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, 1999

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 1, 2000 was 4,622,692. The number of shares of voting and non-voting
Common Stock held by non-affiliates on such date was 4,517,964 with an
approximate aggregate market value of $30,496,257.

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TABLE OF CONTENTS

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

PART I

Item 1. Business.................................................................................. 1
Item 2. Properties................................................................................ 8
Item 3. Legal Proceedings......................................................................... 9
Item 4. Submission of Matters to a Vote of Security Holders....................................... 9

PART II

Item 5. Market for Registrant's Common Equity
and Related Stockholder Matters......................................................... 10
Item 6. Selected Financial Data................................................................... 11
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations..................................................... 12
Item 7A. Quantitative and Qualitative Disclosures About Market Risk................................ 15
Item 8. Financial Statements and Supplementary Data............................................... 15
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure..................................................... 15

PART III

Item 10. Directors and Executive Officers of the Registrant........................................ 16
Item 11. Executive Compensation.................................................................... 18
Item 12. Security Ownership of Certain Beneficial
Owners and Management................................................................... 22
Item 13. Certain Relationships and Investments..................................................... 24

PART IV

Item 14. Exhibits, Financial Statement Schedules,
and Reports on Form 8-K................................................................. 25

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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, as a manufacturer of capital medical devices, has
vertically integrated by offering its medical devices directly to providers on a
fee-per-procedure basis. Medstone currently offers lithotripsy services both in
the United States and internationally on a fee-per-procedure basis in both the
fixed and mobile environment. Medstone intends to expand efforts to grow this
medical service side of its business and has expanded its product offerings to
include several durable medical equipment products marketed to the urology
market. The Company's consolidated revenues during fiscal 1999 came primarily
from Medstone's lithotripsy business.

One continuing element of the Company's strategic plan is the incubation,
financing and staffing of new medical businesses. If and when a new business
proves viable, the Company is then in a position to spin-out separate public
companies 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. At December 31, 1999, the Company held 491,667
shares of Cardiac Science with a balance sheet value of $0 and a market value of
approximately $2,200,000. (See Item 13. "Certain Relationships and Investments",
"Note 9. Related Party Transactions" and "Note 13. Subsequent Events" in the
Notes to Consolidated Financial Statements.) At March 1, 2000, the market price
of Cardiac Science is $5.75 per share, giving the Company's current holding of
Cardiac Science a market value of approximately $2,310,000.

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. At December 31, 1999, the Company held 100,000 shares of Urogen with a
balance sheet value of $0 and a market value of $0.60 per share, or
approximately $60,000. (See Notes 9. "Related Party Transactions" and Note 13.
"Subsequent Events" in the Notes to Consolidated Financial Statements.) At March
1, 2000, the closing market price of Urogen is $18.625 per share, giving the
Company's current holding of Urogen a market value of approximately $1,770,000.

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. The Company consolidates the
revenues of Northern Nevada and Southern Idaho and reflects minority interest
expense for the portion of profits earned by the minority partners. 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. UPR purchased the
operations of Integrated Healthcare Systems, Inc. in July 1996 for $30,000. The
operating results of UPR are included in the consolidated financial statements
of the Company since its incorporation.

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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
Phase III clinical trials in India, with a target of 2002 for the
commercialization of this and the Interferon compounds. The Company has
invested, through December 31, 1999, a total of $325,000 in k.Biotech, giving
the Company a 21% ownership share.

On April 16, 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. The operating results of Medstone International, Ltd. are included
in the consolidated financial statements of the Company since its incorporation,
with all significant intercompany transactions eliminated.

On October 11, 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. The operating results of
Zenith have been included in the Company's consolidated financial results
effective October 1, 1999.

MARKETS

The Company currently operates in 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.

PRODUCTS

Lithotripsy Equipment

The Medstone STS ("System") is 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") from the U.S. Food and Drug
Administration ("FDA") in 1988 authorizing commercial use of the device for
treating patients with kidney stones.

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 Medstone 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

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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
Medstone 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.

The Company also markets the Medstone STS-T ("STS-T"), its transportable
lithotripter for treatment of kidney stones. The STS-T contains components
similar to the STS, except for the ultrasound unit, with all components built to
be modular, allowing the STS-T 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 Company received notification from the FDA on September 16, 1998 that
its PMA supplement regarding the STS-T was accepted, authorizing the commercial
use of the STS-T to treat patients with kidney stones. The Company has placed 27
units in service since shipments commenced in April 1999.

The STS-T currently has ETL certification and the Company is currently
undergoing testing for CE, ISO 9001 and EN 46001 certification.

The Company also has developed and manufactures its own disposable
components for use with the Medstone STS and STS-T. 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.

The Company, as a vertically integrated manufacturer, also offers
fee-for-service lithotripsy in the continental United States. It has placed its
lithotripters in mobile trailers and small trucks and contracts with hospitals,
clinics, and ambulatory surgery centers to provide the equipment necessary to
treat kidney stones, usually on an outpatient basis. This allows small and
mid-size facilities in wide ranging geographic locations to access 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 and transmobile routes.

During 1999, the Company developed a business plan which calls for the
widespread distribution of the Company's transportable lithotripter in a
fee-for-service system. Placement on a "permanent" basis, with an intuitive,
easy to operate lithotripter gives the hospital or surgery center full-time
access to the equipment and the convenience of a fee-for-service payment plan
where fees are incurred only if the equipment is used.

The execution of this new business strategy started in the fourth quarter of
1999 and the Company plans to continue this strategy, along with expanding
geographic coverage of the mobile vans in service, both domestically and in
foreign markets in the future years.

Urotable

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

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urological tables, which are used for various urological procedures, are used
both as in-office devices for physicians and an in-facility devices in a
hospital or clinic setting. The Company is an integrator of products available
on the market and will use the "UTS-Series" for bundling of urological tables
along with lithotripsy products, or sell the "UTS-Series" as a stand-alone
product.

The Company's entry in this market was achieved by $30,000 of development
funding to Arcoma AB, to develop the mobile urological treatment table
successfully introduced in the fourth quarter of 1999.

The Company is also funding $250,000 of development costs for a state of the
art fixed urology table to be introduced in the second half of 2000. This table
will have ideal patient positioning capability along with physician preference
controls as built in features of the system.

X-Ray Generators

With the acquisition of Ltd., the Company manufactures and markets 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
imaging system and the majority of its third party customers are member
countries of the European Union.

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 dissolved. Most stones can be treated with
conservative methods. This includes 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.

The Medstone STS and STS-T provides 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.

Although most stones can be treated with nonsurgical methods, certain stones
still require conventional surgery, 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
more conservative techniques are used. Therefore, stones are treated with
non-invasive methods when possible.

PRODUCTION

Medstone manufactures, under FDA mandated Good Manufacturing Practice
("GMP") requirements, its devices at its plant in Aliso Viejo, California. The
Company moved into its facility in March 1994. Subsequent to that move the
Company was audited by the FDA and received notification from the FDA enabling
it to manufacture and market

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devices in that facility. The Company is currently undergoing testing to receive
the CE mark, EN46001 and ISO 9001 certification, after having received the ETL
mark for its STS-T. Ltd.'s plant in Scotland holds certification from the FDA,
along with CE mark, EN46001 and ISO 9001 qualifications. The Company has
existing capacity in its plants to produce sufficient quantities of its
shockwave lithotripters and X-ray generators to support its commercial needs for
the foreseeable future.

PRODUCT DEVELOPMENT

The Company has focused its research in 1999 on developments intended to
improve performance and convenience of its lithotripter systems. In 1999, the
Company devoted a significant portion of its research and development
expenditures to the Medstone STS-T which was introduced in March 1999. During
1999, the Company has contracted with Arcoma AB ("Arcoma"), a private Swedish
company, to develop several urology specific products for which the Company has
provided $160,000 in development funding for 1999 and an additional $90,000 due
in 2000. The Company will continue to invest significantly in product
enhancements, proprietary products and expand its utilization of Arcoma for
future product development. During the years ended December 31, 1997, 1998, and
1999, the Company's expenditures for research and development totaled
$1,021,349, $1,078,792 and $1,455,429, respectively.

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 coverage
limits of $4 million per incident for a total aggregate amount of $5,000,000 per
incident. The Company's directors and officers' 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.

DEVICES - 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
device. A class III product, such as the Medstone STS and STS-T, and class I and
II devices for which a PMA is necessary generally require initial
Investigational Device Exemption ("IDE") approval by the FDA. An IDE permits
limited clinical evaluation of the product under controlled conditions.
Extensive reporting and monitoring of patient treatments made pursuant to the
IDE are required. After the PMA is obtained, the product may be marketed to an
unrestricted number of users in the United States, but 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.

A subset of medical devices categorized as class I or II and classified as
"old" devices, that is, commercially distributed before March 28, 1976 or
substantially equivalent to a device that was in commercial distribution before
that date, may be marketed after the acceptance of the premarket notification
under a 510(k) exemption. The 510(k) section of the Federal Food, Drug and
Cosmetic Act allows an exemption from the requirement of premarket notification.
The Medstone UTS-Series is sold under a 510(k) exemption received by the
original manufacturer of the components used in the equipment.

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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 9, 1998, the Health Care Finance Administration (HCFA) published
proposed Stark II regulations with the intent of seeking public comments
regarding the proposal and its effects. Stark II proposes that lithotripsy would
be defined as an "inpatient and outpatient hospital procedure" and this
definition would put physician ownership of lithotripsy units in violation of
HCFA regulations. This would apply to patients covered under Medicare, Medicaid
and Champus health care.

With the completion of the comment period in the beginning of March 1998, no
further information is currently available to the Company regarding the proposed
regulations. The regulations, if enacted as first published, could force
physician partnerships to either divest ownership or find a "safe harbor" under
which to operate lithotripsy partnerships.

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 of
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
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.

