidney
stones. A PMA supplement covering the STS-T(C) System was approved by the FDA in
1998.

2

In the STS System ("STS"), a series of shockwaves are created outside the
patient's body and focused to travel through water-based fluids until they enter
the body and disintegrate the stone. Each successive shockwave serves to further
break apart the kidney stone into smaller particles until they are small enough
to be passed in the patient's urine. A treatment typically requires 1200-1600
shockwaves in a procedure which lasts 45 to 60 minutes.

In addition to the shockwave generator, the STS's components include a
customized X-ray table on which the patient lies horizontally with his or her
kidney positioned above the shockwave generator, a computer, an X-ray system, an
ultrasound system, and an electrocardiogram ("ECG") monitor. The computer
generates information regarding the treatment and monitors the patient's
condition. The X-ray/ultrasound system produces images that are converted and
analyzed by the computer and then used by the physician for proper positioning
and to determine when the kidney stone has been sufficiently disintegrated to
terminate the treatment. The ECG monitor supplies the data that allows the
computer to synchronize the shockwaves with phases of the patient's heartbeat.

The Company has developed and copyrighted all the software that controls
the STS. This software, an integral part of the system and therefore subject to
review by regulatory agencies, is licensed for use on a per procedure basis.

On September 6, 2000, the Company was notified by the FDA that its PMA
application for treatment of gallstones with the STS, in conjunction with the
drug Actigall, was approved for commercialization. This makes the STS as the
only dual-modality lithotripter, available for both kidney stone and gallstone
treatments, available in the United States, thereby enhancing the equipment's
appeal to hospitals and surgery centers.

The Medstone STS-T(C) ("STS-T(C)") is a transportable lithotripter for
treatment of kidney stones. The STS-T(C) contains components similar to the STS,
except for the ultrasound unit, with all components built to be modular,
allowing the STS-T(C) to be moved in and out of a hospital surgical suite. This
"in operating room" technology, the current industry direction, allows hospitals
and clinics to set up the lithotripter for patient treatment in existing
surgical operating rooms and, once complete, the lithotripter can be moved to an
equipment holding area or loaded on to a truck for transportation to another
facility. This transportability allows hospitals and clinics the flexibility of
full-time access to a lithotripter without dedication of a surgical suite to a
fixed unit installation.

The STS-T(C) has been commercially distributed for treatment of kidney
stones since the Company's PMA supplement was approved by the FDA in 1998, with
the C-Arm imaging option approved in 2001. The STS-T(C) currently has ETL, ISO
900, private quality certifications, and EN46001 certifications, necessary for
sales to European Union countries, and the Company is currently undergoing
testing for CE mark registration of the STS-T(C).

The Company also has developed and manufactures its own disposable
components for use with the STS and STS-T(C). Electrodes manufactured by the
Company are used to produce electrical sparks in the shockwave generator part of
the device. A disposable coupling bag containing fluid for transmission of the
shockwave is placed between the shockwave generator and the patient's back or
stomach during the treatment. One complete set of the supplies is normally used
in each patient procedure.

Lithotripsy Services

The Company, as a vertically integrated manufacturer, offers
fee-for-service lithotripsy arrangements, using Company-owned equipment, within
the continental United States. It contracts with hospitals, clinics, and
ambulatory surgery centers to provide the equipment necessary for outpatient
treatment of kidney stones. The customer will sign a contract for a period of
time, typically one to three years, and will pay a fixed fee for each patient
treated on the lithotripter or a flat monthly equipment charge.

3

The Company moves some of its fee-for-service Systems from place to place.
Treatments on the mobile STS equipment takes place in a self-contained mobile
trailer and the STS-T(C) is moved from site to site in a small truck and moved
into a facility's operating room. This allows small and mid-size facilities in
wide ranging geographic locations to access on a part-time basis equipment and
technology that otherwise would only be economically viable in larger population
centers. There are currently over 80 sites in the United States that are active
sites on the Company's mobile trailer and transmobile routes.

Since 1999, the Company has also implemented a business plan calling for
the widespread "permanent" distribution of STS-T(C) Systems in fee-for-service
arrangements. The program gives the hospital, clinic or surgery center customers
full-time access to the intuitive, easy to operate lithotripter and the
convenience of a fee-for-service payment plan where fees are incurred only if
the equipment is used.

The fee-for-service procedures are currently provided by the Company using
15 STS Systems housed in mobile trailers, one STS System located at a fixed site
and 25 STS-T(C) Systems which are located in "permanent" sites or moved to
different locations in small trucks.

Urotables
- ---------

With its network of physicians and facilities that utilize lithotripsy
products, the Company has begun using that same contact base to market fixed and
mobile urological treatment tables, the Medstone "UTS-Series." These tables are
used for various urological procedures, both as in-office devices for physicians
and as in-facility devices in hospital or clinic settings. The Company uses the
"UTS-Series" for bundled sales of urological tables along with lithotripsy
products, and also sells the "UTS-Series" as a stand-alone product.

The Company's entry in this market was achieved by $30,000 of development
funding to the Swedish manufacturer, Arcoma AB, to develop the mobile urological
treatment table. The product was successfully introduced in 1999 and the Company
continues to expand its distribution.

The Company is also completing initial installations of a state-of-the-art
fixed urology table. This UroPro imaging table was also developed by Arcoma for
a contract of $250,000. It has multi-plane movement for enhanced patient
positioning capability. Its physician preference settings are programmable into
a multifunction touch screen control panel which will control all table, imaging
and exposure functions. During 2001, the Company paid $140,000 to Arcoma for
development of a tomography option for this table.

X-Ray Generators
- ----------------

Since commencing operations in 1999, Medstone International, Ltd. has
manufactured and marketed a family of compact, high frequency X-ray generators
which are used in medical imaging. The compact design allows installation in a
very space-efficient manner. Its modular design makes repairs in the field time
efficient as components can be replaced at the customer's site. Ltd. supplies
the equipment used in the STS-T(C) imaging system and the Urotable. The majority
of its third party customers are in member countries of the European Union.

Patient Handling Tables
- -----------------------

Drawing from the Company's relationships with the radiology market and
knowledge from the UTS-Series tables, the Company successfully introduced in
2000 a series of patient handling tables. These portable, multi-position tables
are used by pain management clinics for imaging and vascular studies in a cost-
efficient office or clinic setting. The tables can also be used as portable
imaging tables without requiring complete rooms strictly for imaging. The
Company currently offers several models of the tables, including fixed-height or
multi-plane adjustable types.

4

Kidney Stones and Treatment

A kidney stone develops when the salt and mineral substances in urine form
crystals that stick together and grow in size. In most cases, these crystals are
removed from the body by the flow of urine, but they sometimes stick to the
lining of the kidney or settle in places where the urine flow fails to carry
them away. These crystals may gather and grow into a stone ranging in size from
that of a grain of sand to a golf ball. Most stones start to form in the kidney.
Some may travel to other parts of the urinary system, such as the ureter or
bladder, and grow there.

Stones vary in size, composition and the ease with which they can be
dissolved. In some cases, certain medications may be used to lower the amount of
acidity or alkalinity in the urine, thereby dissolving the stones. At present,
stones that contain calcium cannot be so dissolved. Most stones can be treated
with conservative, non-invasive methods. These include increased fluid intake,
changes in diet, and medications. About 90 percent of stones that leave the
kidney will pass through the ureter within three to six weeks. Stones that do
not pass through the ureter may be removed with the aid of a grasping device
(basket). The device is passed through a telescopic instrument (cystoscope) that
the doctor inserts into the bladder or ureter (urethroscope). In some cases, the
stones are removed whole, but sometimes they must be broken into smaller pieces
with ultrasound before they can be removed with the basket.

Although most kidney stones can be treated with such other conservative
methods, certain stones still require either conventional surgery or lithotripsy
treatment, particularly when there is internal scarring and obstruction. With
conventional surgery, an incision is made over the stone site. The hospital stay
and recovery period are several weeks longer than when the more conservative
techniques are used. Therefore, the stones are treated with other methods when
possible.

The Medstone STS and STS-T(C) provide a non-invasive nonsurgical treatment
for stones in the kidney and ureter called extra corporeal shockwave
lithotripsy. In this method, X-rays are used to target the stone, and then high
energy shockwaves are used to break down the stones into gravel which passes out
with urine within a few weeks.

Gallstones and Treatment

Gallstones are hard deposits, of which approximately 85% are cholesterol
and approximately 15% are calcified, which form in the gallbladder and
occasionally may migrate into the common bile duct. Gallstones commonly grow to
an inch or more in diameter and two or more stones may be present in the
gallbladder and common bile duct at the same time. As the stones grow over time,
severe pain can result from inflammation of the gallbladder because of blockage
of the natural flow of bile from the liver in and out of the gallbladder, from
passage of stones through the common bile duct and from inflammation of the
pancreas if the pancreatic duct is blocked. The incidence of gallstones is
almost three times greater in women than in men, increases with age and obesity,
and is doubled in women who take estrogen and oral contraceptives as these
agents increase the body's secretion of cholesterol.

Surgery in which the gallbladder is removed either via laparoscopic or open
surgery historically has been the accepted method for treatment of patients with
gallstones. Although mortality rates for this type of surgery are low in the
U.S. because of the quality of medical care, health care costs associated with
hospital stays are substantial and a patient may be a poor surgical candidate or
may choose a course of treatment not involving surgery. Oral administration of
bile acids has been one method of non-surgical treatment, but this may involve a
lengthy period of treatment.

Under the 2000 approval from the FDA, gallstone disease patients fitting
certain criteria established in the Company's gallstone PMA may be treated with
non-surgical shockwave lithotripsy using the Company's STS and the drug
Actigall. The treatment is similar to the treatment described above for kidney
stones. In the treatment for

5

gallstones, ultrasound images are used to target the stone and the same type of
high energy shock waves are used to fragment the stone. The stone fragments are
ejected from the gallbladder into the digestive tract.

