UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934

(Mark One)

OR

Commission file number: 0-18338

I-FLOW CORPORATION

Registrant’s telephone number, including area code: (949) 206-2700

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

Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $0.001 per share

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 o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes x No o

The aggregate market value of the common stock of the registrant held by non-affiliates as of June 30, 2003 (the last trading day of the second fiscal quarter) was $106,265,316, based on a closing price of $7.43 on the Nasdaq Stock Market on such day. The number of shares of the registrant’s common stock outstanding at March 5, 2004 was 18,424,951.

DOCUMENTS INCORPORATED BY REFERENCE

The information required by Part II, Item 5 and Part III of this annual report on Form 10-K is incorporated by reference to portions of the registrant’s proxy statement for its annual meeting of stockholders to be held on May 25, 2004, which proxy statement will be filed with the Securities and Exchange Commission no later than 120 days after the end of the registrant’s fiscal year ended December 31, 2003.

PART I

Item 1. Business

The Company

I-Flow Corporation (the “Company” or “I-Flow”) designs, develops, manufactures and markets technically advanced, low-cost ambulatory drug delivery systems that seek to redefine the standard of care by providing life enhancing, cost effective solutions for pain management and infusion therapy. The Company’s products are used in hospitals and other settings, including free-standing surgery centers and physicians’ offices.

Since it began in 1985, I-Flow Corporation has established a reputation in the medical and health care industry as an innovator in drug delivery technology. Through product innovation and strategic acquisitions, the Company has emerged as a leader in pain management, offering highly effective therapeutic delivery systems for physicians and their patients. I-Flow’s suite of pain management products provides reliable and simple regional anesthesia techniques that eliminate many of the side effects customarily associated with narcotics and general anesthesia. Patients who use I-Flow’s pain management products generally recover more rapidly after surgery, which results in shorter hospital stays and reduced costs.

I-Flow currently manufactures a line of compact, portable infusion pumps, catheters and pain kits that administer medication directly to the wound site as well as administer local anesthetics, chemotherapies, antibiotics, diagnostic agents, nutritional supplements and other medications. The Company has continued to introduce into the market reliable, lightweight, portable infusion pumps which enable patients to live ambulatory and, therefore, more productive lifestyles. I-Flow sells and distributes its products throughout the United States, Canada, Europe, Asia, Mexico, Brazil, Australia, New Zealand and the Middle East. InfuSystem, Inc., a wholly owned subsidiary of I-Flow Corporation (“InfuSystem”), is primarily engaged in the rental of infusion pumps on a month-to-month basis for the treatment of cancer.

The Company was incorporated in the State of California in July 1985. On July 30, 2001, the Company changed its state of incorporation to Delaware by merging into a wholly owned subsidiary incorporated in Delaware. The Company’s corporate offices are located at 20202 Windrow Drive, Lake Forest, California 92630. I-Flow’s telephone number is (949) 206-2700 and its website is www.iflo.com.

Acquisitions

On January 14, 2000, the Company acquired all of the outstanding stock of Spinal Specialties, Inc. (“Spinal Specialties”), a designer and manufacturer of custom spinal, epidural and nerve block infusion kits based in San Antonio, Texas. Spinal Specialties provides a line of custom, disposable products for chronic and acute pain management that are tailored to the specific needs of a particular hospital, anesthesiologist or pain clinic. I-Flow sold Spinal Specialties on November 1, 2003.

Divestitures

On November 1, 2003, the Company sold Spinal Specialties to Integra LifeSciences Holdings Corporation for approximately $6,000,000 in cash, with net cash proceeds to the Company of approximately $5,000,000. The business of Spinal Specialties is discussed above.

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Aggregate revenues from countries outside of the United States represented approximately 20%, 26% and 24% of the Company’s total revenues for the years ended December 31, 2003, 2002 and 2001, respectively. The Company does not have any capital investments in any foreign operations except for its manufacturing plant in Mexico.

Total revenues attributable to each geographic area in which the Company has sales is as follows:

Backlog

The Company did not have a significant backlog of unfilled orders as of December 31, 2003 or December 31, 2002.

Manufacturing and Operations

A majority of the Company’s products are manufactured by its Mexican subsidiary, Block Medical de Mexico, S.A. de C.V. (“Block Medical”). This plant has been in operation since 1994 and has historically manufactured, and is currently manufacturing, all of the Company’s disposable IV Infusion Therapy devices and elastomeric Regional Anesthesia products. The Company currently intends to maintain the plant in Mexico and to manufacture a substantial portion of its products there. The Company regularly reviews the use of outside vendors for production versus internal manufacturing, and considers factors such as the quality of the products received from outside vendors, the costs of the products, timely delivery and employee utilization.

Product Development

The Company has focused its product development efforts on products in post-operative pain relief and ambulatory infusion systems markets. In each of the years ended December 31, 2003, 2002 and 2001, the Company incurred expenses of approximately $2,361,000, $2,104,000 and $2,238,000, respectively, for product development.

Patents and Trademarks

The Company has filed patent applications in the United States for substantially all of its products. The Company currently holds approximately 40 patents, including patents that relate to both the ON-Q Post-Operative Pain Relief System and the Soaker Catheter. The Company’s patents generally expire between 2009 to 2015, with significant patents expiring in 2009. The Company has also filed for intellectual property right protection in all foreign countries from which it derives significant revenue. In the opinion of management, there are no limitations on the Company’s intellectual property that would have a material adverse effect on the Company.

All of the Company’s product names are either registered trademarks or have trademark applications pending. There can be no assurance that pending patent or trademark applications will be approved or that any patents will provide competitive advantages for the Company’s products or will not be challenged or circumvented by competitors or others.

Regulations Governing the Company’s Products and Manufacturing Operations

I-Flow’s activities are regulated by the Food, Drug and Cosmetic Act (the “Act”). Under the Act, the Company is required, among other matters, to register its facilities and to list its devices with the FDA, to file notice of its intent

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to market new products under Section 510(K) of the Act, to track the location of certain of its products and to report any incidents of death or serious injury relating to its products. To date, there have been no reportable conditions found during any FDA inspection. Failure to comply with any of these regulations can result in civil and criminal penalties being imposed upon the Company and/or the recall, seizure or injunction of products.

The State of California also has similar regulations. Each year the Company is subject to production-site inspections in order to maintain its manufacturing license. State regulations also specify the standards for the storage and handling of certain chemicals and disposal of their wastes.

The Company is also required to comply with federal, state and local environmental laws. To date, there has been no significant environmental issue affecting the Company’s capital expenditures, earnings or competitive position and there is currently no significant use of hazardous materials in the manufacture of its products.

Products intended for export are subject to additional regulations, including compliance with ISO 9000. In May 1995, the Company received ISO 9001 certification, which indicates that I-Flow’s products meet specified uniform standards of quality and testing. The Company was also granted permission to use the CE mark on its products, which reflects approval of the Company’s products for export into 18 member countries of the European Community. In December 1996, the Block Medical operations, including its Mexico facility,were added to the Company’s ISO certification and the Company received permission to use the CE mark on the products manufactured by Block Medical.

