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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

Commission file number: 0-18338

I-Flow Corporation

(949) 206-2700

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 whether the registrant is an accelerated filer (as defined in Rule 12(b)-2 of the Exchange Act). Yes [  ] No[ X ]

As of August 1, 2003 there were 15,924,033 shares of common stock outstanding.

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I-FLOW CORPORATION

FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2003

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I-FLOW CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)

See accompanying notes to unaudited condensed consolidated financial statements.

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I-FLOW CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE OPERATIONS
(Unaudited)

See accompanying notes to condensed consolidated financial statements

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I-FLOW CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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I-FLOW CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation – The accompanying unaudited consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments, and a goodwill impairment charge related to a change in accounting principle discussed in Note 4 below) that, in the opinion of management, are necessary to present fairly the financial position of I-Flow Corporation and its subsidiaries (the “Company”) at June 30, 2003 and the results of its operations and its cash flows for the three and six-month periods ended June 30, 2003 and 2002. Certain information and footnote disclosures normally included in financial statements have been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission although the Company believes that the disclosures in the financial statements are adequate to make the information presented not misleading.

The financial statements included herein should be read in conjunction with the financial statements of the Company included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002 filed with the Securities and Exchange Commission on March 31, 2003.

New Accounting Pronouncements – In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). SFAS 142 addresses the financial accounting and reporting requirements for acquired goodwill and other intangible assets. The Company adopted the provisions of SFAS 142 effective January 1, 2002. Under SFAS 142, the Company is no longer required to amortize goodwill and other intangible assets with indefinite lives. Instead, SFAS 142 requires that goodwill and intangible assets deemed to have an indefinite useful life be reviewed for impairment upon adoption of SFAS 142 and annually thereafter. See Note 4 to condensed consolidated financial statements.

In August 2001, the FASB issued SFAS No. 143, Accounting for Obligations Associated with the Retirement of Long-Lived Assets (“SFAS 143”). SFAS 143 establishes accounting standards for the recognition and measurement of an asset retirement obligation and its associated asset retirement cost. It also provides accounting guidance for legal obligations associated with the retirement of tangible long-lived assets. SFAS 143 is effective for fiscal years beginning after June 15, 2002, with early adoption permitted. The Company adopted the provisions of SFAS 143 on January 1, 2003 and such adoption did not have a material impact on its consolidated results of operations and financial position.

In October 2001, the FASB issued SFAS No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”). SFAS 144 establishes a single accounting model for the impairment or disposal of long-lived assets and new standards for reporting discontinued operations. SFAS 144 superseded SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of and APB Opinion No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. The provisions of SFAS 144 are effective in fiscal years beginning after December 15, 2001 and, in general, are to be applied prospectively. The Company adopted the provisions of SFAS 144 on January 1, 2002 and such adoption did not have a material impact on its consolidated results of operations and financial position.

In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS 146”), which addresses financial accounting and reporting for costs associated with exit or disposal activities and supersedes Emerging Issues Task Force (“EITF”) Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the

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liability is incurred. Under EITF Issue 94-3, a liability for an exit cost as defined in EITF Issue 94-3 was recognized at the date of an entity’s commitment to an exit plan. SFAS 146 also establishes that the liability should initially be measured and recorded at fair value. SFAS 146 is effective for exit and disposal activities initiated after December 31, 2002. The Company adopted the provisions of SFAS 146 on January 1, 2003, and such adoption did not have a material impact on its consolidated results of operations and financial position.

