**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-K**

 

**ý****                                ****AnnualReport pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934**

**for****the fiscal year ended December 31, 2004 or**

 

**o****                                ****TransitionReport pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934**

**for****the transition period from                  to                 **

 

**Commission file****number 0-28290**

 

**AKSYS, LTD.**

(Exact name ofregistrant as specified in its charter)

 
| **Delaware**                                                     | ** ** | **36-3890205**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                             |       |                                  |
| **Two  Marriott Drive, Lincolnshire, IL**                        | ** ** | **60069**                             |
| (Address of  Principal executive offices)                        |       | (Zip Code)                            |

 

Registrant’s telephonenumber, including area code: **(847) 229-2020**

 

Securitiesregistered pursuant to Section 12(b) of the Act:**Notapplicable**

 

Securitiesregistered pursuant to Section 12(g) of the Act:

 

**CommonStock, par value $.01 per share, and related preferred stock purchase rights**

(Title of Class)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes   ý   No  o

 

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

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Exchange Act Rule12b-2).  Yes ýNo o

 

The aggregate marketvalue of the voting stock held by non-affiliates of the registrant wasapproximately $46,335,000 as of June 30, 2004, based on the closing sale priceof $5.83 as reported by the Nasdaq National Market.  This calculation of market value has beenmade for the purpose of this report only and should not be considered as anadmission or conclusion by the registrant that any person is in fact anaffiliate of the registrant.

 

As of March 4, 2005 theregistrant had 29,901,275 shares of Common Stock issued and outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE:  Portions of the registrant’s definitive proxystatement, which will be filed within 120 days after December 31, 2004 areincorporated by reference into Part III of this Form 10-K.

 

 

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**AKSYS,LTD.**

 

**INDEX TOANNUAL REPORT ON FORM 10-K**

 
| ** **        | ** ** | ** **                                                                                  | ** ** | **Page No.** |
|-------------------|------------|---------------------------------------------------------------------------------------------|------------|--------------|
| **PART I**        |       |                                                                                        |       | 1            |
|              |       |                                                                                        |       |         |
| Item 1.           |       | Business                                                                                    |       | 1            |
| Item  2.          |       | Properties                                                                                  |       | 17           |
| Item 3.           |       | Legal Proceedings                                                                           |       | 17           |
| Item  4.          |       | Submission  of Matters to a Vote of Security-Holders                                        |       | 17           |
| Item  4A          |       | Risk  Factors                                                                               |       | 17           |
|              |       |                                                                                        |       |         |
| **PART II**       |       |                                                                                        |       | 26           |
|              |       |                                                                                        |       |         |
| Item  5.          |       | Market  for the Registrant’s Common Stock and Related Stockholder Matters              |       | 26           |
| Item 6.           |       | Selected Financial  Data                                                                    |       | 27           |
| Item  7.          |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |       | 29           |
| Item  7A.         |       | Quantitative  and Qualitative Disclosures About Market Risk                                 |       | 38           |
| Item  8.          |       | Financial  Statements and Supplementary Data                                                |       | 39           |
| Item  9.          |       | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure       |       | 59           |
| Item 9A.          |       | Controls and  Procedures                                                                    |       | 59           |
|              |       |                                                                                        |       |         |
| **PART  III**     |       |                                                                                        |       | 59           |
| ** **        |       |                                                                                        |       | ** **   |
| Item  10.         |       | Directors  and Executive Officers of the Registrant                                         |       | 59           |
|              |       |                                                                                        |       |         |
| **PART IV**       |       |                                                                                        |       | 60           |
|              |       |                                                                                        |       |         |
| Item  15.         |       | Exhibits,  Financial Statement Schedules and Reports on Form 8-K                            |       | 60           |
|              |       |                                                                                        |       |         |
| **SIGNATURES**    |       | 61                                                                                          |
|              |       |                                                                                        |
| **EXHIBIT INDEX** |       | 62                                                                                          |

 

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**PART I**

 

**Item 1.****  Business**

 

**Background**

 

Aksys,Ltd. was founded in 1991 to provide hemodialysis products and services forpatients suffering from end-stage renal disease (“ESRD”), commonly known aschronic kidney failure.  We havedeveloped an automated personal hemodialysis system, known as the AksysPersonal Hemodialysis (PHDä)System (the “PHD System”), which is designed to enable patients to performfrequent hemodialysis at alternate sites (such as their own homes) and tothereby improve clinical outcomes, reduce total ESRD treatment costs andenhance the quality of life of patients. The terms “Aksys,” the “Company,” “we,”“us” and “our” as used in this report refer to Aksys, Ltd., a Delawarecorporation, and, unless we state otherwise or the context otherwise requires,its subsidiaries.

 

On March 27, 2002, we announcedreceipt of Food and Drug Administration (“FDA”) clearance to market the PHDSystem in the United States.  The FDAclearance had no restrictions and included authorization to use the product inthe home.  510(k) clearance by the FDAwas required prior to the commercialization of the PHD System in the UnitedStates.  On October 7, 2002, we announcedthe receipt of EC Certification for CE Mark approval pursuant to the MedicalDevice Directive of the European Economic Area. The certification approved the PHD System for home use.  Such approval was required prior to thecommercialization of the PHD System in the European Economic Area.

 

During the quarter endedSeptember 30, 2002, we commenced commercial activities and were no longerconsidered to be in the development stage.

 

**TheMarketplace**

 

Our target market is theESRD treatment market.  A healthy humankidney continuously removes waste products and excess water from theblood.  ESRD is a slow, progressive lossof kidney function caused by inherited disorders, prolonged medical conditionssuch as diabetes and hypertension, or the long-term use of certainmedications.  ESRD is irreversible andlethal if untreated.  Life can besustained only through transplantation or dialysis.  Transplantation is severely limited due tothe shortage of suitable donors, the incidence of organ transplant rejectionand the age and health of many ESRD patients. The vast majority (over 90%) of patients, therefore, must rely on dialysisfor the remainder of their lives.

 

We estimate that over $25.2billion was spent in the U.S. during 2002 for the treatment of patientssuffering from ESRD, of which more than $7 billion was directly related todialysis treatment.  Based uponinformation published by The Centers for Medicare and Medical Services (“CMS”),the approximate number of ESRD patients in the United States requiring dialysistreatments has grown from 66,000 at the end of 1982 to an estimated 309,000 atthe end of 2002.  The current estimatedannual growth rate of ESRD patients in the U.S. is approximately 5%.  In addition, it is estimated that there wereapproximately 430,000 dialysis patients in Europe and Japan at the end of 2002.  We believe that the sustained growth in theESRD population, especially in the United States, has been caused by (i) theaging of the population (the median age of newly diagnosed ESRD patients in theUnited States is 65), (ii) the longer average life expectancy of patients withdiabetes and hypertension (two patient groups at high risk for ESRD), (iii) therelatively higher growth in the general population of certain ethnic subsetsthat have a higher incidence of ESRD, (iv) competing risk  (i.e., with the decline in vascular diseasesof the heart, there is a rise in vascular diseases of the kidney), and (v) apossible increase in the use of medications that damage the kidneys.

 

Given the expense ofkidney dialysis treatments and the lack of effective alternative therapies, in1972 Congress enacted legislation providing for Medicare funding for alleligible patients with ESRD regardless of age or financial circumstances.  Under this program, after the first 30 monthsof treatment Medicare is responsible for payment of 80% of the rate set by CMSfor reimbursement of outpatient dialysis. Although this program made dialysis available to virtually all patientsin need of treatment, the cost of funding the program grew rapidly, quicklyexceeding original

 

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expectations.  In an effort to hold down these costs,Congress, in 1983, capped the Medicare reimbursement rate for outpatientdialysis at approximately $21,000 per patient per year, and have approved onlymodest increases since then.  The costsof operating dialysis centers, however, such as capital, labor and facilityoverhead, have continued to rise.  Thesecircumstances have forced dialysis providers to seek ways to reduce dialysistreatment costs.

 

**Reimbursement**

 

Demand for our productsand services is influenced by governmental and otherthird-party reimbursement programs because providers of ESRD treatment arereimbursed by Medicare, Medicaid and private insurers.

 

***MedicareReimbursement***

 

Medicare generallyprovides health insurance coverage for persons who are age 65 or older and forpersons who are completely disabled. Medicare also provides coverage for other eligible patients, regardlessof age, who have been medically determined to have ESRD.  For patients eligible for Medicare basedsolely on ESRD (generally patients under age 65), Medicare eligibility beginsthree months after the month in which the patient begins dialysistreatments.  During this three-monthwaiting period either Medicaid, private insurance or the patient is responsiblefor payment for dialysis services.  Thiswaiting period is waived for individuals who participate in a self-caredialysis training program, or are hospitalized for a kidney transplant and thesurgery occurs within a specified time period.

 

For ESRD patients underage 65 who have any employer group health insurance coverage (regardless of thesize of the employer or the individual’s employment status), Medicare coverageis generally secondary to the employer coverage during a 30-month coordinationperiod that follows the establishment of Medicare eligibility or entitlementbased on ESRD.  During the coordinationperiod, an employer group health plan is responsible for paying primarybenefits at the rate specified in the plan, which may be a negotiated rate orthe healthcare provider’s usual and customary rate.  As the secondary payer during thiscoordination period, Medicare will make payments up to the applicable compositerate for dialysis services to supplement any primary payments by the employergroup health plan if the plan covers the services but pays only a portion ofthe charge for the services.

 

Medicare generally is theprimary payer for ESRD patients after the 30-month coordination period.  Under current rules, Medicare is also theprimary payer for ESRD patients during the 30-month coordination period if,before becoming eligible for Medicare on the basis of ESRD, the patient wasalready age 65 or over (or eligible for Medicare based on disability) unlesscovered by an employer group health plan (other than a “small” employer plan)because of current employment.  This ruleeliminates for many dual-eligible beneficiaries the 30-month coordinationperiod during which the employer plan would serve as primary payer andreimburse health care providers at a rate that we believe may be higher thanthe Medicare composite rate.  The rulesregarding entitlement to primary Medicare coverage when the patient is eligiblefor Medicare on the basis of both age (or disability) and ESRD have been thesubject of frequent legislative and regulatory changes in recent years andthere can be no assurance that such rules will not be unfavorably changed inthe future.

 

When Medicare is theprimary payer, it reimburses 80% of the composite rate set by the Medicareprospective reimbursement system for each dialysis treatment.  The beneficiary is responsible for theremaining 20%, as well as any unmet Medicare deductible amount, although anapproved Medicare supplement insurance policy, other private health insuranceor Medicaid may pay on the beneficiary’s behalf.  Reimbursement rates are subject to periodicadjustment based on certain factors, including budget and other legislation andcosts incurred in rendering the services if tied to certain criteria.  The composite reimbursement rate wasunchanged from commencement of the program in 1972 until 1983.  From 1983 through December 1990, numerousCongressional actions resulted in net reductions of the average compositereimbursement rate from a fixed fee of $138 per treatment in 1983 to approximately$125 per treatment in December 1990. Effective January 1, 1991, Congress increased the ESRD compositereimbursement rate, resulting in an average rate of $126 per treatment.  The Balanced Budget Refinement Act of 1999raised the composite rate by 1.2% in 2000 and an additional 2.8% in 2001.

 

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Section 623 of theMedicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA)revised ESRD composite payment rates effective for services furnished afterJanuary 1, 2005.  The statute mandatesthat the current composite rates be increased by 1.6% for dialysis treatmentsfurnished after January 1, 2005.  Thestatute further mandates that the composite payment rates, as increased by the1.6%, must also include a drug add-on adjustment in the amount of 8.7% for thedifference between the payment amounts for separate billable drugs andbiologicals and their acquisition costs, as determined by Inspector GeneralReports.  Effective April 1, 2005, eachESRD facility’s rate will be case-mix adjusted. Section 623(d) of the MMA requires a basic case-mix adjusted compositerate for ESRD facility services.  Thecase-mix adjusted system shall be for a limited number of patientcharacteristics.  For 2005 thesecharacteristics are age, body surface area and body mass index of theindividual ESRD patients.  Section 623(d)also requires an adjustment of .9116% which will be implemented on April 1,2005 to ensure the overall costs of programs are budget neutral.

 

Reimbursement for homedialysis can be made in two ways.  Abeneficiary may choose to receive home dialysis equipment, supplies and supportservices directly from a certified licensed facility or they may choose to makearrangements with a single supplier for equipment and supplies.  If the beneficiary chooses to use a facility,the facility receives the composite rate for each treatment the patientperforms at home.  If the beneficiarychooses to make independent arrangements, the supplier bills Medicare on anassignment basis and payment is made at a capped rate of no more than $1,481,except for continuous cycling peritoneal dialysis (“CCPD”).  There is a monthly payment cap of $1,975 forCCPD.

 

The Medicare ESRDcomposite reimbursement rate has been the subject of a number of reports andstudies.  Actions to change such rateusually occur in the context of federal budget negotiations.

 

We cannot predict what,if any, future changes may occur in the Medicare composite reimbursement rateor in any other reimbursement program. Any reductions in the Medicare composite reimbursement rate or in anyother reimbursement program could have a material adverse effect on ourprospects, revenues and earnings.  Inaddition, there have been various legislative proposals for the reform ofnumerous aspects of Medicare – the occurrence and effect of which areuncertain.  See “—Potential Health CareLegislation.”