Employees

As of March 1, 2004, the Company and its subsidiaries had a total of 255 full-time employees in the United States and an additional 265 employees in Mexico. None of the Company’s employees in the United States or Mexico are covered by a collective bargaining agreement. The Company considers its relationship with its employees to be good. From time to time, the Company also uses temporary employees. These temporary employees are usually engaged to manufacture the Company’s products.

Available Information

Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed with or furnished to the Securities and Exchange Commission pursuant to Section 13(a) or 15(d) of the Exchange Act of 1934, as amended, are available free of charge through our web site at www.iflo.com as soon as reasonably practicable after we electronically file or furnish the reports with or to the Securities and Exchange Commission.

Item 2. Properties

The Company’s headquarters are located in Lake Forest, California, where the Company leases a 51,000 square foot building. The Company entered a lease for the building in 1997 and it has a term of 10 years. The Company has the option to extend the lease for an additional five years, which the Company currently intends to exercise. The Company also leases a plant in Tijuana, Mexico for the manufacture of its ambulatory infusion devices. The plant lease was entered into in 2000 and has a term of five years. The plant currently operates at approximately 60% of capacity. Additionally, the Company’s Infusystem subsidiary entered into leases in July 2002 for 8,120 square feet of general office space and 3,000 square feet of warehouse space in Madison Heights, Michigan. Both leases have a term of five years. The Company believes that its facilities are adequate to meet its current needs.

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Item 3. Legal Proceedings

As of March 1, 2004, the Company was involved in legal proceedings in the normal course of operations. Although the ultimate outcome of the proceedings cannot be currently determined, in the opinion of management any resulting future liability will not have a material adverse effect on the Company and its subsidiaries, taken as a whole.

Item 4. Submission of Matters to a Vote of Security Holders

There were no matters submitted to a vote of security holders during the three months ended December 31, 2003.

EXECUTIVE OFFICERS OF THE REGISTRANT

     The following table sets forth information concerning the executive officers of the Company as March 1, 2004. There are no family relationships between any of the executive officers or directors of the Company. The executive officers are chosen annually at the first meeting of the board of directors following the annual meeting of stockholders and, subject to the terms of any employment agreement, serve at the will and pleasure of the board of directors.

Donald M. Earhart has been Chairman of the Board since March 1991 and Chief Executive Officer since July 1990. Mr. Earhart joined the Company as President and Chief Operating Officer in June 1990. Mr. Earhart, who holds a Bachelor of Engineering degree from Ohio State University and a Masters Degree in Business Administration from Roosevelt University, has over 25 years experience in the medical products industry. Prior to joining the Company, from 1986 to 1990, Mr. Earhart was a corporate officer and the President of the Optical Division of Allergan, Inc. Prior to his employment at Allergan, he was a corporate officer and Division President of Bausch and Lomb and was an operations manager of Abbott Laboratories. He has also served as an engineering consultant at Peat, Marwick, Mitchell & Co. and as an engineer with Eastman Kodak Company.

James J. Dal Porto joined the Company as Controller in October 1989. Mr. Dal Porto was promoted to Treasurer in October 1990, to Vice President of Finance and Administration in March 1991, to Executive Vice President and Chief Financial Officer in March 1993 and to Chief Operating Officer in February 1994. Mr. Dal Porto served as Financial Planning Manager and Manager of Property Accounting and Local Taxation at CalComp, a high technology manufacturing company, from 1984 to 1989. Mr. Dal Porto holds a B.S. in Economics from the University of California, Los Angeles and a M.B.A. from California State University, Northridge.

James R. Talevich joined the Company as Chief Financial Officer in August 2000. Prior to joining the Company, he was Chief Financial Officer of Gish Biomedical, Inc., a publicly held medical device company, from 1999 to 2000 and Chief Financial Officer of Tectrix Fitness Equipment, Inc., a privately held manufacturing company, from 1995 to 1999. Prior to 1995, he held financial management positions with Mallinckrodt Medical, Inc., Sorin Biomedical, Inc., a medical products subsidiary of Fiat S.p.A., Pfizer, Inc., Sensormedics Corporation, a privately held medical device company, Baxter Travenol Laboratories, Inc. and KPMG Peat Marwick. Mr. Talevich holds a B.A. in Physics from California State University, Fullerton and a M.B.A. from the University of California at Los Angeles, and is a Certified Public Accountant.

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RISK FACTORS

I. Risk Factors Relating to Our Business and the Industry in Which We Operate

We have experienced net losses in prior years and have an accumulated deficit. Future losses are possible.

As of December 31, 2003, our accumulated deficit was approximately $15,083,000. We had net income (losses) of $1,267,000, ($3,035,000) and $457,000 for the years ended December 31, 2001, 2002 and 2003, respectively. We may not achieve or maintain profitability in the future, and further losses may arise.

For example, during the year ended December 31, 2003, our total costs and expenses increased by an amount greater than the increase in revenues, compared to the year ended December 31, 2002. There can be no assurance that our future revenue growth, if any, will be greater than the growth of our costs and expenses. If the increase in our total costs and expenses continues to be greater than any increase in our revenues, we will not be profitable.

We may need to raise additional capital in the future to fund our operations. We may be unable to raise funds when needed or on acceptable terms.

During the year ended December 31, 2003, our operating activities used cash of $1,070,000 and our investing activities provided $1,003,000 in the same period. As of December 31, 2003, we had cash on hand of $15,185,000 and net accounts receivable of $12,392,000. We believe our current funds, together with possible additional borrowings on our existing lines of credit and other bank loans, are sufficient to provide for our projected needs to maintain operations for at least the next 12 months. This estimate, however, is based on assumptions that may prove to be wrong. If our assumptions are wrong or if we experience further losses, we may be required to curtail our operations and to seek additional financing.

Any additional equity financings may be dilutive to our existing stockholders and involve the issuance of securities that may have rights, preferences or privileges senior to those of our current stockholders. A debt financing, if available, may involve restrictive covenants on our business that could limit our operational and financial flexibility, and the amount of debt incurred could make us more vulnerable to economic downturns or operational difficulties and limit our ability to compete. Furthermore, financing may not be available when needed and may not be on terms acceptable to us.

We have invested substantial resources into the sales and marketing of the ON-Q^® Post-Operative Pain Relief System. If this product does not achieve significant clinical acceptance or if our direct sales strategy is not successful, our financial condition and operating results will be adversely affected.

Our current strategy assumes that the ON-Q Post-Operative Pain Relief system will be used in a significant number of surgical cases, ultimately becoming the standard of care for many common procedures. We have invested, and continue to invest, a substantial portion of our resources into the establishment of a direct sales force for the sales and marketing of ON-Q. During the year ended December 31, 2003, we invested approximately $16,800,000 in the sales and marketing of ON-Q. A failure of ON-Q to achieve and maintain a significant market presence, or the failure to successfully implement our direct sales strategy, will have a material adverse effect on our financial condition and results of operations.