Markets

The Company's current products and planned future products are targeted at the
urology, radiology and imaging table markets.

The Company's most important current market is the kidney stone treatment
market. In the United States, it is estimated that over 1,500,000 persons per
year suffer from kidney stones and an estimated 375,000 patients per year are
hospitalized with a primary kidney stone. Historically, approximately 180,000 of
these patients have been treated with extra corporeal shockwave lithotripsy each
year. With an estimated installed base of 450 lithotripters in the United
States, there is a sufficient number of lithotripters to respond to this market.

Outside the United States the incidence of kidney stones varies from
country to country. The installed base of extra corporeal shockwave
lithotripters is not as extensive as in the United States. Medstone has sold
systems into Japan, Egypt, Russia, Israel, Saudi Arabia, U.A.E., Hong Kong and
China.

The share of its markets that the Company will obtain will be dependent on
successful development of new products, obtaining appropriate regulatory agency
approvals, market acceptance of the products, the Company's ability to market,
the alternative sources of equivalent products and future developments.

An estimated 25 million Americans have gallstones resulting in
approximately 500,000 surgeries each year. This compares to an estimated 1.5
million Americans with kidney stones resulting in approximately 200,000
extracorporeal shockwave lithotripsy procedures each year. As approved by the
FDA to date, the combination of Medstone's lithotripter with a pharmaceutical
dissolution is indicated for use in treating certain types of gallstones --
symptomic, radiolucent, non-calcified gallstones less than 20 mm in maximum
diameter in certain patients with a functioning gallbladder.

Production

The Company's Aliso Viejo, California facility, first occupied in 1994, is
certified by the FDA under its mandated Good Manufacturing Practices ("GMP"). It
also has ISO 9001 and EN 46001 certifications to produce the STS-T(C). The
Company is planning on completion of CE mark registration for the STS-T(C) in
2002 and has current CE mark registrations for the portable urology and patient
handling table product lines. Ltd.'s plant in Scotland also has GMP
certification from the FDA, along with CE mark, EN46001 and ISO 9001
certifications, for the Company's x-ray generator products. The Company has
existing capacity in its plants to produce sufficient quantities of its
shockwave lithotripters, urotables, patient handling tables and X-ray generators
to support its commercial needs for the foreseeable future.

Product Development

The Company research in 2001 concentrated on the development of the UroPro
urology table tomography option and several variations of the UroProT patient
handling table. The Company also has continued expenditures for refinements to
the STS-T(C) and its user interfaces. During the year, the Company took delivery
of the first production tomography unit. Development expenses for 2002 are
expected to be primarily for the costs associated with refinements, options and
new applications of the basic UroPro urology system. The Company will continue
its development program alliance with Arcoma AB. During the years ended December
31, 2001, 2000, and 1999, the Company's expenditures for research and
development totaled $1,319,625, $1,180,409 and $1,455,429, respectively.

6

Sales and Marketing

Medstone has a direct sales force covering the continental United States.
Outside the United States, the Company uses a network of distributors and direct
sales efforts in the United Kingdom through the Ltd. and Zenith subsidiaries.

The Company generates revenue from cash sales of lithotripters, urology
tables and other equipment. In addition, it obtains recurring revenues from
customers through deferred payments for equipment purchases, sales of disposable
supplies, software license fees, procedure fees, maintenance contracts and other
fee-for-service arrangements. Maintenance services are generally provided under
annual service contracts. Procedure fees are earned based upon usage of the
System. Fee-for-service arrangements may also include monthly flat equipment
usage fees.

The Company offers to hospitals, surgery centers and physician groups use
of Medstone-owned lithotripters on a fee-for-service basis. In the current cost
conscious healthcare environment, many facilities do not have the patient flow
to justify owning, or the available capital to purchase, a lithotripsy machine.
These facilities are candidates for these fee-for-service arrangement. Most
often the service is provided by a lithotripter that is in a mobile van so a
single machine can provide service over a wide geographic area. For facilities
with adequate patient flow, fee-for-service also can be provided with fixed
units installed in these facilities. The Company intends to expand the
geographic coverage of this service, both domestically and, in future years, to
foreign markets.

Marketing for the Company's products is accomplished through advertisement
in medical journals, direct mail, direct physician contact, company
participation in various associations, product exhibition and telephonic
marketing.

Product Liability and Insurance

The Company currently has in force commercial liability insurance, with
coverage limits of $1 million per incident, and $2 million on an annual
aggregate basis. It also has general umbrella liability insurance with a
coverage limit of $4 million per incident for a total aggregate coverage amount
of $5 million per incident. The Company has product liability and directors and
officers liability insurance with a $10 million coverage limit per incident. The
Company's insurance policies provide coverage on a claims-made basis and are all
subject to annual renewals.

Government Regulation

Governmental regulations in the United States and other countries are a
significant factor affecting the research and development, manufacture and
marketing of the Company's products. In the United States, the FDA has broad
authority under the Federal Food, Drug and Cosmetic Act and the Public Health
Service Act to regulate the distribution, manufacture and sale of drugs,
including biologics, and medical devices. Foreign sales of drugs and 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 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 (performance 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 devices.
Currently, the Company's STS and STS-T(C) lithotripters used for treating kidney
stones are Class II devices. In September 2000, kidney stone lithotripters were
reclassified from Class III devices to Class II devices and became eligible for
510(k) exemptions (described below). When used in treatment of gallstones, the
STS is classified as a Class III device. The Company holds a PMA on its STS
lithotripter for unrestricted treatment of gallstones and is also administering
a Post Approval Study as required by its PMA approval. General medical device
regulations

7

regarding FDA inspection of facilities, Good Manufacturing Practices, labeling,
maintenance of records and filings with the FDA continue to be applicable.

A subset of medical devices, including "old" devices commercially
distributed before March 28, 1976 or substantially equivalent to devices that
were in commercial distribution before that date, may be marketed under a
"510(k) exemption." Section 510(k) of the Federal Food, Drug and Cosmetic Act
provides an exemption from the pre-market approval requirement for such devices.
The Medstone UTS-Series is sold under a 510(k) exemption received by the
original manufacturer of the components used in the equipment.

Medstone has obtained from the California Department of Health Services a
license to manufacture medical devices and is subject to periodic inspections
and other regulation by that agency.

Certificate of Need ("CON") laws and regulations are in effect in many
states. Under such laws, a CON issued by a governmental agency is generally
required before the introduction of certain new health care services or before a
hospital or other provider can acquire certain new medical equipment or
facilities having values exceeding specified amounts. Failure to obtain a
required CON may prohibit the purchase of desired equipment or cause the denial
of Medicare or other governmental reimbursements or payments for patient
treatments. In recent years several states have repealed their CON laws and many
other states have made or are considering possible amendments to the laws. Most
of the revisions involve raising the thresholds for review, eliminating certain
types of facilities or services from review or streamlining the review process.

On January 4, 2001, the Health Care Finance Administration ("HCFA"), now
known as the Center of Medicare and Medicaid Services ("CMS"), published final
"Stark II" regulations regarding various inpatient and outpatient services,
including lithotripsy facilities, and physician ownership of such equipment.
Under these regulations, the physician ownership of lithotripsy equipment is not
expressly forbidden, but must, instead, meet strict guidelines in which any
compensation arrangement based on "per use" charges must be at "fair market
value". These regulations apply to the patients covered under Medicare, Medicaid
and Champus health care. During 2001, several groups representing
physician-owners filed suit against CMS and sought on injunction against
implementation of these rules pending outcome of the suit. The judge in the case
denied the injunction and on January 4th, 2002 the regulations became effective.
The trial date is currently set for late 2002. The Company believes that its
contractual arrangements with its customers are in compliance with the new
regulations.

Patents, Copyrights, Trade Secrets and Licenses

The Company's policy is to secure and protect intellectual property rights
relating to its technology. While Medstone believes that the protection provided
by patents or licenses is important to its business, it also relies on trade
secrets, know-how and continuing technological innovation to maintain its
competitive position. The Company has received or filed for certain patents or
copyrights for its lithotripter operating systems and utilizes a licensing
agreement for certain technology incorporated in its X-ray generators.

The Company seeks to preserve the confidentiality of its technology by
entering into confidentiality agreements with its 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.

Competition

The Company's products currently marketed and under development will be
competing with many existing products and therapies for market share. The
Company competes with fully integrated device companies, many of which have
substantially more experience, financial and other resources and superior
expertise in research and development, manufacturing, testing, obtaining
regulatory approvals, marketing and distribution.

8

Future products of the Company are expected to address the urological
market. The Company's competition will be determined in part by the particular
urological disease to which the Company's potential products relate. An
important factor in competition may be the timing of market introduction of its
or competitive products. Accordingly, the relative speed with which Medstone can
develop products, complete the clinical trials and approval processes and supply
commercial quantities of the products to the market are expected to be important
competitive factors. The Company expects that competition among products
approved for sale will be based on, among other things, product efficacy,
safety, reliability, availability, price, patent position and sales, marketing
and distribution capabilities.

The Company's competitive position also depends upon its ability to attract
and retain qualified personnel, obtain patent protection or otherwise develop
proprietary products or processes and secure sufficient capital resources for
the often substantial period between technological conception and commercial
sales.

Shockwave Lithotripters
- -----------------------

The Company's two principal competitors in kidney stone shockwave
lithotripsy are Dornier, a subsidiary of a Singapore-based conglomerate, and
Siemens GmbH, a German conglomerate. In addition, a number of other companies,
both in the U.S. and foreign countries, have PMAs or 510(k) exemptions to sell
their lithotripters for the treatment of kidney stones in the U.S. or are
applying for 510(k) device exemptions for the use of their lithotripters for the
treatment of kidney stones.