 

***MedicaidReimbursement***

 

Medicaid programs arestate-administered programs partially funded by the federal government.  These programs are intended to providecoverage for patients whose income and assets fall below state defined levelsand who are otherwise uninsured.  Theprograms also serve as supplemental insurance programs for the Medicareco-insurance portion and provide certain coverage (*e.g.*,oral medications) that are not covered by Medicare.  State regulations generally follow Medicarereimbursement levels and coverage without any co-insurance amounts.  Certain states, however, requirebeneficiaries to pay a monthly share of the cost based upon levels of income orassets.

 

***PrivateReimbursement***

 

Some ESRD patients haveprivate insurance that covers dialysis services.  As discussed above, health care providersreceive reimbursement for ESRD treatments from the patient or private insuranceduring a “waiting period” of up to three months before the patient becomeseligible for Medicare.  In addition, ifthe private payer is an employer group health plan, it is generally required tocontinue to make primary payments for dialysis services during the 30-monthperiod following eligibility or entitlement to Medicare.  In general, employers may not reduce coverageor otherwise discriminate against ESRD patients by taking into account thepatient’s eligibility or entitlement to Medicare benefits.

 

We believe that beforeMedicare primary coverage is established, private payers may reimburse dialysisexpenses at rates higher than the per-treatment composite rate set byMedicare.  When Medicare becomes apatient’s primary payer, private insurance often covers the per-treatment 20%coinsurance that Medicare does not pay.

 

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***PotentialHealth Care Legislation***

 

Because the Medicareprogram represents a substantial portion of the federal budget, Congress takesaction in almost every legislative session to modify the Medicare program forthe purpose of reducing the amounts otherwise payable by the program to healthcare providers in order to achieve deficit reduction targets or meet otherpolitical goals.  Legislation and/orregulations may be enacted in the future that may significantly modify theMedicare or Medicaid ESRD programs or substantially affect reimbursement fordialysis services.

 

**PrevailingTreatment Methods**

 

Hemodialysis andperitoneal dialysis are the two prevailing methods of dialysis.

 

***Hemodialysis***

 

CMS estimates that as ofDecember 31, 2002, approximately 92% (284,000) of the ESRD dialysis patients inthe United States were receiving hemodialysis. Less than 1% of these patients performed treatment in their homes, andall others received treatment at outpatient facilities.  Outpatient hemodialysis requires that apatient travel to a dialysis clinic three times per week for dialysis sessionslasting three to four hours.  In eachsession, the patient’s blood is cleansed by circulation through an artificialkidney controlled by a dialysis machine.

 

Home hemodialysis wascommon practice prior to Medicare funding, with approximately 42% of the 11,000United States dialysis patients on home hemodialysis in 1973.  Although the initial motivation for performinghome treatment for many patients reflected the lack of availability of dialysisclinics and the desire to reduce the cost of hospital-based dialysis,clinicians report that many of these patients found significant advantages inquality of life when treating themselves at home.  As Medicare funding became available,however, the vast majority of patients began receiving treatment in outpatientfacilities, and hemodialysis machines became more complex and sophisticated asthey evolved for use in clinics.  Thedialysis machines currently used in these centers are predominantly operated bytrained personnel and require significant manual preparation and cleaning inconnection with each treatment session.

 

***PeritonealDialysis***

 

CMS estimates that as ofDecember 31, 2002, approximately 8% (25,000) of the ESRD dialysis patients inthe United States were receiving peritoneal dialysis, with over 99% performingsuch treatment in their homes.  There aretwo principal forms of peritoneal dialysis, and all forms use the patient’speritoneum, a large membrane rich in blood vessels that surrounds many of thebody’s internal organs, as a filter to eliminate toxins and excess fluids fromthe patient’s blood.  Dialysate, ablood-cleansing electrolyte solution, is infused through a catheter into thepatient’s peritoneal cavity.  Once thisfluid absorbs the toxins and excess water that are filtered from the bloodthrough the peritoneum, it is drained from the peritoneal cavity through acatheter.  In the most common form ofperitoneal dialysis, Continuous Ambulatory Peritoneal Dialysis (“CAPD”), theprocess of exchanging dialysate into and out of the patient’s peritoneal cavityoccurs four times daily, seven days per week. The other form, Continuous Cycling Peritoneal Dialysis (“CCPD”), uses aninstrument to automatically perform exchanges of solution through theperitoneal cavity overnight, while the patient sleeps.  Both forms of treatment require strictaseptic technique.

 

***Limitationsof Prevailing Treatment Methods***

 

*Hemodialysis.*  Patients receiving outpatient hemodialysisoften experience a number of chronic and acute health problems.  The chronic problems include hypertension,anemia (low red blood cell count), malnutrition, fluid and electrolyteimbalance, calcium deficiency, insomnia, sexual impotency, decreased mentalacuity and lower energy levels.  Theacute problems include headaches, nausea, hypotension and asthenia (a generallack of strength and vitality), which are associated with thrice weeklydialysis sessions.  In addition, ageneral feeling of ill health tends to increase between dialysis treatments asa result of toxins, sodium and water building up in the patient’s blood.  These side effects have a significant impacton (i) clinical outcomes, with the leading cause of death among ESRD patientsbeing cardiovascular disease, which many clinicians believe is caused in largepart by oscillations in toxins, sodium 

 

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and body fluid levels,(ii) total patient costs, resulting from the frequent need to hospitalize ESRDpatients as well as the need to treat anemia and hypertension with medicationand (iii) patient quality of life, with patients having to not only sufferthrough these chronic and acute health problems and related “hangover”frequently following each treatment, but also to essentially devote three daysper week to the treatment regimen.

 

We believe that thesehealth problems are caused in part by inadequate doses and frequency ofdialysis.  The amount of toxins removedfrom the blood during dialysis is widely accepted to be determined by a formulaindicating that hemodialysis is most efficient in the earlier stages of therapy.  Thus, simply increasing the duration of atreatment session is not the most efficient way to improve the dose ofhemodialysis.  Rather, the efficiency ofhemodialysis and the delivered dose can be improved with more frequent dialysissessions of shorter duration.  Morefrequent sessions also decrease the severe oscillations in toxin and hydrationlevels associated with the prevailing three times per week dialysis regimen andshould result in fewer side effects.

 

The clinical outcomes ofconventional dialysis have contributed to the significant patient treatmentcost.  According to CMS, total annualtreatment costs per dialysis patient have risen from $33,400 in 1988 to $79,000in 2002.  The cost of hospitalization ona fee for service basis represents the most significant component of this increase.While reimbursement for outpatient hemodialysis treatment (the “composite rate”)has been capped since 1983, with only modest increases, reimbursement for theassociated cost of care due to chronic and acute health problems and othercomplications continues to be reimbursed on a fee for service basis.  Under this reimbursement scheme, providershave an incentive to reduce the cost of outpatient dialysis rather than thetotal cost of treating dialysis patients.

 

*PeritonealDialysis.*  Although peritoneal dialysis accounted for 8% of the dialysispatient population in 2002 according to CMS, approximately 22% (or 5,500) ofthe patients in the United States switched to outpatient in-center hemodialysisannually.  We believe that most ofthese patients switched from peritoneal dialysis to outpatient hemodialysisbecause of the following limitations presented by CAPD, the most common form ofperitoneal dialysis: (i) due to the limited efficiency of using the peritonealmembrane as a filter for toxin removal, patients must have a relatively lowbody weight or have some residual kidney function to achieve adequate levels ofdialysis (once residual kidney function is lost, which is eventually the casein most patients, CAPD is no longer a viable treatment for a majority of thepopulation); (ii) CAPD demands considerable responsibility and time to performthe required four exchanges of solution each day, which often causes patient “burnout”and non-compliance with the prescribed regimen; (iii) peritoneal dialysis demandsthat patients follow strict aseptic techniques when changing dialysate bagsbecause the failure to do so often leads to peritonitis, an infection of theperitoneum; and (iv) the supplies used in peritoneal dialysis requireconsiderable storage space given the quantity of dialysate (up to 30 largeboxes per month) used in this treatment.

 

We believe that most newperitoneal dialysis patients choose CCPD, in part, in an attempt to improveclinical outcomes.  Although CCPDaddresses some of the limitations imposed by CAPD, it continues to present arisk of infection of the peritoneum and in many cases requires some residualkidney function to achieve adequate levels of dialysis. Moreover, because CCPDmust often be supplemented with peritoneal dialysis performed by the patientsduring the day using the CAPD method, patient “burnout” also occurs.

 

**Home Hemodialysis as anAlternative**

 

We believe thatincreasing the frequency of hemodialysis treatments while decreasing the lengthof each treatment session can significantly improve clinical outcomes andpatient quality of life while reducing the total cost of managing ESRDpatients.  We completed a clinical trialof the PHD System in November 2000, whereby a total of 23 patients convertedfrom three times per week dialysis at home to a treatment regimen of morefrequent dialysis on the PHD System. Patients showed better clinical outcomesand improved quality of life on more frequent dialysis. Since then, more than 45,000dialysis treatments have been performed by patients on the PHD System,including treatments at home and at clinics during the patient’s trainingperiod.

 

Several other studiesover the past 34 years indicate that increasing the number of dialysistreatments per week leads to dramatic improvements in patients.  Several study centers report that most of theESRD patients who performed hemodialysis on a daily basis reported that dailyhemodialysis gave them a more positive attitude toward treatment

 

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anda higher quality of life.  Neither we northe PHD System was involved in the treatments received by patients in theseother studies and we did not fund these studies.  Moreover, patient selection for these studieswas not randomized; we gathered the data on a retrospective basis fromproviders that we knew were treating patients with a daily hemodialysisregimen.  Consequently there can be noassurance that the patient populations in these studies are representative ofthe general ESRD patient population.  Asa result, these studies should not be deemed to have established the impact ofdaily hemodialysis on clinical outcomes.

 

Despite the potentialbenefits of frequent hemodialysis, several barriers have prevented it frombecoming a viable treatment regimen.  Themost significant is the economic implication of administering more frequenthemodialysis to patients from the traditional three times per weekdialysis.  Under the current cappedMedicare reimbursement level, dialysis providers cannot afford the additionalcosts that would be incurred in providing more frequent treatments inoutpatient facilities.  Requiring morefrequent visits to a dialysis treatment facility would also place additionalburdens on a patient’s lifestyle.

 

There is also a perceptionthat vascular access complications arising from inserting the needles into thepatient’s blood access site may increase with daily treatment sessions.  These complications are common in theclinical setting already and account for a significant portion of the cost oftreating patients.  We believe thatvascular access complications should not increase with more frequenthemodialysis sessions in a home or self-care setting and such complications mayin fact decrease.  That belief is basedon data collected from patients using a native fistula.  We have collected little data from patientsusing artificial blood vessel grafts or central venous catheters, and there isno assurance that such grafts or catheters will withstand daily treatment.  There are a number of approaches to vascularaccess that may enhance more frequent treatments, including (i) the use of “singleneedle” vascular access devices which reduce the number of punctures by half,(ii) the use of central venous catheters which eliminate the need to useneedles at all, (iii) novel graft materials, (iv) new, totally implantedcentral venous catheters with titanium ports and (v) the practice of insertingneedles in the same site each day, which has been demonstrated to have severalbenefits according to publications by Dr. Zbylut J. Twardowski, a leadingdialysis researcher.  We have a licenseagreement with Dr. Twardowski.  See “—IntellectualProperty – *Twardowski License*.”

 

We believe that mostbarriers to a more frequent hemodialysis regimen could be overcome if it wereavailable in the patient’s home, but to date no hemodialysis device has becomesufficiently available to establish home hemodialysis as a standard alternativetherapy for the general dialysis patient population.

 

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**ProductDevelopment**

 

**The Aksys PHD System**

 

By addressing the manydrawbacks of conventional hemodialysis systems, which have prevented thewidespread use of daily home hemodialysis, we believe our products and servicescan be instrumental in improving clinical outcomes, decreasing the totaltreatment costs and improving quality of life for dialysis patients.  The following chart describes how the PHDSystem addresses the drawbacks presented when ESRD patients and helpers use conventionalsystems for home hemodialysis:

 
| **Drawback**         | ** ** | **Conventional  Home Systems**                                                                                                                          | ** ** | **Aksys  PHD System**                                                                                                 | ** ** |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------|------------|
| ** **           | ** ** | ** **                                                                                                                                              | ** ** | ** **                                                                                                            | ** ** |
| Complexity           |       | Complicated equipment  designed for operation only by trained personnel.                                                                                |       | Designed for ease of  operation at home, including computerized, user-friendly interface.                             |       |
|                 |       |                                                                                                                                                    |       |                                                                                                                  |       |
| Time and Effort      |       | Difficult and time  consuming to setup, operate, clean and maintain.                                                                                    |       | Fully automated,  reducing operator involvement.                                                                      |       |
|                 |       |                                                                                                                                                    |       |                                                                                                                  |       |
| Cost of Consumables  |       | Requires frequent  replacement of blood circuit.                                                                                                        |       | Integrated automatic  disinfection system designed to enable safe and effective reuse of blood  circuit.              |       |
|                 |       |                                                                                                                                                    |       |                                                                                                                  |       |
| Storage Requirements |       | Large volume of  consumables and dialysate consumed each month.                                                                                         |       | Substantially fewer and  smaller items consumed with each treatment.                                                  |       |
|                 |       |                                                                                                                                                    |       |                                                                                                                  |       |
| Dirty Dialystate     |       | According to the  national AAMI standards, dialystate may contain significant quantities of  bacteria and endotoxin.                                    |       | Injectable quality  dialysate is produced in which endotoxin cannot be measured even with  extremely sensitive tests. |       |
|                 |       |                                                                                                                                                    |       |                                                                                                                  |       |
| Water purification   |       | Water purification is  accomplished by a separate free-standing device which must be maintained and  disinfected independently of the dialysis machine. |       | Water purification  membrane is integrated into the dialysis instrument and disinfected  simultaneously with it.      |       |

 

We believe that the PHDSystem offers patients simplification and control.  The new technology of the PHD Systemintegrates four systems into one: water purification, delivery of dialysis,dialyzer reprocessing and online manufacturing of infusion-qualitysolution.   The PHD System is a fullyautomated personal dialysis instrument designed to enable operators to performhemodialysis in a self-care setting, such as the patient’s home, on a frequentor daily basis.  The PHD System isdesigned to reduce the patient’s time and effort involved in performing eachhemodialysis treatment with minimal assistance. Through a touch sensitive display screen with instructions available ona graphic video display, the PHD System is designed to be less intimidating andeasier to use than current hemodialysis systems.