Our products are highly regulated by a number of governmental agencies. Any changes to the existing rules and regulations of these agencies may adversely impact our ability to manufacture and market our products.

Our activities are regulated by the Food, Drug and Cosmetic Act. Under the Food, Drug and Cosmetic Act, we are required, among other matters, to register our facilities and to list our devices with the United States Food and Drug Administration (the “FDA”), to file notice of our intent to market certain new products under Section 510(K) of the Food, Drug and Cosmetic Act, to track the location of certain of our products, and to report any incidents of death or serious injury relating to our products. If we fail to comply with any of these regulations, or if the FDA subsequently disagrees with the manner in which we sought to comply with these regulations, we could be subjected

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to substantial civil and criminal penalties and a recall, seizure, or injunction with respect to the manufacture or sale of our products.

Each state also has similar regulations. For example, in California, we are subject to annual production-site inspections in order to maintain our manufacturing license. State regulations also specify standards for the storage and handling of certain chemicals and disposal of their wastes. We are also required to comply with federal, state, and local environmental laws. Our failure to comply with any of these laws could expose us to material liabilities.

Products intended for foreign export are subject to additional regulations, including compliance with ISO 9000. In May 1995, we received ISO 9001 certification, which indicates that our products meet specified uniform standards of quality and testing. We also were granted permission to use the CE mark on certain of our products, which reflects approval of our products for export into 18 member countries of the European Community. In December 1996, the operations of Block Medical de Mexico, S.A. de C.V., a wholly owned subsidiary (“Block Medical”), including its manufacturing facility, were added to our ISO certification and we received permission to use the CE mark on all disposable elastomeric products manufactured by us. If we fail to comply with foreign regulations or to maintain ISO certification or CE approval, the sale of our products could be suspended in one or more of our foreign markets.

Furthermore, federal, state, local or foreign governments may enact new laws, rules and regulations that may adversely impact our ability to manufacture and market infusion devices by, for example, increasing our costs. Any impairment of our ability to market our infusion devices or other products could have a material adverse effect on our financial condition and results of operations.

Our compliance with laws frequently involves our subjective judgment. If we are wrong in any of our interpretations of the laws, we could be subjected to substantial penalties for noncompliance.

In the ordinary course of business, management frequently makes subjective judgments with respect to complying with the Food, Drug and Cosmetic Act, as well as other applicable state, local and foreign laws. If any of these regulatory agencies disagrees with our interpretation of, or objects to the manner in which we have attempted to comply with, the applicable law, we could be subjected to substantial civil and criminal penalties and a recall, seizure or injunction with respect to the manufacture or sale of our products. These types of actions against us or our products could have a material adverse effect on our financial condition and results of operations.

Our intangible assets are subject to potential impairment charges that could adversely affect our results of operations.

As of December 31, 2003, $2,639,000 of our assets consisted of goodwill, an intangible asset acquired through the acquisition of our wholly owned subsidiary, InfuSystem, Inc. (“InfuSystem”). The determination of the value of such intangible assets requires management to make estimates and assumptions that affect our financial statements. For example, we review 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. We compare fair value of our reporting units to book value, as well as consider other factors, to determine whether or not any potential impairment of goodwill exists. In fiscal year 2002, and as a result of the adoption of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS 142”) effective January 1, 2002, we wrote-off $3,474,000 of goodwill related to past acquisitions other than InfuSystem. We cannot guarantee that there will be no additional impairment in the future related to InfuSystem or other acquisitions we may make in the future. Any impairment charge will adversely affect our results of operations.

Our customers frequently receive reimbursement from private insurers and governmental agencies. Any change in the overall reimbursement system may adversely impact our business.

The health care reimbursement system is in a constant state of change. Changes often create financial incentives and disincentives that encourage or discourage the use of a particular type of product, therapy or clinical procedure. Market acceptance and sales of our products may be adversely affected by changes or trends within the reimbursement system. Changes to the health care system that favor technologies other than ours or that reduce

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reimbursements to providers or treatment facilities that use our products may adversely affect our ability to sell our products profitably.

Hospitals, alternate care site providers and physicians are heavily dependent on payment for their services by private insurers and governmental agencies. Changes in the reimbursement system could adversely affect our participation in the industry. Our products fall into the general category of infusion devices and related disposable products with regard to reimbursement issues. Except for payments made to our InfuSystem subsidiary, the majority of reimbursements are not paid directly to us. Rather, healthcare providers will often request that their patients’ health insurance providers provide them with some form of reimbursement for the disposables that are consumed in the patients’ therapy.

We believe that the current trend in the insurance industry (both private and governmental) has been to eliminate cost-based reimbursement and to move towards fixed or limited fees for service, thereby encouraging healthcare providers to use the lowest cost method of delivering medications. This trend may discourage the use of our products, create downward pressure on our average prices, and, ultimately, negatively affect our revenues.

Changes in reimbursement rates may adversely impact InfuSytem’s revenues.

InfuSystem depends primarily on third-party reimbursement for the collection of its revenues. InfuSytem is paid directly by private insurers and governmental agencies, often on a fixed fee basis, for infusion services provided by InfuSystem to patients. InfuSystem’s revenues comprised 28% of our consolidated revenues for the year ended December 31, 2003. If the average fees allowable by private insurers or governmental agencies were reduced, the negative impact on revenues of InfuSystem could have a material adverse effect on our financial condition and results of operations.

Changes in reimbursement rates may adversely impact the revenue that we earn from our developing billing strategy for ON-Q.

Historically, we have charged healthcare providers for each ON-Q unit that they purchase from us. Recently, we, through our InfuSystem subsidiary, have begun to bill private insurers for the use of ON-Q in ambulatory surgery centers, rather than charging these centers for the purchase price of each ON-Q unit. If this sales strategy is successful, we expect to increase our use of this sales strategy for ambulatory surgery centers. Any reduction in the average fees allowable by private insurers for the use of ON-Q in ambulatory surgery centers could negatively affect our ability to generate revenue from the centers and this could have a material adverse effect on our financial condition and results of operations.

Our industry is intensely competitive and changes rapidly. If we are unable to maintain a technological lead over our competitors, our business operations will suffer.

The drug infusion industry is highly competitive. We compete in this industry based primarily on price, service and product performance. Some of our competitors have significantly greater resources than we do for research and development, manufacturing, marketing and sales. As a result, they may be better able to compete for market share, even in areas in which our products may be superior. We continue our efforts to introduce clinically effective, cost-efficient products into the market, but the industry is subject to technological changes and we may not be able to maintain any existing technological advantage long enough to establish our products and to sustain profitability. If we are unable to effectively compete in our market, our financial condition and results of operations will materially suffer.

We rely on independent suppliers for parts and materials necessary to assemble our products. Any delay or disruption in the supply of parts may prevent us from manufacturing our products and negatively impact our operations.