The Company believes that, in addition to the obtaining of FDA and other
governmental approvals, important competitive factors in the markets for
shockwave lithotripters include the reliability, effectiveness in treating
patients and pricing of particular systems. The Company believes the Medstone
Systems compare favorably with other lithotripters presently being offered by
competitors with respect to the precision of their imaging systems, their ease
of patient handling, their simplicity of operation design, their safety features
and their success rate in treating patients.

Fee-for-Service
- ---------------

In the fee-for-service business segment, the Company competes with a number
of service-oriented medical businesses, in a fragmented and highly competitive
industry, both nationally and locally. Moreover, certain of the Company's
current and potential competitors have substantially greater financial resources
than the Company and may compete with the Company for acquisitions and
development of operations in markets targeted by the Company. The Company has
experienced competition in the acquisition of existing lithotripsy facilities
and the development of relationships with treating physicians. The Company has
experienced competition from hospitals or treating physicians who have opened
their own lithotripsy facilities. Such competition could intensify in the event
of a decrease in the purchase price of lithotripters or if the supply of new or
used lithotripters increases over time.

The Company's main competitors in the fee-for-service business are Prime
Medical Services, Inc., a Texas-based mobile lithotripsy provider, and
Healthtronics Surgical Services, Inc., a Georgia-based lithotripsy concern, of
which one operating entity owns lithotripsy provider partnerships, and other
smaller regional and local providers.

Tables and X-ray Generators
- ---------------------------

The Company's main competitors in the urological table business are Liebel
Flarsheim Co., an Ohio-based division of Mallinkrodt which manufactures urology
products, and OEC Medical Systems, Inc., a Utah-based division of GE Medical
Systems, which provides imaging and related products.

The Company's x-ray generators compete in a market which has been highly
competitive and price sensitive. This market includes hospital radiology,
oncology and orthopedic departments as well as clinics and surgery centers. Most
equipment is sold as replacements of existing equipment that has ceased
operating or fails performance criteria.

9

Competition in the x-ray and imaging equipment market is widespread, with
GE Medical Systems, a subsidiary of General Electric, a world wide conglomerate,
and Siemens Medical Systems, a subsidiary of Siemens GmbH, a German
conglomerate, and numerous smaller manufacturers, both domestic and foreign.

Backlog - Shockwave Lithotripsy

The Company's lithotripsy equipment sale backlog for the STS-T(C) was
$380,000 as of March 1, 2002 and $0 as of March 1, 2001. Due to the high per
unit price of the Medstone Systems, equipment backlog can vary significantly
from period to period based upon the number of systems on order. Backlog
consists only of orders evidenced by signed contracts for equipment scheduled
for delivery and installation within 12 months and does not include revenues for
maintenance and per procedure charges, or management services contracts.

Backlog for radiology equipment (urology tables, pain tables and oncology
tables) totaled $1,102,222 as of March 1, 2002 and $1,156,000 as of March 1,
2001.

Human Resources

As of February 15, 2002, Medstone had 102 employees. Of the 102 employees,
6 are engaged directly in research and development activities, 26 are engaged in
manufacturing, 21 are engaged in mobile operations, 23 are engaged in field
service, 12 are engaged in sales and marketing and 14 are employed in general
and administrative positions.

Although Medstone conducts most of its research and development using its
own employees, the Company has funded, and plans to continue to fund, research
using consultants. Consultants provide services under written agreements and are
paid based on the amount of time spent on Company matters. Under their
consulting agreements, Medstone's consultants are required to disclose and
assign to the Company any ideas, discoveries and inventions developed by them in
the course of providing consulting services.

Item 2. PROPERTIES

In March 1994, the Company took occupancy of a 20,600 square-foot facility
located in Aliso Viejo, California. The current lease, signed in April 2000 has
an average monthly rent of $19,449 for the initial term. The initial term will
expire November 30, 2005, with an option to renew for five years at a rental
rate to be negotiated in the future based on the market rates.

Medstone International, Ltd. leases a 5,000 square foot facility in Fife,
Scotland, for manufacturing, warehouse and administrative operations, for
approximately $2,900 per month with a term through October 2005.

Zenith owns a 6,107 square foot building in Manchester, England which it
uses to house administration, warehouse and equipment staging.

United Physicians Resources leases a 1,417 square foot office in Phoenix,
Arizona with a monthly rental expense of $2,150 under an operating lease which
expires in October 2002.

Item 3. LEGAL PROCEEDINGS

The Company carries director and officer liability insurance, and has
indemnification agreements with its officers and directors.

10

From time to time, the Company is subject to legal actions and claims for
personal injuries or property damage related to patients who use its products.
The Company has obtained a liability insurance policy providing coverage for
product liability and other claims. Management does not believe that the
resolution of any current proceedings will have a material financial impact on
the Company or the consolidated financial statements.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Company's annual meeting of shareholders was held on June 21, 2001. At
the meeting Frank R. Pope, David V. Radlinski, Donald J. Regan and Michael C.
Tibbitts were elected directors of the Company.

EXECUTIVE OFFICERS OF THE REGISTRANT

Information regarding the Company's executive officers is included in Item
10 of Part III.

11

PART II

Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The Company's common stock is traded on the NASDAQ Stock Market under the
symbol MEDS. The following table sets forth the high and low sales prices of the
Company's common stock for the two years ended December 31, 2001 and December
31, 2000 as reported in the NASDAQ National Market System for the quarter
indicated.

High Low
---- ---
Year ended December 31, 2001
----------------------------

First quarter $ 6.69 $ 5.25
Second quarter 5.38 4.40
Third quarter 4.75 3.10
Fourth quarter 4.78 3.61

Year ended December 31, 2000
----------------------------

First quarter $ 8.00 $ 4.75
Second quarter 6.75 5.03
Third quarter 9.00 5.30
Fourth quarter 7.44 5.31

The stock markets have experienced extreme price and volume fluctuations
during certain periods. These broad market fluctuations and other factors may
adversely affect the market price of the Company's Common Stock. Any shortfall
in revenue or earnings from levels expected by securities analysts could have an
immediate and significant adverse effect on the trading price of the Company's
common stock in any given period. Additionally, the Company may not learn of
such shortfalls until late in the fiscal quarter, which could result in an even
more immediate and adverse effect on the trading price of the Company's stock.
Finally, the Company participates in a dynamic industry, which often results in
significant volatility of the Company's common stock price.

At March 4, 2002, there were 230 stockholders of record and approximately
1,800 beneficial owners of the Company's Common Stock.

The Company has not paid any cash dividends during its two most recent
fiscal years. The Company's board of directors does not presently anticipate
that any cash dividends will be paid in the foreseeable future.

12

Item 6. SELECTED FINANCIAL DATA

Consolidated Statements of Operations Data:
(in thousands, except per share amounts)

Year ended December 31,
---------------------------------------------------------------
2001 2000 1999 1998 1997
---------- --------- --------- --------- ---------

Revenues:
Net equipment sales $ 3,651 $ 3,284 $ 3,338 $ 2,144 $ 2,722
Procedure, maintenance, and
management fees 18,591 18,930 19,532 21,129 18,476
Interest and dividends 464 608 598 552 536
---------- --------- --------- --------- ---------
Total revenues 22,706 22,822 23,468 23,825 21,734
Costs and expenses:
Cost of sales 13,737 13,942 12,106 11,000 9,503
Research and development 1,320 1,180 1,456 1,079 1,021
Selling 2,682 2,175 2,048 1,988 2,257
General and administrative 2,554 2,651 2,592 2,131 2,231
---------- ---------- --------- --------- ---------
Total operating costs 20,293 19,948 18,202 16,198 15,012
---------- --------- --------- --------- ---------
Operating income 2,413 2,874 5,266 7,627 6,722
Other (income) expense (487) (1,773) (97) (61) (39)
Impairment reserves 3,232 --- --- --- ---
Minority interest in subsidiaries income 757 895 603 628 468
---------- --------- --------- --------- ---------
Income (loss) before provision (benefit)
for income taxes (1,089) 3,752 4,760 7,060 6,293
Provision (benefit) for income taxes (431) 1,663 1,919 2,718 2,329
---------- --------- --------- --------- ---------
Net income (loss) $ (658) $ 2,089 $ 2,841 $ 4,342 $ 3,964
========== ========= ========= ========= ========
Net income (loss) per share:
Basic $ (.16) $ 46 $ 57 $ 84 $ 74
========== ========= ========= ========= ========
Diluted $ N/A $ 46 $ 56 $ 82 $ 72
========== ========= ========= ========= ========

Consolidated Balance Sheet Data:
(in thousands)

December 31,
-----------------------------------------------------------------
2001 2000 1999 1998 1997
---------- --------- --------- --------- -----------

Working capital $ 16,617 $ 15,597 $ 17,539 $ 18,432 $ 16,256
Total assets 28,630 29,877 30,175 29,149 27,688
Total liabilities 4,040 3,569 3,758 3,216 3,567
Stockholders' equity 24,590 26,308 26,417 25,933 24,121

13

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

General

Medstone manufactures, markets and maintains lithotripters. The
lithotripters manufactured by Medstone are approved to treat both kidney stones
and certain gallstones. The Company is also marketing fixed and mobile urology
imaging and pain management tables and x-ray generators for medical imaging.

To date, the Company's consolidated revenues have come primarily from its
lithotripsy business. While it sells lithotripters and related supplies, most of
its lithotripsy revenues come from recurring procedure and maintenance fees and
other fee-for-service arrangements. The Company continues to expand its programs
under which company-owned lithotripters are made available for use by hospitals,
physician groups and surgical centers with charges being based on usage of the
equipment or monthly fees. The Company currently offers such lithotripsy
services throughout the United States using 15 STS Systems in mobile trailers,
one STS System at a fixed site and 25 transportable STS-T(C) Systems which are
at fixed locations or moved to different sites in small trucks.