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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 shockwave lithotripsy are
Dornier, a subsidiary of a Singapore-based conglomerate, and Siemens GmbH, a
German electronic company. In addition, a number of other companies, both in the
U.S. and foreign countries, have PMAs to sell their lithotripters for the
treatment of kidney stones in the U.S. or are conducting clinical studies on the
use of 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
System compares favorably with other lithotripters presently being offered by
competitors with respect to the precision of its imaging systems, its ease of
patient handling, its simplicity of operation design, its safety features and
its success rate in treating patients.

Mobile Lithotripsy Services

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, the
lithotripsy business of Integrated Health Services, Inc., a Maryland based
healthcare 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., a private Ohio-based manufacturer of urology products, and OEC
Medical Systems, Inc., a Utah based publicly-held provider of 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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SALES AND MARKETING

The Company's current products and planned future products are targeted at
the urology market. 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 the sale of equipment, and also from the
sale of software licenses, disposable supplies, procedure fees and service
contracts to hospitals, physicians, and other health care providers.

The Company offers to hospitals, surgery centers and physician groups
lithotripsy services on a fee 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 fee-for-service. In a fee-for-service arrangement 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. Most often this 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 can
be provided with a fixed unit installed in these facilities.

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.

BACKLOG - SHOCKWAVE LITHOTRIPSY

The Company's lithotripsy equipment sale backlog was $375,000 for the STS-T
as of March 1, 2000 and $1,875,000 for the STS as of March 1, 1999. 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.

With the maturity of Medstone's lithotripsy business, recurring revenues
from fee for service and procedure fees and maintenance services have become a
major source of Medstone's revenue stream. Maintenance services are generally
provided under annual service contracts, and procedure and fee for service fees
are earned based upon usage of the System.

HUMAN RESOURCES

As of February 29, 2000, Medstone had 111 employees. Of the 111 employees,
10 are engaged directly in research and development activities, 29 are engaged
in manufacturing, 25 are engaged in mobile operations, 19 are engaged in field
service, 12 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 office, manufacturing,
engineering, and warehouse space, and research and development laboratories,
located in Aliso Viejo, California, under an operating lease with an initial
term

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of two years. The Company's last lease extension, through June 2000, has monthly
rent of $14,410. The Company is currently negotiating facility leases with
sufficient space to accommodate projected activities.

Medstone International, Ltd. leases a 10,000 square foot building in Fife,
Scotland, for manufacturing, warehouse and administrative operations for
approximately $5,000 per month with a term through December 2000.

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.

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 24, 1999. At
the meeting Frank R. Pope, David V. Radlinski, Donald 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.

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PART II

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

Prior to January 24, 1991, the Company's common stock was traded on the
NASDAQ Stock Market under the symbol MSHK. On January 24, 1991, the Company
changed its name to Cytocare, Inc. and began trading on the NASDAQ Stock Market
under the symbol CYTI. On September 25, 1995, the Company changed its name to
Medstone International, Inc. and began trading 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, 1999 and
December 31, 1998 as reported in the NASDAQ National Market System for the
quarter indicated.

HIGH LOW

YEAR ENDED DECEMBER 31, 1999

First quarter $ 8-1/2 $ 6-1/8
Second quarter 8-9/16 6-1/2
Third quarter 7-5/32 6
Fourth quarter 6-17/32 4-3/8

YEAR ENDED DECEMBER 31, 1998

First quarter $ 10-7/8 $ 8
Second quarter 11-1/2 8-1/4
Third quarter 9-3/8 5-15/16
Fourth quarter 8-1/4 5-1/4

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 highly dynamic industry,
which often results in significant volatility of the Company's common stock
price.

At March 1, 2000, there were 341 stockholders of record and
approximately 2,800 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.

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ITEM 6. SELECTED FINANCIAL DATA

CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
(in thousands, except per share amounts)

YEAR ENDED DECEMBER 31,
---------------------------------------------------------------
1999 1998 1997 1996 1995
---------- --------- --------- --------- ---------

Revenues:
Net equipment sales $ 3,338 $ 2,144 $ 2,722 $ 2,420 $ 4,588
Procedure, maintenance, and
management fees 19,532 21,129 18,476 14,884 12,797
Interest and dividends 598 552 536 676 1,005
---------- --------- --------- --------- ---------
Total revenues 23,468 23,825 21,734 17,980 18,390
Costs and expenses:
Cost of sales 12,106 11,000 9,503 8,009 7,633
Research and development 1,456 1,079 1,021 522 927
Selling 2,048 1,988 2,257 2,146 2,050
General and administrative 2,592 2,131 2,231 1,666 1,656
Lawsuit settlement cost --- --- --- 5,500 ---
Legal and other (income)/expense (97) (61) (39) 402 164
--------- ---------- -------- ---------- ---------
Total costs and expenses 18,105 16,137 14,973 18,245 12,430
---------- ---------- --------- --------- ---------
Income (loss) before provision/(benefit)
for income taxes 5,363 7,688 6,761 (265) 5,960
Minority interest in subsidiary income 603 628 468 143 ---
Provision (benefit) for income taxes 1,919 2,718 2,329 (170) 2,086
---------- ---------- --------- --------- ---------
Net income (loss) $ 2,841 $ 4,342 $ 3,964 $ (238) $ 3,874
========== ========= ========= ========= =========
Net income (loss) per share:(1)
Basic $ .57 $ .84 $ .74 $ (.04) $ .74
========== ========== ========= ========= =========
Diluted $ .56 $ .82 $ .72 $ (.04) $ .70
========== ========== ========= ========= =========

CONSOLIDATED BALANCE SHEET DATA:
(in thousands)

DECEMBER 31,
1999 1998 1997 1996 1995
---------- --------- --------- --------- -----------

Working capital $ 17,539 $ 18,432 $ 16,256 $ 14,983 $ 18,465
Total assets 30,175 29,149 27,688 25,395 25,910
Total liabilities 3,758 3,216 3,567 4,230 3,753
Stockholders' equity 26,417 25,933 24,121 21,165 22,157

- ----------------------------------
(1) Restated in accordance of SFAS Statement No. 128 "Earnings Per Share".

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

GENERAL

Medstone manufactures, markets and maintains lithotripters, and
continues to expand its Fee-for-Service Program to supply lithotripsy equipment
to providers on a per procedure basis. The Company is also marketing a urology
imaging and treatment table, used for various urological functions. To date, the
Company's consolidated revenues have come primarily from Medstone's lithotripsy
business.

As a manufacturer of medical devices, the Company has been vertically
integrating by offering its medical devices directly to providers. It currently
offers lithotripsy procedures using 15 mobile systems and two fixed sites in the
United States on a per procedure basis. With the ability to offer quality
equipment at reasonable prices, Medstone intends to continue the growth of this
manufacturer direct business.

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 1, 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.

The Company began the year with approximately $11.6 million in cash and
marketable securities, no debt, inventories of $3.6 million, and total assets of
$29.1 million. After purchase of $2.4 million of treasury stock, acquisitions
totaling $1.0 million and fixed asset additions of $2.7 million, the Company
ended the year with approximately $9.7 million in cash and marketable
securities, no debt, inventories of $5.8 million and total assets of $30.0
million.

Through its continuing research and development, management of the
Company is putting in place the scientific and engineering base it believes is
necessary to carry it through the next phases of its growth plans.

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, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998

Total revenue of $23.5 million in 1999 represented a 1% decrease in
revenue when compared to $23.8 million in 1998, breaking a string of several
years of continuous revenue growth. Results were lower in the procedure,
maintenance and management fee revenue partially offset by an increase in the
equipment revenue generated by 1999's sales activity.

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Revenue from procedure, maintenance and management fees decreased to
$19.5 million in 1999, an 8% decrease, when compared to the $21.1 million in
revenue in 1998. This decline was due to the market pressures of the widespread
availability of transportable lithotripters that caused patient volume to shift
as customers purchased lower costs lithotripsy systems and average revenue per
patient decreased. With the lower price for transportable technology, some
larger patient volume customers chose to purchase equipment from the Company or
its competitors and price concessions were instituted for continuing customers.
In 1999, procedure revenue from third party owned equipment decreased by 11%
compared to the prior year, due to declines in both volume and lower per
procedure fees. Maintenance fees decreased by 20% in the current period when
compared to 1998 due to lower average contract prices and a lower number of
sites under maintenance contracts. The Company also realized revenue of $604,000
in 1999 from sales of the imaging product lines acquired with the Zenith and Ltd
operations.

Net equipment sales in 1999 increased to $3.3 million, or 56%, from
$2.1 million for the comparable period of the prior year. This was due to the
increased shipments of equipment related to the introduction of the STS-T
transportable lithotripter in 1999, even though transportable lithotripters
carry a lower average unit sales price when compared to the fixed unit models.
The activity level of equipment upgrades remained level in the current year
compared to the prior year.

Interest income increased by 9%, or $47,000, in the year ended December
31, 1999 when compared to the same period of the prior year as average invested
cash balances increased even as yields remained level from year to year.

Costs on recurring revenue increased to $10.2 million in 1999, or a 12%
increase when compared to the $9.0 million in 1998 due to the Company's strategy
of placing STS-T equipment in customer sites on a permanent basis, making the
technology always available to the customer, rather than a scheduled service
program. This approach has a large up-front investment with the results
reflected in the patient volume as utilization increases.

Cost of equipment sales decreased to 58% of revenue for the year ended
December 31, 1999 compared to 89% of revenue for the year ended December 31,
1998. In absolute dollars the costs remained level from year to year as the
Company realized substantial cost savings from the introduction of its
transportable lithotripter even as total unit shipments doubled.

Research and development costs increased by $377,000, or 35% when
compared to 1998 levels due to increased spending on the transportable
lithotripter and continued development of the "UTS Series" of products.

Selling expenses increased by $60,000, or 3%, in 1999 when compared to
1998 due to the introductory advertising expenses for the Medstone STS-T
transportable lithotripter and the Company's trade show expenses for the medical
imaging business.