While we perform final assembly and testing of our completed infusion systems, certain component parts, as well as molded products, are obtained from outside vendors based on our specifications. The loss or breakdown of our relationships with these outside vendors could subject us to substantial delays in the delivery of our products to

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customers. Significant delays in the delivery of our products could result in possible cancellation of orders and the loss of customers. Furthermore, we have numerous suppliers of components and materials that are sole-source suppliers. Because these suppliers are the only vendors with which we have a relationship for that particular component or material, we may be unable to produce and sell products if one of these suppliers becomes unwilling or unable to deliver components or materials meeting our specifications. Our inability to manufacture and sell products to meet delivery schedules could have a material adverse effect on our reputation in the industry, as well as our financial condition and results of operations.

If one of our products proves to be defective or is misused by a healthcare practitioner or patient, we may be subject to claims of liability that could adversely affect our financial condition and the results of our operations.

A defect in the design or manufacture of our products, or a failure of our products to perform for the use that we specify, could have a material adverse effect on our reputation in the industry and subject us to claims of liability for injuries and otherwise. Misuse of our product by a practitioner or patient that results in injury could similarly subject us to claims of liability. We currently have in place product liability insurance in the amount of $5,000,000 for liability losses, including legal defense costs. Any substantial underinsured loss would have a material adverse effect on our financial condition and results of operations. Furthermore, any impairment of our reputation could have a material adverse effect on our sales, revenues, and prospects for future business.

We are dependent on our proprietary technology and the patents, copyrights, and trademarks that protect our products. If competitors are able to independently develop products of equivalent or superior capabilities, the results of our operations could be adversely impacted.

We rely substantially on proprietary technology and capabilities. We have filed patent applications in the United States for substantially all of our products. As of December 31, 2003, we held approximately 40 patents, including patents that relate to both the ON-Q Pain Relief System and the Soaker™ Catheter. We have also filed for intellectual property rights protection in all foreign countries in which we currently derive significant revenue. Our patents generally expire between 2009 and 2015, with the most significant patents expiring in 2009. Without sufficient intellectual property protection, our competitors may be able to sell products identical to ours and cause a downward pressure on the selling price of our products.

There can be no assurance that pending patent or trademark applications will be approved or that any patents will provide competitive advantages for our products or will not be challenged or circumvented by competitors. Our competitors may also independently develop products with equivalent or superior capabilities or otherwise obtain access to our capabilities.

We manufacture the majority of our products in Mexico. Any difficulties or disruptions in the operation of our plant may adversely impact our operations.

The majority of our products are manufactured by Block Medical, a wholly owned subsidiary. We may encounter difficulties with the uncertainties inherent in doing business in a foreign country, including economic, political and regulatory uncertainties. Our stockholders’ equity may also be adversely affected by unfavorable translation adjustments arising from differences in exchange rates from period to period. In addition, we have not and currently do not hedge or enter into derivative contracts in an effort to address foreign exchange risk. If there are difficulties or problems in our Mexico facility, or other disruptions in our production and delivery process affecting product availability, these difficulties could have a material adverse effect on our business, financial condition and results of operations.

A significant portion of our sales is to customers in foreign countries. We may lose revenues, market share, and profits due to exchange rate fluctuations and other factors related to our foreign business.

In the year ended December 31, 2003, sales to customers in foreign countries comprised approximately 20% of our revenues. Our foreign business is subject to economic, political and regulatory uncertainties and risks that are unique to each area of the world. Fluctuations in exchange rates may also affect the prices that our foreign

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customers are willing to pay, and may put us at a price disadvantage compared to other competitors. Potentially volatile shifts in exchange rates may negatively affect our financial condition and operations.

We currently rely on two distributors for a significant percentage of our sales. If our relationship with these distributors were to deteriorate, our sales may materially decline.

During the year ended December 31, 2003, sales to B. Braun Medical S.A. (France) and B. Braun Medical, Inc., a national distributor in the United States, accounted for approximately 10% and 7%, respectively, of our net revenues. Any deterioration in our relationship with B. Braun Medical S.A. or B. Braun Medical, Inc. could cause a material decline in our overall sales and a material adverse effect on our business.

The preparation of our financial statements in accordance with accounting principles generally accepted in the United States requires us to make estimates, judgments, and assumptions that may ultimately prove to be incorrect.

The accounting estimates and judgments that management must make in the ordinary course of business 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 periods presented. If the underlying estimates are ultimately proven to be incorrect, subsequent adjustments could have a material adverse effect on our operating results for the period or periods in which the change is identified. Additionally, subsequent adjustments could require us to restate our financial statements. Restating financial statements could result in a material decline in the price of our stock.

II. Risk Factors Related Specifically to Our Common Stock

The average trading volume for our common stock is relatively low when compared to most larger companies. As a result, there may be less liquidity and more volatility associated with our common stock, even if our business is doing well.

Our common stock has been traded publicly since February 13, 1990, and since then has had only a few market makers. The average daily trading volume for our shares during the month of February 2004 was approximately 297,000 shares. There can be no assurance that a more active or established trading market for our common stock will develop or, if developed, will be maintained.

The market price of our common stock has been and is likely to continue to be highly volatile. Market prices for securities of biotechnology and medical device companies, including ours, have historically been highly volatile, and the market has from time to time experienced significant price and volume fluctuations that appear unrelated to the operating performance of particular companies. The following factors, among others, can have a significant effect on the market price of our securities:

•		announcements of technological innovations, new products, or clinical studies by us or others;
•		government regulation;
•		developments in patent or other proprietary rights;
•		future sales of substantial amounts of our common stock by existing stockholders or by us; and
•		comments by securities analysts and general market conditions.

The realization of any of the risks described in these “Risk Factors” could have a negative effect on the market price of our common stock.

In the future, our common stock may be removed from listing on the Nasdaq quotation system and may not qualify for listing on any stock exchange, in which case it may be difficult to find a market in our stock.

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If our common stock is no longer traded on a national trading market, it may be more difficult for you to sell shares that you own, and the price of our common stock would likely be negatively affected. Currently, our common stock is traded on the Nasdaq National Market. Nasdaq has a number of continued listing requirements, including a minimum trading price requirement. Failure to comply with any Nasdaq continued listing requirement could cause our common stock to be removed from listing on Nasdaq. Should this occur, we may not be able to secure listing on other exchanges or quotation systems, and this would have a material adverse effect on the price and liquidity of our common stock.

Future sales of our common stock by existing stockholders could negatively affect the market price of our stock and make it more difficult for us to sell stock in the future.

Sales of our common stock in the public market, or the perception that such sales could occur, could result in a decline in the market price of our common stock and make it more difficult for us to complete future equity financings. A substantial number of shares of our common stock and shares of common stock subject to outstanding warrants may be resold pursuant to currently effective registration statements. As of December 31, 2003, there were:

•		18,305,787 shares of common stock that have been issued in registered offerings and are freely tradable in the public markets;
•		250,011 shares of common stock underlying warrants which have been registered for resale under a Registration Statement on Form S-3 (Registration No. 333-109096);
•		147,000 shares of vested and unvested restricted common stock that have been issued under our restricted stock plans; and
•		an aggregate of 3,237,412 shares of common stock that may be issued on the exercise of stock options outstanding under our equity incentive plans.
•		In addition, pursuant to a registration statement on Form S-3, declared effective February 17, 2004, we registered an aggregate amount of $50,000,000 of our equity securities for issuance from time to time.

