UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

___________

FORM 10-Q

(Mark One)

Commission file number: 0-18338

I-FLOW CORPORATION

     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 12b-2 of the Exchange Act).  Yes [ X ] No[   ]

     As of November 3, 2004 there were 21,712,472 shares of common stock outstanding.

I-FLOW CORPORATION

FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2004

Table of Contents

I-FLOW CORPORATION

See accompanying notes to condensed consolidated financial statements.

1

I-FLOW CORPORATION

See accompanying notes to condensed consolidated financial statements.

2

I-FLOW CORPORATION

See accompanying notes to condensed consolidated financial statements.

3

I-FLOW CORPORATION

(Unaudited)

1. Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation – The accompanying unaudited condensed consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary to present fairly the financial position of I-Flow Corporation and its subsidiaries (the “Company”) at September 30, 2004 and the results of its operations and cash flows for the three and nine-month periods ended September 30, 2004 and 2003. 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 included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 as filed with the Securities and Exchange Commission on March 15, 2004.

The Company sold Spinal Specialties, Inc., a wholly owned subsidiary (“Spinal Specialties”), on November 1, 2003 to Integra LifeSciences Holdings Corporation for approximately $6,000,000 in cash and net proceeds of approximately $5,000,000.

The Company has restated its financial statements for the three and nine-month periods ended September 30, 2003 to present the operations of Spinal Specialties as discontinued operations. Reported in income from discontinued operations, net of tax, for the three and nine-month periods ended September 30, 2003 are net product sales from Spinal Specialties of $1,163,000 and $3,372,000, income before taxes of $180,000 and $422,000, and income tax expense of $59,000 and $162,000, respectively.

Use of Estimates – The preparation of financial statements in conformity with generally accepted accounting principles in the United States necessarily requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

New Accounting Pronouncements – In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”). 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 matters, revised the implementation date to first fiscal years or interim periods ending after March 15, 2004, with the exception of Special Purpose Entities (“SPE’s”). 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 adopted FIN46R in the first quarter of 2004 and such adoption did not have a material impact on its financial statements.

In May 2003, the FASB issued Statement of Financial Accounting Standard 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:

4

•		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 requires 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 SFAS 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 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 150, but would be classified as liabilities by the parent, the classification and measurement provisions of SFAS 150 are deferred indefinitely. For other mandatorily redeemable noncontrolling interests that were issued before November 5, 2003, the measurement provisions of SFAS 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.

The adoption of the provisions of SFAS 150 did not have a material impact on the Company’s consolidated financial statements.

Accounting for Stock-Based Compensation – The Company accounts for employee and director 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, and has adopted the disclosure-only alternative of SFAS 123, Accounting for Stock-Based Compensation. Stock options issued to consultants and vendors are accounted for at fair value.

Because the Company has adopted the disclosure-only provisions of SFAS 123, no compensation cost has been recognized for stock option grants to employees or 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 loss and net loss per share would have been the pro forma amounts indicated below:

5

The amounts in the above table related to stock-based employee and director compensation included in net loss, net of tax (using the effective tax rate for the periods presented) relate to employee and director stock options only and exclude compensation expense related to consultant stock options and restricted stock.

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 nine months ended September 30, 2004 and 2003: no dividend yield; expected volatility of 94% in 2003 and 90% in 2004; risk-free interest rate of 3.04% in 2003 and 3.64% in 2004; and expected lives of 5 years.

Reclassifications – Certain prior year amounts have been reclassified to conform to the presentation at September 30, 2004.

2. Inventories

Inventories consisted of the following:

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 of 46,000 shares and 148,000 shares as of September 30, 2004 and 2003, respectively.

6

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

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

Options to purchase 320,000 and 183,000 shares of common stock have been excluded from the treasury stock method of calculation for diluted weighted average common shares for the three and nine-month periods ended September 30, 2004, respectively, as their exercise prices exceeded the average market price of the Company’s common stock for these periods and their effect would be anti-dilutive. Also excluded from the calculation were 46,000 unvested shares of restricted stock for the three and nine month periods ended September 30, 2004.