In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees and Indebtedness of Others. FIN 45 elaborates on the disclosures to be made by the guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002 while the provisions of the disclosure requirements are effective for financial statements of interim or annual reports ending after December 15, 2002. The Company adopted the disclosure provisions of FIN 45 during the fourth quarter of fiscal 2002 and such adoption did not have a material impact on the consolidated financial statements. The Company adopted the recognition provisions of FIN 45 effective January 1, 2003 and such adoption did not have a material impact on the consolidated results of operations and financial position.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure (“SFAS 148”). SFAS 148 amends SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), to provide alternative methods for voluntary transition to SFAS 123’s fair value method of accounting for stock-based employee compensation. SFAS 148 also requires disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income (loss) and earnings (loss) per share in annual and interim financial statements. The Company has adopted the provisions of SFAS 148 effective January 1, 2003, and has included the additional required disclosures below under the heading Accounting for Stock Based Compensation. This adoption did not have a material impact on the consolidated financial statements.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities. In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either does not have equity investors with voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The Company adopted the provisions of FIN 46 effective February 1, 2003, and such adoption did not have a material impact on its consolidated results of operations and financial position because the Company currently has no variable interest entities.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. SFAS 150 improves the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity. SFAS 150 requires that those instruments be classified as liabilities in statements of financial position. The Statement is effective for financial instruments entered into or modified after May 31, 2003, otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. On June 15, 2003, the Company adopted SFAS 150 which had no material impact on the Company’s financial condition and results of operations.

Accounting for Stock Based Compensation – The Company accounts for employee stock options using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees and FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans. Stock options issued to consultants and vendors are accounted for at fair value.

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The Company has adopted the disclosure-only provisions of SFAS 123, Accounting for Stock-Based Compensation. Accordingly, no compensation cost has been recognized for stock option grants to employees and non-employee directors with exercise prices equal to the fair market value of the underlying shares at the grant date. Had compensation cost for the Company’s option plans been determined based on the fair value of the options at the grant date consistent with the provisions of SFAS 123, the Company’s net income (loss) and net income (loss) per share would have been the pro forma amounts indicated below:

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants during the six months ended June 30, 2003 and fiscal year 2002: no dividend yield; expected volatility 94%; risk-free interest rate of 3.04%; and expected lives of five years.

2. Inventories

Inventories consisted of the following:

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3. Earnings (Loss) Per Share

Basic net income (loss) per share is computed using the weighted average number of common shares outstanding during the periods presented, excluding unvested restricted stock which the Company has a right to repurchase in the event of early termination of employment.

Diluted net income (loss) per share is computed using the weighted average number of common and common equivalent shares outstanding during the periods utilizing the treasury stock method for stock options and unvested restricted stock.

The following is a reconciliation between the number of shares used in the basic and diluted net income (loss) per share calculations:

Potential common shares of 32,000 and 772,000 have been excluded from diluted weighted average common shares for the three and six-month periods ended June 30, 2003 and, respectively, as the effect would be anti-dilutive.

Potential common shares of 1,938,000 and 1,689,000 have been excluded from diluted weighted average common shares for the three and six-month periods ended June 30, 2002, respectively, as the effect would be anti-dilutive.

4. Goodwill and Other Intangible Assets

SFAS 142 addresses the financial accounting and reporting requirements for acquired goodwill and other intangible assets. The Company adopted the provisions of SFAS 142 in January 2002. Under SFAS 142, the Company is no longer required to amortize goodwill and other intangible assets with indefinite lives. Instead, SFAS 142 requires that goodwill and intangible assets deemed to have an indefinite useful life be reviewed for impairment upon adoption of SFAS 142 and annually thereafter.

Under SFAS 142, goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value. The Company’s reporting units are consistent with the operating segments underlying the reporting segments identified in Note 5. - Business Segments.

In accordance with SFAS 142, the Company completed a test for impairment in June 2002 and concluded that consolidated goodwill in the amount of $3,474,000 was impaired. The Company recorded a non-cash charge of $3,474,000 to reduce the carrying value of its goodwill retroactively to the January 1, 2002 adoption date. Such charge is not included in operating income and is reflected as a cumulative effect of a change in accounting principle, effective January 1, 2002, in the accompanying Condensed Consolidated Statements of Operations and Comprehensive Operations.

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The total impairment amount of $3,474,000 is attributable to the Company’s manufacturing and marketing business segment, and represents the previously unamortized goodwill resulting from the Company’s purchase of substantially all of the assets of Block Medical, Inc. on July 22, 1996, and the Company’s acquisition of all of the outstanding stock of Spinal Specialties, Inc. on January 14, 2000. In calculating the impairment charge, the fair value of the impaired reporting unit was estimated using a market multiple methodology. The impairment of the goodwill associated with the manufacturing and marketing segment resulted from the low profitability of the business segment.