In June 1996, the Company completed the acquisition of a 60% interest in
Northern Nevada, a lithotripsy partnership which deals directly with patient and
insurers, and also founded UPR as a majority-owned subsidiary of the Company, to
expand the Company's service orientation to the urologist practitioner. Both
entities signify the Company's emphasis on growth through expansion of
relationships and acquisition. In March 1997, the Company completed the
acquisition of a 60% interest in Southern Idaho Lithotripsy Associates LLC,
another operator of "retail" lithotripsy operations in Southern Idaho, and
operating results have been consolidated effective March 1997. In April 1999,
the Company purchased certain assets of Creos, Ltd., a manufacturer of high
performance x-ray generators and a supplier to the Company. The Company then
commenced manufacturing operations in a facility, located in Fife, Scotland,
formerly occupied by Creos, Ltd. In October 1999, the Company purchased the
outstanding shares of Zenith Medical Systems, Ltd., a distributor of major
imaging equipment to the British National Health Service, located in Manchester,
England. Both 1999 acquisitions' operating results have been consolidated
effective with their respective acquisition dates.

Goodwill represents approximately 11% and 12% of the Company's total assets
and stockholders' equity, respectively, at December 31, 2001. Goodwill resulted
from the excess of the purchase price of Northern Nevada, Southern Idaho and
Zenith Medical Systems, Ltd. over the fair value of the net assets acquired.
Goodwill was amortized over periods ranging from 15 to 40 years, the expected
period of benefit, using the straight-line method. As of January 1, 2002, the
Company will adopt SFAS 142 and no longer amortize goodwill on a periodic basis.
The Company will review the recoverable life of these intangible assets annually
to determine any impairment of the assets and write them down to their net
realizable value when necessary. The Company reviews other long-lived assets for
impairment whenever changes in circumstances indicate that the carrying value of
the asset may not be recoverable. Based upon the Company's analysis, which
includes a comparison of the carrying amounts of such assets to the Company's
historical actual cash flows and estimated future undiscounted cash flows, the
Company is not aware of any material portion of goodwill or other long-lived
assets which will dissipate over a shorter period than the amortization period
used.

From time to time, the Company makes investments in businesses which are
accounted for under the equity method. In 2001, the Company made an equity
investment of $1 million in Arcoma AB. During 2000, the Company made an
investment, including a subordinated loan, in Medicredit.com aggregating $3
million. During 1998 and 1999, the Company made an aggregate investment in
k.Biotech of $325,000. For 2001, the Company's share of net losses in these
unconsolidated subsidiaries and impairment reserves amounted to $3,354,106.
These net losses were composed of losses of $91,000 for Arcoma operations and
$325,000 for k. Biotech operations and reserves and losses and reserves of
$2,938,100 for Medicredit.com. The Company's share of losses in unconsolidated
subsidiaries in 2000, related to Medicredit.com, approximated $61,000. No
earnings or losses in unconsolidated subsidiaries were recognized in 1999. The
Company does not have additional financial commitments to these unconsolidated
subsidiaries. The future performance of the unconsolidated subsidiaries is
uncertain and therefore, the Company may recognize earnings or losses in
unconsolidated subsidiaries in the future.

14

Through its research and development, acquisitions and clinical
submissions, management believes that it is hiring and retaining the appropriate
personnel necessary to continue growth and development of the Company's product
lines and brand recognition.

In the ordinary course of business, the company has made a number of
estimates and assumptions relating to the reporting of results of operations and
financial condition in the preparation of its financial statements in conformity
with accounting principles generally accepted in the United States of America.
Actual results could differ significantly from those estimates under different
assumptions and conditions. The Company believes that the following discussion
addresses the Company's most critical accounting policies, which are those that
are most important to the portrayal of the Company's financial condition and
results. The Company constantly re-evaluates these significant factors and makes
adjustments where facts and circumstances dictate. Historically, actual results
have not significantly deviated from those determined using the necessary
estimates inherent in the preparation of financial statements. Estimates and
assumptions include, but are not limited to, customer receivables, inventories,
equity investments, fixed asset lives, contingencies and litigation. The Company
has also chosen certain accounting policies when options were available,
including:

. The first-in, first-out (FIFO) method to value a majority of our
inventories; and

. The intrinsic value method, or APB Opinion No. 25, to account for our
common stock incentive awards; and

. We record an allowance for credit losses based on estimates of
customers' ability to pay. If the financial condition of our customers
were to deteriorate, additional allowances may be required.

These accounting policies are applied consistently for all years presented.
Our operating results would be affected if other alternatives were used.
Information about the impact on our operating results is included in the
footnotes to our consolidated financial statements.

From time to time, the Company is subject to legal actions and claims for
personal injuries or property damage related to patients who use its products.
The Company has obtained a liability insurance policy providing coverage for
product liability and other claims. Management does not believe that the
resolution of any current proceedings will have a material financial impact on
the Company or the consolidated financial statements.

Results of Operations

Year Ended December 31, 2001 Compared to Year Ended December 31, 2000
- ---------------------------------------------------------------------

Revenue for 2001 totaled $22.7 million or a 1% decrease compared to revenue
of $22.8 million in 2000. Revenues from procedures, maintenance and management
fees decreased to $18.6 million in 2001 when compared to the $18.9 million in
revenue in 2000. This decrease was due to the continuing trend of lower revenue
per patient as competition forces price concessions during contract renewals
even as patient counts on both third party and Company owned equipment increased
in 2001. Overall, patient volume increased in 2001 by 3% on third party owned
equipment and 7% on Company owned equipment when compared to 2000. Revenue from
radiographic supplies increased in the current year due to a significant
contract for Medstone Ltd. x-ray generators and higher shipment volume of spare
parts. Partially offsetting the increased radiology revenue was a decrease in
service contract revenue as some maintenance contracts have expired and renewals
are at lower rates.

Equipment revenues increased by $367,000, or 11%, in 2001 when compared to
the same period in 2000 due to the increased number of imaging tables shipped by
the Company in 2001. The Company shipped 92 various patient handling tables in
2001, compared to 29 in the prior year. Partially offsetting this increase in
imaging table revenue was a reduction of the number of lithotripters shipped in
the current year, from 7 in 2000 to 6 in the current year.

Interest income decreased by 24% in 2001 when compared to 2000 due to
significantly lower investment yields resulting from the numerous cuts in the
prime interest rate and a reduction of almost $900,000 in the average invested
cash balance in 2001 compared to 2000.

15

Costs on recurring revenue decreased by $657,000 in 2001 when compared to
the same period of 2000. As a percentage of revenue, the recurring revenue cost
of sales decreased from 62% in 2000 to 59% in 2001. This decrease was due to the
reduced operating costs of the fixed-site fee-for-service lithotripsy units and
reduced costs of operation for the mobile trailer fleet as more units reach the
end of their depreciable lives.

Cost of equipment sales increased to $2.7 million in 2001, or 74% of sales
in the current year compared to $2.3 million, or 69%, for the year ended
December 31, 2000. This increase is due to the lower margin associated with the
sale of imaging tables compared to lithotripsy equipment.

Research and development costs increased by $138,000, or 12%, in the twelve
months ending December 31, 2001 when compared to the same period of 2000. This
increase is due to the development work on optional equipment for the UroPro
urology imaging table. The Company has also developed several enhancements for
the STS-T(C) lithotripter that will be introduced in 2002.

Selling costs increased from $2,175,000 in the year ending December 31,
2000 to $2,682,000 in the same period of 2001. This increase was due to higher
staffing levels, as the Company increased its number of imaging product
specialists and increased tradeshow expenses as the Company exhibited its
products at more regional imaging tradeshows. The Company also increased its bad
debt expense as the economic downturn increased the number of customers
extending payment of invoices and had a dispute with a distributor over amounts
owed on imaging tables.

General and administrative expenses decreased by $97,000 or 4% in the
twelve months ended December 31, 2001 compared to the same period in the prior
year due to lower consulting expenses for the gallstone treatment filing with
the FDA in 2000 and lower audit expenses due to management's decision to change
auditing firms.

Gain on sale of investments decreased to approximately $ 628,000 in the
twelve months ending December 31, 2001 compared to $1,882,000 in the same period
of 2000. In 2001, the Company sold 187,000 shares of Cardiac Science, Inc.
common stock, while in 2000, the Company sold 304,667 shares of Cardiac Science,
Inc. common stock and 5,000 shares of Genstar common stock. The net book value
of all shares sold is $0.

Other expense increased to $141,000 for the year ending December 31, 2001
from $109,000 in the same period of 2000, due to a loss on disposal of assets in
the current year.

Reserves for impairment of investments and long-term receivables increased
by $3,232,673 from no comparable value in the prior year as a result of the
Company's review of its k. Biotech and Medicredit investments and loans.

Minority interest in subsidiaries income decreased by $199,000 or 24% in
the twelve months ended December 31, 2001 compared to the same period of the
prior year. This decrease was due to lower profits in the Northern Nevada and
Southern Idaho operations.

Equity loss from unconsolidated subsidiaries increased to $121,000 for the
year ended December 31, 2001 compared to $61,000 in the same period of 2000 due
to losses at Arcoma in the current year.

Provision (benefit) for income taxes for the year 2001 changed by
$2,094,000 as a result of losses and reserves and the deferred tax benefits in
the current year when compared to the same period of 2000.

16

Year Ended December 31, 2000 Compared to Year ended December 31, 1999
- ---------------------------------------------------------------------

The Company recorded total revenue of $22.8 million in 2000, a 3% decrease
compared to the $23.5 million in total revenue recognized for the year ending
December 31,1999. Revenues from procedures, maintenance fees and fee-for-service
decreased to $18.9 million in 2000 when compared to the $19.5 million in revenue
in 1999. Pricing pressures continue to force per patient charges lower as
competing equipment has saturated the market with low cost, transportable
lithotripsy equipment. Patient volume and per patient fees both decreased during
2000 as sites continued to transition to lower cost equipment and more sites are
selecting a flat daily or monthly fee in anticipation of the release of final
Stark II regulations which occurred on January 4, 2001. Procedure fees from
third party equipment decreased by 11%, the second year in a row with decreased
fees. Although patient volume increased by 4% in 2000 when compared to 1999 fees
per procedure decreased. The Company experienced an increase in volume as
STS-T(C) units, which commenced shipment in 1999, reached full utilization and
also renewed interest in the Company's lithotripsy products was achieved due to
the approval of the gallstone procedure. Revenue from radiographic supplies
increased in the current year due to a full year of activity from both the
Medstone Ltd., and Zenith operations and additional activity from the expanding
product offerings from the Company during 2000.