We cannot estimate the number of shares of common stock that may actually be resold in the public market because this will depend on the market price for our common stock, the individual circumstances of the sellers, and other factors. If stockholders sell large portions of their holdings in a relatively short time, for liquidity or other reasons, the market price of our common stock could decline significantly.

Anti-takeover devices may prevent a sale, or changes in the management, of I-Flow.

We have in place several anti-takeover devices, including a stockholder rights plan, that may have the effect of delaying or preventing a sale, or changes in the management, of I-Flow. For example, one anti-takeover device provides for a board of directors that is separated into three classes, with their terms in office staggered over three year periods. This has the effect of delaying a change in control of the board of directors without the cooperation of the incumbent board. In addition, our bylaws do not allow stockholders to call a special meeting of stockholders or act by written consent, and also require stockholders to give written notice of any proposal or director nomination to us within a specified period of time prior to any stockholder meeting.

We may also issue shares of preferred stock without stockholder approval and upon terms that our board of directors may determine in the future. The issuance of preferred stock could have the effect of making it more difficult for a third party to acquire a majority of our outstanding stock, and the holders of such preferred stock could have voting, dividend, liquidation, and other rights superior to those of holders of our common stock.

We do not pay dividends and this may negatively affect the price of our stock.

I-Flow has not paid dividends on its common stock and does not anticipate paying dividends on its common stock in the foreseeable future. The future price of our common stock may be depressed because we do not pay dividends.

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PART II

Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters

Common Stock Information

The Company’s common stock trades on The Nasdaq National Market under the symbol “IFLO.” Set forth below are the high and low sales prices for the Company’s common stock for each full quarter period within the two most recent fiscal years.

American Stock Transfer & Trust Company is the Company’s transfer agent for its common stock. As of March 1, 2004, the Company had 312 stockholders of record. The Company has not paid, and does not currently expect to pay in the foreseeable future, cash dividends on its common stock.

Information About Our Equity Compensation Plans

The information regarding the securities authorized for issuance under the Company’s equity compensation plans required by Item 5 is incorporated by reference to the Company’s proxy statement for its 2004 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year ended December 31, 2003.

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Item 6. Selected Financial Data

The following selected consolidated financial data have been derived from the Company’s audited consolidated financial statements. The information set forth below is not necessarily indicative of the expectations of results for future operations and should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this Annual Report on Form 10-K.

(1)		Certain amounts previously reported have been reclassified to conform with the 2003 presentation.
(2)		Effective January 1, 2002, the Company changed its method of accounting for goodwill and other intangible assets as a result of adopting Statement of Financial Accounting Standards No. 142, “Accounting for Goodwill and Other Intangible Assets.” The Company recognized a transitional goodwill impairment loss of $3,474,000 as a cumulative effect of a change in accounting principle during the six months ended June 30, 2002. The amounts previously reported for the first quarter of 2002 have been revised to include the $3,474,000 cumulative effect of this change in accounting principle. The effect of the change on the first quarter 2002 results was to reduce net income by $3,474,000, or $0.22 per diluted share, for the cumulative effect of this accounting change.
(3)		In November 2003, the Company sold Spinal Specialties, Inc., a wholly owned subsidiary. The operations of Spinal Specialties have been excluded from continuing operations for all periods presented. See Note 3 of Notes to Consolidated Financial Statements.

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SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

(Amounts in thousands, except per share amounts)

(1)		During the fourth quarter of 2002, the Company recorded approximately $750,000 of inventory variances as an increase in inventory and a reduction of cost of sales due primarily to lower than planned production levels.
(2)		Effective January 1, 2002, the Company changed its method of accounting for goodwill and other intangible assets as a result of adopting Statement of Financial Accounting Standards No. 142, “Accounting for Goodwill and Other Intangible Assets.” The Company recognized a transitional goodwill impairment loss of $3,474,000 as a cumulative effect of a change in accounting principle during the six months ended June 30, 2002. The amounts previously reported for the first quarter of 2002 have been revised to include the $3,474,000 cumulative effect of this change in accounting principle. The effect of the change on the first quarter 2002 results was to reduce net income by $3,474,000, or $0.22 per diluted share, for the cumulative effect of this accounting change.
(3)		In November 2003, the Company sold Spinal Specialties, Inc., a wholly owned subsidiary. The operations of Spinal Specialties have been excluded from continuing operations for all periods presented. See Note 3 of Notes to Consolidated Financial Statements.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

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 current 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-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 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. 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

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. The Company records a provision for the estimated amount of future returns based upon historical experience and any notification received of pending returns. Although such returns have historically been insignificant, the Company cannot guarantee that it will continue to experience the same return rates as it has 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 materialize.

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 experiences significant extended payment terms with certain of these third party payors, but 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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Accounts Receivable

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 to estimate the amount that will ultimately be uncollectible and therefore should be reserved. The percentages are increased as the accounts age. 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. In which case, 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 operates at a profit in the future and generates 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 the Company’s effective tax rate and a material adverse impact on operating results.

Intangible Assets

Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), required the Company to cease amortizing goodwill and indefinite life intangibles effective January 1, 2002. 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 fair value of its reporting units to their carrying value, as well as other factors, to determine whether or not any potential impairment of goodwill exists. If a potential impairment exists, an impairment loss is recognized to the extent the carrying value of goodwill exceeds the difference between the fair value of the reporting unit and the fair value of its other assets and liabilities. The Company cannot guarantee that there will be no impairment in the future. See Note 2 to Consolidated Financial Statements.

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Divestiture of Spinal Specialties

The Company sold Spinal Specialties, Inc., a wholly owned subsidiary, on November 1, 2003 to Integra LifeSciences Holdings Corporation for approximately $6,000,000 in cash and net proceeds of approximately $5,000,000. Assets and liabilities included in the sale consisted primarily of approximately $722,000 of accounts receivable, $1,155,000 of inventory, $400,000 of fixed assets, and $313,000 of accounts payable and accrued liabilities. The Company recorded a pretax gain on the sale of $2,999,000, a tax provision on the gain of $716,000, and an after-tax gain of $2,283,000. The reported gain has been reduced by a charge of $327,000 related to the acceleration of vesting of certain stock options upon the closing of the sale. This amount has been accounted for as an increase in common stock.

The net income of Spinal Specialties prior to divestiture is presented in the Company’s Consolidated Statements of Operations and Comprehensive Operations as income (loss) from discontinued operations, net of tax. Reported in income (loss) from discontinued operations, net of tax, are net product sales from Spinal Specialties of $3,795,000, $3,454,000 and $2,774,000 in 2003, 2002 and 2001, respectively, and income (loss) before taxes from Spinal Specialties of $532,000, $42,000 and $(524,000) in 2003, 2002 and 2001, respectively. Also reported in income (loss) from discontinued operations, net of tax, is income tax expense (benefit) of $204,000, $18,000 and $(211,000) for 2003, 2002, and 2001, respectively.