 

The PHD System isdesigned to evaluate the performance of the artificial kidney in removingtoxins from the patient’s blood prior to each treatment to ensure that theprescribed dose of hemodialysis is achieved during the treatment.  The PHD System also automatically evaluatesthe water treatment filters and indicates whether a replacement is required andverifies that all critical safety systems, sensors and alarms are operatingcorrectly.

 

To begin a treatmentsession on the PHD System, the operator connects the blood tubing to thevascular access device.  A user-friendly,touch-sensitive monitor prompts the patient through the treatment and displaysprocedure

 

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andpatient-specific information for review. The PHD System is designed to monitor during the treatment a variety ofvital statistics, including the patient’s blood flow rate, the amount of waterremoved from the patient, the length of the treatment session and other keyparameters.  The treatment can besuspended at any time by the patient.  Ifthe patient’s blood pressure drops below normal levels during the treatment,the system prompts the patient to take appropriate action.  Data from a hemodialysis treatment isdisplayed for viewing by the patient.

 

At the end of a treatmentsession, the operator reconnects the blood tubing set to the system andreplaces the two small bottles of acid and bicarbonate powder, which are usedto produce the dialysate for the patient’s next treatment.  The PHD System then automatically flushes anddisinfects all fluid pathways, performs a self-diagnostic test to determinewhether the disinfection was adequate and readies itself for the next treatmentsession without further patient involvement.

 

**Services Supporting the PHDSystem**

 

To fully servicehemodialysis patients, we are developing a service network to provide supportfor patients and dialysis providers in all aspects relating to the use andmaintenance of the PHD System.  Ourservice network provides the following: (i) delivery and installation of thePHD System, (ii) technical service through a 24 hour call center and throughfield representatives who maintain and repair all components of the PHD System,(iii) delivery of consumables used in dialysis such as the artificial kidneyand arterial and venous blood tubing (which are replaced periodically), waterpurification components and dialysate concentrate and (iv) customer servicerepresentatives who interface with the dialysis provider to address the statusof, and any necessary changes in, the patient’s treatment as ordered by thepatient’s physician.  We believe that byproviding all of the products and services necessary to perform hemodialysis athome as well as in other self-care settings and nursing homes, we can establishand maintain lasting relationships with patients and dialysis providers.

 

The PHD System isintended to reduce total treatment costs for ESRD patients, includinghospitalization costs.  There is noreliable way at this time, however, to quantify the potential savings in totaltreatment costs.  We have priced the PHDSystem at a level to fit within current reimbursement guidelines.  Thus, we expect there will be little or noreduction in dialysis cost (as opposed to total treatment costs) associatedwith the PHD System.

 

Although we believe thatthe PHD System provides a solution to many of the problems presented byconventional dialysis modalities, there are a number of risks that must beovercome in order for the PHD System to succeed, including, among others,achieving market acceptance and the uncertainty of obtaining regulatoryclearance or approval in jurisdictions other than the United States and theEuropean Economic Area.

 

**2005 Activities**

 

During 2005, we expectthat approximately $30 to $32 million of cash, short- and long-term investmentswill be devoted to expanding commercialization of the PHD System, includingsales and marketing activities, and service and support of the PHD System.Resources will also be directed toward using the PHD System’s platformtechnology to develop follow-on products.  Based on our cash position and short and longterm investments as of December 31, 2004, and projected usages in 2005, wecurrently anticipate that we will seek to raise capital in the latter half of2005 or early 2006.  As discussed under “Management’sDiscussion and Analysis of Financial Condition and Results of Operations —Liquidity and Capital Resources — Recent Financing Activities,” under the termsof our settlement with the Durus funds, we are prohibited from registeringshares of our common stock until May 2005 (or in some instances longer if theDurus funds have commenced an offering of their shares, in which case we may besubject to a lock-up period under our registration rights agreement with theDurus funds).  Because the Durus fundscontinue to own approximately 70% of our common stock and we are still in theearly stages of our commercialization efforts, we may not be able to raisesufficient capital to fund our operations beyond 2005.

 

###### **Salesand Marketing**

###### ** **

In October 1997, theNational Kidney Foundation released the results of the first comprehensiveeffort to standardize practices at U.S. dialysis centers (the Dialysis OutcomesQuality Initiative, or DOQI guidelines). The

 

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recommendationscalled for minimum doses of dialysis. This recommendation supports our belief that patients who receive ahigher dose as a result of daily dialysis will benefit through improvedclinical outcomes.  We believe that thePHD System offers the potential for better clinical outcomes, lower totaltreatment costs and improved quality of life for dialysis patients.  The relatively poor patient outcomesresulting from current dialysis treatment methods and the increasing total costof treating ESRD patients have created significant demand for improved dialysissystems.  Through the PHD System, weintend to capitalize on this demand by pursuing the following strategies.

 

*Target Specific Market Segments*.  We currently market our products and servicesdirectly to providers of dialysis services; these providers may be independentbusinesses or national chains.  We arestaging the product availability across target geographies in order to developefficiencies in our service network.  Webelieve the PHD System will be particularly well received by patients livingfar from their dialysis centers, and we want to first have a service networkthat is well positioned to support these patients.  In the meantime, we are focusing on coregeographies with a high density of potential patients.

 

*Provide a Broad Range of DialysisProducts and Services. *Wehave developed a portfolio of services surrounding the PHD System.  These services include the delivery,installation and maintenance of the equipment as well as training, technicalsupport, nurse administration support and delivery of consumable supplies.  The PHD may be sold or rented, and theservices and additional products are provided for a single monthly fee.

 

*MeasuringQuality of Patient Care.** *The PHD System monitors manycomponents of patient treatments.  Thesepatient treatment metrics allow the health care provider to record and documentquality of care.  There arewell-established CMS guidelines for treating ESRD patients and we anticipatefuture payment structures will require documentation of quality measurements.

 

*Clinicaland Patient Education.** *Although home hemodialysis was anestablished modality in the 1970’s, many of today’s healthcare practitionersare unfamiliar with the requirements for establishing a home program and theprocess of managing patients in a home environment.  We focus a portion of the marketing effort ondirectly educating health care professionals about the benefits of morefrequent dialysis and the benefits of treating patients at home.  In addition, we educate the patientpopulation about this treatment modality as an option to be considered inconjunction with their physician.

 

*PhasedDomestic and International Market Launch.*  We believe that there is worldwide demand fora cost effective, more clinically effective approach to dialysis.  In addition to our market launch in theUnited States, we have also begun selling in the United Kingdom, and haveestablished marketing and regulatory resources in Japan.  As of December 31, 2002, we estimate thatthere were approximately 225,000 dialysis patients in Europe and 205,000dialysis patients in Japan.

 

We operate with arelatively small direct sales force to market our products and services,primarily to healthcare providers such as hospitals, dialysis clinics, managedcare organizations and nephrology physician groups.  We distribute and provide technical supportfor the PHD System through a combination of in-house resources and contractedthird parties.

 

Our largest customers,the Northwest Kidney Center, Dialysis Centers of Lincoln and Berkshire MedicalDialysis Center, accounted for 24%, 10% and 9%, respectively, of our revenues(by dollar volume) for fiscal year 2004.

 

**Manufacturingand Suppliers**

 

We do not currentlymanufacture any component of the PHD System or related consumables.  With respect to the PHD System, we havecontracted with Delphi Medical Systems (‘‘Delphi’’), a contract manufacturer ofmedical devices, to assemble and produce the dialysis machine.  Our agreement with Delphi remains in effectthrough February 28, 2006, subject to earlier termination under specifiedcircumstances.  The contractautomatically renews on an annual basis unless a six-month advance notice isprovided by either party to terminate.  Delphispecializes in the custom manufacturing of medical instrumentation and iscertified to ISO 13485 for manufacture of such

 

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products.  ISO 13485 is an internationally recognizedquality systems standard for the medical device industry.  Delphi is also FDA registered and qualitysystem regulations (“QSR”) compliant.  Wemay identify additional manufacturing locations in the future, whether or notowned by Delphi, to avoid having to rely on a single location.  There can be no assurances that we will beable to do so on acceptable terms.  Themanufacturing of our products is subject to quality regulations and otherrequirements prescribed by regulatory agencies. There can be no assurance that Delphi or any other manufacturer of ourproducts will continue to comply with applicable regulatory requirements orthat Delphi or any other manufacturer will be able to supply us with productsin sufficient quantity or at all.

 

Certain key accessoriesof the PHD System, such as the dialyzer, are available from othermanufacturers.  Other accessories andsupplies, such as the blood tubing set and the dialysate chemicals supplied topeople using the PHD System are custom made and packaged to our specificationsby FDA-registered and QSR-compliant companies. There can be no assurances thatany of these accessories and supplies will continue to be available on termsacceptable to us or at all.

 

**Researchand Development**

 

As of December 31, 2004,we employed a research and development staff of 41 full time employees, most ofwhom are engineers and technicians.  Inaddition, we used contractors on an as needed basis to assist in thedevelopment process.   The research anddevelopment staff is composed of specialists in the fields of mechanicalengineering, electrical engineering, software engineering, biomedical andsystems engineering, chemistry and microbiology.  For the years ended December 31, 2004, 2003and 2002, we incurred total research and development expenditures ofapproximately $6,684,465, $5,474,220, and $5,522,772, respectively.

 

###### **Competition**

###### ** **

We compete in the kidneydialysis market with suppliers of hemodialysis and peritoneal dialysis devices,supplies and services.  We do not competewith providers of dialysis services such as the national dialysis providers ormanaged care companies.  Rather, we aremarketing our products and services to these providers and working with them tomake home hemodialysis a viable alternative to currently available treatmentmethods.

 

Our primary competitorsin supplying dialysis equipment, supplies and services are Baxter InternationalInc., Fresenius Medical Care AG and Gambro AB. These companies and most of our other potential competitors havesubstantially greater financial, scientific and technical resources, researchand development capabilities, marketing and manufacturing resources andexperience than we have, and greater experience in developing products,providing services and obtaining regulatory approvals.

 

Our ability tosuccessfully market our products and services could be adversely affected bypharmacological and technological advances in preventing the progression ofESRD in high-risk patients (such as those with diabetes and hypertension),technological developments by others in the area of dialysis, the developmentof new medications designed to reduce the incidence of kidney transplant rejectionand progress in using kidneys harvested from genetically-engineered animals asa source of transplants.  There can be noassurance that competitive pressure or pharmacological or technologicaladvancements will not have a material adverse effect on our business.

 

We believe thatcompetition in the market for kidney dialysis equipment, supplies and servicesis based primarily on clinical outcomes, price, product performance,cost-effectiveness, reliability and technological innovation and that competitionin the home hemodialysis market will be based on these factors as well as onproducts being relatively easy to use, transport and maintain.  Certain kidney dialysis equipmentmanufacturers and service providers currently own and operate, or may in the futureacquire, dialysis treatment facilities and other providers.  As a result, our ability to sell our productsand services to these providers may be adversely affected.

 

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###### **GovernmentRegulation**

###### ** **

**Food and Drug Administration**

 

The PHD System isregulated as a medical device by the FDA under the Federal Food, Drug andCosmetic Act (the “FDC Act”).   Pursuantto the FDC Act, the FDA regulates the manufacture and distribution of medicaldevices in the United States. Noncompliance with applicable requirements can result in, among otherthings, fines, injunctions and civil penalties; recall or seizure of products;total or partial suspension of production; denial or withdrawal of pre-marketclearance or approval of devices; recommendations by the FDA that we not beallowed to enter into government contracts; and criminal prosecution.  The FDA also has authority to require repair,replacement or refund of the cost of any device illegally manufactured ordistributed by us.

 

In the United States,medical devices are classified into one of three classes (Class I, II or III)on the basis of the controls deemed necessary by the FDA to reasonably ensuretheir safety and effectiveness.  Class Idevices are subject to general controls (*e.g.*, labelingand adherence to some of the QSRs). Class II devices are subject to general and special controls (*e.g.*, performance standards, post-market surveillance andpatient registries).  Class III devicesare those which must receive pre-market approval by the FDA to ensure theirsafety and effectiveness (*e.g.*,life-sustaining, life-supporting and implantable devices or new devices whichhave been found not to be substantially equivalent to legally marketeddevices).