Equipment revenues decreased by 2% in 2000 when compared to the same period
in 1999 as the number of lithotripters sold decreased to 7 in 2000, compared to
10 in 1999 and average sales prices decreased slightly. Offsetting this decrease
in lithotripters was the introduction of the imaging tables in 2000, with a
total of 29 various units sold in 2000. This equipment included pain management
tables, radiology tables and portable urology tables along with the imaging
systems associated with several unit sales.

Interest income increased by 1% in the current year when compared to the
same period of the prior year due to higher investment yields even though the
average invested balance has decreased substantially.

Costs on recurring revenue increased to $11.7 million, or 62% of recurring
revenue in 2000, compared to $10.2 million, or 52% of recurring revenue in 1999
due to the continuation of the Company's program of placement of a large number
of fixed-site fee-for-service lithotripsy units at hospitals and surgery
centers. It is expected that these units will drive long-term patient volume
growth with the continuous availability of equipment, along with the expectation
of additional volume due to the gallstone approval. Costs of providing
maintenance increased also due to the higher number of Company-owned units in
service.

Cost of equipment sales increased to $2.3 million in 2000, or 69% of sales
in the current year compared to $1.9 million, or 58%, for the year ended
December 31, 1999. This increase is due to the lower margin associated with the
sale of radiology equipment when compared to the historical higher margin on
lithotripsy equipment. Lithotripsy equipment margins deteriorated slightly due
to unabsorbed overhead expenses due to lower actual production levels when
compared to plan.

Research and development costs decreased by 19%, or $275,000 in the twelve
months ending December 31, 2000 when compared to the same period of 1999. This
decrease is due to the majority of the development work on the UroPro-2000
urology imaging table occurring earlier in 2000 and reduced staffing after
completion in 1999 of the final development of the STS-T(C).

Selling costs increased by $126,000, or 6%, for the year ending December
31, 2000 compared to the same period in 1999 due to higher advertising,
tradeshow and consulting expenses with the introduction of the new imaging table
products. The Company has also increased its efforts to sell into the government
contract market and is incurring expenses to establish reimbursement guidelines
for gallstone lithotripsy.

General and administrative expenses increased by $59,000 or 2% in the
twelve months ended December 31, 2000 compared to the same period in the prior
year due to higher consulting expenses for the gallstone post-approval work,
higher audit expenses due to the expanded scope of the Company's operations, and
a full year's expenses in Medstone Ltd.

Gain on sale of investments was approximately $1,882,000 in the twelve
months ending December 31, 2000 compared to $244,000 in the same period of 1999.
In 2000, the Company sold 304,667 shares of Cardiac Science, Inc. common stock
and 5,000 shares of Genstar common stock, while in 1999 the Company sold
warrants to purchase 87,500 shares of Cardiac Science common stock. The net book
value of these sales was $0.

17

Minority interest in subsidiaries income increased by $292,000 or 48% in
the twelve months ended December 31, 2000 when compared to the same period of
the prior year due to substantially higher activity in the Northern Nevada and
Southern Idaho operations. Also the Company, through its equity investment in
Medicredit, recognized a $61,000 expense for its portion of the operating losses
of Medicredit from April 1, 2000 through December 31, 2000.

Provision for income taxes for the year 2000 decreased by $256,000 as a
result of lower taxable income in the current year when compared to the same
period of 1999.

Liquidity and Capital Resources

The Company began the year 2001 with approximately $6.1 million in cash and
short-term investments, no debt, inventories of $6.1 million, and total assets
of $29.9 million. After the purchase of $1.0 million of treasury stock, an
investment in Arcoma of $1.0 million, fixed asset additions of $1.4 million and
other cash usages, offset by proceeds from the sale of long-term investments of
$.6 million and net cash provided by operating activities of $4.0 million, the
Company ended the year with approximately $6.5 million in cash and short-term
investments, no debt, inventories of $6.3 million and total assets of $28.6
million.

During 2001, the Company purchased 197,000 shares of treasury stock for
$1,038,266. The Company estimates that the purchase resulted in a 5% increase in
basic net income per share.

The Company's long-term capital expenditure requirements will depend upon
numerous factors, including the progress of the Company's research and
development programs, the time required to obtain regulatory approvals, the
resources that the Company devotes to the development of self-funded products,
proprietary manufacturing methods and advanced technologies, the cost of
acquisition and/or new revenue opportunities, the ability of the Company to
obtain additional licensing arrangements and to manufacture products under those
arrangements, the demand for its products if and when approved and possible
acquisitions of products, technologies and companies.

The Company believes that its existing working capital and funds
anticipated to be generated from operations will be sufficient to meet the cash
needs for continuation of its present operations during 2002. See "Safe Harbor
Statement under the Private Securities Litigation Reform Act of 1995."

Recently Issued Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board issued Statements of
Financial Accounting Standards No. 141, Business Combinations, and No. 142,
Goodwill and Other Intangible Assets, effective for fiscal years beginning after
December 15, 2001. Under the new rules, goodwill (and intangible assets deemed
to have indefinite lives) will no longer be amortized but will be subject to
annual impairment tests in accordance with the Statements. Other intangible
assets will continue to be amortized over their useful lives.

The Company will apply the new rules on accounting for goodwill and other
intangible assets beginning in 2002. Application of the non-amortization
provisions of the Statement is expected to result in an increase in net income
of $60,000 per year. During 2002, the Company will perform the first of the
required impairment tests of goodwill and indefinite lived tangible assets as of
January 1, 2002 and has not yet determined what the effect of these tests will
be on the earnings and financial position of the Company.

SFAS No. 143, "Accounting for Asset Retirement Obligations," addresses
financial accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and the associated asset retirement
costs. This Statement applies to legal obligations associated with the
retirement of long-lived assets that result from the acquisition, construction,
development and (or) the normal operation of a long-lived asset. The provisions
of this Statement are required to be applied starting with fiscal years
beginning after June 15, 2002. The adoption of SFAS No. 143 is not expected to
have a material effect on the Company's financial statements.

SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets," addresses financial accounting and reporting for the impairment or
disposal of long-lived assets. SFAS 144 replaces SFAS 121 and amends certain
other accounting pronouncements. The provisions of this Statement are effective
for financial

18

statements issued for fiscal years beginning after December 15, 2001. The
adoption of SFAS No. 144 is not expected to have a material effect on the
Company's financial statements.

Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995

Forward-looking statements in this report, including without limitation,
statements relating to the Company's plans, strategies, objectives,
expectations, intentions and adequacy of resources, are made pursuant to the
safe harbor provisions of the Private Securities Litigation Reform Act of 1995.
Investors are cautioned that such forward-looking statements involve risks and
uncertainties including without limitation the following: (i) the Company's
plans, strategies, objectives, expectations and intentions are subject to change
at any time at the discretion of the Company, (ii) the Company's plans and
results of operations will be affected by the Company's ability to manage its
growth; (iii) the Company's businesses are highly competitive and the entrance
of new competitors into or the expansion of the operations by existing
competitors in the Company's markets and other changes could adversely affect
the Company's plans and results of operations; and (iv) other risks and
uncertainties indicated from time to time in the Company's filings with the
Securities and Exchange Commission.

19

Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company has no financial instruments which are subject to market risk.
Although the Company's earnings and cash flows are subject to fluctuations due
to changes in the interest rates on its investments, a hypothetical 10% adverse
decrease in the interest rates would not have a material adverse effect on the
results of operations because the majority of the Company's investments are
short-term treasury bills. A 10% reduction in interest rates would reduce
interest income by approximately $50,000 annually. Due to the short period to
maturity, the Company believes that the impact of a 10% reduction in interest
rates would not have a material effect on the carrying value of its securities.

The Company's earnings and cash flows at Medstone International, Ltd., a
Scottish subsidiary, are subject to fluctuations due to changes in foreign
currency rates. The Company believes that changes in the foreign currency
exchange rate would not have a material adverse effect on its results of
operations as the majority of its foreign transactions are delineated in
Medstone International, Ltd.'s functional currency, the British Pound.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

See Item 14. "Exhibits, Financial Statement Schedules, and Reports on Form
8-K."

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

On November 30, 2001, the Company dismissed Ernst & Young LLP as the
Company's auditors. Also as of November 30, 2001, the Company retained Moss
Adams LLP as auditor of the Company's financial statements for the fiscal year
ending December 31, 2001.

As of November 30, 2001 there were no disagreements between the Company and
Ernst & Young LLP regarding accounting or financial disclosures.

20

PART III

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Directors

The following are the directors of the Company:

Name Age Principal Occupation
---- --- --------------------
David V. Radlinski 57 Chairman of the Board and
Chief Executive Officer of the Company

Frank R. Pope 52 Executive Managing Director
The Global Financial Group

Donald J. Regan 67 Chairman of the Board
Advanced Biocatalytics Corporation.

Michael C. Tibbitts 54 Executive Vice President
Quality System Solutions

David A. Reed 69 Consultant
DAR Consulting Group

Jack Olshansky 73 Consultant

Mr. Radlinski has been the Chairman of the Board and Chief Executive
Officer of the Company since September 1995. He had been the President of the
Company's subsidiary, Medstone International, Inc., and Chief Financial Officer
and Secretary of the Company from January 1991 to September 1995. From July 1987
to January 1991, he was the Company's Executive Vice President of Finance, Chief
Financial Officer and Secretary. From 1984 to 1987, he was Vice President of
Finance and Chief Financial Officer of Printronix, Inc., a publicly-owned
company which manufactured computer printers.