The changes in carrying amount of goodwill by segment for fiscal year 2002 and the six months ended June 30, 2003 are as follows:

As of June 30, 2003, the remaining goodwill of $2,639,000 is attributable to the Company’s rentals business segment and the Company has determined that there was no impairment of this goodwill as of June 30, 2003.

Amortizable intangible assets in the accompanying consolidated balance sheets are as follows:

The Company amortizes patents and licensing rights over a period of seven and five years, respectively. Amortization expense for the three and six months ended June 30, 2003 was $73,000 and $145,000, respectively, compared to $62,000 and $121,000 for the same periods in the prior year. Amortization expense of intangible assets is expected to be approximately $300,000 in each of the next five fiscal years.

5. Business Segments

The Company operates in two business segments: manufacturing and marketing of medical infusion products, and rentals of medical infusion pumps.

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Business segment information is as follows for the three and six-month periods ended June 30, 2003 and 2002:

6. Guarantees and Indemnifications

The Company from time to time enters into certain types of contracts that contingently require the Company to indemnify parties against third party claims. These contracts primarily relate to: (i) divestiture and acquisition agreements, under which the Company may provide customary indemnifications to either (a) purchasers of the Company’s businesses or assets; or (b) entities from which the Company is acquiring assets or businesses; (ii) certain real estate leases, under which the Company may be required to indemnify property owners for environmental and other liabilities, and other claims arising from the Company’s use of the applicable premises; (iii) certain agreements with the Company’s officers, directors and employees, under which the Company may be required to indemnify such persons for liabilities arising out of their relationship with the Company; and (iv) Company license, consulting, distribution and purchase agreements with its customers and other parties, under which the Company may be required to indemnify such parties for intellectual property infringement claims, product liability claims, and other claims arising from the Company’s provision of products or services to such parties.

The terms of such obligations vary. Generally, a maximum obligation arising out of these types of agreements is not explicitly stated and, therefore, the overall maximum amount of these obligations cannot be reasonably estimated. Historically, the Company has not been obligated to make significant payments for these obligations and, thus, no liabilities have been recorded for these obligations. The fair value of indemnities, commitments and guarantees that the Company issued during the three and six-month periods ended June 30, 2003 was not significant to the Company’s financial position, results of operations, or cash flows.

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Forward-Looking Statements

Statements by the Company in this report and in other reports and statements released by the Company are and will be forward-looking in nature and express the Company’s opinions about trends and factors that may impact future operating results. Statements that use words such as “believes,” “anticipates,” or “expects” or use similar expressions are intended to identify forward-looking statements. Forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those expected, and readers are cautioned not to place undue reliance on these forward-looking statements. The Company undertakes no obligation to republish revised forward-looking statements to reflect the occurrence of unanticipated or subsequent events. Readers are also urged to carefully review and consider the various disclosures made by the Company in this report which seek to advise interested parties of the risks and other factors that affect the Company’s business. Interested parties should also review the Company’s reports on Forms 10-K, 10-Q and 8-K and other reports that are periodically filed with the Securities and Exchange Commission. The risks affecting the Company’s business include, without limitation, reliance on the success of the home health care industry, the Company’s success in pursuing its direct sales strategy, the reimbursement system currently in place and future changes to that system, competition in the industry, economic and political conditions in foreign countries, currency exchange rates, inadequacy of booked reserves, technological changes, and product availability. All forward-looking statements, whether made in this report or elsewhere, should be considered in context with the various disclosures made by the Company about its business.

Critical Accounting Policies

I-Flow prepares its consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. Accordingly, the Company is required to make estimates, judgments and assumptions that the Company believes are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. The critical accounting policies which the Company believes are the most important to aid in fully understanding and evaluating its reported financial results include the following:

Revenue Recognition and Accounts Receivable

The Company recognizes revenue from product sales at the time of shipment and passage of title. The Company offers the right of return for defective products, and continuously monitors and tracks product returns. Also, the Company records a provision for the estimated amount of future returns based upon historical experience and any notification received of pending returns. Although product returns have historically been insignificant, the Company cannot guarantee that it will continue to experience the same return rates as in the past. Any significant increase in product returns could have a material adverse impact on the Company’s operating results for the period or periods in which the returns occur.