 

The PHD System isclassified as a Class II device. On March 30, 1999, we filed an InvestigationalDevice Exemption (“IDE”) with the FDA, a prerequisite for conducting a clinicalevaluation of the PHD System.  Wereceived full IDE approval in July 1999, and in September 1999 began theclinical trial of the PHD System. Twenty-five patients participated in the trial at three centers.  The protocol for the study called forpatients to dialyze at home on existing hemodialysis equipment for 10 weeks,followed by one month in the center on the PHD System and two months at home onthe PHD System.  The clinical trial wascompleted in November 2000, with 23 patients receiving dialysis on the PHDSystem.  Over 45,000 dialysis treatmentshave now been performed by patients on the PHD System, including in the homeand at clinics during the patient’s training period.

 

On March27, 2002, we announced receipt of FDA clearance to market the PHD System in theUnited States.  The FDA clearance had norestrictions and included authorization to use the product in the home.  We had been working toward satisfying theregulatory requirements of the FDA since submitting a 510(k) pre-marketnotification for clearance to market the PHD System in January 2001.  The FDA required 510(k) clearance prior tothe commercialization of the PHD System in the United States.

 

The FDC Act requires thatmedical devices be manufactured in accordance with the FDA’s current QSRs.  These regulations require, among otherthings, that (i) the manufacturing process be regulated and controlled by theuse of written procedures and (ii) the ability to produce devices which meetthe manufacturer’s specifications be validated by extensive and detailedtesting of every aspect of the process. They also require investigation of any deficiencies in the manufacturingprocess or in the products produced and detailed record keeping.  Manufacturing facilities are thereforesubject to FDA inspection on a periodic basis to monitor compliance with QSRs.  If violations of the applicable regulationsare noted during FDA inspections of the manufacturing facilities of ourcontract manufacturers, there may be a material adverse effect on the continuedmarketing of our products.

 

Even though the FDA hascleared the PHD System, the FDA will periodically inspect the manufacturingfacilities and processes for compliance with QSRs.  In addition, in the event that additionalmanufacturing sites are added or manufacturing processes are changed, such newfacilities and processes may be subject to FDA inspection for compliance withQSRs.

 

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**Foreign Government Regulation**

 

On October 7, 2002, weannounced receipt of EC Certification for CE Mark approval pursuant to theMedical Device Directive of the European Economic Area.  The certification approved the PHD System forhome use.  Such approval was requiredprior to the commercialization of the PHD System in the European Economic Area.

 

We plan to market the PHDSystem in several foreign markets, including continental Europe and Japan,either through subsidiaries or through partnerships with others.  Requirements pertaining to the PHD Systemvary widely from country to country.  Webelieve the extent and complexity of regulations of medical devices such as thePHD System is increasing worldwide.  Weanticipate that this trend will continue and that the cost and time required to obtain approval to market in any given country willincrease, with no assurance that such approval will be obtained.

 

**IntellectualProperty**

 

As of March 1, 2005, weeither owned or had exclusive rights to 45 U.S. patents and 28 foreign patentsfor technologies that are important to developing a safe, convenient,self-contained hemodialysis system.  We have two additional patent applications pendingin the United States, and have additional patent applications pending inseveral other countries that have significant hemodialysis markets.  We expect to file additional patentapplications in the United States with respect to the PHD System as newtechnology is developed.

 

*Twardowski License.*On April 1, 1993, we entered into a License Agreement (the “Twardowski License”)with Dr. Zbylut Twardowski granting to us worldwide exclusive license to thepatent filed on August 21, 1991 entitled “Artificial Kidney for Frequent(Daily) Hemodialysis” expiring August 21, 2011, and several subsequent patents(the “Twardowski Patents”).  TheTwardowski Patents relate to an artificial kidney intended to provide frequent(daily) home hemodialysis.  The TwardowskiLicense continues for as long as the Twardowski Patents remain in effect.  The Twardowski License provides for royaltypayments to Dr. Twardowski based on the revenue we receive from the sale orlease of the licensed product, with certain minimum semiannual royaltypayments.  If we fail to make any suchminimum royalty payment, Dr. Twardowski has the option to convert theTwardowski License to a non-exclusive license. There can be no assurance that the Twardowski Patent will provide ussignificant exclusivity or benefit in our markets.  Furthermore, competitors may developalternative technology that achieves the same advantages as the TwardowskiPatents.

 

*Boag License.*  On April 1, 1993, we also entered into aLicense Agreement (the “Boag License”) with Cynthia P. Walters for the use of apatent entitled “Dialyzer Reuse System” issued on September 22, 1987, whichexpires April 29, 2005 (the “Boag Patent”). We do not believe the expiration of this license will have an adverseeffect on our ongoing operations.  TheBoag License is exclusive subject to the rights of Servall Corp. to market itsHR3000 product, a device for facilitating reuse of consumables withconventional hemodialysis machines.  TheBoag Patent relates to a dialysis reuse system for cleaning, sterilizing andtesting a hemodialysis machine and its associated dialyzer and blood tubingset.  The Boag License continues for aslong as the Boag Patent remains in effect. The Boag License provides for royalty payments to Ms. Walters based onthe revenue we receive from the sale or lease of the licensed product with aminimum semiannual royalty payment. Commencing with the third semiannual period after the first licensedproduct is sold, if we pay no more than the minimum semiannual royalty payment fortwo consecutive semiannual periods, the licensor has the right to convert theBoag License to a non-exclusive license. Also, commencing with the first semiannual period occurring five yearsafter the first licensed product is sold, if we pay no more than the minimumsemiannual royalty payment for two consecutive semiannual periods, the licensorhas the right to terminate the Boag License. In the event of infringement of the patent by third parties, our rightto enforce the patent is subject to the licensor’s superior right to bring suiton its own and to recover all damages without accounting to us.  There can be no assurance that the BoagPatent will provide us significant exclusivity or benefit in our markets.  Furthermore, competitors may develop alternativetechnology that achieves the same advantages as the Boag Patent.

 

*Allergan License.***  **On March 11, 1996,we entered into a License Agreement (the “Allergan License”) with Allergan,Inc. for the use of a U.S. patent entitled “Pressure Transducer Magnetically-CoupledInterface Complementing Minimal Diaphragm Movement DuringOperation” issued February 28, 1995, which expires on

 

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December 16, 2013, andits foreign counterparts (the “Allergan Patent”).   We have exclusive worldwide rights to thepatented technology, limited to the field of use of kidney dialysis machinesand methods.  The Allergan Licensecontinues for as long as the Allergan Patent remains in effect and provides forroyalty payments to Allergan based on manufacturing of the PHD System, whichincorporates the patented technology.  Royalty payments are to be made quarterly, with minimum annual royaltypayments beginning in 1998.  If we failto pay the full minimum annual royalties, the License Agreement willterminate.  If we pay at least half ofthe minimum annual royalties but do not pay such royalties in full, the LicenseAgreement shall be converted to a non-exclusive license.   The Company pays the minimum annualroyalties and, as such, the license remains exclusive.  There can be no assurance that the AllerganPatent will provide us significant exclusivity or benefits in our markets.   Furthermore, competitors may developalternative technology that achieves the same advantages as the AllerganPatent.

 

There can be no assurancethat any of our pending patent applications will be approved by the patentoffices in the various jurisdictions in which they were filed.  In addition, there can be no assurance thatwe will develop additional proprietary products or processes that arepatentable or that any patents that may be issued to or be licensed by us willprovide us with competitive advantages. There can be no assurance that our patent applications or patents thatmay be issued to or be licensed by us will not be challenged by any thirdparties or that the patents of others will not prevent the commercialization ofproducts incorporating our technologies. Furthermore, there can be no assurance that others will not or have notindependently developed similar products, duplicated and designed any of ourproducts or design around the patents that may be issued to or be licensed byus.  Any of the foregoing results couldhave a material adverse effect on our business, operating results and financialcondition.

 

Our commercial successdepends, in part, on our ability to avoid infringing patents issued toothers.  The field of dialysis includes asignificant number of patents that have been issued to third parties.  We may receive from third parties, includingpotential or actual competitors, notices claiming that we are infringing thirdparty patents or other proprietary rights. If it was determined that we were infringing any third-party patent, wecould be required to pay substantial damages, alter our products or processes,obtain licenses or cease certain activities. In addition, if patents are issued to others which contain claims thatcompete or conflict with our licensed patents or patent applications, and suchcompeting or conflicting claims are ultimately determined to be valid, we maybe required to pay damages, to obtain licenses to these patents, to develop orobtain alternative technology or to cease using such technology.  If we are required to obtain any licenses,there can be no assurance that we will be able to do so on commerciallyfavorable terms, if at all.  Our failureto obtain a license to any technology that we may require to commercialize ourproducts could have a material adverse impact on our business, operating resultsand financial condition.

 

In addition to patentlicenses and applications for patents, we possess trade secrets, copyrights,proprietary know-how and unpatented technological advances.  We seek to protect these assets, in part, byconfidentiality agreements with our business partners, consultants and vendorsand non-competition agreements with our officers and employees.  There can be no assurance that theseagreements will not be breached, that we will have adequate remedies for anybreach or that our trade secrets and proprietary know-how will not otherwisebecome known or be independently developed by others.

 

**Employees**

 

As of December 31, 2004,we had 119 full-time employees, 41 of whom were employed in research anddevelopment capacities, 27 of whom were employed in the technical and clinicalservices area, 15 of whom were employed in sales and marketing efforts, 17 ofwhom were employed in the general and administrative area, 15 of whom wereemployed in manufacturing, operations and regulatory groups, and 4 of whom wereemployed in the United Kingdom subsidiary. We consider our employee relations to be good.

 

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**ExecutiveOfficers**

 

The information underthis Item is furnished pursuant to Instruction 3 to Item 401(b) of RegulationS-K.  Executive Officers of the Companyare elected by and serve at the discretion of the Board of Directors.

 

**William C. Dow, 58**

Mr. Dow was appointedPresident and Chief Executive Officer and a director of the Company in September1999.  From August 1997 until joining theCompany in September 1999, he served as President and Chief Executive Officerof PLC Systems Inc., a manufacturer of lasers used in cardiac surgery.  From 1993 to 1997, he served as President andChief Executive Officer of Deknatel Snowden Pencer Worldwide, Inc., a $100million medical device manufacturer that became a manufacturing and marketingsubsidiary of Genzyme Corporation in 1996. Mr. Dow has over 25 years of experience in the medical device and serviceindustry having held various positions in sales, marketing, distribution andgeneral management with Griffith Micro Science, Kendall, Terumo and AmericanHospital Supply.  Mr. Dow is a graduateof the United States Naval Academy with a Bachelor of Science in Engineeringand served as both a pilot and a Supply Corps officer in the U.S. Navy.

 

**Laurence P. Birch, 45**

Mr. Birch joined theCompany in February 2005 as Senior Vice President and will assume the duties ofChief Financial Officer effective March 17, 2005.  From 2003 until he joined the Company, Mr.Birch served as Managing Director for Stratego Partners, a corporate costmanagement company.  From 2002 to 2003,he served as Chief Financial Officer of Seurat, Inc.  From 2001 to 2002, he served as ChiefFinancial Officer of Fieldglass, Inc. From 2000 to 2001, he served as Senior Vice President and ChiefFinancial Officer of Technology Solutions, Inc. In 2000 he served as Chief Financial Officer of Brigade, Inc.  From 1999 to 2000, he served as Chief FinancialOfficer of Gateway Homecare, Inc.  Mr.Birch has over fifteen years experience in the healthcare sector which includeshis fourteen years with Baxter International and American Hospital Supply invarious financial positions.  Mr. Birchreceived his Bachelor of Science degree in finance from the University ofIllinois, his Masters of Business Administration degree from the KelloggGraduate School of Management at Northwestern University, and is a CertifiedPublic Accountant.

 

**Lawrence D. Damron, 58**

Mr. Damron was appointed SeniorVice President and Chief Financial Officer in May 2002, and became a member ofthe board of directors in August 2004. Effective March 17, 2005 Mr. Damron willresign his position as Chief Financial Officer and effective May 1, 2005 hewill resign from his Senior Vice President’s position, but will continue as amember of the board of directors.  Mr.Damron has over 25 years of experience in the healthcare sector.  From June 1999 to December 2000, he served asthe Chief Financial Officer for Everest Healthcare Services Corporation, aprovider of dialysis and other blood treatment services.  From July 1997 until June 1999, he was SeniorVice President, Finance and Treasurer at Evanston Northwestern Healthcare.  Mr. Damron was with Baxter Internationalsince 1985 in a number of key management positions including CorporateTreasurer from 1992 until 1997.  From1980 until 1985, he was with American Hospital Supply in a variety of financialpositions.  Mr. Damron received hisBachelor of Arts degree in economics from the University of Cincinnati and hisMasters of Arts degree in international relations from the University ofSouthern California.  He received hisMasters of Business Administration from Harvard University, and is a CertifiedPublic Accountant.  Mr. Damron served asa Lieutenant in the U.S. Navy.  He serveson the board of directors of Bio-Logic Systems Corporation and Trinity Health.