Since April 2000, Mr. Pope has been the Executive Managing Director of The
Global Financial Group, a private fund management firm. He is also Managing
Director of Verdigris Capital, a private investment firm. From April 1981 to
October 1996, Mr. Pope was a General Partner with Technology Funding, a venture
capital investment firm. He was also the Executive Vice President, Chief
Financial Officer and a director of Technology Funding Inc. Mr. Pope is also a
director of Thermatrix, Inc., a chemical processor company, a director of
Breadcrumbs.com, Inc., a private developer of a new internet search engine, and
a director and officer of Advanced BioCatalytics Corp., a private biotech
company. Mr. Pope is a C.P.A. and a member of the California Bar. He has been a
director of the Company since January 1991.

Mr. Regan, an attorney, is currently the President and Chairman of the
Board of Advanced Biocatalytics Corporation, a founder and director of
Breadcrumbs, Inc., and a consultant to Kinsell, Newcomb & De Dios, Inc., a
municipal securities investment banking firm. Mr. Regan has practiced
securities, municipal finance, nonprofit corporation, real estate, and business
transactions law for over thirty years. He has published several articles on
securities law and served as a lecturer for the Practicing Law Institute. He has
been a director of the Company since September 1995.

Mr. Tibbitts is currently Executive Vice President of Quality System
Solutions, a medical software company. From May 1991 to May 1999, he was Vice
President of Gulf South Medical Supply, Inc., a medical supply distributor.
Prior to joining that corporation, he was employed for 19 years by Johnson &
Johnson in two divisions:

21

Sterile Design (which manufactured and marketed kit packages) and Surgikos
(which manufactured and marketed surgical supplies). He has been a director of
the Company since May 1996.

Mr. Reed, now retired, was formerly president and chief executive officer
of St. Joseph Health System in Orange, California. He was also formerly the
Board Chairman of Mission Hospital Regional Medical Center in Mission Viejo,
California. He serves as a Board Chairman of PacifiCare Health Systems, a
publicly traded health care company. He has been a director of the Company since
August 1999.

Mr. Olshansky, appointed to the Board in February 2002, recently retired
from Montgomery Medical Ventures, a venture capital fund dedicated to emerging
companies in the medical field. Mr. Olshansky spent over 15 years on developing
and financing over 50 companies during his tenure at Montgomery Medical
Ventures. He currently serves on the Board of Directors of 4 companies in the
medical field. From 1953 to 1983 Mr. Olshansky was involved with Baxter Travenol
Laboratories, the Inspiron division of C.R. Bard and Cutter's Medical Division,
where he held various executive management positions.

Executive Officers

The names, ages and positions of all the executive officers of the Company
as of March 4, 2002 are listed below, followed by a brief account of their
business experience during the past five years. Officers are normally appointed
annually by the Board of Directors at a meeting of the directors immediately
following the Annual Meeting of Shareholders. There are no family relationships
among these officers nor any arrangements or understandings between any officer
and any other person pursuant to which an officer was selected. None of these
officers has been involved in any court or administrative proceeding within the
past five years adversely reflecting on his or her ability or integrity.

Name Age Position
---- --- --------

David V. Radlinski 57 Chief Executive Officer and Chairman of the Board

Mark Selawski 46 Vice President of Finance,
Chief Financial Officer and Secretary

Eva Novotny 44 Executive Vice President of Sales and Marketing

Mr. Radlinski has been the Chairman and Chief Executive Officer of the
Company since September 1995. He had been the President of the Company's
subsidiary, Medstone International, Inc., and Chief Financial Officer and
Secretary of the Company from January 1991 to September 1995. From July 1987 to
January 1991, he was the Company's Executive Vice President of Finance, Chief
Financial Officer and Secretary. From 1984 to 1987, he was Vice President of
Finance and Chief Financial Officer of Printronix, Inc., a publicly-owned
company which manufactured computer printers.

Mr. Selawski has been the Chief Financial Officer, Vice President of
Finance and Secretary of the Company since September 1995. He had previously
served as the Company's Manager of Planning and Analysis since joining the
Company in 1988. Prior to joining the Company he held various finance management
positions with several high-tech manufacturing companies.

Ms. Novotny has been Executive Vice President of Sales and Marketing of the
Company since October 1997. Prior to joining the Company, she was Director of
Marketing for Imagyn Medical, formerly UroHealth, a medical device company, from
June 1995 to October 1997. From 1985 to 1995, she was employed by Mentor
Corporation, a manufacturer of aesthetic and general surgery products, as a
Marketing Manager and later as Director of Marketing for Mentor Urology.

Section 16(a) Beneficial Ownership Reporting Compliance

22

The Company is not aware of any director, officer or 10% shareholder who
during 2001 failed to file on a timely basis any report regarding the Company's
securities required by Section 16(a) of the Securities Exchange Act of 1934.

23

Item 11. EXECUTIVE COMPENSATION

Executive Compensation

The following table sets forth certain information regarding compensation
paid by the Company during each of the Company's last three fiscal years to the
Company's Chief Executive Officer and to each of the Company's other executive
officers.

SUMMARY OF COMPENSATION TABLE

Long Term Compensation
------------------------------------------
Annual Compensation Awards Payouts
-----------------------------------------------------------------------------------
Restricted Securities
Other Annual Stock Underlying LTIP All Other
Name and Fiscal Salary Bonus Compensation Award(s) Options Payouts Compensation
Principal Position Year (S)/(1)/ ($) ($) ($) (#)/(2)/ ($) ($)
- ------------------------------------------------------------------------------------------------------------------------------------

David V. Radlinski 2001 250,000 500 2,426 --- 150,000 --- ---
Chairman of the Board and 2000 250,000 --- 2,224 --- --- --- ---
Chief Executive Officer 1999 250,000 --- 2,426 --- --- --- ---

Mark Selawski 2001 113,860 500 --- --- 20,000 --- ---
Chief Financial Officer, 2000 101,667 5,500 --- --- --- --- ---
Vice President of Finance 1999 105,625 500 --- --- --- --- ---
and Secretary

Eva Novotny 2001 120,000 500 --- --- 20,000 --- ---
Executive Vice President 2000 120,000 5,500 --- --- --- --- ---
of Sales and Marketing 1999 120,000 500 --- --- --- --- ---

- ---------------------------------
(1) In addition to the cash compensation shown in the table, executive officers
of the Company may receive indirect compensation in the form of perquisites
and other personal benefits. For each of the named executive officers, the
amount of this indirect compensation in 2001, 2000 and 1999 did not exceed
the lesser of $50,000 or 10% of the executive officer's total salary and
bonus for that year.

(2) Options to acquire shares of Common Stock granted or repriced.

Employment Agreements

Mr. Radlinski - On August 13, 1998, the Company entered into an employment
agreement with Mr. Radlinski to assure his continued service to the Company. The
agreement runs for a term of five years, expiring on August 13, 2003. The
agreement provides for a base salary of not less than $250,000 per year, subject
to adjustments as authorized by the Board of Directors.

Mr. Radlinski is also eligible for bonuses based on performance of the
Company's Common Stock. The Common Stock's closing price must attain and remain
at or above various levels, ranging from $11 to $21, for a period of 90
consecutive days. If these breakpoint prices are achieved within a set number of
months, the longest which is 48 months, from the commencement of the contract, a
cash bonus will be paid following the achievement

24

period. Each breakpoint bonus can be earned separately if achieved within the
stated achievement period, but each bonus can only be awarded once.

Concurrent with the commencement of this agreement, the exercise prices of
Mr. Radlinski's existing stock options to purchase up to 350,000 shares of the
Company's Common Stock from $7.13 to $10.63 were reduced to equal $6.375 per
share, the closing price per share of the Company's Common Stock on the
commencement date as reported on the NASDAQ National Market System. Such option
agreements were amended to provide that they shall become fully exercisable,
regardless of any otherwise applicable vesting requirements, (i) concurrently
with any termination of Mr. Radlinski's employment by the Company without "Good
Cause" (as defined), or (ii) if there is an acquisition of substantially all of
the Company's assets or business while he is still employed by the Company and
he does not immediately enter into an employment agreement with a buying or
surviving party in the transaction (a "change in control").

If he had been terminated without "Good Cause" or a change of control
occurred within the first three years of the agreement, a severance payment of
five times his then current base salary would have been due and payable. If he
is terminated without "Good Cause" or such a change of control occurs within the
fourth year of the agreement, a severance payment of four times his then current
base salary will be due and payable. If he is terminated without "Good Cause" or
a change of control occurs within the fifth year of the agreement, a severance
payment of three times his then current base salary will be due and payable.

In addition to the preceding paragraph, if Mr. Radlinski had been
terminated without Good Cause in the first three years of this agreement, he
would have become a consultant to the Company for a period of five years
following termination at a monthly compensation of $16,500 per month. If he is
terminated without Good Cause in the fourth year of this agreement, he will
become a consultant to the Company for a period of four years following
termination at the same monthly compensation. If he is terminated without Good
Cause in the fifth year of this agreement, he will become a consultant to the
Company for a period of three years following termination at the same monthly
compensation. The Company, during the consulting contract, shall provide term
life insurance equivalent to the unpaid amount of the consulting fees as
established above, payable to the beneficiary of his designation.

Mr. Selawski and Ms. Novotny - On August 13, 1998, the Company entered into
employment agreements with both Mr. Selawski and Ms. Novotny to assure their
continued service to the Company. The agreements ran for a term of three years
and expired without renewal on August 13, 2001. The agreements provided for a
base salary of not less than $100,000 per year for Mr. Selawski and $120,000 per
year for Ms. Novotny, subject to adjustments as authorized by the Board of
Directors.