Consolidated Results of Operations for the Year Ended December 31, 2003 Compared to the Year Ended December 31, 2002

Revenue

Net revenues during the year ended December 31, 2003 were $47,043,000 compared to $34,663,000 for the prior year, an increase of 36%. Net product revenues increased 40% in 2003 to $34,021,000 compared to $24,370,000 in 2002. Rental income, comprised of the revenues of the Company’s InfuSystem subsidiary, increased by 27% to $13,022,000 for the year ended December 31, 2003 from $10,293,000 for the prior year.

The Company’s product revenues during 2003 and 2002 were generated in two primary market segments: Regional Anesthesia and IV Infusion Therapy. Regional Anesthesia product revenues for 2003, which included revenue from the PainBuster and ON-Q Post-Operative Pain Relief Systems and the Soaker Catheter, increased by 88% to $16,112,000 in 2003 compared to $8,582,000 for fiscal 2002. The increase was primarily due to increased clinical usage of the ON-Q Post-Operative Pain Relief System by surgeons in the United States. Average selling prices have remained fairly constant throughout the year. Significant factors in the revenue increase and trend toward the use of regional anesthesia for post-operative pain include the progressive increase during 2003 in the size of the Company’s direct sales force and favorable results in published clinical studies.

IV Infusion Therapy product sales, which included the Company’s intravenous elastomeric pumps, mechanical infusion devices and electronic infusion pumps and disposables, increased 13% in 2003 to $17,909,000 from $15,788,000 in 2002. The year-to-year increase primarily resulted from increased sales of IV Infusion Therapy products to distributors in the United States. Pursuant to a distribution agreement, B. Braun Medical, Inc. distributes I-Flow’s elastomeric pumps to B. Braun Medical Inc.’s IV Infusion Therapy customers in the United States. The Company has a separate agreement with B. Braun Medical S.A. (France), a manufacturer and distributor of pharmaceuticals and infusion products, to distribute I-Flow’s elastomeric infusion pumps in Western Europe, Eastern Europe, the Middle East, Asia Pacific, South America and Africa.

Rental revenues provided by the Company’s InfuSystem subsidiary within the Oncology Infusion Services market increased 27% to $13,022,000 in 2003 compared to $10,293,000 in 2002. The revenue increase is substantially due to InfuSystem’s co-marketing activities with major pharmaceutical companies, which contributed to an increased usage of new drugs and clinical protocols requiring the use of ambulatory electronic pumps as opposed to oral application of chemotherapy drugs. This increase in rental billings was slightly offset by changes to initial estimates of contractual rental revenue of approximately $400,000 recorded during fiscal year 2003 as a result of lower reimbursement levels than initially projected. InfuSystem revenues fluctuate based upon a number of factors, including the number of client facilities utilizing the InfuSystem pump management system, the number of contracts with managed care organizations and the number of potential patients covered by those contracts, and periodic fluctuations in the

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prevalence of continuous infusional administration of chemotherapy as opposed to oral administration of drug therapies.

Cost of Revenue

Cost of revenues was $17,210,000 during the year ended December 31, 2003 compared to $11,986,000 in the prior year, an increase of 44%. Cost of revenues in 2003 included a write-down of $582,000 for tooling and inventory related to the Company’s declining electronic IV pump business. The write-down consisted of $394,000 for excess and obsolete inventory and $188,000 for tooling. The Company expects to phase out its electronic pump products for the IV Infusion Therapy Market during the first quarter of 2004. As a percentage of net product sales, product cost of revenue increased by approximately two percentage points in 2003 to 39% due to the write-down of assets related to the electronic IV pump business. Rental cost of revenues increased by $1,011,000, or 34%, to $4,018,000 due to increases in operating supplies and material costs, and increased depreciation expense due to the increasing size of the Company’s rental fleet of chemotherapy pumps. As a percentage of rental revenues, rental cost of revenue increased by approximately two percentage points.

Selling and Marketing Expenses

Selling and marketing expenses for the year ended December 31, 2003 increased $8,652,000, or 74%, from the prior year. This increase was primarily attributable to increases in direct sales force salaries and commissions ($4,398,000), travel and entertainment ($865,000), non-cash compensation expense related to the vesting of restricted stock granted to sales personnel ($327,000), increases in marketing expenses ($866,000) and other costs related to the hiring and operation of an expanded direct sales force in the United States during fiscal 2003 to support sales and marketing of the ON-Q Post-Operative Pain Relief System. As a percentage of total revenues, selling and marketing expenses increased by 9 percentage points, to 43%. The Company intends to continue to invest significant resources to promote ON-Q during 2004. As of December 31, 2003, the Company employed 99 sales professionals in support of its ON-Q sales effort, an increase of approximately 175% compared to December 31, 2002.

General and Administrative Expenses

General and administrative expenses for the year ended December 31, 2003 increased $2,242,000 or 28% from the prior year. The increase is attributable to increases in compensation ($881,000), provision for bad debts ($573,000), investor relations ($84,000), telephone ($90,000), depreciation expense ($91,000) and other costs associated with the growth of the business. The increase in compensation resulted from increased staffing and year-end bonuses. The increase in the provision for bad debts includes a $279,000 accrual for the estimated amount of uncollectible 2003 billings by the Company’s rental business and other bad debt reserves determined based upon the growth in the Company’s operations and analyses of the accounts receivable agings. As a percentage of total revenues, general and administrative expenses decreased for fiscal 2003 by one percentage point to 22%.

Product Development Expenses

Product development expenses include research and development for new products and the cost of obtaining and maintaining regulatory approvals of products and processes. Product development expenses for the year ended December 31, 2003 increased $257,000, or 12%, as compared to fiscal 2002. The increase included a $90,000 write-down of the carrying value of patents related to the Company’s declining electronic IV pump business, and increased compensation, consulting fees and outside services. The Company will continue to incur product development expenses as it continues its efforts to introduce new technology and cost-efficient products into the market. Product development expense as a percentage of net product sales decreased by approximately two percentage points to 7% during 2003 compared to 2002.

Income Taxes

During the year ended December 31, 2003, the Company recorded an income tax benefit from continuing operations of $1,173,000, compared to income tax expense of $305,000 recorded for the year ended December 31, 2002. The Company’s effective tax rate decreased to 35.9% in the year ended December 31, 2003 compared to 42.4% in 2002. The reduction in the effective tax rate is the result of the method of taxation by the State of

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Michigan. This tax, which is based upon the activity of InfuSystem only, was calculated in a way that generated a current year tax for 2003, even though the overall activity of the Company resulted in a loss. As a result, the overall benefit received from the current year loss is reduced.

Goodwill

In accordance with SFAS 142, the Company completed its adoption test for goodwill impairment in June 2002 and concluded that consolidated goodwill in the amount of $3,474,000 was impaired effective 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. See Note 2 to the Notes to Consolidated Financial Statements, “Goodwill and Other Intangible Assets.” There was no impairment in 2003.