 

**Jerry D. Fisher, 57**

Mr. Fisher was appointed SeniorVice President and Chief Technical Officer in October 2004. Mr. Fisher has over30 years of experience in the healthcare sector.  Prior to joining the Company, he served invarious roles with Baxter International, Inc. from 1970 to 2003. Mr. Fisher wasVice President of Technology Resources for Baxter from 2000 to 2003.  He was Vice President Quality Affairs ofBaxter Hyland Immuo division from 1998 to 2000. Mr. Fisher was a board member and founder of The Consortium for PlasmaScience, LLC; a member of the New York Academy of Sciences; the AmericanAssociation for the Advancement of Science; the American Chemical Society, andholds seven patents.  He earned hisMasters of Science degree in Analytical Chemistry in 1975 from IndianaUniversity. In 1981 he earned his MBA from Lake Forest School of Management.

 

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**Richard P. Goldhaber, 61**

Mr. Goldhaber wasappointed Senior Vice President Special Projects in October 2004.  From 2000 until 2004 Mr. Goldhaber served asChief Technical Officer of the Company. Prior to joining the Company, from 1993to 2000, he was Vice President of Research and Development at MinntechCorporation, a company that develops, manufactures and distributes dialysisrelated products.  Prior to Minntech,from 1965 to 1993, he held positions of increasing responsibility in productdevelopment with Baxter International Inc., including 20 years developingdialysis products.  Mr. Goldhaberreceived his Bachelor of Science in Mechanical Engineering from PurdueUniversity, and his Masters of Science inPhysiology from Illinois Institute of Technology.

 

**Rodney S. Kenley,****55**

Mr. Kenley was appointed SeniorVice President of Advanced Product Development in February 2004.  Mr. Kenley founded Aksys in 1991 and servedin varying capacities, including CEO, COO, and VP, Business Development, untilhe left in 1999.  During his five yearsaway from the Company, Mr. Kenley founded OrthAssist, a company which providesmanagement services for orthopedic physician offices.  Mr. Kenley rejoined the Company in February2004.  He has 30 years of experience inhealthcare, most of which have been spent in the Renal Replacement Therapyarena.  Prior to founding Aksys, he heldseveral positions at Baxter Healthcare from 1977 through 1990, includingInternational Marketing Manager, Business Unit Manager for Peritoneal andHemodialysis products, Manager of New Business Development, Director ofWorldwide Product Planning, Director of Advanced Product Development, and VP ofElectronic Drug Infusion.  Mr. Kenley receivedhis Bachelor of Arts degree in Biology and Chemistry from Wabash College, aMasters of Science degree in Molecular Biology from Northwestern University,and a Masters of Management from the Kellogg Graduate School of Management atNorthwestern University.

 

**Lawrence A. Rohrer, 54**

Mr. Rohrer was appointed SeniorVice President, Global Sales and General Manager, International in May2003.  Mr. Rohrer has over 25 years ofexperience in the healthcare sector. From 1996 until joining the Company in May 2003, he served as VicePresident of Marketing and Business Development for the non-hospitalmedical/surgical distribution business at Cardinal Health Inc., a provider ofproducts and services supporting the healthcare industry.  From 1995 to 1996 he was Vice President,Business Development in the Nephrology Division of Caremark, International, a pharmaceutical services company.  From 1978 through 1994, Mr. Rohrer served invarious positions of increasing responsibility in engineering, marketing, andsales management with the Renal Division of Baxter International.  Mr. Rohrer received his Bachelor of Sciencedegree in aeronautical engineering from the University ofNotre Dame, his Masters of Science degree in Mechanical Engineering fromNorthwestern University, and his Masters of Business Administration degree fromNorthern Illinois University.  Mr. Rohrerserved as a Captain in the U.S. Air Force.

 

**Nancy S. Schmelkin, 46**

Ms. Schmelkin wasappointed Senior Vice President, Global Marketing and Customer Care in October2002. Ms. Schmelkin has over 15 years of experience in the healthcaresector.  Prior to joining the Company shewas the Director of Marketing for Motorola Life Sciences, a division ofMotorola focusing on technology in the field of genomics from 2000 to 2002.  From 1984 to 1996 Ms. Schmelkin served invarious positions of increasing responsibility with Baxter International.  Ms. Schmelkin received her Bachelor of Artsfrom Grinnell College and her Masters of Business Administration in Marketingand Finance from Northwestern University.

 

**Thomas F. Scully, 58**

Mr. Scully was appointed SeniorVice President of Manufacturing and Global Logistics in January 2002**. **Mr. Scully****joined the Company in January 1996, and served as VicePresident of Operations through December 2001. Mr. Scully has over 30 years of experience in the healthcaresector.  From 1971 to 1995, Mr. Scullyworked at Baxter International in various operational roles, including VicePresident, Sales and Operations of the Renal Division.  In that role, Mr. Scully was involvedprincipally in the design, development and management of the Renal Division’shome care operations network.  Mr. Scullyreceived his Bachelor of Arts degree from the University ofNotre Dame and his Master’s of Management degree from NorthwesternUniversity.  Mr. Scully served as aCaptain in the U.S. Army.

 

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###### **ProductLiability Exposure**

###### ** **

Ourbusiness exposes us to potential product liability risks relating to theproduction, marketing and sale of dialysis products.  There can be no assurance that we will beable to avoid significant product liability exposure.  Upon commencement of the first human use ofthe PHD System in January 2000, we initiated product liability insurancecoverage, with a limit of $10 million. There can be no assurance that such insurance coverage is sufficient, orthat additional coverage will be available on acceptable terms or at all orthat any insurance policy, if obtained, will provide adequate protectionagainst potential claims.  Furthermore,our agreements with contract manufacturers require us to obtain productliability insurance, and the failure to obtain adequate insurance coveragecould materially and adversely affect our ability to produce the PHDSystem.  A successful claim broughtagainst us in excess of any insurance coverage maintained by us could have amaterial adverse effect on our business, operating results and financialcondition.  In addition, we have agreedto indemnify certain of our contract manufacturers against certain liabilitiesresulting from the sale of the PHD System.

 

**ForeignOperations**

 

In April 1996, weestablished Aksys Japan, K.K. (“AJKK”), our indirect, wholly owned Japanesesubsidiary.   AJKK had no employees as ofDecember 31, 2004.   We have engaged theservices of a business consultant to act on behalf of AJKK in pursuing businessopportunities in Japan.  The primarypurpose of AJKK is to establish a presence for regulatory, business developmentand eventual technical and customer support as we progress through the stagesof clinical studies, regulatory approval and market launch.   All efforts and decisions are directed fromour headquarters in Lincolnshire, Illinois.

 

In 1999, we entered intoa co-development and license agreement with Teijin Limited of Osaka,Japan.  Under the agreement, Teijin hasthe right to develop, manufacture, seek regulatory approval, and upon suchapproval, to market, rent and sell the PHD System in Japan.  Teijin will pay royalties to us of 10% ofrevenues received in connection with their sales and rentals of PHD Systems inJapan.  Under the agreement, we have anoption to sell the PHD System in Japan, but our exercise of this option wouldcause the royalty rate to drop to 5%. Teijin is a leading Japanese manufacturer of synthetic fibers, chemicalsand plastics, with annual sales in excess of $8 billion, of which over $880million is derived from pharmaceuticals and medical products.

 

In August 1998, weestablished Aksys Healthcare, Ltd. (“AHL”), our indirect, wholly ownedsubsidiary in the United Kingdom.  AHL isa sales office which employed four individuals at December 31, 2004.  The primary purpose of AHL is to establishand develop our business in the United Kingdom and ultimately, continentalEurope.  In 2004, AHL recorded six salesand one rental agreement.

 

**AvailableInformation**

 

We file annual, quarterlyand current reports, proxy statements and other information with the Securitiesand Exchange Commission (“SEC”).  You mayread and copy any document we file at the SEC’s public reference room at Room1024, 450 Fifth Street, NW, Washington, D.C. 20549.  Please call the SEC at 1-800-SEC-0330 forinformation on the public reference room. The SEC maintains a web site (www.sec.gov) that contains annual,quarterly and current reports, proxy statements and other information thatissuers (including us) file electronically with the SEC.

 

We make available free ofcharge, through a direct link from our web site (www.aksys.com) to the SEC’sweb site, our annual reports on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K, Forms 3, 4 and 5 filed on behalf of directors andexecutive officers, and any amendments to those reports filed or furnishedpursuant to the Securities Exchange Act of 1934 as soon as reasonablypracticable after such documents are electronically filed with, or furnishedto, the SEC.

 

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**Item 2.****  Properties.**

 

We lease approximately41,500 square feet of office space in Lincolnshire, Illinois to conduct ourresearch, development, marketing and administrative functions.  This lease was initiated September 1, 1996and with an expiration date of August 31, 2006. In November 2004, we amended the lease with an extension in the term ofthe lease to December 31, 2011.  Webelieve that our present facilities are adequate for our operations.  At present, all manufacturing has beencontracted out to third party subcontractors.

 

**Item 3.****  Legal Proceedings.**

 

In July 2004, an allegedshort-seller of Aksys stock filed a lawsuit against the Durus funds and us inthe Federal District for the State of Connecticut (*Collier v. Aksys, Ltd. et al., District of Connecticut, Civil ActionNo. 3:04-CV-01232*).  Thelawsuit is a purported class action filed on behalf of all short-sellers ofAksys stock during the period of January 1, 2003 through July 24, 2003.  The plaintiff is alleging violations offederal securities laws in connection with the Durus funds’ accumulation of ourstock.  We believe that all the claimsagainst us are without merit.  InSeptember 2004, we entered into an agreement with counsel for plaintiffswhereby we were dismissed from the lawsuit without prejudice.

 

**Item 4.****  Submission ofMatters to a Vote of Security-Holders.**

 

There were no matterssubmitted for a vote of our stockholders during the quarter ended December 31,2004.

 

**Item 4A.****  Risk Factors**

 

###### **RiskFactors**

###### ** **

*Investingin our common stock involves a high degree of risk. You should carefullyconsider the risks and uncertainties described below before investing.  If any of the following risks actually occur,our business, financial condition or results of operations would likelysuffer.  In that case, the market priceof the common stock could fall, and you may lose all or part of the money youpaid to buy such common stock.  Alsoconsider carefully the statements under the heading ‘‘Note on Forward-LookingInformation’’ below.  You should beprepared to accept the occurrence of any and all of the risks associated withpurchasing our common stock, including a loss of all of your investment.*

 

**Risksrelated to Our Business**

 

***We have a history of operating losses and a significant accumulateddeficit, and we may not achieve or maintain profitability in the future.***

 

We havenot been profitable since our inception in January 1991.  As of December 31, 2004, we had anaccumulated deficit of approximately $157 million.  We expect to continue to incur additionallosses for the foreseeable future as a result of a high level of operatingexpenses, significant up-front expenditures, production and marketingactivities and very limited revenue from our core business.  We may never realize significant revenuesfrom our core business or be profitable. Factors that will influence the timing and amount of our profitabilityinclude:

 

•                  market acceptance of the PHD System;

•                  our success in commercializing the PHD System, which will be difficultto achieve;

•                  our ability to effectively and efficiently manufacture, market anddistribute the PHD System; and

•                  our ability to sell or rent the PHD System and related services at aprice that covers our per unit costs, which result may be difficult to achieve,in part because of the significant restrictions on the reimbursement ofdialysis treatment by the Medicare program, as discussed below, and the highcost of manufacturing the PHD System.

 

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We facesignificant challenges in shifting from the development stage to thecommercialization stage for the PHD System. Our prospects must be considered in light of the risks, expenses anddifficulties frequently encountered in such a transition, and there can be noassurance that we will have any significant revenues or that we will everachieve profitable operations.

 

***Our cost to produce the PHD System and deliver related services andsupplies currently exceeds the market price of the PHD System and relatedservices and supplies.***

 

Thepricing of the PHD System and related services and supplies is constrained bylimitations on governmental and third party reimbursement programs.  Although a team of our engineering personnelis currently implementing plans to reduce costs through redesign of PHDsubsystems and we are attempting to source alternative materials and suppliers,there can be no assurance that these efforts will enable us to achieveprofitable operations.

 

Inaddition, the cost of services and supplies for the PHD System currentlyexceeds the market price as a result of the need to have a local presence offield service and clinical service personnel in each geographical area that PHDSystems are sold.  Although we anticipatethat as more PHD units are placed in these geographical areas the per unit cost of services and supplies will decrease, therecan be no assurance that we will be successful in placing a sufficient numberof PHD units in the field to achieve these per unit cost reductions.  Furthermore, the PHD System is comprised ofnew, complex, highly automated technologies, which operate in a rigorousprocess.  While we continue to realizeimprovements in the PHD System’s reliability as a result of the acquisition anddevelopment of new parts and subsystems, there can be no assurance that we willbe successful in reaching industry norms for reliability.  If we are unable to improve the reliabilityof the PHD System, our operating costs will be adversely impacted and we maynot achieve profitability as a result.

 

If aPHD is unavailable for treatments for more than a few days, the patient assignedto the machine must go back to his dialysis clinic for in-center treatmentuntil his PHD is repaired.  Although wehave experienced infrequent incidents of patients on the PHD System needing togo back in center for treatments to date, we cannot assure you, based on ourlimited experience, that such incidents will not occurmore frequently in the future.

