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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-K

               Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

               Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best 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.  o

               The number of shares of the Common Stock of the registrant outstanding as of March 3, 2003 was 3,758,220.   The number of shares of voting and non-voting Common Stock held by non-affiliates on such date was 3,665,512 with an approximate aggregate market value of $11,399,742.

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

               The number of shares of the Common Stock of the registrant outstanding as of June 30,  2002 was 3,920,020.  The number of shares voting and non-voting Common Stock held by non-affiliates on such date was 3,827,312 with an approximate aggregate market value of $19,327,926.

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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 basis 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 2002 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. 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.

               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).  In September 2002, Genstar’s Board of Directors agreed to a merger with Vascular Genetics, a private biotech company.   Shareholders approved the merger and name change on February 4, 2003, with the combined company named  CorAutus Genetics, Inc. (“CorAutus”).  On February 5, 2003, the company  began trading under the symbol CAQ.  At March 3, 2003, when the market price of the CorAutus stock was $0.30 per share, the Company held 95,000 shares of CorAutus with a market value of approximately $28,500. 

               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.

               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.

               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

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countries, primarily in lower Asia and Africa.  k. Biotech is currently evaluating various funding options to be able to continue to the next step in its business plan.  The Company had 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.

              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.

               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.   During 2001, the Company reviewed the value of the investment and note and recorded reserves equivalent to the outstanding balances of each due to likelihood of repayment.  As of December 31, 2001, the net carrying value of both the investment and note were $0.  In December 2002, the Company  completed a sale of the 46% interest and $2 million note to a private partnership for $1 million in cash.  The Company no longer has any financial interest in Medicredit.  (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 and is currently providing contract development servicing on two products.  (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.

               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

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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 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 9001, private quality certifications, and EN46001 certifications, necessary for sales to European Union countries.

               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.

               The Company moves some of its fee-for-service Systems from place to place.  Treatments on the mobile  STS equipment take 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.

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               The fee-for-service procedures are currently provided by the Company using 14 STS Systems housed in mobile trailers, one STS System located at a fixed site and 27 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 a line of fixed and portable urological treatment tables.  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 these tables for bundled sales of urological tables along with lithotripsy products, and also sells the tables 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 improve this table for changing market demands.

               One of the Company’s flagship products, the UroPro, has been successfully introduced and is expected to become a significant portion of the Company’s revenue in the future.  This imaging table was also developed by Arcoma for a contract of $250,000 with a tomography option developed for $140,000 in 2001.  It has multi-plane movement for enhanced patient positioning capability and physician preference settings are programmable into a multifunction touch screen control panel which control all table, imaging and exposure functions.

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, 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.

Digital Detector Systems

               Expanding on its radiology market knowledge, the Company began development of a multi-plane digital x-ray system in 2002.  Called the Multi-Rad, this system uses flat plate digital technology to allow a single system to take digital x-rays in a standing or supine position thereby offering lower costs compared to the current digital imaging products in the market.  Arcoma assisted in the early-stage development of this product, for which the company paid consulting fees.  This product continues to be developed in 2003 and will be a major focus of the development expenses in 2003.

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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 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.

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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 200,000 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 are 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 dissolving agent 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 2003 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 2002 concentrated on the development of the new Multi-Rad digital imaging system that incorporates a flat plate digital x-ray detector.  This potential product will continue  to be developed during 2003, along with  refinements of the STS-T(C) and UroPro systems and their user interfaces.  The Company will continue its development program alliance with Arcoma AB.   During the years ended December 31, 2002, 2001, and 2000, the Company’s expenditures for research and development totaled $1,467,937,  $1,319,625 and $1,180,409, respectively.

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

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               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.

               In January  2001,  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.   During 2001, several groups representing physician-owners filed suit against CMS and sought, but did not receive, an injunction against implementation of these rules.  The regulations as announced became effective on January  4, 2002.  During 2002, the trial concluded that lithotripsy was not a designated service under Stark II, and CMS is not challenging the results of the trial.  The Company believes that its contractual arrangements with its customers are in compliance with the 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. 

               Future products of the Company are expected to address the urological as well as the radiology markets.  The Company’s competition will be determined in part by the particular urological disease or radiological devices 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

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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.

               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.

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Backlog

               The Company’s lithotripsy equipment sale backlog for the STS-T(C) was $0 as of March 1, 2003 and $380,000 as of March 1, 2002.  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 $1,129,173 as of March 10, 2003 and $1,102,222 as of March 1, 2002.

Human Resources

               As of February 28, 2003, Medstone had 98 employees.  Of the 98 employees, 6 are engaged directly in research and development activities, 19 are engaged in manufacturing, 20 are engaged in mobile operations, 22 are engaged in field service, 15 are engaged in sales and marketing and 16 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.

               During February 2002, United Physicians Resources extended its original operating lease and expanded  to 2,654 square feet of occupancy in Phoenix, Arizona.  This extension, which expires in September 2005, has  an average rental expense of approximately $4,178 per month.

Item 3.          LEGAL PROCEEDINGS

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

               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.

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

               The Company’s annual meeting of shareholders was held on June 28, 2002.  At the meeting Jack Olshansky, Frank R. Pope, David V. Radlinski, David A. Reed  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.

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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, 2002 and December 31, 2001 as reported in the NASDAQ National Market System for the quarter indicated.

          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 3, 2003, there were 227 stockholders of record and approximately 1,700 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.

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Item 6.          SELECTED FINANCIAL DATA

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