Concurrent with the commencement of these agreements, the exercise prices
of Mr. Selawski's existing stock options to purchase up to 80,000 shares of the
Company's Common Stock at from $7.13 to $9.68 were reduced to equal $6.375 per
share, the closing price per share of the Company's Common Stock on the
commencement date as reported on the NASDAQ National Market System. Ms.
Novotny's existing stock options to purchase up to 70,000 shares of the
Company's Common Stock at from $9.68 to $10.68 were reduced to equal $6.375 per
share, the closing price per share of the Company's Common Stock on the
commencement date as reported on the NASDAQ National Market System. Each such
option agreement was amended to provide that it shall become fully exercisable,
regardless of any otherwise applicable vesting requirements, (i) concurrently
with any termination of the officer's employment by the Company without Good
Cause, or (ii) if there is an acquisition of substantially all of the Company's
assets or business while such officer is still employed by the Company and he or
she does not immediately enter into an employment agreement with a buying or
surviving party in the transaction. If the officer was terminated without "Good
Cause" or such a change of control occurred within the term of the agreement, a
severance payment of two times his or her then current base salary would have
been due and payable.

Stock Option Grants During 2001

25

The following table provides information related to the stock options
granted in 2001.

Potential
Individual Grants Realizable
- ---------------------------------------------------------------------------- Value at Assumed
Shares % of Total Annual Rates of
Underlying Employee Stock Price
Options Options Appreciation for
Granted or Granted or Exercise Option Term
Repriced Repriced in Price Expiration -------------------
Name (#)(1) Fiscal Year ($/Share)(2) Date 5% ($) 10% ($)
---- ------ ----------- ------------ ---- ------- --------

David V. Radlinski 50,000 16% 4.85 6/20/07 82,450 186,725
100,000 33% 5.00 9/25/07 170,000 385,000

Mark Selawski 20,000 7% 4.85 6/20/07 32,980 74,960

Eva Novotny 20,000 7% 4.85 6/20/07 32,980 74,960

- ---------------
(1) The options granted or repriced vest equally over a 60-month period
commencing upon the original grant date. The first six months after a grant
does not allow exercise of the option for the then vested shares. The
options are for a 6-year term, subject to earlier termination in certain
events related to termination of employment. The option exercises may be
accelerated if there is a termination of employment or an acquisition of
substantially all of the Company's assets or business, as described under
"Employment Agreements" above. The Compensation Committee retains
discretion, subject to the option plans' limits, to modify the terms of
outstanding options.

(2) Subject to certain conditions, the exercise price may be paid by delivery
of already owned shares and the tax withholding obligations related to
exercise may be paid by reduction of the underlying shares.

26

Stock Options Held at End of Fiscal Year

The following table provides information related to options exercised
during 2001 and options held by the named executive officers at December 31,
2001.

Number of Securities Value of Unexercised
Underlying Unexercised In-the-Money
Value Options at FY-End (#) Options at FY-End ($)/(2)/
Shares Acquired Realized ---------------------------- ------------------------------
Name on Exercise (#) ($)/(1)/ Exercisable Unexercisable Exercisable Unexercisable
---- --------------- ------ ----------- ------------- ----------- -------------

David V. Radlinski --- --- 191,667 158,333 --- ---

Mark Selawski --- --- 55,000 25,000 --- ---

Eva Novotny --- --- 58,334 31,666 --- ---

- -----------------------
(1) The value is calculated based on the difference between the option exercise
price and the market price for the Company's Common Stock on the exercise
date, multiplied by the number of shares purchased. For this purpose, the
surrender or withholding of shares to pay the exercise price is not taken
into account.

(2) The closing price for the Company's Common Stock as reported by the
National Association of Securities Dealers (NASD) on December 31, 2001 was
$4.25. Value is calculated on the basis of the difference between the
option exercise price and $4.25, multiplied by the number of shares of
Common Stock underlying the option.

Compensation Committee Interlocks and Insider Participation

During 2001 Donald J. Regan and Frank R. Pope served as the members of the
Company's Compensation Committee. Neither such individual is a current or former
officer or employee of the Company or any of its subsidiaries. During 2001 there
were no compensation committee interlocks between the Company and other entities
involving Medstone executive officers serving as directors or members of
compensation or similar committees of such other entities.

Compensation of Directors

The Company currently compensates its outside directors, Messrs. Regan,
Tibbitts, Pope, Reed and Olshansky, a $10,000 annual retainer, paid quarterly,
and $1,000 per Board meeting for their services, and reimburses all directors
for expenses incurred by them in connection with the Company's business.

Under the Nonemployee Director Stock Option Plan which expired in June
1999, each new nonemployee director was automatically granted an option to
purchase up to 5,000 shares as of the effective date of his or her first
appointment to the Board or first election to the Board by the shareholders,
whichever is earlier. Subject to acceleration of the option exercises in the
event of certain events specified in the plan, including certain changes in
control based on altered makeup of the Company's Board or stockholders, each
such option becomes exercisable with respect to 1/60 of the shares issuable for
each elapsed full month during the five-year period after its grant date during
which the optionee remains on the Company's board. The exercise price of each
option equals the fair market value of the underlying Common Stock on the date
the option was granted. Each option will expire six years after its grant,
except that the expiration will be extended until one year after the optionee's
death if it occurs less than one year before the option's expiration date. An
option granted under the plan is not transferrable during the grantee's lifetime
and must be exercised within one year following his or her death, or within 90
days after the grantee ceases to be a member of the Board for any other reason,
and will only be exercisable to the extent it is exercisable on the date the
grantee leaves the Board. Under this plan, Mr. Regan was granted 5,000 shares in
September 1995 and Mr. Tibbitts was granted 5,000 shares in May 1996. Both
grants have exercise prices of $6.375 after repricing of the options on August
13, 1998. Mr. Regan's option expired in September 2001 and was not exercised.

27

Options to purchase 15,000 shares of Common Stock were issued to Mssrs.
Pope, Regan and Tibbitts in November 1996 and have exercise prices of $6.375
after repricing of the options on August 13, 1998. The options were exercisable,
after six months following their grant dates, in incremental amounts equal to
1/48 of the underlying shares for each elapsed calendar month during which the
director remained on the Company's Board. The terms of the options were five
years, subject to earlier termination related to the director no longer serving
on the Board. These options expired as of November 2001 and were not exercised.
Additionally, each such director was granted options under the Company's 1997
Stock Incentive Plan, on August 13, 1998 and June 24, 1999, for 4,000 shares at
an exercise price of $6.375 and $7.375, respectively. These options are
exercisable, after six months following their grant dates, in incremental
amounts equal to 1/36 of the underlying shares for each elapsed calendar month
during which the director remains on the Company's Board. The term of the
options are four years, subject to early termination related to the director no
longer serving on the Board.

Upon his becoming a director in July 1999, Mr. Reed was granted an option
under the 1997 Stock Incentive Plan to purchase up to 5,000 shares of Common
Stock at an exercise price of $6.56 per share. Subject to acceleration of the
option exercise in the event of certain events specified in the option
agreement, including certain changes in control based on altered makeup of the
Company's Board or shareholders, the option becomes exercisable, after six
months following its grant date, with respect to 1/60 of the shares issuable for
each elapsed full month during the five-year period after its grant date during
which Mr. Reed remains on the Company's Board. The option term is six years,
subject to early termination related to Mr. Reed no longer serving on the Board,
but the option will be extended one year after his death if it occurs less than
one year before the expiration date.

Upon his becoming a director in February 2002, Mr. Olshansky was granted an
option under the 1997 Stock Incentive Plan to purchase up to 5,000 shares of
Common Stock at an exercise price of $4.85 per share. Subject to acceleration of
the option exercise in the event of certain events specified in the option
agreement, including certain changes in control based on altered makeup of the
Company's Board or shareholders, the option becomes exercisable, after six
months following its grant date, with respect to 1/60 of the shares issuable for
each elapsed full month during the five-year period after its grant date during
which Mr. Olshansky remains on the Company's Board. The option term is six
years, subject to early termination related to Mr. Olshansky no longer serving
on the Board, but the option will be extended one year after his death if it
occurs less than one year before the expiration date.

Subject to certain exceptions set forth in the applicable plan or agreement
provisions, the exercisability of the outstanding options held by the
nonemployee directors will be accelerated, and the options will thereafter
terminate, if there is a reorganization, merger or consolidation as a result of
which the Company is not the surviving corporation or the Company's outstanding
shares are changed into or exchanged for cash, property or securities not of the
Company's issue, or if there is a sale of all or substantially all of the
Company's assets. Such accelerations will not apply if appropriate provision is
made in the transaction for the assumption of such options by, or the
substitution of new options for such options covering the stock of, the
surviving, successor or purchasing corporation or its affiliate.

28

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth the number of shares of the Company's Common
Stock known to the Company to be beneficially owned as of March 4, 2002 by each
person who owns beneficially more than 5 percent of the outstanding shares of
Common Stock, by each of the present directors, by each of the executive
officers named in the Executive Compensation table in Item 11 and by all
executive officers and directors of the Company as a group, and the percentage
of the total outstanding shares of Common Stock such shares represented as of
March 4, 2002.