General and administrative expenses increased by 22% or $461,000 from
1998 to 1999, due to the increased staffing costs for foreign operations, costs
associated with the strategic planning process during 1999 and legal costs
associated with actions against the Company.

Other income/expense increased by $36,000 in 1999 when compared to 1998
due to recognition of gains on sale of Cardiac Science securities partially
offset by an investment reserve in 1999 compared to the gain on sales of a joint
venture in 1998.

Minority interest expense decreased to $603,000 in 1999 compared to
$628,000 in 1998 due to a slight decrease in the per patient revenue and the
corresponding effect on profitability.

Provision for income taxes decreased due to a lower level of
profitability in the current year when compared to the prior year.

YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997

Total revenue increased to $23.8 million, or by 10%, for the year ended
December 31, 1999 when compared to the year ended December 31, 1997. Equipment
revenues decreased by $578,000 in the current year when

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compared to the prior year, due to a decline in the number of unit shipments
only partially offset by an increase in average unit selling prices. Also
decreasing was revenue from equipment upgrades when compared to the year ended
1997.

Revenue from procedure, maintenance and management fees, increased by
$2,652,000, or 14%, in the current year when compared to the prior year as the
Company's fee-for-service revenues continue to increase as the number of
patients treated in 1998 increased by 26% when compared to the number of
patients treated in the fee-for-service, Northern Nevada and Southern Idaho
operations in 1997. Higher patient counts in both Northern Nevada and Southern
Idaho, the former due to higher activity and the latter due to full year results
and increased activity, resulted in a 22% increase in revenue for those two
operating entities, even though there was a slight decrease in the average per
patient revenue. Pricing pressures on procedure revenue from third-party owned
equipment resulted in a 7% decrease in the per procedure fee, even though the
number of procedures increased by 5% when compared to 1997.

Interest income increased by 3% for the year ended December 31, 1999
when compared to the prior year as the Company's average invested cash balance
increased slightly, partially offset by a decrease in average investment yield.

Cost of equipment sales decreased to $1,901,000 in 1998 compared to
$2,040,000 in 1997 due to the decline in the number of unit shipments offset by
an increase in the option content needed to complete sales, along with costs
associated with a foreign installation, in the current year.

Cost on recurring revenues increased to $9,099,000 or 43% of revenues
in 1998 compared to $7,463,000 or 40% in 1997, due to the addition of several
new vans in new geographic areas in 1998 and the associated overhead needed for
operations. Pricing pressure also contributed to the slight decline in the gross
margins on recurring revenues.

Research and development costs increased in 1998 by $57,000, or 6%,
when compared to the same period of 1997, due to slightly higher spending on
payroll and related costs as the Company completed its development of its new
transportable lithotripter, introduced into the marketplace in March 1999.

Selling expenses decreased $269,000, or 12%, in 1998 compared to 1997
due to lower payroll as the Company refocused its marketing effort and the
associated lower travel expenses and lower bad debt expenses.

General and administrative expenses declined to $2,131,000 in 1998
compared to $2,231,000 in 1997 representing a 4% decrease. This decrease was due
mainly to lower payroll as the United Physician Resources subsidiary was refined
and lower bad debt in the Northern Nevada and Southern Idaho operations. This
was partially offset by an increase in legal expenses.

Legal and other (income)/expense increased by $22,000 in 1998 compared
to 1997 due to the gain on investment in a joint venture only partially offset
by increased goodwill amortization for a full year on the Southern Idaho
acquisition.

Minority interest expenses of $628,000 in 1998 increased from $468,000
in 1997 due to both a full year's activity for Southern Idaho and increased
activity in both Southern Idaho and Northern Nevada.

Provision for income taxes increased in the current year compared to
the prior year due to both an increase in taxable income and a higher effective
tax rate in 1998.

LIQUIDITY AND CAPITAL RESOURCES

At December 31, 1999, the Company had cash and short-term investments
of approximately $9.7 million. These funds were generated from operating
activities.

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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 1999. See "Safe Harbor
Statement under the Private Securities Litigation Reform Act of 1995."

IMPACT OF YEAR 2000

In prior years, the Company discussed the nature and progress of its
plans to become Year 2000 ready. In late 1999, the Company completed its
remediation and testing of systems. As a result of those planning and
implementation efforts, the Company experienced no significant disruptions in
mission critical information technology and non-information technology systems
and believes those systems successfully responded to the Year 2000 date change.
The Company's expenses for the remediation was immaterial. The Company is not
aware of any material problems resulting from Year 2000 issues, either with its
products, its internal systems, or the products and Year 2000 issues of third
parties. The Company will continue to monitor its mission critical computer
applications and those of its suppliers and vendors throughout the year 2000 to
ensure that any latent Year 2000 matters that may arise are addressed promptly.

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.

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.

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

None.

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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 55 Chairman of the Board and
Chief Executive Officer of the Company

Frank R. Pope 50 Managing Director
Verdigris Capital

Donald J. Regan 65 Vice President and General Counsel
Kinsell, Newcomb & De Dios, Inc.

Michael C. Tibbitts 52 Vice President
Quality System Solutions

David A. Reed 67 Consultant
DAR Consulting Group

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.

Mr. Pope is Managing Director of Verdigris Capital, a private merchant
banking 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. and a director and
officer of Advanced BioCatalytics Corp. 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 is currently the Vice President and General Counsel of
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 specializes in revenue and project finance
bonds. 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: 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 has been appointed, in August 1999, as a director of the
Company. Mr. Reed is retired president and chief executive officer of St. Joseph
Health System in Orange, California. He is the Board

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Chairman of Mission Hospital Regional Medical Center in Mission Viejo,
California. He also serves as a board Member of PacifiCare Health Systems, a
publicly traded company.

EXECUTIVE OFFICERS

The names, ages and positions of all the executive officers of the
Company as of March 2000 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 55 Chief Executive Officer and Chairman of the Board

Mark Selawski 44 Vice President of Finance,
Chief Financial Officer and Secretary

Eva Novotny 42 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, from June 1995 to October
1997. From 1985 to 1995, she was employed by Mentor Corporation as a Marketing
Manager and later as Director of Marketing for Mentor Urology.

SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

The Company is not aware of any director, officer or 10% shareholder
who during 1998 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.

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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 during fiscal 1999.

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 ($)(1) ($) ($) ($) (#)(2) ($) ($)
------------------ ------ ------ ----- ------------ ---------- ---------- -------- -------------

David V. Radlinski 1999 250,000 --- 2,426 --- --- --- ---
Chairman of the Board and 1998 219,135 --- 2,426 --- 350,000 --- ---
Chief Executive Officer 1997 200,300 --- --- --- 100,000 --- ---

Mark Selawski 1999 105,625 500 --- --- --- --- ---
Chief Financial Officer, 1998 99,038 300 --- --- 80,000 --- ---
Vice President of Finance 1997 85,833 11,300 --- --- 20,000 --- ---
and Secretary

Eva Novotny(3) 1999 120,000 500 --- --- --- --- ---
Executive Vice President 1998 120,000 300 --- --- 70,000 --- ---
of Sales and Marketing 1997 25,300 --- --- --- 50,000 --- ---

- ---------------------------------
(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 1999, 1998 and 1997
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.

(3) Ms. Novotny joined the Company as of October 15, 1997.

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 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

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$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 is terminated without "Good Cause" or a change of control occurs
within the first three years of the agreement, a severance payment of five times
his then current base salary will be 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 is terminated
without Good Cause in the first three years of this agreement, he will 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 run for a term of three
years, expiring on August 13, 2001. The agreements provide 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 is terminated without "Good
Cause" or such a change of control occurs within the term of the agreement, a
severance payment of two times his or her then current base salary will be due
and payable.

19
22
STOCK OPTION GRANTS DURING 1999

No options were granted during 1999.

STOCK OPTIONS HELD AT END OF FISCAL YEAR

The following table provides information related to options exercised
during 1999 and options held by the named executive officers at December 31,
1999.

NUMBER OF SECURITIES VALUE OF UNEXERCISED
UNDERLYING UNEXERCISED IN-THE-MONEY
OPTIONS AT FY-END (#) OPTIONS AT FY-END ($)(2)
------------------------------- ---------------------------------
SHARES ACQUIRED VALUE
NAME ON EXERCISE (#) REALIZED ($)(1) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
---- --------------- ---------------- ----------- ------------- ----------- -------------

David V. Radlinski --- --- 235,000 115,000 --- ---
Mark Selawski --- --- 48,000 32,000 --- ---
Eva Novotny --- --- 28,334 41,666 --- ---

- --------------------------------
(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, 1999 was
$4.75. Value is calculated on the basis of the difference between the
option exercise price and $4.75, multiplied by the number of shares of
Common Stock underlying the option.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

During 1999 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
1999 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 and Reed, $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. In addition, the
Company has agreed to pay a total of $150,000 to the outside directors for their
services on the Special Committee of the Board in 1998 and 1999. The Special
Committee was formed by the Company on November 13, 1998 to evaluate strategic
alternatives available to the Company, including potential acquisitions,
strategic relationships and sale of all or part of the Company's business.
During 1999 the Company paid Messrs. Pope and Regan $44,000 each and Mr.
Tibbitts $32,000 for their participation in the Special Committee.

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

20
23
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.

Options to purchase 15,000 shares of Common Stock were issued to
Messrs. 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 are
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 remains on the Company's Board. The terms of the
options are five years, subject to earlier termination related to the director
no longer serving on the Board. 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.

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.

21
24
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 1, 2000 by each
person who owns beneficially more than 5 percent of the outstanding shares of
Common Stock, by each of the present directors and nominees for director, by
each of the executive officers named in the Executive Compensation 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 1, 2000.