The Company recognizes rental revenues from medical pumps over the term of the related agreement, generally on a month-to-month basis. Pump rentals are billed at the Company’s established rates, which often differ from contractually allowable rates provided by third party payors such as Medicare, Medicaid and commercial insurance carriers. The Company records net rental revenues at the estimated realizable amounts from patients and third party payors. The Company may experience significant extended payment terms with certain of these third party payors, however, it continuously monitors reimbursement rates from third party payors and timing of payments. Any change in reimbursement or collection rates could have a material impact on the Company’s operating results for the period or periods in which the change is identified.

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Bad Debts

The Company performs various analyses to evaluate accounts receivable balances. It records an allowance for bad debts based upon the estimated collectibility of the accounts such that the recorded amounts reflect estimated net realizable value. The Company applies specified percentages to the accounts receivable agings related to product sales to estimate the amount that will ultimately be uncollectible and therefore should be reserved. The percentages are increased as the accounts age. The collectibility of accounts receivable related to rental revenues from medical pumps is estimated based upon current and historical collection and reimbursement rates for that business segment. If the actual uncollected amounts significantly exceed the estimated allowance, the Company’s operating results would be significantly and adversely affected.

Inventories

The Company values inventory at the lower of the actual cost to purchase or manufacture the inventory and the current estimated market value of the inventory. The Company regularly reviews inventory quantities on hand and records a provision for excess and obsolete inventory on specifically identified items based primarily upon the estimated forecast of product demand and production requirements for the next two years. A significant increase in the demand for the Company’s products could result in a short-term increase in the cost of inventory purchases while a significant decrease in demand could result in an increase in the amount of excess inventory quantities on hand. Additionally, the Company’s estimates of future product demand may prove to be inaccurate such that the Company may have understated or overstated the provision required for excess and obsolete inventory. In the future, if inventory is determined to be overvalued, the Company would be required to recognize such costs in cost of goods sold at the time of such determination. Likewise, if inventory is determined to be undervalued, the Company may have over-reported cost of goods sold in previous periods and would be required to recognize such additional operating income at the time of sale. Therefore, although the Company seeks to ensure the accuracy of its forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of its inventory and reported operating results.

Deferred Taxes

The Company recognizes deferred tax assets and liabilities based upon the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. The Company regularly reviews its deferred tax assets for recoverability and establishes a valuation allowance based upon historical taxable income, projected future taxable income and the expected timing of the reversals of existing temporary differences. If the Company continues to operate at a profit in the future and generate sufficient future taxable income, it could be required to reverse the current valuation allowance against the deferred tax assets which would result in a substantial decrease in the Company’s effective tax rate. Likewise, if the Company is unable to operate at a profit and unable to generate sufficient future taxable income, it could be required to establish an additional valuation allowance against all or a significant portion of its deferred tax assets resulting in a substantial increase in its effective tax rate and a material adverse impact on operating results.

Intangible Assets

The Company’s business combinations have at various times resulted in the acquisition of goodwill and other intangible assets, which may affect the amount of future period amortization expense and impairment expense that the Company may incur. The determination of the value of such intangible assets requires management to make estimates and assumptions that affect its consolidated financial statements. The Company reviews the recoverability of the carrying value of goodwill on an annual basis or more frequently if an event occurs or circumstances change to indicate that an impairment of goodwill has possibly occurred. The Company compares market value to book value of each reporting unit to determine whether or not any potential impairment of goodwill exists. The Company cannot guarantee that there will be no additional impairment in the future. See Note 4 to Condensed Consolidated Financial Statements.