Options to purchase zero and 13,000 shares of common stock have been excluded from the treasury stock method of calculation for diluted weighted average common shares for the three and nine-month periods ended September 30, 2003, respectively, as their exercise prices exceeded the average market price of the Company’s common stock for these periods and their effect would be anti-dilutive. Also excluded from the calculation were 148,000 unvested shares of restricted stock for the three and nine month periods ended September 30, 2003.

4. Other Intangible Assets

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

The Company amortizes patents over a period of seven years. Amortization expense for the three and nine months ended September 30, 2004 was $83,000 and $237,000, respectively, compared to $70,000 and $200,000 for the same periods in the prior year. Amortization expense of intangible assets recorded as of September 30, 2004 is expected to be approximately $245,000 in each of the next five fiscal years.

5. Stockholders’ Equity

During September 2003, the Company sold 1,666,740 shares of common stock at $7.50 per share with net proceeds to the Company of $11,563,000. In connection with the sale of the common stock, the Company granted the

7

investors warrants to purchase 250,011 shares of common stock with an exercise price of $10.00 per share. The estimated fair value of these warrants on the grant date was $1,272,000 as calculated by the Black-Scholes pricing model. These warrants are fully exercisable and expire five years from the date of grant. As of September 30, 2004, warrants to purchase 225,111 shares of common stock were outstanding. The following weighted average assumptions were used to calculate the fair value of these warrants using the Black-Scholes pricing model: contractual life of five years; stock volatility of 87%; risk-free interest rate of 2.730%; and no dividends during the term.

On April 19, 2004, the Company completed a public offering of 2,990,000 shares of common stock at $15.50 per share, of which 390,000 shares were issued pursuant to the exercise of the underwriters’ over-allotment option. The shares were sold at a price to the public of $15.50 per share resulting in net proceeds to the Company of approximately $43,088,000.

6. Operating Segments and Revenue Data

The Company operates in two reportable operating segments: the manufacturing and marketing of medical infusion pumps (the “Manufacturing and Marketing” operating segment) and the rental and third party billing of electronic medical infusion pumps that are manufactured by companies other than I-Flow Corporation (the “Rentals” operating segment.) The Manufacturing and Marketing operating segment consists of two major market segments, the IV Infusion Therapy market segment and Regional Anesthesia market segment. The Rentals operating segment consists of the activities of InfuSystem, Inc., a wholly owned subsidiary of the Company, which provides infusion pumps for chemotherapy to the Oncology Infusion Services market segment.

Operating segment information is as follows for the three and nine-month periods ended September 30, 2004 and 2003:

The Company had a major customer which accounted for 7% and 9% of total revenues, respectively, for the three and nine month periods ended September 30, 2004 and 10% and 11% of total revenues, respectively, for the three and nine-month periods ended September 30, 2003.

8

7. Guarantees and Indemnifications

From time to time, the Company enters into 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 leased 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; (iv) underwriting agreements for the offering of securities; and (v) license, consulting, distribution and purchase agreements with the Company’s 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. The Company has not issued any significant indemnities, commitments or guarantees during the three or nine month periods ended September 30, 2004 and 2003 requiring recognition; thus, no liabilities have been recorded.

As of November 4, 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.

9

Item 2.	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 that 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, among others: implementation of our direct sales strategy; dependence on our suppliers and distributors; reliance on the success of the home health care industry; our continuing compliance with applicable laws and regulations, such as the Food, Drug and Cosmetic Act, and the FDA’s concurrence with our management’s subjective judgment on compliance issues; 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 and acceptance. 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 on 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 that the Company believes are the most important to aid in fully understanding and evaluating its reported financial results are:

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 on 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 delays in payment with certain of these third party payors, but it continuously monitors reimbursement rates of the third party payors and the timing of such payments. Any change in reimbursement or collection rates could have a material adverse impact on the Company’s operating results for the period or periods in which the change is identified.