NUMBER OF SHARES
BENEFICIALLY PERCENTAGE OF
NAME AND ADDRESS OF BENEFICIAL OWNER OWNED(1) OWNERSHIP
------------------------------------ -------- ---------

FMR Corp. 561,200 12.1%
82 Devonshire Street
Boston, MA 02109
Hathaway & Associates, Ltd. 440,000 9.5%
119 Rowayton Avenue
Rowayton, CT 06853
Dimensional Fund Advisors, Inc. 358,200 7.7%
1299 Ocean Ave., 11th Floor
Santa Monica, CA 90401
David V. Radlinski(2)(3) 346,648(4) 7.1%
100 Columbia, Suite 100
Aliso Viejo, CA 92656
Mark Selawski(3) 57,513(5) 1.2%
100 Columbia, Suite 100
Aliso Viejo, CA 92656
Eva Novotny(3) 33,800(6) (11)
100 Columbia, Suite 100
Aliso Viejo, CA 92656
Donald J. Regan(2) 24,308(7) (11)
462 Stevens Avenue, Suite 308
Solana Beach, CA 92075
Michael C. Tibbitts(2) 22,375(8) (11)
27001 La Paz Road, Suite 448B
Mission Viejo, CA 92691
Frank R. Pope(2) 18,458(9) (11)
3460 Baker St.
San Francisco, CA 94123
David A. Reed 417(10) (11)
24681 La Plaza, Suite 240
Dana Point, CA 92629
All executive officers and directors 503,102 10.0%
as a group (7 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.

(3) Executive officer of the Company.

(4) Includes 257,500 shares issuable upon exercise of presently outstanding
stock options.

(5) Includes 53,333 shares issuable upon exercise of presently outstanding
stock options.

22
25
(6) Includes 33,000 shares issuable upon exercise of presently outstanding
stock options.

(7) Includes 17,708 shares issuable upon exercise of presently outstanding
stock options.

(8) Includes 20,375 shares issuable upon exercise of presently outstanding
stock options.

(9) Includes 16,458 shares issuable upon exercise of presently outstanding
stock options.

(10) Includes 417 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 398,791 shares issuable upon exercise of presently outstanding
stock options.

23
26
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 11.42857143 reverse
stock split, reducing the Company's holdings to 546,772 shares.

During 1999, the Company evaluated the market value of Cardiac Science
and, with the prevailing share price, sold 55,105 shares of Cardiac Science
during the third quarter of 1999 for a gain of approximately $244,000.

Also during the fourth quarter of 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
transportable lithotripsy product. The Company has purchased $300,000, or
300,000 shares, of DIS preferred stock, which represents a 14% ownership
interest. DIS commenced shipments to the Company as of January 1999.

As of June 30, 1999 the Company reviewed the financial performance of
DIS and has established a general investment reserve of $300,000 for impairment
of its investment in DIS.

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 has purchased $325,000 of
preferred stock to assist k. Biotech in establishing itself as a viable business
entity. Two of the Company's directors, Messrs. Pope and Regan, are investors in
k.Biotech and Mr. Regan serves as k. Biotech's President. Additional funding
from international sources is currently being evaluated.

CHINESE JOINT VENTURE

The Company, along with Acuity International ("Acuity") and Phenix
Optical Ltd ("Phenix"), a Chinese company, created a joint venture, in March
1998, to provide lithotripsy services to inland Chinese areas. Each entity was a
1/3 owner of the joint venture. The Company recognized a gain of $105,000 on its
contribution of equipment to the joint venture in the first quarter of 1998, and
recorded its investment of $92,000 as other assets. In December 1998, documents
were drawn to turn ownership over to Phenix in return for delivery of optical
products to both Acuity and the Company. In 1999, the Company received optical
products in release of its share in the joint venture and final release
documents were processed. The Company is carrying the value of the optical
products at their estimated fair value, which is the same value as its
investment established in the joint venture, with the intention of remarketing
these products.

24
27
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
Report of Independent Auditors 26
Consolidated Balance Sheets at December 31, 1999 and 1998 27
Consolidated Statements of Operations for the
years ended December 31, 1999, 1998 and 1997 28
Consolidated Statements of Stockholders' Equity
for the years ended December 31, 1999, 1998 and 1997 29
Consolidated Statements of Cash Flows for the
years ended December 31, 1999, 1998 and 1997 30
Notes to Consolidated Financial Statements 31

2. Schedule to Consolidated Financial Statements
Schedule II - Valuation and Qualifying Accounts 43

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 were no reports on Form 8-K filed with the Commission during
the quarter ended December 31, 1999.

(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)
10.28 Facility Lease on 100 Columbia (6)
10.29 1997 Stock Incentive Plan (5)(7)
10.30 Employment Agreement with David Radlinski (5)
10.31 Employment Agreement with Mark Selawski (5)
10.32 Employment Agreement with Eva Novotny (5)
21 Subsidiaries
23.1 Consent of Independent Auditors
27 Financial Data Schedule
28.2 Form of Cytocare, Inc. Information Statement -
Distribution to Shareholders of Stock of Cardiac
Science, Inc. (8)
28.3 Form of Medstone International, Inc. Information
Statement - Distribution to Shareholders of Stock of
Endocare, Inc. and Urogen Corp. (9)

- ---------------------------------------
(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 annual
report on Form 10-K for the year ended December 31, 1993.

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

(8) Previously filed with the same exhibit number with the Company's current
report on Form 8-K dated June 26, 1991, and incorporated herein by
reference.

(9) Previously filed with the Company's current report on Form 8-K dated
February 9, 1996, and incorporated herein by reference.

The Company will furnish to a requesting beneficial owner of its securities
a copy of any such exhibits upon payment of a fee equal to $.20 per exhibit
page.

25
28
Report of Independent Auditors

Stockholders and Board of Directors
Medstone International, Inc.

We have audited the accompanying consolidated balance sheets of Medstone
International, Inc. and subsidiaries (the "Company") as of December 31, 1999 and
1998, and the related consolidated statements of operations, stockholders'
equity, and cash flows for each of the three years in the period ended December
31, 1999. Our audits also included the financial statement schedule listed in
the Index at Item 14(a). These financial statements and schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
Medstone International, Inc. and subsidiaries at December 31, 1999 and 1998, and
the consolidated results of their operations and their cash flows for each of
the three years in the period ended December 31, 1999, in conformity with
accounting principles generally accepted in the United States. Also, in our
opinion, the related financial statement schedule, when considered in relation
to the basic financial statements taken as a whole, presents fairly in all
material respects the information set forth therein.

ERNST & YOUNG LLP

Orange County, California
February 10, 2000

26
29
MEDSTONE INTERNATIONAL, INC.
CONSOLIDATED BALANCE SHEETS

DECEMBER 31,
--------------------------------
1999 1998
------------ ------------

ASSETS
Current assets:
Cash and cash equivalents $ 1,061,422 $ 1,128,463
Short-term investments held to maturity 8,629,990 10,494,075
Accounts receivable, less allowance for doubtful accounts of
$571,252 and $602,564 in 1999 and 1998, respectively 3,291,372 3,535,581
Inventories, less allowance for inventory obsolescence
of $307,203 and $337,437 in 1999 and 1998, respectively 5,760,887 3,595,906
Deferred tax assets 1,273,386 1,139,903
Prepaid expenses and other current assets 366,774 719,598
------------ ------------
Total current assets 20,383,831 20,613,526

Buildings, property and equipment, at cost:
Building 359,324 --
Lithotripters 11,163,744 9,054,296
Equipment 1,698,185 1,077,352
Furniture and fixtures 879,458 788,457
Leasehold improvements 147,200 145,007
------------ ------------
14,247,911 11,065,112
Less accumulated depreciation and amortization (8,308,841) (6,362,955)
------------ ------------
Net property and equipment 5,939,070 4,702,157
------------ ------------

Goodwill, net 3,409,916 3,182,096
Other assets, net 442,195 651,494
------------ ------------
$ 30,175,012 $ 29,149,273
============ ============

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 611,492 $ 389,589
Accrued expenses 716,619 485,108
Accrued income taxes 263,058 183,593
Accrued payroll expenses 346,262 303,687
Customer deposits -- 86,125
Deferred revenue 907,326 733,889
------------ ------------
Total current liabilities 2,844,757 2,181,991

Deferred tax liabilities 628,856 714,737
Minority interest 284,350 319,868
Commitments and contingencies (Notes 7 and 8)
Stockholders' equity:
Common stock - $.004 par value, 20,000,000 shares authorized,
5,667,142 and 5,650,505 shares issued and outstanding at
December 31, 1999 and 1998, respectively 22,669 22,602
Additional paid-in capital 19,177,274 19,076,104
Accumulated earnings 14,619,507 11,778,357
Accumulated other comprehensive loss (13,942) (1,177)
Treasury stock, at cost, 974,650 shares at December 31,
1999 and 587,100 shares at December 31, 1998 (7,388,459) (4,943,209)
------------ ------------

Total stockholders' equity 26,417,049 25,932,677
------------ ------------
$ 30,175,012 $ 29,149,273
============ ============

See accompanying notes

27
30
MEDSTONE INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE YEAR ENDED DECEMBER 31,
----------------------------------------------------
1999 1998 1997
------------ ------------ ------------

Revenues:
Procedures and maintenance fees,
and management fees $ 19,532,046 $ 21,128,586 $ 18,476,342
Net equipment sales 3,337,650 2,144,500 2,722,360
Interest and dividend income 598,661 551,723 535,601
------------ ------------ ------------
Total revenues 23,468,357 23,824,809 21,734,303

Costs and expenses:
Costs related to procedures
and maintenance fees 10,186,243 9,098,822 7,463,418
Cost of equipment sales 1,920,117 1,900,803 2,040,031
Research and development 1,455,429 1,078,792 1,021,349
Selling 2,048,390 1,988,331 2,256,933
General and administrative 2,592,308 2,131,373 2,231,006
Other income expense (97,274) (61,045) (39,327)
------------ ------------ ------------

Total costs and expenses 18,105,213 16,137,076 14,973,410
------------ ------------ ------------