The Company also reviews the recoverability of the carrying value of identified intangibles and other long-lived assets on an annual basis or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of these assets is determined based upon the forecasted undiscounted

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future net cash flows from the operations to which the assets relate, utilizing our best estimates, appropriate assumptions and projections at the time. These projected future cash flows may significantly vary over time as a result of increased competition, changes in technology, fluctuations in demand, consolidation of customers and reductions in average selling prices. If the carrying value is determined not to be recoverable from future operating cash flows, the asset would be deemed impaired and an impairment loss would be recognized to the extent the carrying value exceeded the estimated fair market value of the asset.

Results of Operations

Net revenues during the three and six-month periods ended June 30, 2003 were $12,563,000 and $23,727,000 compared to $9,505,000 and $18,055,000 for the same periods in the prior year, representing increases of 32% and 31%, respectively. The net increases in revenues of $3,058,000 and $5,672,000 for the three and six-month periods ended June 30, 2003 compared to the comparable periods in the prior year were primarily due to increases in regional anesthesia product revenues of $1,849,000 or 58% and $3,505,000 or 63%, respectively. The regional anesthesia revenue increase resulted from increased market penetration by the Company’s ON-Q® Post Operative Pain Relief System and by the Company’s Spinal Specialties subsidiary. Revenues in both other market segments also increased over the prior year. For the three and six months ended June 30, 2003, Oncology infusion services increased $712,000 and $1,251,000 and I.V. infusion therapy increased $497,000 and $916,000, respectively, when compared to the comparable periods in the prior year. The increase in Oncology infusion services revenues is related to the increased clinical usage of new chemotherapy drugs and protocols requiring the use of continuous intravenous pump services.

The Company incurred cost of sales of $4,823,000 and $8,972,000 during the three and six-month periods ended June 30, 2003 compared to $3,792,000 and $7,248,000, respectively, for the comparable periods in the prior year. This represents an increase of 27% and 24%, respectively. This increase is primarily due to higher sales volume. However, during the three and six-month periods ended June 30, 2003, cost of sales as a percentage of net revenues decreased from the prior year by approximately two percentage points, primarily due to increased sales of higher-margin products including the Company’s ON-Q® Post Operative Pain Relief System during the three and six months ended June 30, 2003.

Selling and marketing expenses for the three and six-month periods ended June 30, 2003 increased over the comparable periods in the prior year by $1,863,000 or 63% and $3,469,000 or 65%, respectively. As a percentage of net revenues, selling and marketing expenses increased by seven percentage points for the three month period ended June 30, 2003 and by eight percentage points for the six month period ended June 30, 2003 compared to the comparable periods in the prior year. These increases were primarily due to additional salaries, commissions, travel expenses and recruiting costs related to the expansion of the Company’s direct sales force. The increase also consisted of increased marketing expenses related to the Company’s ON-Q® Post-Operative Pain Relief System.

General and administrative expenses for the three and six-month periods ended June 30, 2003 increased by $338,000 or 17% and $883,000 or 22% compared to the comparable periods in the prior year. These increases were primarily due to increased outside professional services and accrued compensation costs. As a percentage of net revenues, general and administrative expenses decreased by approximately two percentage points and one percentage point, respectively, for the three and six-month periods ended June 30, 2003 when compared to the comparable periods in the prior year.

Product development expenses for the three and six-month periods ended June 30, 2003 decreased compared to the comparable periods in the prior year by $45,000 or 8% and $69,000 or 6%, respectively. This decrease was primarily due to reduced consulting expenses and other outside services due to the completion of specific projects. The Company will continue to incur product development expenses as it continues its efforts to introduce new and improved technology and cost-efficient products into the market. Product development expense as a percentage of net revenues for the three and six-month periods ended June 30, 2003 decreased by approximately two percentage points compared to the comparable periods in the prior year.

During the three and six-month periods ended June 30, 2003, the Company recorded income tax expense of $17,000 and $29,000, respectively, compared to income tax expense of $71,000 and $163,000 for the comparable periods in

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the prior year. The Company’s effective tax rates for the three and six months ended June 30, 2003 were 43.6% and 42.6% compared to 40.1% and 40.2%, respectively, for the comparable periods in the prior year.