Consolidated Results of Operations for the Year Ended December 31, 2002 Compared to the Year Ended December 31, 2001

Revenue

Net revenues from continuing operations during the year ended December 31, 2002 were $34,663,000 compared to $30,531,000 for the prior year, an increase of 14%. Net product revenues increased 21% in 2002 to $24,370,000 compared to $20,168,000 in 2001. Rental income, comprised of the revenues of the Company’s InfuSystem subsidiary, decreased by 1% to $10,293,000 for the year ended December 31, 2002 from $10,363,000 for the prior year.

Regional Anesthesia revenues from continuing operations for 2002 and 2001 exclude revenues of $3,454,000 and $2,774,000, respectively, related to discontinued operations, specifically the Company’s former Spinal Specialties subsidiary which was sold on November 1, 2003. Regional Anesthesia product revenues for 2002, which included revenue from the PainBuster and ON-Q Post-Operative Pain Relief Systems and the Soaker Catheter, increased by 57% to $8,582,000 in 2002 compared to $5,467,000 for fiscal 2001. The increase was primarily due to increased sales of ON-Q in the United States, which included the effect of higher average selling prices related to a change in the Company’s method of distribution, effective January 1, 2002, from a single United States distributor to a direct Company-employed sales force. The increase from the prior year also included the effect of an inventory repurchase of approximately $963,000 from Ethicon Endo-Surgery in December 2001 which was accounted for as a sales return. The repurchase was initiated in connection with the termination of the Company’s distribution agreement with Ethicon Endo-Surgery, previously the Company’s exclusive United States distributor for the ON-Q Post-Operative Pain Relief System. Under the termination agreement, the Company regained the exclusive United States distribution rights to the ON-Q Post-Operative Pain Relief System effective January 1, 2002.

IV Infusion Therapy product sales, which included the Company’s intravenous elastomeric pumps, mechanical infusion devices and electronic infusion pumps and disposables, increased 7% in 2002 to $15,788,000 from $14,701,000 in 2001. The year-to-year increase resulted from increased sales of IV Infusion Therapy products to international distributors.

Revenues for Oncology Infusion Services provided by the Company’s InfuSystem subsidiary decreased 1% to $10,293,000 in 2002 compared to $10,363,000 in 2001 as noted above. InfuSystem revenues fluctuate based upon a number of factors, including the number of client facilities utilizing the InfuSystem pump management system, the number of contracts with managed care organizations and the number of potential patients covered by those contracts, and periodic fluctuations in the prevalence of continuous infusional administration of chemotherapy as opposed to oral administration of drug therapies. No material changes to initial estimates of contractual rental revenue were recorded during the fiscal year.

Cost of Revenue

Cost of revenues was $11,986,000 during the year ended December 31, 2002 compared to $11,916,000 in the prior year, an increase of 1%. As a percentage of total revenues, cost of revenues decreased by four percentage points to 35% for the year ended December 31, 2002 compared to the prior year, primarily due to higher average selling prices for the Company’s ON-Q Post-Operative Pain Relief System caused by the change in the manner of

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distribution of those products. As a percentage of net product sales, product cost of revenue decreased by approximately six percentage points in 2002 to 37 percent, primarily due to the change in distribution of the ON-Q Post-Operative Pain Relief System from an OEM basis to direct sales. As a percentage of rental revenues, rental cost of revenue decreased by approximately two percentage points due to reduced direct operating costs.

Selling and Marketing Expenses

Selling and marketing expenses for the year ended December 31, 2002 increased $6,915,000, or 143%, from the prior year. This increase was primarily attributable to additional salaries, commissions, travel expenses, and recruiting costs related to the hiring and operation of a new direct sales force during fiscal 2002 necessary to support sales of the ON-Q Post-Operative Pain Relief System. The increase in selling and marketing expenses in 2002 compared to the prior year related to the cost of the new direct sales force amounted to $5,826,000. The remaining charge of $994,000 resulted from increased marketing expenses. As a percentage of total revenues, selling and marketing expenses increased 18 percentage points to 34% in 2002 over the prior year.

General and Administrative Expenses

General and administrative expenses for the year ended December 31, 2002 decreased $742,000, or 8%, from the prior year. The total decrease included a reduction of approximately $628,000 in goodwill amortization expense due to the cessation of goodwill amortization effective January 1, 2002 in accordance with SFAS 142. See “New Accounting Pronouncements” on page 25 and Note 2 to Notes to Consolidated Financial Statements. The remainder of the decrease is attributable to reduced employee bonus expense. As a percentage of total revenues, general and administrative expenses decreased by approximately six percentage points to 34% in 2002 compared to the prior year.

Product Development Expenses

Product development expenses include research and development for new products and the cost of obtaining and maintaining regulatory approvals of products and processes. Product development expenses for the year ended December 31, 2002 decreased $134,000 or 6% primarily due to reduced consulting expenses and engineering project materials. Product development expense as a percentage of net product sales decreased by approximately two percentage points to 9% during 2002 compared to 2001.

Income Taxes

During the year ended December 31, 2002, the Company recorded income tax expense from continuing operations of $305,000, compared to income tax expense of $1,067,000 recorded for the year ended December 31, 2001. The Company’s effective tax rate increased slightly to 42.4% in the year ended December 31, 2002 compared to 40.3% in 2001.

Goodwill

In accordance with SFAS 142, and as noted above, 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. See Note 2 to the Notes to Consolidated Financial Statements, “Goodwill and Other Intangible Assets.”

Liquidity and Capital Resources

During the year ended December 31, 2003, cash of $1,070,000 was used in operating activities consisting primarily of net income of $457,000, which included income from discontinued operations of $328,000, and the gain on the sale of Spinal Specialties of $2,283,000, plus non-cash expenses of $3,952,000, less net changes in operating assets and liabilities of $2,812,000 and net cash used in discontinued operations of $56,000. The increases in accounts receivable and inventory resulted from the overall increase in revenues.

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During the year ended December 31, 2003, cash of $1,003,000 was provided by investing activities of the Company. This amount was primarily attributable to the sale of Spinal Specialties which resulted in net cash proceeds to the Company of $5,044,000, partially offset by the acquisition of leasehold improvements, furniture, fixtures, equipment and other assets of $3,671,000 for use in the Company's operations. The Company anticipates capital expenditures of approximately $3,000,000 in 2004 that will be paid for by existing cash and cash equivalents and working capital balances.

During the year ended December 31, 2003, cash of $13,556,000 was provided by financing activities consisting primarily of $11,563,000 in net proceeds to the Company from the sale of 1,666,740 shares of the Company’s common stock in a private placement transaction at a sales price of $7.50 per share. In addition, the Company received $2,070,000 in proceeds from the exercise of stock options and warrants which was partially offset by payments on capital lease obligations of $77,000.

As of December 31, 2003, the Company had cash and cash equivalents of $15,185,000, net receivables of $12,392,000 and net working capital of $31,467,000. 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 to increase its borrowings in order to fund an increase its expenditures for selling and marketing expenses, to fund increased product development, to make acquisitions, or for other purposes.