Income before provision
for income taxes and minority interest 5,363,144 7,687,733 6,760,893
Minority interest in subsidiary income 602,594 627,639 467,595
Provision for income taxes 1,919,400 2,718,000 2,329,000
------------ ------------ ------------
Net income $ 2,841,150 $ 4,342,094 $ 3,964,298
============ ============ ============

Net income per share:
Basic $ .57 $ .84 $ .74
============ ============ ============
Diluted $ .56 $ .82 $ .72
============ ============ ============

Number of shares used in the computation of net income per share:
Basic 4,956,508 5,162,112 5,390,352
============ ============ ============
Diluted 5,034,850 5,286,967 5,510,668
============ ============ ============

See accompanying notes

28

31
MEDSTONE INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

COMMON STOCK ACCUMULATED
------------------------- ADDITIONAL OTHER
NUMBER OF PAID-IN ACCUMULATED STOCK PURCHASE COMPREHENSIVE
SHARES AMOUNT CAPITAL EARNINGS NOTE RECEIVABLE INCOME (LOSS)
---------- ------ ---------- ----------- --------------- --------------

BALANCE AT DECEMBER 31, 1996 5,465,603 $22,314 $18,715,068 $ 3,471,965 $(134,800) $ (1,168)

Net income -- -- -- 3,964,298 -- --
Other comprehensive income:
Unrealized gain on
short-term
investments -- -- -- -- -- 589

Total Comprehensive income

Common stock options
exercised 56,385 225 283,192 -- -- --
Treasury stock repurchased (156,000) -- -- -- -- --
---------- ------- ----------- ----------- --------- --------

BALANCE AT DECEMBER 31, 1997 5,365,988 22,539 18,998,260 7,436,263 (134,800) (579)

Net income -- -- -- 4,342,094 -- --
Other comprehensive income:
Unrealized loss on
short-term
investments -- -- -- -- -- (598)

Total Comprehensive
income

Common stock options
exercised 15,717 63 77,844 -- -- --
Repayment of stock
purchase note -- -- -- -- 134,800 --
Treasury stock
repurchased (318,300) -- -- -- -- --
---------- ------- ----------- ----------- --------- --------

BALANCE AT DECEMBER 31, 1998 5,063,405 22,602 19,076,104 11,778,357 -- (1,177)

Net income -- -- -- 2,841,150 -- --
Other comprehensive income:
Unrealized gain on
short-term
investments -- -- -- -- -- 1,177
Unrealized loss on
foreign currency
translation -- -- -- -- -- (13,942)

Total Comprehensive income

Common stock options
exercised 16,637 67 101,170 -- -- --
Treasury stock
repurchased (387,550) -- -- -- -- --
---------- ------- ----------- ----------- --------- --------

BALANCE AT DECEMBER 31, 1999 4,692,492 $22,669 $19,177,274 $14,619,507 $ -- $(13,942)
========== ======= =========== =========== ========= ========

TREASURY
STOCK TOTAL
----------- ------------

BALANCE AT DECEMBER 31, 1996 $ (908,370) $ 21,165,009

Net income -- 3,964,298
Other comprehensive income:
Unrealized gain on
short-term
investments -- 589
------------
Total Comprehensive income 3,964,887
------------

Common stock options
exercised -- 283,417
Treasury stock repurchased (1,292,366) (1,292,366)
----------- ------------

BALANCE AT DECEMBER 31, 1997 (2,200,736) 24,120,947

Net income -- 4,342,094
Other comprehensive income:
Unrealized loss on
short-term
investments -- (598)
------------
Total Comprehensive
income 4,341,496
------------

Common stock options
exercised -- 77,907
Repayment of stock
purchase note -- 134,800
Treasury stock
repurchased (2,742,473) (2,742,473)
----------- ------------

BALANCE AT DECEMBER 31, 1998 (4,943,209) 25,932,677

Net income -- 2,841,150
Other comprehensive income:
Unrealized gain on
short-term
investments -- 1,177
Unrealized loss on
foreign currency
translation -- (13,942)
------------
Total Comprehensive income 2,828,385
------------

Common stock options
exercised -- 101,237
Treasury stock
repurchased (2,445,250) (2,445,250)
----------- ------------

BALANCE AT DECEMBER 31, 1999 $(7,388,459) $ 26,417,049
=========== ============

See accompanying notes

29

32
MEDSTONE INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

YEAR ENDED DECEMBER 31,
--------------------------------------------------
1999 1998 1997
------------ ------------ ------------

Cash flows from operating activities:
Net income $ 2,841,150 $ 4,342,094 $ 3,964,298
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization 2,075,884 1,946,746 1,613,385
Provision for doubtful accounts 35,000 130,000 251,000
Writedown of investment 300,000 -- --
Minority interest in partnership 602,595 627,639 467,595
Changes in operating assets and liabilities:
Accounts receivable 309,763 (544,794) (684,802)
Inventories (1,992,704) (915,686) (220,441)
Deferred tax assets (219,364) (183,183) 427,017
Note receivable -- -- 1,250,000
Prepaid expenses and other current assets 374,474 (263,624) (298,974)
Accounts payable 215,090 (498,151) (873,182)
Accrued expenses 104,189 274,687 909
Accrued income taxes 69,388 816,444 (922,752)
Accrued payroll expenses 42,575 64,183 (98,957)
Deferred revenue (39,756) (347,010) 38,856
Customer deposits (86,125) (46,574) 132,699
Other, net (4,444) 124,616 10,862
------------ ------------ ------------

Net cash provided by operating activities 4,627,715 5,527,387 5,057,513
------------ ------------ ------------

Cash flows from investing activities:
Purchases of investments (23,351,435) (25,798,243) (42,258,678)
Proceeds from sales of investments 25,216,697 25,205,077 39,460,528
Investments in non-public companies (100,000) (617,369) --
Purchase of net assets (751,712) -- (2,300,000)
Investment by minority in partnership -- -- 193,179
Distribution of minority interest (638,300) (676,800) (328,000)
Purchases of property and equipment, net (2,718,288) (1,106,832) (1,597,545)
------------ ------------ ------------

Net cash used in investing activities (2,343,038) (2,994,167) (6,830,516)
------------ ------------ ------------

Cash flows from financing activities:
Proceeds from issuance of common stock 101,237 77,907 283,417
Proceeds from stock purchase note -- 134,800 --
Purchase of treasury stock (2,445,250) (2,742,473) (1,292,366)
Loan payments (7,705) -- --
------------ ------------ ------------

Net cash used in financing activities (2,351,718) (2,529,766) (1,008,949)

Net increase (decrease) in cash and cash equivalents (67,041) 3,454 (2,781,952)
Cash and equivalents at beginning of year 1,128,463 1,125,009 3,906,961
------------ ------------ ------------
Cash and equivalents at end of year $ 1,061,422 $ 1,128,463 $ 1,125,009
============ ============ ============

Supplemental cash flow disclosures:
Cash paid during the year for:
Income taxes $ 1,925,645 $ 2,588,819 $ 2,911,351
============ ============ ============

Supplemental disclosures of non-cash investing activities:
Liabilities assumed in connection with the
purchase transaction (Note 3) $ 365,110 $ -- $ --
============ ============ ============

See accompanying notes

30

33
MEDSTONE INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 1999

1. ORGANIZATION AND OPERATIONS OF THE COMPANY

Medstone International, Inc. ("Medstone" or the "Company") designs,
manufactures and markets the Medstone STS(TM) Shockwave Therapy System (the
"System") for the noninvasive disintegration of kidney stones in human patients.
The Company also generates revenues from use of the System under procedure fees
and fee for service arrangements and from repairs and maintenance. The Company
operations occur mainly with customers located in the United States.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of consolidation

The consolidated financial statements include the accounts of the
Company; Medstone International, Ltd., a Scottish subsidiary group; United
Physicians Resources, an 80% owned physicians practice management operation
incorporated in June 1996; Northern Nevada Lithotripsy Associates, LLC, a 60%
owned Nevada Limited Liability Company; Southern Idaho Lithotripsy Associates,
LLC, a California Limited Liability Company, also 60% owned (See Note 3); and
Medstone Sales Corporation, a 100% owned foreign sales corporation. All
majority-owned subsidiaries are consolidated and all material intercompany
accounts and transactions are eliminated. Investments in less than 20% owned
affiliates are accounted for on the cost method, unless the Company is able to
exercise significant influence over the affiliates operating and financial
policies, in which case the investments are accounted for on the equity method.

Reclassifications

Certain prior year balances have been reclassified to conform with the
December 31, 1999 presentation.

Use of estimates

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of revenue and
expenses during the reporting period. Actual results could differ from those
estimates. Significant estimates made in preparing these financial statements
include the allowance for doubtful accounts.

Statement of cash flows

The Company considers all highly liquid investments with a maturity of
three months or less when purchased to be cash equivalents.

Short-term Investments

The Company applies the provisions of Statement of Financial Accounting
Standards No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," to its short-term investments. Under this statement, management
determines the appropriate classification of such securities at the time of
purchase and reevaluates such classification as of each balance sheet date.
Based on its intent, the Company's investments are classified as
held-to-maturity and are carried at amortized cost.

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34
The amortized cost and market value of investments at December 31,
1999, by contractual maturity, is shown below.

AMORTIZED
COST MARKET VALUE
----------- ------------

Due in one year or less $ 8,629,990 $ 8,760,399

Comprehensive income

As of January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 130, Reporting Comprehensive Income (SFAS 130). SFAS
No. 130 establishes new rules for the reporting and display of comprehensive
income and its components; however, the adoption of this Statement had no impact
on the Company's net income or stockholders' equity. SFAS No. 130 requires
unrealized gains or losses on available-for-sale securities and unrealized gains
or losses on foreign currency translation, to be included in other comprehensive
income. Prior financial statements have been reclassified to conform to the
requirements of SFAS No. 130.