In accordance with SFAS 142, the Company completed a test for goodwill impairment in June 2002 and concluded that consolidated goodwill in the amount of $3,474,000 was impaired as of January 1, 2002. The Company recorded a non-cash charge of approximately $3,474,000 to reduce the carrying value of its goodwill which was recorded as a cumulative effect of a change in accounting principle in 2002. See Note 4 – Goodwill and Other Intangible Assets.

Liquidity and Capital Resources

During the six-month period ended June 30, 2003, cash of $290,000 was used in operating activities consisting of net income of $39,000 plus non-cash expenses of $1,160,000, less net changes in operating assets and liabilities of $1,489,000.

The Company used cash in investing activities during the six-month period ended June 30, 2003 aggregating $2,050,000, compared to $1,506,000 for the same period in the prior year. The expenditures in the six months ended June 30, 2003 consisted of $2,040,000 used to acquire capital equipment including electronic infusion pumps for the Company’s rental business segment, computer equipment, purchased software, leasehold improvements, furniture, fixtures, tooling and equipment for use in the Company’s operations, and a net outflow related to other assets, primarily patents, of $10,000.

During the six-month period ended June 30, 2003, cash of $2,219,000 was provided by financing activities consisting of $1,000,000 in proceeds from the Company’s bank line of credit, $816,000 in proceeds from notes payable, and $490,000 in proceeds from the exercise of stock options, partially offset by $87,000 of net principal payments on notes payable.

As of June 30, 2003, the Company had cash and cash equivalents of $1,517,000, net accounts receivable of $11,657,000, and net working capital of $16,783,000. Management believes the Company’s funds, together with possible borrowings on its existing lines of credit and other bank loans, are sufficient to provide for its short and long-term needs for operations as currently projected. The Company may decide to sell additional equity securities or increase its borrowings in order to fund or increase its expenditures for selling and marketing, to fund increased product development, or for other purposes.

The Company has a working capital line of credit with a bank expiring in December 2003. Under the line of credit, the Company may borrow up to the lesser of $4,000,000 or 80% of eligible accounts receivable and 25% of eligible inventory, as defined, at the bank’s prime rate plus 0.50% (4.75% at June 30, 2003). As of June 30, 2003, there were funds available for borrowing of $3,000,000 and the amount outstanding under the line was $1,000,000. The Company also has a term loan facility with the bank for a maximum amount of $2,000,000, at the bank’s prime rate plus 1.00%, expiring in December 2003. There was no amount outstanding under the term loan as of June 30, 2003.

The Company’s InfuSystem subsidiary has a revolving line of credit with a bank under which it may borrow up to $3,500,000 or 80% of eligible accounts receivable, as defined, at the bank’s prime rate less 0.25% (4.00% at June 30, 2003). There were no outstanding borrowings under the line of credit as of June 30, 2003 and there were funds available for borrowing of $3,167,000. The credit line expires June 30, 2004. In addition, InfuSystem has a loan facility under which it may borrow up to $2,500,000 for the purchase of equipment. As of June 30, 2003, $800,000 was outstanding under the term loan.

The lines of credit and the notes are collateralized by substantially all of the Company’s assets and require the Company to comply with certain covenants principally relating to working capital and liquidity. As of June 30, 2003, the Company was in compliance with all such covenants.

New Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). SFAS 142 addresses the

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financial accounting and reporting requirements for acquired goodwill and other intangible assets. The Company adopted the provisions of SFAS 142 effective January 1, 2002. Under SFAS 142, the Company is no longer required to amortize goodwill and other intangible assets with indefinite lives. Instead, SFAS 142 requires that goodwill and intangible assets deemed to have an indefinite useful life be reviewed for impairment upon adoption of SFAS 142 and annually thereafter. See Note 4 to Condensed Consolidated Financial Statements.