Accounts Receivable

The Company performs various analyses to evaluate accounts receivable balances. It records an allowance for bad debts based on the estimated collectibility of the accounts such that the recorded amounts reflect estimated net

10

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 are less than the previously estimated allowance, a favorable adjustment would result. 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 on 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 and thus 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 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 on 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 on 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.

Goodwill

Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), required the Company to cease amortizing goodwill and indefinite life intangible assets 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. In calculating the potential impairment charge, the fair value of the reporting unit is estimated using a market multiple methodology. 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 4 to Condensed Consolidated Financial Statements.

Divestiture of Spinal Specialties

The Company sold Spinal Specialties, Inc., a wholly owned subsidiary (“Spinal Specialties”), on November 1, 2003 to Integra LifeSciences Holdings Corporation for approximately $6,000,000 in cash and net proceeds of approximately $5,000,000.

11

The net income of Spinal Specialties prior to divestiture is presented in the Company’s operations as income from discontinued operations, net of tax. Reported in income from discontinued operations, net of tax, for the three and nine months ended September 30, 2003 are net product sales from Spinal Specialties of $1,163,000 and $3,372,000, income before taxes of $180,000 and $422,000, and income tax expense of $59,000 and $162,000, respectively.

Overview and Recent Developments

The Company designs, develops and markets technically advanced, low-cost drug delivery systems and services that provide life-enhancing, cost-effective solutions for pain relief and intravenous infusion therapy. The Company focuses on three distinct markets: Regional Anesthesia, IV Infusion Therapy and Oncology Infusion Services. The Company’s products are used in hospitals, ambulatory surgery centers, physicians’ offices and patients’ homes.

The Company’s strategic focus for future growth is on the Regional Anesthesia market and, more specifically, on the Company’s pain relief products marketed under its ON-Q® brand. The Company intends to continue to expand its sales and marketing efforts to further penetrate the United States post-surgical pain relief market for its ON-Q products.

On November 9, 2004, the Company announced the first coverage by Medicare for ON-Q® PainBuster®. This result arose out of a specific case in which ON-Q PainBuster was used for a patient following surgery. Historically, all of Medicare’s regional contractors enforced policies that resulted in denied payments for ON-Q PainBuster. The decision that ON-Q was medically necessary, and therefore payable by Medicare, was made by an administrative law judge based upon the law and clinical evidence submitted by the Company on appeal. With this decision, the Company intends to request that each Medicare contractor revise its coverage policy so that such contractors will begin to provide payment for ON-Q PainBuster when it is used to treat post-operative pain. Additionally, private payer systems commonly establish coverage decisions based upon Medicare policy. Accordingly, the Company plans to leverage this coverage decision with private insurers as well.

Results of Operations

Revenue

Net revenues during the three and nine-month periods ended September 30, 2004 were $18,688,000 and $50,024,000 compared to $11,822,000 and $33,340,000, respectively, for the same periods in the prior year, representing increases of 58% and 50%, respectively. During the three and nine-month periods ended September 30, 2004, net product revenues increased 58%, to $13,476,000, and 52%, to 36,073,000, respectively, compared to the same period in the prior year. Rental income, comprised of the revenues of the Company’s InfuSystem subsidiary, increased by 59%, to $5,212,000, and 45%, to $13,951,000 for the three and nine-month periods ended September 30, 2004, respectively, compared to the same period in the prior year.

The Company’s product revenues from the Manufacturing and Marketing operating segment during the three and nine months ended September 30, 2004 and 2003 were generated in two primary market segments: Regional Anesthesia and IV Infusion Therapy. Regional Anesthesia product revenues increased by 117%, to $8,735,000, and by 102%, to $21,969,000, during the three and nine months ended September 30, 2004, respectively, compared to $4,032,000 and $10,886,000 for the same periods in the prior year. This increase resulted from increased market penetration by the Company’s ON-Q® PainBuster® Post-Operative Pain Relief System. Regional Anesthesia products include the ON-Q® PainBuster® Post-Operative Pain Relief System, the ON-Q® C-bloc® Continuous Nerve Block System and the Soaker ^TM Catheter.