The components of accumulated other comprehensive loss are as follows:

FOREIGN UNREALIZED
CURRENCY GAINS ON
TRANSLATION AVAILABLE- FOR-
ADJUSTMENT SALE SECURITIES TOTAL
---------- --------------- -----

Balance at December 31, 1997 $ -- $ (579) $ (579)
Unrealized loss on short-term
investments -- (598) (598)
-------- ------- --------
Balance at December 31, 1998 -- (1,177) (1,177)
Foreign currency translation adjustment (13,942) -- (13,942)
Unrealized gain on available-for-
sale securities -- 1,177 1,177
-------- ------- --------
Balance at December 31, 1999 $(13,942) $ -- $(13,942)
======== ======= ========

Concentrations of credit risk

Financial instruments which potentially subject the Company to
concentrations of credit risk consist principally of cash and cash equivalents,
and short-term investments, which are not federally insured, and accounts
receivable. The Company's short-term investments consist principally of U.S.
Treasury Bills, U.S. Government Agency Notes and Commercial Paper.

The Company sells its products primarily to hospitals worldwide. Credit
is extended based on an evaluation of the customer's financial condition and
collateral generally is not required. The Company's ten largest customers
accounted for approximately 16% of accounts receivable at December 31, 1999.

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35
Inventories

Inventories are stated at the lower of cost (first-in, first-out) or
market and consist of the following:

DECEMBER 31,
-------------------------------------
1999 1998
----------------- ----------------

Raw materials $ 3,699,983 $ 2,449,877
Work in process 427,600 203,540
Finished goods 1,633,304 942,489
----------------- ----------------
$ 5,760,887 $ 3,595,906
================= ================

Building, Property and Equipment

Building, property and equipment are carried at cost. Depreciation and
amortization are computed on the straight-line method over the following
estimated useful lives:

Building 50 years
Lithotripters 5 years
Equipment 5 years
Furniture and fixtures 5 years
Leasehold improvements Life of lease

Depreciation expense for the years ended December 31, 1999, 1998 and
1997 was $1,987,000, $1,863,000, and $1,538,000, respectively.

Goodwill

The Company recorded goodwill resulting from the excess of the purchase
prices of Northern Nevada, Southern Idaho and Zenith Medical Systems, Ltd. over
the fair market value of the net assets. Goodwill is being amortized over
periods ranging from fifteen to forty years using the straight-line method.
Accumulated amortization at December 31, 1999 and 1998 is $269,635 and $180,569,
respectively.

Long-Lived Assets

Long-lived assets and certain identifiable intangibles held and used by
the Company are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. Based upon the Company's analysis, the Company believes no material
impairment of the carrying value of its long-lived assets, inclusive of
intangible assets, existed at December 31, 1999 and 1998. The Company's analysis
was based on a comparison of the carrying amount of such assets to the Company's
historical actual cash flows and to an estimate of future undiscounted cash
flows.

Earnings Per Share

The Company has adopted SFAS No. 128, "Earnings Per Share," and applied
this pronouncement to all periods presented. This statement requires the
presentation of both basic and diluted net income per share for financial
statement purposes. Basic net income per share is computed by dividing income
available to common stockholders by the weighted average number of common shares
outstanding. Diluted net income per share includes the effect of the potential
shares outstanding, including dilutive stock options and warrants using the
treasury stock method. All earnings per share amounts for all periods have been
restated to conform with the SFAS No. 128 requirements.

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36
The following table sets forth the computation of earnings per share:

YEAR ENDED DECEMBER 31,
---------------------------------------------------------
1999 1998 1997
---------------- --------------- -----------------

Numerator: Net income ................... $ 2,841,150 $ 4,342,094 $ 3,964,298
================ =============== =================

Denominator for weighted
average shares outstanding......... 4,956,508 5,162,112 5,390,352
================ =============== =================

Basic earnings per share................. $ .57 $ .84 $ .74
================ =============== =================

Effect of dilutive securities:
Weighted average shares
outstanding................... 4,956,508 5,162,112 5,390,352
Stock options...................... 78,342 124,855 120,316
---------------- --------------- -----------------

Denominator for diluted earnings
per share ...................... 5,034,850 5,286,967 5,510,668
================ =============== ===============

Diluted earnings per share............... $ .56 $ .82 $ .72
================ =============== ===============

Stock Compensation

The Company has elected to follow Accounting Principles Board Opinion
No. 25, Accounting for Stock Issued to Employees, (APB 25) and related
Interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under FASB
Statement No. 123, Accounting for Stock-Based Compensation, requires the use of
option valuation models that were not developed for use in valuing employee
stock options. Under APB 25, because the exercise price of the Company's
employee stock options equals the market price of the underlying stock on the
date of grant, no compensation expense is recognized.

To calculate the pro forma information required by Statement 123, the
Company uses the Black-Scholes option pricing model. The Black-Scholes model was
developed for use in estimating the fair value of traded options which have no
vesting restrictions and are fully transferable. In addition, option valuation
models require the input of highly subjective assumptions including the expected
stock price volatility. Because the Company's employee stock options have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in management's opinion, the existing models do not
necessarily provide a reliable single measure of the fair value of its employee
stock options.

Revenue recognition

Revenues recognized in the fee-for-service segment of the Company's
operations are invoiced as the customer uses the equipment in the month that
service has been provided.

Revenues from equipment sales are recognized in accordance with the
underlying contractual terms of each sale. Typically, revenue recognition
requires the transfer of title upon shipment, customer acceptance, receipt of
specified down payments and performance of all significant contractual
obligations.

Service and maintenance contract revenues are deferred and amortized
over the terms of the related contracts.

Advertising

The Company expenses advertising costs including promotional
literature, brochures and trade shows as incurred. Advertising expense was
$58,000, $135,000 and $126,000 for the years ended December 31, 1999, 1998 and
1997, respectively.

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37
Business Segments and Geographic Information

Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 131, Disclosures about Segments of an Enterprise and
Related Information (SFAS 131). SFAS No. 131 also establishes standards for
related disclosures about products and services, geographic areas and major
customers. The adoption of SFAS 131 did not affect results of operations or
financial position, but did affect the following disclosure of segment
information.

The Company operates in two business segments, equipment sales and fees
for procedures, maintenance and management. The equipment sales segment is not
significant. The fees for procedures, maintenance and management segment
represents recurring revenue from procedure fees and fee for service
arrangements for use and the maintenance of lithotripter equipment. The
accounting policies of these segments are the same as those described in the
summary of significant accounting policies except that certain expenses, such as
amortization of certain intangibles and certain corporate expenses, are not
allocated to the segments. Asset categories used for allocation to segment
reporting include net accounts receivable, net inventory, net property and
equipment and net goodwill.

Selected financial information for the Company's reportable segments as
of and for the years ended December 31, 1999, 1998 and 1997 follows (in
thousands):

1999 1998 1997
--------------- -------------- ----------------

Revenue:
Equipment sales $ 3,338 $ 2,145 $ 2,722
Fees for procedures, maintenance
and management 19,532 21,128 18,476
Nonreportable segment 598 552 536
--------------- -------------- ----------------
$ 23,468 $ 23,825 $ 21,734
=============== ============== ================
Operating income (loss):
Equipment sales 678 (537) 169
Fees for procedures, maintenance
and management 4,085 7,751 6,121
Nonreportable segment 600 474 471
--------------- -------------- ----------------
$ 5,363 $ 7,688 $ 6,761
=============== ============== ================
Assets:
Equipment sales 3,228 1,764 1,529
Fees for procedures, maintenance
and management 15,173 13,252 13,117
--------------- -------------- ----------------
$ 18,401 $ 15,016 $ 14,646
=============== ============== ================
Depreciation and amortization:
Equipment sales 206 149 96
Fees for procedures, maintenance
and management 1,870 1,798 1,517
--------------- -------------- ----------------
$ 2,076 $ 1,947 $ 1,613
=============== ============== ================
Expenditures for long-lived assets:
Equipment sales 288 199 963
Fees for procedures, maintenance
and management 3,259 864 2,934
--------------- -------------- ----------------
$ 3,547 $ 1,063 $ 3,897
=============== ============== ================

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38
Selected financial information for the Company's operations by
geographic segment is as follows (in thousands):

1999 1998 1997
--------------- -------------- ----------------

REVENUE:
United States $ 22,733 $ 22,977 $ 21,199
Europe and Middle East 459 17 27
Asia Pacific Rim 276 831 508
--------------- -------------- ----------------
$ 23,468 $ 23,825 $ 21,734
=============== ============== ================

LONG-LIVED ASSETS:
United States $ 17,263 $ 14,898 $ 13,603
Europe 820 --- ---
--------------- -------------- ----------------
$ 18,083 $ 14,898 $ 13,603
=============== ============== ================

3. ACQUISITIONS AND INVESTMENTS IN JOINT VENTURES

Purchase of Assets of Creos, Ltd.

In April 1999, Medstone International, Ltd., a wholly-owned
subsidiary of the Company located in Scotland, purchased certain assets of Creos
Ltd. from its liquidator for $165,600 cash. The acquisition has been accounted
for as a purchase and did not generate any goodwill. Medstone International, Ltd
then commenced manufacturing x-ray generator products previously produced by
Creos Ltd. The operating results of Medstone International, Ltd. are included in
the consolidated financial statements of the Company since April 1999.

Purchase of Zenith Medical Systems, Ltd.

In October 1999, Medstone International, Ltd. purchased all
outstanding shares of Zenith Medical Systems, Ltd., for $870,000 cash less
$284,000 of acquired cash for a net cost of $586,000. The acquisition has been
accounted for as a purchase and, accordingly, the excess of cost over the fair
value of net assets acquired has been recorded as goodwill of approximately
$317,000 and is being amortized over its expected benefit period of 15 years.
Zenith Medical Systems Ltd., is a distributor of major medical imaging systems
to the British National Health Service located in Manchester, England. The
operating results of Zenith Medical Systems, Ltd. are included in the
consolidated financial statements of the Company since October 1999.