 

***Our business will fail if we cannot successfully commercialize the PHDSystem; because we have only recently begun this commercialization process, oursuccess cannot be predicted and is uncertain. Our success is dependent on many variables entirely outside of ourcontrol.***

 

Acceptanceof the PHD System in the marketplace by both potential users and purchasers(two separate groups with at times conflicting interests) is uncertain, andfailure to achieve sufficient market acceptance will significantly limit ourability to generate revenue and become profitable.  The success of the PHD System is dependent onmany variables, including its safety, effectiveness and cost-effectiveness asan alternative dialysis modality.  Thefailure to conclusively demonstrate each of these factors could significantlyhinder market acceptance of our PHD System, and the failure of our PHD Systemto achieve sustained commercial viability or market acceptance would have amaterial adverse effect on us and your investment in Aksys.  Moreover, successful commercialization willdepend upon, among other things, market acceptance of the efficacy of dailyhemodialysis.  This will requiresubstantial marketing efforts and the expenditure of significant funds by us toinform nephrologists, dialysis clinics, other healthcare providers and dialysispatients of the benefits of daily hemodialysis, and thus the benefits of thePHD System.

 

Inmarketing the PHD system, we may encounter significant clinical and marketresistance to:

 

•                  using the PHD System;

•                  home hemodialysis, which is currently employed by only a smallpercentage of patients suffering from end-stage renal disease; and

•                  daily hemodialysis, which to our knowledge has never been awidely accepted dialysis alternative.

 

Therecan be no assurance that our efforts will be successful or that the PHD Systemwill ever achieve market acceptance.  Inaddition, the PHD System is a personal system, designed for use by a singlepatient, and requires several hours after a dialysis treatment to prepareitself for the next treatment session. As such, it is very unlikely to

 

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be used in the prevailing method of outpatienthemodialysis, which generally involves treating patients three times per weekfor treatment sessions lasting between three and four hours. In this prevailingmethod of hemodialysis, patients receiving treatment on a given day are treatedin shifts, with patients on succeeding shifts using dialysis machines employedduring prior shifts.

 

A numberof other factors will affect the future success and sales of our product. Thesefactors include:

 

•                  the amount of government and private reimbursement for dialysistreatment;

•                  whether the system will be safe or effective or that it will be cost-effectiverelative to other dialysis treatment alternatives;

•                  whether daily hemodialysis will be shown to be more clinicallyeffective than alternative dialysis modalities;

•                  whether patients will be reluctant to administer and monitor the PHDSystem with limited or no supervision; and

•                  whether there are unexpected side effects, complications or othersafety issues associated with daily hemodialysis (or the PHD System) that mayadversely affect the market for our products and services.

 

***We are entirely dependent on the PHD System, our sole product.***

 

Sinceour inception, we have devoted substantially all of our efforts to thedevelopment of the PHD System. We expect to be entirely dependent for theforeseeable future on sales of, and services relating to, the PHD System forrevenues.  Our dependence on a singleproduct creates significant risk for our company and stockholders.

 

***Uncertainty and amount of third-party reimbursement could affect ourprofitability.***

 

Althoughmost private insurance policies cover a substantial portion of the cost ofdialysis treatment in the United States, most patients receiving dialysistreatment in the United States are insured by Medicare or Medicaid.  Medicare and Medicaid provide reimbursementfor dialysis treatment at set composite rates, which have not increasedsignificantly since 1983.  There can beno assurance that the current limitations or requirements on Medicare andMedicaid reimbursement for dialysis will not have a materially adverse effecton the market for the PHD System, that health administration authoritiesoutside of the United States will provide reimbursement at acceptable levels orat all or that current or future reimbursement rates will be sufficient toenable us to maintain prices at levels sufficient to become profitable.

 

***Competitors and technological advances could cause us to lose currentand future business opportunities and materially harm our results of operationsand ability to grow.***

 

Thedialysis industry is characterized by competition for financing, executivetalent, intellectual property and product sales.  Most of our competitors have substantiallygreater financial, scientific and technical resources, research and developmentcapabilities, manufacturing and marketing resources, technical and servicenetworks and experience than us, and greater experience in developing products,providing services and obtaining regulatory approvals.  If our competitors succeedin developing products that are more effective and/or less costly than the PHD System,our sales as well as our prospects for achieving profitability may be adverselyimpacted.  We also expect that thenumber of our competitors and potential competitors will increase.  There can be no assurance that we will beable to compete successfully against any existing or potential competitors.

 

In orderto compete effectively, we will need, among other things, to demonstrate theclinical and cost effectiveness of daily home hemodialysis using the PHDSystem.  Our ability to successfullymarket our products and services could be adversely impacted by pharmacologicaland technological advances in preventing the progression of ESRD in patients(such as those with diabetes and hypertension), technological developments byothers, development of new medications designed to reduce the incidence ofkidney transplant rejection and progress in using kidneys harvested fromgenetically-engineered animals as a source of transplants.

 

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***If we cannot develop adequate distribution, customer service andtechnical support networks, we may not be able to market and distribute our PHDSystem effectively.***

 

Our strategyinvolves contracting with dialysis providers to have us supply to dialysispatients the PHD System, dialysate and other consumables, patient training,customer service and maintenance and other technical service.  To provide these services, we must developnetworks of employees or independent contractors in each of the areas in whichwe intend to operate.  There can be noassurance that we will be able to organize these networks on a cost-effectivebasis.  The failure to establish thesenetworks on a cost-effective basis would have a materially adverse effect on ourresults of operations.

 

***Our future sales could be adversely affected due to our limitedmarketing experience.***

 

Wecurrently market our products and services primarily through our own salesforce.  We have limited experience insales, marketing and distribution.  Therecan be no assurance that we will be able to build an adequate marketing staffor sales force or that the cost of such will not be prohibitive, or that ourdirect sales and marketing efforts will be successful.

 

***We are subject to extensive government regulation, which can be costly,time consuming and subject us to unanticipated interruptions or delays in ourcommercial operations.***

 

The PHDSystem, our sole product, is subject to stringent government regulation in theUnited States and other countries.  Inthe United States, the PHD System is regulated as a medical device by theFDA.  In March 2002, we announced receiptof clearance from the FDA to market the PHD System in the United States.  The FDA clearance had no restrictions andincluded authorization to use the product in the home; however, FDA clearanceunder 510(k) is subject to continual review and later discovery of previouslyunknown problems may result in restrictions on product marketing or withdrawalof the product from the market.

 

In theEuropean Economic Area, the PHD System is regulated as a medical device underthe Medical Device Directive.  In October2002, we announced receipt of EC Certification for CE Mark approval pursuant tothe Medical Device Directive.  Thecertification approved the PHD System for home use.  Such approval was required prior to thecommercialization of the PHD System in the European Economic Area.

 

Additionalgovernment regulations may be established or imposed in the United States orthe European Economic Area, or the interpretation or enforcement of suchregulations may change, which could materially impact the regulatory clearanceswe have received for the PHD System and its continued commercialization.

 

Inaddition, various statutes and regulations also govern the testing, labeling,storage, record keeping, distribution, sale, marketing, advertising andpromotion of our products, which present significant compliance burdens for ourcompany.  Failure to comply withapplicable requirements can result in fines, recalls or seizures of products,total or partial suspension of production, withdrawal of existing productapprovals or clearances, refusal to approve or clear new applications or noticesand criminal prosecution.

 

Themanufacture of the PHD System must also comply or ensure compliance withcurrent QSR regulations promulgated by the FDA. We may be required to expend time, resources and effort in productmanufacturing and quality control to ensure compliance even though our PHDSystem is manufactured currently by an independent contractor.  If violations of the applicable regulationsare noted during FDA inspections of manufacturing facilities, it may have amaterially adverse effect on the continued marketing of our products.

 

Youshould also be aware that proper regulatory approvals have not been completedin any jurisdictions other than the United States and the European EconomicArea.  There can be no assurance orguarantee that any of these approvals will be obtained in a timely manner or atall.

 

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***We rely on independent contract manufacturers for the manufacture ofour PHD System.  Our inability tomanufacture the PHD System, and our dependence on independent contractors, maydelay or impair our ability to generate revenues, or adversely affect ourprofitability.***

 

To besuccessful, our PHD System must be manufactured in commercial quantities and atacceptable cost.  Production of thisproduct, especially in commercial quantities, will create technical as well asfinancial challenges for us.  We may encounterunexpected delays or costs in the scale-up of manufacturing operations.  Further, manufacturing or quality controlproblems may arise (and among other things increase our costs) as we increaseproduction of the PHD System or as additional manufacturing capacity isrequired in the future.

 

Wecurrently rely on single contract manufacturers to manufacture each of themajor components of the PHD System.  Suchcontractors are not employed or otherwise controlled by us and are generallyfree to conduct their business at their own discretion.  Although certain of our contractmanufacturers have entered into contracts with us to manufacture components ofthe PHD System, such contracts can be terminated at any time under certaincircumstances by us or by the contractors, and can be breached at anytime.  Further, work stoppages and theslowing of production at a single independent contractor would have amaterially adverse effect on our results of operations.

 

Thereare also other risks inherent in using single sources of supply.  We have not made alternative arrangements forthe manufacture of the major components of the PHD System and we may not beable to implement acceptable alternative arrangements on a timely basis, or atall.  It is likely that a significantinterruption in supply would result if we utilize or were required to utilize adifferent manufacturing contractor for any of the major components of the PHDSystem.  The loss of the services of anyof our contract manufacturers would have a materially adverse effect on ourresults of operations.  In addition, weor our manufacturers may not be able to obtain, on a timely basis, componentsor other supplies necessary to manufacture or use the PHD System.

 

***We will need additional capital in the future which, if not availableto us, may alter our business plans or limit our ability to achieve growth andwhich, if raised, will dilute your ownership interest in us.***

 

Ourcapital requirements have been and will continue to be significant.  Prior to the payments we received in Februaryand May 2004 in connection with the Durus settlement, we have been dependentprimarily on the net proceeds of public and private sales of our equitysecurities.  See “Management’s Discussionand Analysis of Financial Condition and Results of Operations — Liquidity andCapital Resources — Recent Financing Activities.”  Our proceeds to date from equity offeringsare approximately $152 million.  Wecurrently have no committed sources of, or other arrangements with respect to,additional financing.  We do not believethat our existing capital resources, together with future operating cash flows,will be sufficient to fund our future operations through 2006.  Our capital requirements will depend on manyfactors, including without limitation:

 

•                  manufacturing scale-up and associated costs;

•                  costs associated with establishing marketing, distribution, patienttraining and technical and patient support networks;

•                  continued progress in research and development; and

•                  the costs involved in protecting our proprietary rights.

 

During2005, we expect that approximately $30 to $32 million of cash and short andlong term investments will be devoted to expanding commercialization of the PHDsystem.  Based on our cash position andshort and long term investments as of December 31, 2004, and projected usagesin 2005, we currently anticipate that we will seek to raise capital in thelatter half of 2005 or early 2006.  Asdiscussed under “Management’s Discussion and Analysis of Financial Condition andResults of Operations — Liquidity and Capital Resources — Recent FinancingActivities,” under the terms of our settlement with the Durus funds, we areprohibited from registering shares of our common stock until May 2005 (or insome instances longer if the Durus funds have commenced an offering of theirshares, in which case we may be subject to a lock-up period under ourregistration rights agreement with the Durus funds).  Because the Durus funds continue to own approximately72% of our common stock and we are still in the early stages of ourcommercialization efforts, we may not be able to raise sufficient capital tofund our operations beyond

 

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2005.  In the event that we are able to raisecapital through additional issuances of our equity securities, our thenexisting stockholders may suffer substantial dilution, and any debt financingwe may be able to obtain could result in the imposition of significantfinancial and operational restrictions on us.

 

***We may not be able to protect our intellectual property rights and, asa result, we could lose competitive advantages that could adversely affect ouroperating results.***

 

Oursuccess depends, in part, on our ability and the ability of our licensors to obtain,assert and defend patent rights, protect trade secrets and operate withoutinfringing the proprietary rights of others. We currently own or have rights to 45 U.S. patents and 28 foreignpatents.  There can be no assurance,however, that:

 

•                  we will be able to obtain additional licenses to patents of others orthat we will be able to develop additional patentable technology of our own;

•                  any patents issued to us will provide us with competitive advantages orthat the patents or proprietary rights of others will not have an adverseeffect on our ability to do business;

•                  others will not independently develop similar products;

•                  others will not design around or infringe such patents or proprietaryrights owned by or licensed to us; and

•                  any patent obtained or licensed by us will be held to bevalid and enforceable if challenged by another party.

 

We areaware that numerous patents have been issued relating to methods ofdialysis.  Although we endeavor toprotect our patent rights from infringement, it is possible that by virtue ofthe numerous patents that have been, or potentially will be, issued relating tohemodialysis methods, we may not be aware, or become aware, of patents issuedto our competitors or others that conflict with our own or those of ourlicensors.  Such conflicts could resultin a rejection of important patent applications or the invalidation ofimportant patents, which could have a materially adverse effect on ourcompetitive position.  In the event ofsuch conflicts, or in the event we believe that competitive products infringepatents to which we hold rights, we may pursue patent infringement litigationor interference proceedings against, or may be required to defend against suchlitigation or proceedings involving, holders of such conflicting patents orcompeting products.  Such litigation orproceedings may have a materially adverse effect on our competitive position,and we may not be successful in any such litigation or proceeding.  Litigation and other proceedings relating topatent matters, whether initiated by us or a third party, can be expensive andtime consuming, regardless of whether the outcome is favorable to us, and canresult in the diversion of substantial financial, managerial and otherresources.  An adverse outcome couldsubject us to significant liabilities to third parties or require us to ceaseany related development or commercialization activities.  In addition, if patents that containdominating or conflicting claims have been or are subsequently issued to othersand such claims are ultimately determined to be valid, we may be required toobtain licenses under patents or other proprietary rights of others.  The licenses required under any such patentsor proprietary rights may not be made available on terms acceptable to us, ifat all.  If we do not obtain suchlicenses, we could encounter delays or could find that the development,manufacture or sale of products requiring such licenses is foreclosed which mayadversely effect our results of operations.