IV Infusion Therapy product sales, which included the Company’s intravenous elastomeric pumps, mechanical infusion devices and electronic infusion pumps and disposables, increased 5% and 10%, to $4,741,000 and $14,104,000, for the three and nine months ended September 30, 2004, respectively, from $4,515,000 and $12,835,000 for the same periods in the prior year.

Revenues from the Rentals operating segment provided by the Company’s InfuSystem subsidiary within the Oncology Infusion Services market increased 59%, to $5,212,000, and 45%, to $13,951,000, for the three and nine-month periods ended September 30, 2004, respectively, from $3,275,000 and $9,619,000 for the same periods in the prior year. This increase resulted primarily from the increased clinical usage of new chemotherapy drugs and protocols requiring the use of continuous intravenous pump services.

Cost of Revenue

The Company incurred cost of revenues of $5,377,000 and $15,280,000 during the three and nine-month periods ended September 30, 2004, respectively, compared to $4,312,000 and $11,799,000 for the comparable periods in the prior year. This represents increases of 25% and 30%, respectively. These increases are primarily due to higher sales volume. As a percentage of net product sales, product cost of revenues decreased for the three and nine-month periods ended September 30, 2004 by approximately nine percentage points and six percentage points, respectively, compared to the same periods in the prior year. This decrease was due to increased sales of higher-margin products,

12

including the Company’s ON-Q® PainBuster® Post-Operative Pain Relief System, during the three and nine-month periods ended September 30, 2004. As a percentage of rental revenues, rental cost of revenue decreased for the three and nine-month periods ended September 30, 2004 by approximately four percentage points and two percentage points, respectively, compared to the same periods in the prior year.

Selling and Marketing Expenses

Selling and marketing expenses for the three and nine-month periods ended September 30, 2004 increased over the same periods in the prior year by $6,413,000, or 121%, and $15,622,000, or 114%, respectively. For the three months ended September 30, 2004, these increases were primarily attributable to increases in compensation and related expenses ($4,845,000), travel and entertainment ($557,000), recruiting fees ($230,000), outside commissions and royalties ($204,000), advertising and promotions ($135,000), and other costs related to the expansion of the Company’s direct sales force. As a percentage of net revenues, selling and marketing expenses for the three months ended September 30, 2004 increased by 18 percentage points compared to the same period in the prior year.

For the nine-month period ended September 30, 2004, the increase included increases in compensation and related expenses ($10,793,000), travel and entertainment ($1,750,000), outside commissions and royalties ($507,000), conferences and conventions ($550,000), advertising and promotions ($378,000), marketing samples ($312,000), recruiting fees ($233,000), temporary help ($225,000) and other costs related to the expansion of the Company’s direct sales force. In a transaction effective January 1, 2002 I-Flow re-acquired from Ethicon Endo-Surgery the contractual rights to distribute ON-Q on a direct basis. Since that time, ON-Q revenues have increased rapidly, and the company’s primary strategy has been to rapidly increase market awareness of the clinical and economic advantages of ON-Q technology through a combination of clinical studies, sales force expansion and marketing programs. The number of quota-carrying sales representatives in the Company’s hospital sales force as of September 30, 2004 was approximately double the number in the previous year. As a percentage of net revenues, selling and marketing expenses for the nine months ended September 30, 2004 increased by 18 percentage points compared to the same period in the prior year.