Investment in 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 new
transportable lithotripsy product. DIS commenced shipments of that product to
the Company in January 1999. The Company has purchased 300,000 shares of DIS
preferred stock for $300,000, which represents a 14% ownership interest. In
1999, the Company recorded an investment writedown of $300,000 as a result of
its review of the realizable value of its investment.

Investment in 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's investment in k.Biotech
preferred stock was $325,000, representing a 21% ownership interest, and
$225,000, representing a 15.3% ownership interest, at December 31, 1999 and
1998, respectively. The investment in k. Biotech is accounted for under

36
39
the equity method because the Company has the ability to exercise significant
influence over k.Biotech and is included in other assets. k. Biotech is
continually seeking additional funding from international sources to finance its
required investment in plant and equipment.

Investment in Chinese Joint Venture

The Company, along with Acuity International ("Acuity") and Phenix
Optical Ltd ("Phenix"), a Chinese company, created a joint venture in March 1998
to provide lithotripsy services to inland Chinese areas. Each entity was a 1/3
owner of the joint venture. The Company recorded its investment of $92,000 as
other assets. In December 1998, documents were drawn and executed to turn
ownership over to Phenix in return for delivery of optical products to both
Acuity and the Company. In 1999, the Company received the optical products in
release of its share in the joint venture. The Company estimates the resale
value of the optical products to approximate the value of the investment
established in the joint venture. The Company intends to sell these optical
products.

Purchase of Southern Idaho

On March 18, 1997, the Company completed the acquisition of a 60%
interest in Southern Idaho Lithotripsy Associates, LLC, an operator of a
"retail" lithotripsy operation in southern Idaho, for a purchase price of $2.3
million in cash. The assets acquired, accounted for on the purchase method,
consisted of the accounts receivable and contracts to provide services to
insurers. The operating results of Southern Idaho are included in the
consolidated financial statements of the Company since March 1, 1997.

Unaudited pro forma consolidated results after giving effect to the
businesses acquired during the fiscal 1999 would not have been materially
different from the reported amounts for 1999 and 1998 due to the immateriality
of these acquisitions.

4. INCOME TAXES

The Company provides for income taxes under the liability method.
Accordingly, deferred income tax assets and liabilities are computed for
differences between the financial statement and tax bases of assets and
liabilities that will result in taxable or deductible amounts in the future
based on enacted tax laws and rates applicable to the periods in which the
differences are expected to affect taxable income. Valuation allowances are
established when necessary to reduce deferred tax assets to amounts which are
more likely than not to be realized.

The provision for income taxes consists of the following:

YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, 1999 DECEMBER 31, 1998 DECEMBER 31, 1997
-------------------- -------------------- ----------------------

Current:
Federal $ 1,653,400 $ 2,270,000 $ 1,454,000
State 486,000 631,000 448,000
----------------- ----------------- ------------------
Total current 2,139,400 2,901,000 1,902,000
----------------- ----------------- ------------------

Deferred:
Federal (168,000) (153,000) 338,000
State (52,000) (30,000) 89,000
----------------- ----------------- -------------------
Total deferred (220,000) (183,000) 427,000
----------------- ------------------ -------------------
Provision for income taxes $ 1,919,400 $ 2,718,000 $ 2,329,000
================= ================= ===================

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40
The following is a reconciliation of the provision for income taxes at the
federal statutory rate compared to the Company's effective tax rate:

YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, 1999 DECEMBER 31, 1998 DECEMBER 31, 1997
----------------- ----------------- -----------------

Income tax at the
statutory rate $ 1,885,000 $ 2,400,000 $ 2,299,000
State income taxes
(net of federal benefit) 286,000 398,000 282,000
Minority interest (195,000) --- (159,000)
Other (56,600) (80,000) (93,000)
----------------- ---------------- --------------
Provision for income taxes $ 1,919,400 $ 2,718,000 $ 2,329,000
================= ================ ==================

The tax effect of temporary differences that give rise to significant
portions of the deferred tax assets and deferred tax liabilities are as follows:

DECEMBER 31, 1999 DECEMBER 31, 1998
----------------- -----------------

DEFERRED TAX ASSETS (LIABILITIES):

State taxes $ 165,000 $ 199,000
Cardiac investment reserve 417,000 321,000
Inventory reserve 131,000 145,000
Bad debt reserve 246,000 204,000
Accruals not currently deductible for tax 87,000 74,000
Inventory adjustment 66,000 55,000
Product reserves 161,000 141,000
------------------- -------------------
Deferred tax assets 1,273,000 1,139,000
------------------- -------------------

Depreciation and amortization (629,000) (714,000)
------------------ -------------------
Deferred tax liabilities (629,000) (714,000)
------------------ -------------------

Net deferred tax assets $ 644,000 $ 425,000
=================== ===================

5. STOCK OPTIONS

In June 1989, the Company's stockholders approved the 1989 Stock
Incentive Plan ("1989 Plan") which provides for the granting of a variety of
stock-related securities, including shares of common stock, stock options and
stock appreciation rights to employees and other selected individuals. In May
1991, the Company's stockholders amended the 1989 Plan to increase the number of
shares issuable to 1,593,783 and eliminated the provision for an automatic
increase in the number of shares issuable on January 1 of each year by one
percent of the then outstanding shares. In May 1997, the Company terminated the
1989 Plan as to the granting of additional options. As of December 31, 1999,
566,428 options for shares of common stock had been granted and remain
outstanding under this plan.

In June 1989, the Company's stockholders also approved the Nonemployee
Director Stock Option Plan. This plan provides for the issuance of up to 50,000
shares of the Company's common stock upon exercise of options granted under the
plan. On June 1, 1999, this plan expired and no additional shares may be granted
under this plan. Outstanding options shall continue to vest and remain
exercisable in accordance with the grants outstanding. As of December 31, 1999,
10,000 options for shares of common stock had been granted and remain
outstanding under this Plan.

Options to purchase 15,000 shares of common stock were issued to each
then current members of the Board in November 1996 and have exercise prices of
$6.375 after repricing of the options on August 31, 1998. The options

38
41
are exercisable, after six months following their grant dates, in incremental
amounts equal to 1/48 of the underlying shares of each elapsed calendar month
during which the director remains on the Company's Board. The terms of the
options are five years, subject to earlier termination related to the director
no longer serving on the Board. As of December 31, 1999, 45,000 options for
shares of common stock had been granted and are outstanding.

In May 1997, the Company's stockholders approved the 1997 Stock Incentive
Plan which provides for the granting of a variety of stock-related securities,
including shares of common stock, stock options and stock appreciation rights to
employees and other selected individuals. The Plan allows for the issuance of up
to 800,000 shares, with increases each January 1 that the Plan is in effect by a
number of shares equal to one percent of the total number of outstanding shares
of common stock on that date. As of January 1, 1999 the number of shares
authorized by the plan increased to 895,585. As of December 31, 1999, 501,000
options for shares of common stock had been granted and are outstanding under
this plan.

Effective August 13, 1998, the Company repriced all outstanding options
granted under all plans with exercise prices exceeding the closing market value
of the stock on that date. Accordingly, the exercise price of these options was
reduced to $6.375 per share.

A summary of the Company's stock option plans as of the end of 1999 and
1998 and changes during the years is presented below:

DECEMBER 31, 1999 DECEMBER 31, 1998 DECEMBER 31, 1997
------------------------------- ------------------------------ ----------------------------
WEIGHTED-AVE. WEIGHTED-AVE. WEIGHTED-AVE.
SHARES EXERCISE PRICE SHARES EXERCISE PRICE SHARES EXERCISE PRICE
------------- -------------- ------------ -------------- ---------- --------------

Outstanding, beginning of year 1,082,902 $ 6.39 970,803 $ 8.34 743,926 $ 8.22
Granted 92,500 6.70 230,000 6.52 422,000 8.08
Exercised (16,637) 6.09 (15,717) 4.95 (56,385) 5.03
Canceled (36,337) 6.48 (102,184) 7.90 (138,738) 8.23
------------- ----------- ------------ ----------- ---------- ------------

Outstanding, end of year 1,122,428 $ 6.45 1,082,902 $ 6.39 970,803 $ 8.34
============ =========== ============ =========== ========= ============

Available for future grants 394,585 470,810 593,000
============ ============ =========

Exercisable at end of year 663,457 474,446 316,899
============ ============ =========

Weighted-average fair value
of options granted during the year $ 3.64 $ 3.56 $ 2.54
============ ============ =========

The following table summarizes information about stock options
outstanding at December 31, 1999:

OPTIONS OUTSTANDING
-------------------------------------------------------
NUMBER
RANGE OF OUTSTANDING WEIGHTED-AVERAGE WEIGHTED-AVERAGE
EXERCISE PRICES AT 12/31/99 EXERCISE PRICE REMAINING TERM
--------------- ----------- ---------------- -----------------

$5.19 to $5.47 18,894 $ 5.320 1.9 years
$5.50 to $6.50 990,534 $ 6.375 3.8 years
$6.51 to $7.50 113,000 $ 7.295 2.6 years
--------------- ------- ------- ---------
$5.19 to $7.50 1,122,428 $ 6.450 3.8 years
=============== ========== ======= =========

In calculating pro forma information regarding net income and net
income per share, as required by Financial Accounting Standards Board Statement
No. 123, Accounting for Stock-Based Compensation, the fair value was estimated
at the date of grant using a Black-Scholes option pricing model with the
following weighted-average assumptions for the options on the Company's common
stock for the years ended December 31, 1999, 1998, and 1997, respectively: risk
free interest rates of 6% for all periods; dividend yields of 0% for all
periods; volatility of the

39
42
expected market prices of the Company's common stock of .469, .542 and .316; and
expected life of the options of 5.5 years for all periods.

For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. The Company's
proforma information for the years ended December 31, 1999, 1998 and 1997
follows (in thousands, except per share information):

YEAR ENDED DECEMBER 31,
--------------------------------------------
1999 1998 1997
------------- ----------- -----------

Pro forma net income $ 2,464 $ 4,077 $ 3,381
Pro forma diluted net income
per share $ .50 $ .77 $ .61

These pro forma amounts do not give effect to options granted prior to
January 1, 1995.