In August 2001, the FASB issued SFAS No. 143, Accounting for Obligations Associated with the Retirement of Long-Lived Assets (“SFAS 143”). SFAS 143 establishes accounting standards for the recognition and measurement of an asset retirement obligation and its associated asset retirement cost. It also provides accounting guidance for legal obligations associated with the retirement of tangible long-lived assets. SFAS 143 is effective for fiscal years beginning after June 15, 2002, with early adoption permitted. The Company adopted the provisions of SFAS 143 on January 1, 2003 and such adoption did not have a material impact on its consolidated results of operations and financial position.

In October 2001, the FASB issued SFAS No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”). SFAS 144 establishes a single accounting model for the impairment or disposal of long-lived assets and new standards for reporting discontinued operations. SFAS 144 superseded SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of and APB Opinion No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. The provisions of SFAS 144 are effective in fiscal years beginning after December 15, 2001 and, in general, are to be applied prospectively. The Company adopted the provisions of SFAS 144 on January 1, 2002 and such adoption did not have a material impact on its consolidated results of operations and financial position.

In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS 146”), which addresses financial accounting and reporting for costs associated with exit or disposal activities and supersedes Emerging Issues Task Force (“EITF”) Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF Issue 94-3, a liability for an exit cost as defined in EITF Issue 94-3 was recognized at the date of an entity’s commitment to an exit plan. SFAS 146 also establishes that the liability should initially be measured and recorded at fair value. SFAS 146 is effective for exit and disposal activities initiated after December 31, 2002. The Company adopted the provisions of SFAS 146 on January 1, 2003, and such adoption did not have a material impact on its consolidated results of operations and financial position.

In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees and Indebtedness of Others. FIN 45 elaborates on the disclosures to be made by the guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002 while the provisions of the disclosure requirements are effective for financial statements of interim or annual reports ending after December 15, 2002. The Company adopted the disclosure provisions of FIN 45 during the fourth quarter of fiscal 2002 and such adoption did not have a material impact on the consolidated financial statements. The Company adopted the recognition provisions of FIN 45 effective January 1, 2003 and such adoption did not have a material impact on the consolidated results of operations and financial position.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure (“SFAS 148”). SFAS 148 amends SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), to provide alternative methods for voluntary transition to SFAS 123’s fair value method of accounting for stock-based employee compensation. SFAS 148 also requires disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income (loss) and earnings (loss) per share in annual and interim financial statements. The Company has adopted the provisions of SFAS 148 effective January 1, 2003, and has included the additional required disclosures under the heading Accounting for Stock Based

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Compensation in the footnotes to the Company’s financial statements. This adoption did not have a material impact on the consolidated financial statements.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities. In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either does not have equity investors with voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The Company adopted the provisions of FIN 46 effective February 1, 2003, and such adoption did not have a material impact on its consolidated results of operations and financial position because the Company currently has no variable interest entities.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. SFAS 150 improves the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity. SFAS 150 requires that those instruments be classified as liabilities in statements of financial position. The Statement is effective for financial instruments entered into or modified after May 31, 2003, otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. On June 15, 2003, the Company adopted SFAS 150 which had no material impact on the Company’s financial condition and results of operations.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Foreign Currency

The Company has a subsidiary operating in Mexico. As a result, the Company is exposed to potential transaction gains and losses resulting from fluctuations in foreign currency exchange rates. The Company has not and currently does not hedge or enter into derivative contracts in an effort to address foreign exchange risk.

Item 4. CONTROLS AND PROCEDURES.

As of the end of the period covered by this quarterly report on Form 10-Q, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic SEC filings. There have been no significant changes in the Company’s internal control over financial reporting during the period covered by this quarterly report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II - OTHER INFORMATION

Item 1.		Legal Proceedings
		In February 2002, the Company initiated a patent infringement action against a manufacturer of catheter products. The Company believes this manufacturer was providing to a large orthopedic company a catheter that was claimed to be functionally equivalent to the Company’s Soaker™ Catheter.
		The lawsuit was settled in April 2003 pursuant to the terms of a Confidential Settlement Agreement. The Company granted a license to the manufacturer as a part of that settlement. In addition, the manufacturer agreed to not refer to, advertise or promote the catheter, or any of its catheter products, as providing uniform distribution of fluid throughout the fenestrated area of the catheter or generically as a “soaker.”