General and Administrative Expenses

General and administrative expenses for the three and nine-month periods ended September 30, 2004 increased by $1,421,000, or 59%, and $4,089,000, or 57%, respectively, compared to the comparable periods in the prior year. For the three months ended September 30, 2004, these increases included increases in compensation and related expenses ($536,000), bad debt provision ($225,000), consulting fees ($349,000), professional accounting fees ($137,000), and legal expenses ($133,000), as well as other increases due to growth of the Company. As a percentage of net revenues, general and administrative expenses remained constant when compared to the same period in the prior year.

For the nine-month period ended September 30, 2004, the increases included increased compensation and related expenses ($1,511,000), increases in bad debt provision, primarily for the Company’s Infusystem subsidiary ($1,285,000), consulting fees ($419,000), professional accounting fees ($171,000), and legal expenses ($130,000), as well as other increases due to growth of the Company. The increase in the bad debt provision resulted from significantly increased sales volume in the Regional Anesthesia and Oncology (InfuSystem) markets, and the accelerated settlement and adjustment of old accounts receivable by InfuSystem. As a percentage of net revenues, general and administrative expenses increased by one percentage point compared to the same period in the prior year.

Product Development Expenses

Product development expenses for the three and nine-month periods ended September 30, 2004 increased by $154,000, or 26%, and $402,000, or 25%, respectively, compared to the same periods in the prior year. For the three months ended September 30, 2004, these increases included increased compensation and related expenses ($65,000), pre production costs ($28,000), engineering supplies ($14,000) and amortization of patents ($13,000).

For the nine months ended September 30, 2004, the increase included increased compensation and related expenses ($158,000), consulting fees ($65,000), amortization of patents ($37,000), engineering supplies ($35,000), outside sterilization ($27,000) and pre production costs ($30,000). 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 expenses as a percentage of net revenues for each of the three and nine-month periods ended September 30, 2004 decreased by approximately one percentage point compared to the same periods in the prior year, primarily due to higher sales levels.

Income Taxes

During the three and nine-month periods ended September 30, 2004, the Company recorded income tax benefits of $1,044,000 and $2,830,000, respectively, compared to income tax benefits of $343,000 and $417,000 for the same periods in the prior year. The Company’s effective tax rates for the three and nine-month periods ended September

13

30, 2004 were 37.1% and 37.2% compared to 40.4% and 40.7%, respectively, for the comparable periods in the prior year, primarily due to changes in consolidated state tax rates.

Liquidity and Capital Resources

During the nine-month period ended September 30, 2004, cash of $6,578,000 was used in operating activities consisting of a net loss of $4,774,000 partially offset by net non-cash expenses of $4,546,000, less net changes in operating assets and liabilities of $6,350,000, primarily related to increased selling expenses, accounts receivable, provision for doubtful accounts and inventories.

During the nine-month period ended September 30, 2004, cash of $6,201,000 was used in investing activities, compared to $3,207,000 for the same period in the prior year. The expenditures in the nine-month period ended September 30, 2004 consisted of $5,777,000 used to acquire capital equipment, including electronic infusion pumps for the Company’s Rentals operating 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 the acquisition of other assets, primarily patents, of $424,000.

During the nine-month period ended September 30, 2004, net cash of $44,006,000 was provided by financing activities consisting primarily of $43,088,000 in net proceeds from a public offering of common stock completed April 19, 2004 and $918,000 in proceeds received upon the exercise of options and warrants to purchase common stock. See Note 5 to the Condensed Consolidated Financial Statements.

As of September 30, 2004, the Company had cash and cash equivalents of $46,400,000, net accounts receivable of $13,783,000 and net working capital of $66,016,000. Management believes the current funds, together with possible additional borrowings on the existing lines of credit and other bank loans, are sufficient to provide for the Company’s projected needs to maintain operations for at least the next 12 months. 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 Silicon Valley Bank which expires on April 30, 2005. Under the line of credit, the Company may 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 (4.75% at September 30, 2004). As of September 30, 2004, there were funds available for borrowing of $4,000,000 and no outstanding borrowings.