Number of Shares
Beneficially Percentage of
Name and Address of Beneficial Owner Owned(1) Ownership
------------------------------------ -------- ---------

FMR Corp. 561,200 14.1%
82 Devonshire Street
Boston, MA 02109

Hathaway & Associates, Ltd. 399,000 10.0%
119 Rowayton Avenue
Rowayton, CT 06853

Dimensional Fund Advisors, Inc. 364,700 9.2%
1299 Ocean Ave., 11th Floor
Santa Monica, CA 90401

David V. Radlinski/(2)//(3)/ 290,881/(4)/ 7.0%
100 Columbia, Suite 100
Aliso Viejo, CA 92656

Lloyd I. Miller III 289,060/(5)/ 7.3%
4550 Gordon Drive
Naples, FL 34102

Eva Novotny/(3)/ 65,133/(6)/ 1.6%
100 Columbia, Suite 100
Aliso Viejo, CA 92656

Mark Selawski/(3)/ 62,847/(7)/ 1.6%
100 Columbia, Suite 100
Aliso Viejo, CA 92656

Donald J. Regan/(2)/ 14,378/(8)/ /(11)/
462 Stevens Avenue, Suite 308
Solana Beach, CA 92075

Michael C. Tibbitts/(2)/ 9,778/(8)/ /(11)/
27001 La Paz Road, Suite 448B
Mission Viejo, CA 92691

Frank R. Pope/(2)/ 9,778/(8)/ /(11)/
3460 Baker St.
San Francisco, CA 94123

David A. Reed/(2)/ 2,750/(9)/ /(11)/
24681 La Plaza, Suite 240
Dana Point, CA 92629

Jack Olshansky/(2)/ 347/(10)/ /(11)/
78305 Sunrise Canyon Avenue
Palm Desert, CA 92211

All executive officers and directors 454,142 10.5%
as a group (8 persons)/(12)/

- ---------------
(1) All such shares were held of record with sole voting and investment power,
subject to applicable community property laws, by the named individual
and/or by his wife, except as indicated in the following footnotes.

(2) Director of the Company.

29

(3) Executive officer of the Company.

(4) Includes 208,333 shares issuable upon exercise of presently outstanding
stock options.

(5) Includes 84,110 shares in which Mr. Miller shares voting and dispositive
power as adviser to the trustee of certain family trusts.

(6) Includes 64,333 shares issuable upon exercise of presently outstanding
stock options.

(7) Includes 58,667 shares issuable upon exercise of presently outstanding
stock options.

(8) Includes 7,778 shares issuable upon exercise of presently outstanding stock
options.

(9) Includes 2,750 shares issuable upon exercise of presently outstanding stock
options.

(10) Includes 167 shares issuable upon exercise of presently outstanding stock
options.

(11) Percentage information is omitted because the beneficially owned shares
represent less than 1% of the outstanding shares of the Company's Common
Stock

(12) Includes 357,584 shares issuable upon exercise of presently outstanding
stock options.

30

Item 13. CERTAIN RELATIONSHIPS AND INVESTMENTS

Cardiac Science, Inc.
- ---------------------

During 1991, the Company was a party to the formation of Cardiac Science,
Inc., for which the Company purchased 5,353,031 (pre-split) shares of common
stock, for a cash payment of $.0016 per share. This purchase represented 77.3%
of the outstanding stock. As of July 8, 1991, the Company distributed, as a
dividend to its stockholders of record on that date, one share of Cardiac
Science, Inc. stock for each share of Medstone stock held. The Company retained
629,768 (pre-split) shares of common stock of Cardiac Science, Inc.

From 1991 through 1996, the Company performed various financings for
Cardiac Science and received warrants to purchase Cardiac Science common stock.
Due to exercise of warrants, common stock issued in lieu of interest and
unsecured advances, the Company received 5,619,054 (pre-split) shares of Cardiac
Science.

In April 1997, Cardiac Science effectuated a 1 for 11.42857142 reverse
stock split, reducing the Company's holdings to 546,772 shares.

Since mid-1999, the Company has been actively selling its position in
Cardiac Science, selling 55,105 shares for a gain of approximately $244,000 in
1999, selling 304,667 shares for a gain of approximately $1,855,000 in 2000, and
selling 187,000 shares for a gain of approximately $628,000 in 2001. The Company
no longer holds any shares of Cardiac Science common stock.

Also during 1999, the Company, which held unexpired warrants to purchase
87,500 shares at $.011 each, sold these warrants for a cash price of $3.00 per
share, resulting in a gain of approximately $262,000.

Digital Imaging Systems, Inc.
- -----------------------------

In 1998, the Company entered into a supply agreement with Digital Imaging
Systems, Inc. ("DIS") for components integral in the Company's STS-T(C). The
Company purchased $300,000, or 300,000 shares, of DIS preferred stock, which
represented a 14% ownership interest. DIS commenced shipments of the components
to the Company as of January 1999. In 1999, the Company recorded an investment
writedown of $300,000 for impairment as a result of its review of the realizable
value of its investment in DIS shares. Since early 2001, the Company no longer
purchases equipment from DIS and, as of August 2001, DIS has ceased operations
while it seeks additional funding and revenue sources.

k. Biotech
- ----------

In 1998, the Company was made aware of an opportunity to invest in a
developmental biotech drug company catering to the members of the International
Centre for Genetic Engineering and Biotechnology ("ICGEB"), a United Nations
sponsored institute. k. Biotech purchased license agreements for formulas,
developed by the ICGEB, for commercialization purposes in the Indian
sub-continent as its primary market. The Company purchased $325,000 of preferred
stock to assist k. Biotech in establishing itself as a viable business entity.
As of September 2001, the Company had recognized $45,338 as its share of the
losses of k.Biotech, and had reserved the remaining $279,662 investment as
k.Biotech seeks additional funds to continue the next stage of its business
plan. Two of the Company's directors, Mssrs. Pope and Regan, are investors in
k.Biotech and Mr. Regan serves as k. Biotech's President.

Medicredit.com, Inc.
- --------------------

In April 2000, the Company purchased common stock representing a 46%
interest in Medicredit.com, Inc. ("Medicredit") for $1 million in cash.
Medicredit, a California-based company, funds and service loans to physicians to
finance elective surgeries in the cosmetic and cash paying sector of healthcare.
Mssrs. Radlinski and Selawski serve on the Medicredit Board of Directors. Along
with the cash investment in Medicredit, the Company also agreed to a
subordinated line of credit of up to $2 million at the prime interest rate.
Based on the Company's review of the current cash flow and equity balance of
Medicredit as of December 31, 2001, it was determined that a reserve of the
entire balance of $953,011 should be recorded against the investment carrying
value and a reserve of

31

the entire balance of $2 million should be recorded against the subordinated
debt value. As of March 4, 2002, the Company's 46% ownership interest and credit
line are both fully reserved, reducing the carrying value of each to $0.

The Company also records its share of Medicredit's profits and losses in
equity loss from unconsolidated subsidiaries in the Company's Consolidated
Financial Statements.

Arcoma AB
- ---------

In September 2001 the Company purchased common stock representing a 25%
interest in Arcoma AB ("Arcoma") for $1 million in cash. Arcoma, based in Vaxjo,
Sweden, is a designer and manufacturer of medical imaging tables/devices. Arcoma
is a supplier of several types of tables that the Company currently markets,
including the UroPro 2000 table introduced in 2000. The Company will continue to
expand its distribution of Arcoma-designed devices in the United States in
future years. The investment in Arcoma is accounted for under the equity method.
The investment, net of the company's share of net losses for the period from
September 1, 2001 through December 31, 2001 of $91,000, is included in
Investment in unconsolidated subsidiaries in the Company's Consolidated
Financial Statements.

32

PART IV

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a) Index to Consolidated Financial Statements Page
----
1. Consolidated Financial Statements
Reports of Independent Auditors 34
Consolidated Balance Sheets at December 31, 2001 and 2000 36
Consolidated Statements of Operations for the
years ended December 31, 2001, 2000 and 1999 37
Consolidated Statements of Stockholders' Equity
for the years ended December 31, 2001, 2000 and 1999 38
Consolidated Statements of Cash Flows for the
years ended December 31, 2001, 2000 and 1999 39
Notes to Consolidated Financial Statements 40

2. Schedule to Consolidated Financial Statements
Schedule II - Valuation and Qualifying Accounts 53
All other schedules are omitted because they are not applicable
or the required information is included in the consolidated
financial statements or notes thereto.

(b) Reports on Form 8-K
There was one report filed with the Commission on Form 8-K on December 7,
2001 relating to the change of the Company's auditors.

(c) Exhibits

Exhibit No. Description
----------- ------------------------
3.1 Certificate of Incorporation of the Company, as amended (1)
3.2 Restated and Amended Bylaws of the Company (2)
4.2 Specimen Certificate of the Company's Common Stock (3)
10.26 1989 Stock Incentive Plan (4)(5)
10.27 Non-employee Director Stock Option Plan (4)(5)
10.29 1997 Stock Incentive Plan (5)(6)
10.30 Employment Agreement with David Radlinski (5)(7)
10.31 Employment Agreement with Mark Selawski (5)(7)
10.32 Employment Agreement with Eva Novotny (5)(7)
10.33 Amended Lease for Aliso Viejo Property (8)
21 Subsidiaries
23.1 Consent of Independent Auditors
28.2 Form of Cytocare, Inc. Information Statement - Distribution
to Shareholders of Stock of Cardiac Science, Inc. (9)
28.3 Form of Medstone International, Inc. Information Statement
- Distribution to Shareholders of Stock of Endocare, Inc.
and Urogen Corp. (10)
- ---------------------------------------

(1) Previously filed with the same exhibit number with the Company's
Registration Statement on Form S-1 under the Securities Act of 1933, Reg.
No. 33-16340 and with the Company's Quarterly Report on Form 10-Q for the
quarter ended June 30, 1998 and incorporated herein by reference.

(2) Previously filed with the same exhibit number with the Company's Quarterly
Report on Form 10-Q for the quarter ended June 30, 1999, and incorporated
herein by reference.

(3) Previously filed with the same exhibit number with the Company's
Registration Statement on Form S-1 under the Securities Act of 1933, Reg.
No. 33-16340 and incorporated herein by reference.

(4) Previously filed with the same exhibit number with the Company's Quarterly
Report on Form 10-Q for the quarter ended June 30, 1989, and incorporated
herein by reference.

(5) Compensatory plan or arrangement.

(6) Previously filed with the same exhibit number with the Company's Quarterly
Report on Form 10-Q for the quarter ended June 30, 1997.

(7) Previously filed with the same exhibit number with the Company's Quarterly
Report on Form 10-Q for the quarter ended September 30, 1998.

(8) Previously filed with the same exhibit number with the Company's Quarterly
Report on Form 10-Q for the quarter ended March 31, 2000.

(9) Previously filed with the