Item 2.

Changes in Securities and Use of Proceeds

In December 2001, the Board of Directors of the Company approved a restricted stock plan (the “2001 Restricted Stock Plan”) pursuant to which employees of the Company may be offered the opportunity to acquire common stock of the Company. On February 27, 2003, the Board of Directors of the Company approved an amendment to the 2001 Restricted Stock Plan to authorize an additional 250,000 shares for issuance under the 2001 Restricted Stock Plan, however, subsequent to the Board’s approval, the Board of Directors decided to terminate any future issuances under the 2001 Restricted Stock Plan. As of July 31, 2003, a total of 70,000 shares of restricted common stock were issued and outstanding under the 2001 Restricted Stock Plan. On May 29, 2003, the Board of Directors of the Company approved a new restricted stock plan (the “2003 Restricted Stock Plan”) pursuant to which employees of the Company may be offered the opportunity to acquire common stock of the Company. The Board of Directors authorized a total of 250,000 shares for issuance under the 2003 Restricted Stock Plan. In July 2003, the Company issued 90,000 shares of restricted stock under the 2003 Restricted Stock Plan. Generally, the restrictions on the shares issued under both the 2001 and 2003 Restricted Stock Plans lapse over a period of three years, subject to possible acceleration based upon the achievement of individual performance goals.

On May 8, 2003, in connection with entering into the Amended and Restated Loan and Security Agreement with Silicon Valley Bank, the Company issued a warrant to Silicon Valley Bank to purchase 15,625 shares of the Company’s common stock at an exercise price of $3.84 per share. The warrant is immediately exercisable and expires on May 8, 2010. In addition, the Company has granted certain registration rights to Silicon Valley Bank in connection with the issuance of the warrant.

Proposals and Vote Tabulations

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		Election of Directors
		Each of the directors listed below was elected and will continue to serve on the Company’s board of directors until the 2006 annual meeting of stockholders and until their successors are duly elected and qualified.

Item 6.         Exhibits and Reports on Form 8-K

	(a)		Exhibits
	Set forth below is a list of the exhibits included or incorporated by reference as part of this report:

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(1)		Incorporated by reference to exhibit with this title filed with the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on August 3, 2001.
(2)		Incorporated by reference to exhibit with this title filed with the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001.
(3)		Incorporated by reference to exhibit with this title filed with the Company’s Registration Statement (#33-32263-LA) declared effective February 1, 1990.
(4)		Incorporated by reference to exhibit with this title filed with the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on August 7, 1996.
(5)		Incorporated by reference to exhibit with this title filed with the Company’s Post Effective Amendment to its Registration Statement (#33-41207-LA) declared effective November 6, 1992.
(6)		Incorporated by reference to exhibit with this title filed with the Company’s Annual Report on Form 10-K for its fiscal year ended December 31, 1991.
(7)		Incorporated by reference to exhibit with this title filed with the Company’s Annual Report on Form 10-K for its fiscal year ended December 31, 1995.
(8)		Incorporated by reference to exhibit with this title filed with the Company’s Registration Statement on Form S-8 (#333-16547) declared effective November 20, 1996.
(9)		Incorporated by reference to exhibit with this title filed with the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 25, 1997.
(10)		Incorporated by reference to exhibit with this title filed with the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on February 19, 1998.
(11)		Incorporated by reference to exhibit with this title filed with the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2000.
(12)		Incorporated by reference to exhibit with this title filed with the Company’s Annual Report on Form 10-K for its fiscal year ended September 30, 1990.
(13)		Incorporated by reference to exhibit with this title filed with the Company’s Annual Report on Form 10-K for its fiscal year ended December 31, 2000.
(14)		Incorporated by reference to exhibit with this title filed with the Company’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on March 13, 2002.
(15)		Incorporated by reference to exhibit with this title filed with the Company’s Registration Statement on Form S-3, filed February 10, 1997.
(16)		Incorporated by reference to exhibit with this title filed with the Company’s Annual Report on Form 10-K for its fiscal year ended December 31, 2002.