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% (4.5% at September 30, 2004). As of September 30, 2004, there were funds available for borrowing of $3,500,000 and no outstanding borrowings. The credit line expires on June 30, 2006. In addition, InfuSystem has a loan facility under which it may borrow up to $2,500,000 for the purchase of equipment. As of September 30, 2004, there were no outstanding borrowings under the loan facility.

The lines of credit and loan facility are collateralized by substantially all of the Company’s assets and require the Company to comply with covenants principally relating to working capital and liquidity. As of September 30, 2004, the Company believes that it was in compliance with all such covenants.

Contractual Obligations and Commercial Commitments

As of September 30, 2004, future payments related to contractual obligations and commercial commitments are as follows:

14

New Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”). 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 matters, revised the implementation date to first fiscal years or interim periods ending after March 15, 2004, with the exception of Special Purpose Entities (“SPE’s”). 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 adopted FIN46R in the first quarter of 2004 and such adoption did not have a material impact on its financial statements.

In May 2003, the FASB issued Statement of Financial Accounting Standards 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 requires 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 SFAS 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 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 150, but would be classified as liabilities by the parent, the classification and measurement provisions of SFAS 150 are deferred indefinitely. For other mandatorily redeemable noncontrolling interests that were issued before November 5, 2003, the measurement provisions of SFAS 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.

The adoption of the provisions of SFAS 150 did not have a material impact on the Company’s consolidated financial statements.

15

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.

We have carried out an evaluation, under the supervision and the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of the end of the fiscal quarter covered by this report. Based upon that evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective in providing reasonable assurance that (a) the information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (b) such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

We are evaluating the effectiveness of our internal controls over financial reporting in order to comply with Section 404 of the Sarbanes-Oxley Act of 2002. Section 404 requires us to evaluate annually the effectiveness of our internal controls over financial reporting as of the end of each fiscal year beginning in 2004, and to include a management report assessing the effectiveness of our internal controls over financial reporting in all annual reports beginning with our Annual Report on Form 10-K for the fiscal year ending on December 31, 2004. Section 404 also requires our independent accountant to attest to, and report on, management’s assessment of our internal controls over financial reporting. In evaluating our internal controls over financial reporting, we have identified a number of changes that need to made to our internal controls, primarily related to better documenting the controls and related changes to information systems used in financial reporting. We began making these changes during the third quarter of 2004. The changes made during the third quarter of 2004 did not, individually or in the aggregate, have a material effect on our internal controls over financial reporting.

16

PART II — OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

     As of November 4, 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 2.	UNREGISTERED SALES OF SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

     On July 27, 2004, the Company announced that its board of directors had authorized the repurchase of up to 1,000,000 shares of the Company’s common stock. The shares may be repurchased in open market or privately negotiated transactions in the discretion of management, subject to its assessment of market conditions and other factors. The stock repurchase program will be in effect until July 26, 2005, unless the program is terminated sooner or extended by the board of directors. As of September 30, 2004, the Company had not repurchased any equity securities under the stock repurchase program.

Item 5. OTHER INFORMATION

Risk Factors. We are updating and restating our risk factors as follows:

RISKS RELATING TO OUR BUSINESS AND INDUSTRY

We have experienced net losses in prior periods and have an accumulated deficit. We may not achieve profitability in the future.

As of September 30, 2004, our accumulated deficit was approximately $19,858,000. We had net losses of $1,770,000 and $4,774,000 for the three and nine-month periods ended September 30, 2004, respectively. We had net income (loss) 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 have invested, and continue to invest, substantial resources into the sales and marketing of our ON-Q products. If these products do 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 our ON-Q products will be used in a significant number of surgical procedures, 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 our ON-Q products. During the year ended December 31, 2003, we invested approximately $16,800,000 in the sales and marketing of our ON-Q products. A failure of our ON-Q products 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 (“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

17

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 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 the 15 member countries of the European Union (the “EU”) and three non-EU countries. 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 we manufacture. 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.