6. STOCK REPURCHASE PLAN

On August 3, 1999, the Company announced its most recent Stock
Repurchase Program of up to 500,000 shares of its common stock. The three Stock
Repurchase Programs announced by the Company authorized repurchase of up to
1,100,000 shares of its common stock. For the year ending December 31, 1999, the
Company repurchased a total of 387,550 shares at a cost of $2,445,250. For the
year ended December 31, 1998 the Company repurchased a total of 318,300 shares
at a cost of $2,742,473. For the year ended December 31, 1997, the Company
repurchased a total of 156,000 shares at a cost of $1,292,366.00. The Company
has repurchased a total of 974,650 shares since the inception of its Stock
Repurchase Programs at a total cost of $7,388,459 with all amounts recorded as
treasury stock. The Company's current repurchase program was active as of
December 31, 1999.

7. COMMITMENTS

In March 1994, the Company took occupancy of office, manufacturing,
engineering, warehouse space, and research and development laboratories under an
operating lease with an initial term of two years. Under lease extensions, the
current monthly lease rate is $14,410 through June 2000.

In April 1999, the Company's subsidiary took possession of
manufacturing, office and warehouse space under an operating lease through
December 1999 at a monthly rent of $3,233. In December 1999, a new twelve month
lease was entered into at a monthly rent of $4,849, commencing January 1, 2000.

The future minimum lease payments under all operating leases are as
follows:

Minimum Rental
--------------

2000 $ 174,000
2001 $ 30,000
2002 $ 23,000

Total net rent expense under all operating leases for the years ended
December 31, 1999, 1998 and 1997 was $227,000, $194,000 and $182,000,
respectively.

8. CONTINGENCIES

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

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43
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.

9. RELATED PARTY TRANSACTIONS

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 the Company's 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 common stock.

In April 1997, Cardiac Science effectuated a 1 for 11.42857143 reverse
stock split, reducing the Company's holdings to 546,772 shares, which was the
number of shares held until 1999. During 1999, the Company evaluated the market
value of Cardiac Science and, with the prevailing share price, sold 55,105
shares of Cardiac Science during the third quarter of 1999 for a gain of
approximately $244,000, which was included in other income. As of December 31,
1999, the Company holds 491,667 shares of Cardiac Science. This remaining
investment has been recorded at a net investment value of $0 since 1997 due to
Cardiac Science's previous historical financial performance and market
valuation.

The Company also held warrants to purchase 87,500 (post-split) shares
of Cardiac Science at $.011 each, with an expiration date of September 2004. In
the fourth quarter of 1999, the Company sold these warrants for a cash price of
$3.00 per share and recognized a gain of approximately $262,000 which was
included in other income.

k. BIOTECH

During the year, the Company increased its ownership interest in
k.Biotech, Inc. by $100,000 for a total investment of $325,000 which represents
a 21% interest. Two members of the Board of Directors of the Company are also
shareholders of k.Biotech, Inc. and one member of the Board of Directors is the
President of k.Biotech.

DIGITAL IMAGING SYSTEMS

During 1998, the Company obtained a 14% ownership interest in Digital
Imaging Systems, Inc. ("DIS") for $300,000 and entered into a supply agreement
whereby the Company will purchase equipment up to $1.1 million from DIS. In
1999, the Company recorded an investment writedown of $300,000 as a result of
its review of the realizable value of this investment. DIS commenced shipments
of its products to the Company in January 1999 pursuant to the supply agreement.

UROGEN CORP.

Urogen Corp. was a subsidiary of the Company until early 1996 at which
time the Company spun off this subsidiary as a separate company. The Company
distributed all the stock of Urogen to its stockholders, except for 100,000
shares which the Company retained. The 100,000 shares of Urogen common stock
have a book value of $0 at both December 31, 1999 and 1998. The market value of
the Urogen common stock is approximately $60,000 at December 31, 1999.

41
44
10. EMPLOYEE BENEFIT PLAN

In January 1990, the Company established a defined contribution profit
sharing 401(k) plan for all eligible employees. The plan provides for the
deferral of up to 15% of an employee's qualifying compensation under Section
401(k) of the Internal Revenue Code. Contributions by the Company may be made to
the plan at the discretion of the Board of Directors. During 1997, the Company's
Board of Directors elected to match the employee contributions $.25 on a dollar,
up to a maximum company contribution of $2,000 per year. In 1999, 1998 and 1997,
the Company's contribution totaled $50,557, $44,430 and $37,991, respectively.

11. MAJOR CUSTOMERS AND FOREIGN SALES

During the year ended December 31, 1999, no single customer accounted for
10% or more of total revenues and the Company derived 3% of its total revenues
from sales to foreign customers. During the year ended December 31, 1998, no
single customer accounted for 10% or more of total revenues and the Company
derived 4% of its total revenues from sales to foreign customers. During the
year ended December 31, 1997, no single customer accounted for 10% of total
revenues of the Company and the Company derived 2% of its total revenues from
sales to foreign customers.

12. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

The tables below set forth selected quarterly financial information for
1999 and 1998 (in thousands, except per share amounts):

1999 1ST QUARTER 2ND QUARTER 3RD QUARTER 4TH QUARTER
---- ------------ ------------- -------------- -------------

Net sales $ 4,904 $ 6,493 $ 6,440 $ 5,632
Gross profit 2,437 3,434 3,172 2,317
Net income 532 633 1,182 494
Basic earnings per share $ .11 $ .12 $ .23 $ .10

1998 1ST QUARTER 2ND QUARTER 3RD QUARTER 4TH QUARTER
---- ----------- ----------- ------------ ---------------

Net sales $ 5,852 $ 6,268 $ 6,263 $ 5,442
Gross profit 2,964 3,441 3,425 2,995
Net income 956 1,195 1,273 918
Basic earnings
per share $ .18 $ .23 $ .25 $ .18

13. SUBSEQUENT EVENTS

In January 2000, the Company sold 89,167 shares of Cardiac Science
Common Stock for gross proceeds of approximately $410,000.

On January 21, 2000, after purchasing an additional 69,800 shares for a
cost of $391,675, the Company suspended any further activity in its Stock
Repurchase Program.

On January 27, 2000, the Company sold 5,000 shares of Urogen common
stock for gross proceeds of approximately $28,000.

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45
MEDSTONE INTERNATIONAL, INC.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS

ADDITIONS
--------------------------------------
BALANCE AT CHARGED TO CHARGED TO BALANCE AT
BEGINNING COSTS AND OTHER END
DESCRIPTION OF YEAR EXPENSES ACCOUNTS DEDUCTIONS OF YEAR
- ----------- ---------- --------------- --------------- --------------- -----------
FOR THE YEAR ENDED
DECEMBER 31, 1999:
- ------------------

Allowance for
doubtful accounts $602,564 $ 35,000 $ -- $ 66,312(b) $571,252
======== =============== =============== =============== ========

Allowance for
inventory obsolescence $337,437 $ -- $ -- $ 30,234(a) $307,203
======== =============== =============== =============== ========

FOR THE YEAR ENDED
DECEMBER 31, 1998:

Allowance for
doubtful accounts $534,918 $ 130,000 $ -- $ 62,354(b) $602,564
======== =============== =============== =============== ========

Allowance for
inventory obsolescence $337,437 $ -- $ -- $--- $337,437
======== =============== =============== =============== ========

FOR THE YEAR ENDED
DECEMBER 31, 1997:

Allowance for
doubtful accounts $220,312 $ 251,000 $ 66,606 $ 3,000(b) $534,918
======== =============== =============== =============== ========

Allowance for
inventory obsolescence $440,000 $ -- $ -- $102,563(a) $337,437
======== =============== =============== =============== ========

(a) Write-off of inventory
(b) Write-off of bad debt

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46
SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized.

MEDSTONE INTERNATIONAL, INC.

By: /s/ David V. Radlinski
---------------------------------
David V. Radlinski
Chief Executive Officer

Dated: March 27, 2000

Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant and in the capacities indicated on March 27, 2000.

SIGNATURE TITLE
--------- -----

Chairman of the Board,
/s/ David V. Radlinski Chief Executive Officer
- ----------------------------------- and Director
David V. Radlinski (Principal Executive Officer)

/s/ Mark Selawski
- ----------------------------------- Chief Financial Officer
Mark Selawski (Principal Financial and Accounting Officer)

/s/ Donald J. Regan
- ----------------------------------- Director
Donald J. Regan

/s/ Frank R. Pope
- ----------------------------------- Director
Frank R. Pope

/s/ David A. Reed
- ----------------------------------- Director
David A. Reed

/s/ Michael C. Tibbitts
- ----------------------------------- Director
Michael C. Tibbitts

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47
EXHIBIT INDEX

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)
10.28 Facility Lease on 100 Columbia (6)
10.29 1997 Stock Incentive Plan (5)(7)
10.30 Employment Agreement with David Radlinski (5)
10.31 Employment Agreement with Mark Selawski (5)
10.32 Employment Agreement with Eva Novotny (5)
21 Subsidiaries
23.1 Consent of Independent Auditors
27 Financial Data Schedule
28.2 Form of Cytocare, Inc. Information Statement - Distribution to Shareholders of Stock
of Cardiac Science, Inc. (8)
28.3 Form of Medstone International, Inc. Information Statement - Distribution to
Shareholders of Stock of Endocare, Inc. and Urogen Corp. (9)

- ---------------------------------------
(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 annual
report on Form 10-K for the year ended December 31, 1993.

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

(8) Previously filed with the same exhibit number with the Company's current
report on Form 8-K dated June 26, 1991, and incorporated herein by
reference.

(9) Previously filed with the Company's current report on Form 8-K dated
February 9, 1996, and incorporated herein by reference.

The Company will furnish to a requesting beneficial owner of its securities
a copy of any such exhibits upon payment of a fee equal to $.20 per exhibit
page.