 

We relyon proprietary know-how and confidential information and employ variousmethods, such as entering into confidentiality and noncompete agreements withour current employees and with certain third parties to whom we have divulgedproprietary information, to protect the processes, concepts, ideas anddocumentation associated with our technologies. Such methods may not afford significant protection to us, and we may notbe able to protect adequately our trade secrets or our competitors or othercompanies may acquire information that we consider proprietary.

 

***Product liability claims may reduce demand for the PHD System or resultin damages that exceed our insurance coverage.***

 

Ourbusiness exposes us to potential product liability risks that are inherent inthe production, marketing and sale of dialysis products.  We currently maintain product liabilityinsurance with a coverage limit of $10 million. Our

 

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insurance policy may not provide adequate protection againstpotential claims.  Furthermore, ouragreements with contract manufacturers require us to maintain product liabilityinsurance, and the failure to obtain such insurance could materially andadversely affect our ability to produce our PHD System.  A successful claim brought against us inexcess of any insurance coverage obtained by us could have a materially adverseeffect upon our business, financial condition and results of operations.  In addition, we have agreed to indemnifycertain of our contract manufacturers against certain liabilities resultingfrom the use of our PHD System.

 

***Our business is likely to be hurt if we are unable to keep our seniorexecutive officers and key scientific personnel.***

 

We aredependent upon the services of our senior executives, such as William C. Dow,our President and Chief Executive Officer, and key scientific personnel.  We do not maintain key-man life insurance onour senior executives.  In addition, wedo not have employment agreements, other than certain severance,confidentiality and non-competition agreements, with any of our personnel.  Our business would likely be interrupted ifwe lost the services of Mr. Dow or other senior executives or key employees,which could have a materially adverse effect on operations.  Also, our continued commercialization willdepend upon, among other things, the successful recruiting and retention ofhighly skilled managerial and marketing personnel with experience in businessactivities such as those we contemplate. Competition for the type of highly skilled individuals sought by us isintense, and we may not be able to retain existing employees or find, attractand retain other skilled personnel on acceptable terms.

 

**RisksRelated to Our Common Stock**

 

***The market price of our common stock may be subject to significantvolatility.***

 

Theprice of our common stock may fluctuate widely depending upon many factors,including our perceived prospects and those of the dialysis market ingeneral.  Since our initial publicoffering in May 1996, our common stock price has traded between $3.50 and$23.50 per share and we have generally experienced relatively low tradingvolume in relation to the aggregate number of shares outstanding.

 

Factorsthat may have a significant impact on the market price or liquidity of ourcommon stock include:

 

•                  reports by official or unofficial health or medical authorities, thegeneral media or the FDA regarding the potential benefits or detriments of ourPHD System or of similar products distributed by other companies, or of dailyor home dialysis;

•                  announcements of technological innovations or new products by us or ourcompetitors;

•                  events or announcements relating to our relationships with others,including our third party manufacturers;

•                  developments or disputes concerning patents or proprietary rights;

•                  regulatory developments in both the United States and foreigncountries;

•                  economic and other factors, as well as period-to-period fluctuations inour financial results; and

•                  sales of our common stock by the Durus fund.

 

Externalfactors may also adversely affect the market price for the common stock.  The common stock currently trades on theNasdaq National Market.  The price andliquidity of the common stock may be significantly affected by the overall tradingactivity and market factors on the Nasdaq National Market.

 

Futuresales of substantial amounts of our common stock in the public market and theexistence of a substantial number of authorized but unissued shares of ourcommon stock could adversely affect market price of the common stock, and alsocould impair our ability to raise additional capital through the sale of ourequity securities.

 

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***The resale by the Durus fund of a substantial number of shares of ourcommon stock could adversely impact the market price of our common stock.***

 

Based on information contained in a Schedule 13D filed by the Durusfund with the SEC on November 19, 2004, we believe the Durus fund owns21,498,118 shares of our common stock, representing approximately 72% of ouroutstanding shares.  We have filed aregistration statement covering these shares and 498,100 shares held by theArtal fund.  This registration statementwas declared effective by the SEC on May 17, 2004, and enables the Durus fundand the Artal fund to resell their shares in public offerings at theirdiscretion.  As a part of the settlement,the Durus fund has agreed that it will reduce its ownership of our common stockover time and that its position in our common stock would be under 15% withintwo years after the registration statement has become effective, subject toextensions under specified circumstances. See “Management’s Discussion and Analysis of Financial Condition andResults of Operations — Liquidity and Capital Resources — Recent FinancingActivities.”  Although we believe thatthe Durus fund and the Artal fund will effectuate the sale of their shares inan orderly manner and will seek to obtain the best prices available inconnection with any sales, the timing, volume and manner of any sales is withintheir discretion.

 

TheDurus fund and the Artal fund’s sale of their shares may have a negative effecton the market price of our common stock due to, among other factors, theselling pressure such sales may cause. Moreover, the perception in the market that a significant portion of ouroutstanding shares may soon be sold may also have a negative effect on themarket price of our common stock.  Theseevents may cause other holders of our common stock to sell their shares, or itmay encourage short sales, all of which could contribute to a decline in themarket price of our stock.  In addition,these factors may have a materially adverse effect on our ability to raisecapital through the issuance of our equity securities.

 

***We do not intend to pay cash dividends on our common stock in theforeseeable future.***

 

We havenever declared or paid any cash dividends on our common stock.  For the foreseeable future, we intend toretain any earnings to finance the development of our business, and we do notanticipate paying any cash dividends on our common stock.  Payment of any future dividends on our commonstock will depend upon our earnings and capital requirements, the terms of anyindebtedness we incur and other factors our board of directors considersappropriate.

 

***We will likely issue additional shares of our common stock and/orpreferred stock in the future, which would dilute your voting and ownershippercentage.***

 

Certainevents over which you have no control could result in the issuance ofadditional shares of our common stock, which would dilute your voting andownership interest in our Company.  As ofFebruary 28, 2005, there were 29,901,275 shares of our common stock issued andoutstanding and there were 675,424 shares of common stock reserved for issuanceunder our equity incentive and stock purchase plans.  As of February 28, 2005, there wereoutstanding options, warrants and other rights to acquire up to approximately2,986,611 shares of common stock.  We mayalso issue additional shares of common stock or preferred stock:

 

•                  to raise additional funds for working capital, commercialization,production and marketing activities;

•                  upon the exercise or conversion of outstanding options and warrants;and

•                  in lieu of payment of cash dividends.

 

Underthe terms of the registration rights agreement we entered into with the Durusfund and the Artal fund, we may not register shares of our capital stock forour own account or for the account of another third party until May 2005 (or insome instances longer if these shareholders have commenced an offering of theirshares, in which case we may be subject to a lock-up period under our ownregistration rights agreement with them). See “Management’s Discussion and Analysis of Financial Condition andResults of Operations — Liquidity and Capital Resources — Recent FinancingActivities.”  We anticipate that sometimeafter this period, we will need to issue shares of capital stock in order tofund our operations.

 

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***Our charter documents, rights agreement and Section 203 of the DGCLcould make it more difficult for a third party to acquire us.***

 

OurRestated Certificate of Incorporation (“Charter”) and Amended and Restated Bylaws(“Bylaws”) contain certain provisions that are intended to enhance thelikelihood of continuity and stability in the composition of our board ofdirectors and which may have the effect of delaying, deferring or preventing afuture takeover or change in control of the Company unless the takeover orchange of control is approved by our board of directors.  Such provisions may also render the removalof the current board of directors and of management more difficult.  These provisions provide for, among otherthings:

 

•                  a classified board of directors;

•                  “fair price” provision, which requires that our stockholders receiveequivalent consideration at both stages of a two-step acquisition (such as atender offer followed by a merger);

•                  a prohibition on stockholder action through written consents;

•                  a requirement that special meetings of stockholders be called only byour board of directors or our chief executive officer;

•                  advance notice requirements for stockholder proposals and nominations;

•                  limitations on the ability of stockholders to amend, alter or repealour Charter or our Bylaws; and

•                  the authority of our board of directors to issue, without stockholderapproval, preferred stock with such terms as the board of directors maydetermine.

 

Eachoutstanding share of our common stock includes one preferred stock purchaseright (individually a “Right” and collectively the “Rights”) as provided underour Rights Agreement.  Each Rightentitles the holder, until the earlier of October 28, 2006 or the redemption ofthe Rights, to purchase one one-thousandth of a share of Junior ParticipatingPreferred Stock, Series A, par value $1.00 per share (the “Series A PreferredStock”), at a price of $85.00 per one one-thousandth of a share (as may beadjusted to reflect stock splits, stock dividends or certain other dilutiveevents since the issuance of the Rights). The Series A Preferred Stock is nonredeemableand will have 1,000 votes per share (subject to adjustment).  We have reserved 50,000 shares of Series A Preferred Stock for issuance upon exercise of suchRights.  In the event that any personbecomes the beneficial owner of 15% or more of our common stock, the Rights(other than Rights held by the acquiring stockholder) would become exercisablefor a number of shares of common stock having a market value of two times theexercise price of the Right. Furthermore, if after any person becomes the beneficial owner of 15% ormore of our common stock, we are acquired in a merger or other businesscombination or 50% or more of our assets or earnings power were sold, eachRight (other than Rights held by the acquiring person) would become exercisablefor that number of shares of common stock (or securities of the survivingcompany in a business combination) having a market value of two times theexercise price of the Right.

 

OneRight will be issued in respect of each share of common stock issued before theearlier of October 28, 2006 or the redemption of the Rights.  As of the date hereof, the Rights are notexercisable, certificates representing the Rights have not been issued and theRights automatically trade with shares of common stock.

 

TheRights have certain anti-takeover effects. The Rights may cause substantial dilution to a person that attempts toacquire the Company on terms not approved by the board of directors, exceptpursuant to an offer conditioned on a substantial number of Rights beingacquired.  The Rights should notinterfere with any merger or other business combination approved by the boardof directors prior to the time a person has acquired beneficial ownership of15% or more of the common stock, because until such time the Rights maygenerally be redeemed by the Company at one cent per Right.

 

Asdiscussed under “Management’s Discussion and Analysis of Financial Conditionand Results of Operations — Liquidity and Capital Resources — Recent FinancingActivities,”  wehave amended our Rights Agreement to conditionally exempt the Durus fund andthe other defendants therefrom.

 

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We aresubject to the “business combination” statute of the General Corporation Law ofthe State of Delaware (the “DGCL”).  Ingeneral, Section 203 of the DGCL prohibits a publicly-held Delawarecorporation from engaging in a “business combination” with an “interestedstockholder,” for a period of three years after the date of the transaction inwhich a person became an “interested stockholder,” unless:

 

•                  prior to such date the board of directors of the corporation approvedeither the “business combination” or the transaction which resulted in thestockholder becoming an “interested stockholder,”

•                  upon consummation of the transaction which resulted in the stockholderbecoming an “interested stockholder,” the “interested stockholder” owns atleast 85% of the voting stock of the corporation outstanding at the time thetransaction commenced, excluding for purposes of determining the number ofshares outstanding those shares owned (1) by persons who are directors andalso officers and (2) employee stock plans in which employee participantsdo not have the right to determine confidentially whether shares held subjectto the plan will be tendered in a tender or exchange offer, or

•                  on or subsequent to such date the “business combination” is approved bythe board of directors and authorized at an annual or special meeting ofstockholders by the affirmative vote of at least 66(2)/3%of the outstanding voting stock which is not owned by the “interestedstockholder.”

 

A “businesscombination” includes mergers, stock or asset sales and other transactionsresulting in a financial benefit to the “interested stockholders.”  An “interested stockholder” is a person who,together with affiliates and associates, owns (or within three years, did own) 15%or more of the voting stock of the subject corporation.  Although Section 203 permits us to electnot to be governed by its provisions, we have not made this election.  As a result of the application ofSection 203, potential acquirors of our company may be discouraged fromattempting to effect an acquisition transaction with us, thereby possiblydepriving holders of our securities of certain opportunities to sell orotherwise dispose of such securities at above-market prices pursuant to suchtransactions.

 

The foregoing summaries do not purport to be complete and are subjectto, and are qualified in their entirety by reference to, our Charter andBylaws, our Rights Agreement and the DGCL. Copies of our Charter, Bylaws and Rights Agreement are filed as exhibitsto filed as exhibits to this report and deemed to beincorporated herein in their entirety.

 

#### **PARTII**

#### ** **

**Item 5.****  Market forthe Registrant’s Common Stock and Related Stockholder Matters.**

 

Our common stock trades on the Nasdaq National Market under the symbol “AKSY”.  The following table lists the quarterly highand low prices of the common stock for the period from January 1, 2003 throughDecember 31, 2004.