The Company has a working capital line of credit with Silicon Valley Bank. The line of credit facility expired in December 2003 and was renewed in January 2004. Under the terms of the original agreement, the Company could borrow up to the lesser of $4,000,000 or the sum of 80% of eligible accounts receivable plus 25% of eligible inventory, as defined, at the bank’s prime rate plus 0.50% (a total rate of 4.5% at December 31, 2003). Under the terms of the renewed agreement, the interest rate on the line of credit is the bank’s prime rate (4.0% at December 31, 2003), and the borrowing limit remained unchanged. The amended agreement expires on April 30, 2005. As of December 31, 2003, there were no outstanding borrowings.

The Company also had a term loan facility with Silicon Valley Bank that provided for borrowings up to a maximum amount of $2,000,000 at the bank’s prime rate plus 1.00%. There was no amount outstanding under the term loan as of December 31, 2003. The term loan facility expired according to its terms in December 2003 and was not renewed.

The Company’s InfuSystem subsidiary has a revolving line of credit with a bank under which it may borrow up to the lesser of $3,500,000 or 80% of eligible accounts receivable, as defined, at the bank’s prime rate less 0.25% (3.75% at December 31, 2003). There were no outstanding borrowings under the line of credit as of December 31, 2003 and there were funds available for borrowing of $3,500,000. 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 December 31, 2003, there were no outstanding borrowings under the loan facility.

The Company’s lines of credit 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 December 31, 2003, the Company was in compliance with all such covenants.

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Contractual Obligations and Commercial Commitments

As of December 31, 2003, future payments related to contractual obligations and commercial commitments are as follows:

New Accounting Pronouncements

In August 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“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 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) (“EITF Issue 94-3”). 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 and such adoption did not have a material impact on the Company’s 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 its consolidated financial statements. The Company adopted the recognition provisions of FIN 45 on January 1, 2003 and such adoption did not have a material impact on its consolidated financial statements.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure (“SFAS 148”). SFAS 148 amends Statement 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 financials statements. The provisions of SFAS 148 are effective in fiscal years

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ending after December 15, 2002. The Company has evaluated the provisions of SFAS 148 and those provisions did not have a material adverse impact on its consolidated financial statements since the Company has not adopted the fair value method. See Note 1 to the Consolidated Financial Statements for calculation of pro forma net income (loss).

In January 2003, the FASB issued 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 (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. With respect to variable interest entities created before January 31, 2003, in December 2003 the FASB issued FIN 46R which, among other things, revised the implementation date to first fiscal years or interim periods ending after March 15, 2004, with the exception of Special Purpose Entities (“SPE”). The consolidated requirements apply to all SPE’s in the first fiscal year or interim period ending after December 15, 2003. As the Company has determined that it does not have any SPE’s to which these interpretations apply, the Company will adopt FIN46R in the first quarter of 2004. The Company does not believe that the adoption of FIN 46R will have a material impact on its financial statements.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“SFAS 150”). SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both debt and equity and requires an issuer to classify the following instruments as liabilities in its balance sheet:

•		a financial instrument issued in the form of shares that is mandatorily redeemable and embodies an unconditional obligation that requires the issuer to redeem it by transferring its assets at a specified or determinable date or upon an event that is certain to occur;
•		a financial instrument, other than an outstanding share, that embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation, and required the issuer to settle the obligation by transferring assets; and
•		a financial instrument that embodies an unconditional obligation that the issuer must settle by issuing a variable number of its equity shares if the monetary value of the obligation is based solely or predominantly on (1) a fixed monetary amount, (2) variations in something other than the fair value of the issuer’s equity shares, or (3) variations inversely related to changes in the fair value of the issuer’s equity shares.

In November 2003, the FASB issued FASB Staff Position (FSP) No. 150-3 which deferred the effective dates for applying certain provisions of FSAS No. 150 related to mandatorily redeemable financial instruments of certain nonpublic entities and certain mandatorily redeemable noncontrolling interests for public and nonpublic entities.

For public entities, SFAS No. 150 is effective for mandatorily redeemable financial instruments entered into or modified after May 31, 2003 and is effective for all other financial instruments as of the first interim period beginning after June 15, 2003.

For mandatorily redeemable noncontrolling interests that would not have to be classified as liabilities by a subsidiary under the exception in paragraph 9 of SFAS No. 150, but would be classified as liabilities by the parent, the classification and measurement provisions of SFAS No. 150 are deferred indefinitely. For other mandatorily redeemable non controlling interests that were issued before November 5, 2003, the measurement provisions of SFAS No. 150 are deferred indefinitely. For those instruments, the measurement guidance for redeemable shares and noncontrolling interests in other literature shall apply during the deferral period.

SFAS No. 150 is to be implemented by reporting a cumulative effect of a change in accounting principle. The Company does not believe that the adoption of SFAS No. 150 will have a material impact on its consolidated financial statements.

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Item 7A. Quantitative and Qualitative Disclosures about Market Risk

The Company’s financial instruments include cash and cash equivalents and long-term debt. At December 31, 2003, the carrying values of the Company’s financial instruments approximated fair values based upon current market prices and rates.

The Company has a subsidiary 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 the foreign exchange risk.

Item 8. Financial Statements and Supplementary Data

Financial Statements

The Independent Auditors’ Report and the Consolidated Financial Statements listed in the “Index to Consolidated Financial Statements” in Item 15 are filed as part of this report.

Financial Statement Schedule

SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS

The above schedule has been restated to exclude discontinued operations.

(1)

Deductions in all years reported represent reductions to the reserve accounts and the related asset accounts. Specifically, deductions from the reserve for allowance for doubtful accounts represent the write-off of uncollectible accounts receivable balances. Deductions from the reserve for obsolete inventories represent the write-off and disposal of specific inventory items.

Selected Quarterly Financial Data

See information set forth above under the heading “Selected Quarterly Financial Data” on page 17.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

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Item 9A. Controls and Procedures

(a) The Company carried out an evaluation, under the supervision and with the participation of its 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 as of the end of the period covered by this report. Based upon that evaluation, the 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 filings with the Securities and Exchange Commission.

(b) There was no change in the Company’s internal control over financial reporting that occurred during the Company’s most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART III

Item 10. Directors and Executive Officers of the Registrant

Except for information concerning our executive officers which is included in this report under the heading “Executive Officers of the Registrant”, the information required by Item 10 is incorporated by reference to the Company’s proxy statement for its 2004 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended December 31, 2003.

Item 11. Executive Compensation

The information required by Item 11 is incorporated by reference to the Company’s proxy statement for its 2004 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended December 31, 2003.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information required by Item 12 is incorporated by reference to the Company’s proxy statement for its 2004 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended December 31, 2003.

Item 13. Certain Relationships and Related Transactions

The information required by Item 13 is incorporated by reference to the Company’s proxy statement for its 2004 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended December 31, 2003.

Item 14. Principal Accountant Fees and Services

The information required by Item 14 is incorporated by reference to the Company’s proxy statement for its 2004 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended December 31, 2003.

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PART IV

Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.

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