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 nine-month period ended September 30, 2004, our operating activities used cash of $6,578,000 and our investing activities used cash of $6,201,000. As of September 30, 2004, we had cash on hand of $46,400,000 and net accounts receivable of $13,783,000. 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/or seek additional financing.

Any additional equity financings may be dilutive to our existing stockholders and may involve the issuance of securities that 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, if available, may not be on terms acceptable to us.

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

As of September 30, 2004, $2,639,000 of our assets consisted of goodwill, an intangible asset acquired through the acquisition of InfuSystem. The determination of the value of such intangible assets requires management to make

18

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 market 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, 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 deferred tax assets may not be realized.

The Company accounts for income taxes under the provisions of SFAS No. 109, Accounting for Income Taxes. Under this method, deferred tax assets and liabilities are established for temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities at tax rates expected to be in effect when such assets or liabilities are realized or settled. At September 30, 2004 the Company had net deferred tax assets of $10,916,000, including a valuation allowance of $3,449,000. If the Company is unable to generate sufficient taxable income in the future to utilize the deferred tax assets, the Company may be required to write down the deferred tax assets. A write-down or write-off of the deferred tax assets would have a material adverse impact on the Company’s income tax expense and net income for the period or periods in which the adjustment occured.

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 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 currently not paid directly to us. Rather, health care 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 health care 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 InfuSystem’s revenues.

InfuSystem depends primarily on third-party reimbursement for the collection of its revenues. InfuSystem 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 both the three and nine-month periods ended September 30, 2004. 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 our ON-Q products.

Historically, we have charged health care 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 our ON-Q products 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 our ON-Q products 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.

19

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

The drug infusion industry is highly competitive. We compete in this industry based primarily on product performance, service and price. 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 achieve and sustain profitability. We may also see significant pricing pressure if new competitors enter into our target markets. 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.

Although we perform the final assembly and testing of our 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 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 a 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 health care 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 $10,000,000 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. We currently hold approximately 40 patents, including patents that relate to both the ON-Q® Post-Operative Pain Relief System (now known as the ON-Q® PainBuster® Post-Operative Pain Relief System) and the Soaker^TM Catheter. We have also filed for intellectual property right protection in all foreign countries in which we currently derive significant revenue. Our patents generally expire between 2009 and 2015, with significant patents expiring in 2009. Without sufficient intellectual property right 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 or others. Our competitors may also independently develop products with equivalent or superior capabilities or otherwise obtain access to our capabilities.

20

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 in Mexico 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 sales, market share and profits due to exchange rate fluctuations and other factors related to our foreign business.

For the three and nine-month periods ended September 30, 2004, sales to customers in foreign countries comprised approximately 14% and 16% of our revenues, respectively. 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 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 one or both of these distributors were to deteriorate, our sales may materially decline.

During the nine-month period ended September 30, 2004, sales to B. Braun Medical S.A. (France), a distributor in Europe, and B. Braun Medical, Inc., a national distributor in the United States, accounted for approximately 13% 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 have 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 resulting from errors 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.

RISKS RELATED 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 October 2004 was approximately 135,000 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:

21

	•		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.

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 September 30, 2004, there were:

	•		21,579,875 shares of common stock that have been issued in registered offerings and are freely tradable in the public markets;
	•		225,111 shares of common stock underlying warrants which have been registered for resale under a Registration Statement on Form S-3 (Registration No. 333-109096);
	•		128,000 shares of vested and unvested restricted common stock that have been issued under our restricted stock plans; and
	•		an aggregate of 4,058,798 shares of common stock that may be issued upon the exercise of stock options and stock rights outstanding under our equity incentive plans.

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.

22

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

We have not paid dividends on our common stock and do not anticipate paying dividends on our common stock in the foreseeable future. The future price of our common stock may be depressed because we do not pay dividends.

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.

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.

23

Item 6. EXHIBITS

The Exhibit Index included herewith is incorporated herein.

24

SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

25

INDEX TO EXHIBITS