 

| **Fiscal  Year** | ** ** | **Fiscal  Quarter** | ** ** | **High  Closing  Price** | ** ** | **Low  Closing  Price** | ** ** |
|------------------|------------|---------------------|------------|--------------------------|------------|-------------------------|------------|
| 2004             |       | 1st                 |       | $                        | 10.97      |                    | $          | 6.12 |   |
|             |       | 2nd                 |       | 6.99                     |       | 4.40                    |       |
|             |       | 3rd                 |       | 6.23                     |       | 4.56                    |       |
|             |       | 4th                 |       | 6.93                     |       | 4.69                    |       |
|             |       |                |       |                     |       |                    |       |
| 2003             |       | 1st                 |       | $                        | 7.17       |                    | $          | 4.79 |   |
|             |       | 2nd                 |       | 12.90                    |       | 7.00                    |       |
|             |       | 3rd                 |       | 15.75                    |       | 7.60                    |       |
|             |       | 4th                 |       | 10.05                    |       | 6.62                    |       |

 

There were 212 stockholders of record of our common stock as of March4, 2005.  In addition, we estimate thatthere were approximately 4,800 holders of our common stock at February 28,2005, who held shares in “street name.” We

 

26

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have not paid cash dividends to date, and managementanticipates that all future earnings will be retained for development of ourbusiness.

 

**EquityCompensation Plan Information**

 

Thefollowing table sets forth information about the Company’s common stock thatmay be issued under all of the Company’s existing equity compensation plans asof December 31, 2004, including the 1993 Stock Option Plan, the 1996 StockAwards Plan and the 2001 Employee Stock Purchase Plan.

 
| **Plan category**                                               | ** ** | **(a)  Number of securities to be  issued upon exercise of  outstanding options,  warrants or rights** | ** ** | **(b)  Weighted-average  exercise price of  outstanding options,  warrants or rights** | ** ** | **(c)  Number of securities  remaining available for  future issuance under  equity compensation plans  (excluding securities  reflected in column (a))** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                      | ** ** | ** **                                                                                             | ** ** | ** **                                                                             | ** ** | ** **                                                                                                                                                | ** ** |
| **Equity compensation plans approved by  security holders**     |       | 2,051,181                                                                                              |       | $                                                                                      | 6.814      |                                                                                                                                                      | 871,662    |   |
| **Equity compensation plans not approved by  security holders** |       | None                                                                                                   |       | N/A                                                                                    |       | None                                                                                                                                                      |       |
| ** **                                                      |       |                                                                                                   |       |                                                                                   |       |                                                                                                                                                      |       |
| **Total**                                                       |       | 2,051,181                                                                                              |       | $                                                                                      | 6.814      |                                                                                                                                                      | 871,662    |   |

 

**Item 6.****  Selected Financial Data*.***

 

The selected statements of operations data as of December 31, 2004,2003 and 2002 and balance sheet data as of December 31, 2004 and 2003 set forthbelow have been derived from our audited financial statements included as Item8 to this Annual Report on Form 10-K. The selected statements of operations data as of December 31, 2001 and2000 and balance sheet data as of December 31, 2002, 2001 and 2000 set forthbelow have been derived from our audited financial statements that have notbeen included in this Annual Report on Form 10-K.  Our historical financial data is notnecessarily indicative of future results and should be read in conjunction withthe financial statements and notes thereto and “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” included elsewherein this Annual Report on Form 10-K.

 

27

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| ** **                                     | ** ** | **2004**    | ** **  | **2003**    | ** ** | **2002(1)**       | ** ** | **2001**    | ** **        | **2000**    | ** ** |
|------------------------------------------------|------------|-------------|-------------|-------------|------------|-------------------|------------|-------------|-------------------|-------------|------------|
| **Consolidated Statement of Operations Data:** | ** ** | ** **  | ** **  | ** **  | ** ** | ** **        | ** ** | ** **  | ** **        | ** **  | ** ** |
| Revenues:                                      |       |        |        |        |       |              |       |        |              |        |       |
| Product                                        |       | $           | 1,457,704   |        | $          | 1,192,706         |       | $           | 276,680           |        | $          | — |   | $ | — |   |
| Service and supplies                           |       | 958,355     |        | 298,757     |       | 21,986            |       | —      |              | —      |       |
| Joint development income                       |       | —      |        | —      |       | —            |       | —      |              | 3,434,809   |       |
| Total Revenue                                  |       | 2,416,059   |        | 1,491,463   |       | 298,666           |       | —      |              | 3,434,809   |       |
|                                           |       |        |        |        |       |              |       |        |              |        |       |
| Cost of sales:                                 |       |        |        |        |       |              |       |        |              |        |       |
| Product                                        |       | 4,795,181   |        | 4,349,091   |       | 1,996,654         |       | —      |              | —      |       |
| Service and supplies                           |       | 5,867,759   |        | 3,343,102   |       | 774,274           |       | —      |              | —      |       |
| Total Cost of sales:                           |       | 10,662,940  |        | 7,692,193   |       | 2,770,928         |       | —      |              | —      |       |
|                                           |       |        |        |        |       |              |       |        |              |        |       |
| Operating costs and expenses:                  |       |        |        |        |       |              |       |        |              |        |       |
| Research and development                       |       | 6,684,465   |        | 5,474,220   |       | 5,522,772         |       | 10,882,796  |              | 14,541,873  |       |
| Sales and marketing                            |       | 4,791,684   |        | 4,188,939   |       | 2,305,110         |       | 1,753,499   |              | 1,025,315   |       |
| General and administrative                     |       | 7,388,863   |        | 6,676,665   |       | 5,699,356         |       | 5,121,223   |              | 4,738,737   |       |
| Total operating expenses                       |       | 18,865,012  |        | 16,339,824  |       | 13,527,238        |       | 17,757,518  |              | 20,305,925  |       |
|                                           |       |        |        |        |       |              |       |        |              |        |       |
| Operating loss                                 |       | (27,111,893 | )           | (22,540,554 | )          | (15,999,500       | )          | (17,757,518 | )                 | (16,871,116 | )          |
| Other income and expense, net                  |       | (466,084    | )           | 258,076     |       | 294,956           |       | 515,892     |              | 1,159,961   |       |
|                                           |       |        |        |        |       |              |       |        |              |        |       |
| Income tax expense                             |       | (105,512    | )           | —      |       | —            |       | —      |              | —      |       |
|                                           |       |        |        |        |       |              |       |        |              |        |       |
| Net loss                                       |       | $           | (27,683,489 | )           | $          |  (22,282,478 | )          | $           |  (15,704,544 | )           | $          | (17,241,626 | ) | $ | (15,711,155 | ) |
|                                           |       |        |        |        |       |              |       |        |              |        |       |
| Net loss per share(2)                          |       | $           |  (0.93 | )           | $          |  (0.79       | )          | $           | (0.65             | )           | $          |  (0.94 | ) | $ |  (0.93 | ) |
|                                           |       |        |        |        |       |              |       |        |              |        |       |
| Weighted average shares outstanding(2)         |       | 29,825,659  |        | 28,218,819  |       | 24,301,029        |       | 18,418,410  |              | 16,934,532  |       |

 
| ** **                                         | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|------------------|------------|
| ** **                                         | ** ** | **2004**         | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| **Consolidated Balance Sheet Data:**               | ** ** | ** **       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash, cash equivalents and short-term  investments |       | $                | 31,116,769 |   | $ | 20,175,097 |   | $ | 11,509,757 |   | $ | 11,249,935 |   | $ | 19,121,697 |   |
| Working capital                                    |       | 32,611,166       |       | 20,392,362 |   | 11,872,340 |   | 10,548,397 |   | 16,636,100 |   |
| Total assets                                       |       | 52,945,441       |       | 29,638,151 |   | 16,509,492 |   | 14,454,503 |   | 22,188,020 |   |
| Long-term liabilities(3)                           |       | 13,754,784       |       | 177,253 |   | 147,644 |   | 159,061 |   | 158,444 |   |
| Accumulated deficit                                |       | (156,612,489     | )          | (128,929,000 | ) | (106,646,522 | ) | (90,941,978 | ) | (73,700,352 | ) |
| Total stockholders’ equity                    |       | 31,007,431       |       | 23,128,062 |   | 13,647,629 |   | 12,603,629 |   | 19,349,018 |   |
|                                                    |            |                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)   The Companycommenced commercial activities during the quarter ended September 30, 2002 andwas no longer considered to be in the developmentstage.

(2)   Computed on thebasis described in Note 1 of Notes to Consolidated Financial Statements.

(3)   Consists primarilyof long term notes payable and a long-term relocation reserve to cover costsassociated with moving PHDs from one patient to another.

 

28

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**Item 7.****  Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

 

**Overview**

 

Since our inception in January 1991, we have been engaged in thedevelopment of hemodialysis products and services for patients suffering fromESRD.  We have developed an automatedpersonal hemodialysis system, known as the Aksys PHDäPersonal Hemodialysis System (the “PHD System”), which is designed to enablepatients to perform frequent hemodialysis at alternate sites (such as their ownhomes) and to thereby improve clinical outcomes, reduce total ESRD treatmentcosts and enhance the quality of life of patients.  During the quarter ended September 30, 2002,we commenced commercial activities and were no longer considered to be in thedevelopment stage.  We have not beenprofitable since we commenced operations and we expect to incur additionallosses in the foreseeable future.

 

On March 27, 2002, we announced receipt of FDA clearance to market thePHD System in the United States.  The FDAclearance had no restrictions and included authorization to use the product inthe home. The FDA required 510(k) clearance prior to the commercialization ofthe PHD System in the United States.

 

On October 7, 2002, we announced receipt of EC Certification for CEMark approval pursuant to the Medical Device Directive of the European EconomicArea.  The certification approved the PHDSystem for home use.  Such approval wasrequired prior to the commercialization of the PHD System in the EuropeanEconomic Area.

 

**Critical Accounting Policies and Estimates**

 

The preparation of financial statements requires management to makeestimates and assumptions that affect amounts reported therein.  We believe the following critical accountingpolicies affect our more significant judgments and estimates used in thepreparation of our consolidated financial statements:

 

*Revenue recognition*

 

We recognize revenue in accordance with Staff Accounting Bulletin (SAB)No. 104, *Revenue Recognition*, and its relatedinterpretations.  Revenue is recognizedwhen the following conditions exist: (1) there is persuasive evidence of anarrangement, (2) the product has been delivered and installed or services andsupplies have been provided to the customer, (3) the sales price is fixed ordeterminable and (4) collectability is reasonably assured.

 

During the quarter ended September 30, 2003, we adopted Emerging IssuesTask Force (EITF) Issue No. 00-21, *Accounting for RevenueArrangements with Multiple Deliverables*, which did not have animpact on our financial position, results of operations or cash flows.

 

We recognize revenue from product sales at the time of installation ofthe PHD System.  Services and suppliesare sold to customers in a monthly service agreement, not dependent on servicetime incurred or materials used. Services and supplies revenue is recognized uniformly over the term ofthe agreement.

 

We also lease the PHD System to customers on a short-term basis (12months or less) and long-term basis (up to 24 months) and recognize revenue onthese operating leases on a straight-line basis over the lease term.   We have no contracts with distributors andsell our product directly to our customers through our own sales force.

 

*Accrued liabilities and contingencies*

 

We are required to make certain estimates and assumptions that affectthe amounts recorded as accrued liabilities and contingencies.  We base our estimates on historicalexperience and on various other factors, such as changing business conditionsand management expectations, that we believe to bereasonable to determine the amount of

 

29

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accrued liabilities and contingencies to berecorded.  If actual results differ fromthese estimates, additional expenses might be recorded.

 

*Net deferred tax assets valuation*

 

We record our net deferred tax assets in the amount that we expect torealize based on projected future taxable income.  In assessing the appropriateness of ourvaluation, assumptions and estimates are required such as our ability togenerate future taxable income.  In theevent that we were to determine that we would be able to realize deferred taxassets in the future in excess of our net recorded amount, an adjustment to thedeferred tax asset would increase our income in the period such determinationwas made.   Given our historical lossesand uncertainty with respect to our ability to generate taxable income, we haveestablished a full valuation allowance at December 31, 2004 and 2003 to reduce thenet deferred tax asset to zero.

 

*Valuation of Inventories*

 

Inventories are stated at the lower of weighted average cost ormarket.  The weighted average cost ofinventory approximates the first-in, first-out method (FIFO) for allinventories.  Management performsperiodic assessments to determine the existence of obsolete inventory or todetermine if there has been a decline in the market value of inventory, andrecords necessary provisions to reduce such inventory to the net realizablevalue.

 

**Contractual Obligations**

 

The following table reflects a summary of our contractual cashobligations as of December 31, 2004:

 
| **Contractual Cash Obligations**       | ** ** | **Total** | ** ** | **Less than 1 year** | ** ** | **1-3 years** | ** ** | **3-5 Years** | ** ** | **More Than 5  Years** | ** ** |
|----------------------------------------|------------|-----------|------------|----------------------|------------|---------------|------------|---------------|------------|------------------------|------------|
| Long-Term Debt                         |       | $         | 16,100,000 |                 | $          | -0-           |       | $             | -0-        |                   | $          | 16,100,000 |   | $ | -0- |   |
| Short-Term Line of Credit              |       |      | 3,400,000  |                 |       | 3,400,000     |       | -0-           |       | -0-                    |       | -0- |   |
| Operating Leases                       |       |      | 3,204, 764 |                 |       | 437,256       |       |          | 796,258    |                   |       | 902,625 |   |   | 1,068,625 |   |
| Royalties                              |       |      | 1,777,255  |                 |       | 251,667       |       |          | 500,000    |                   |       | 500,000 |   |   | 525,588 |   |
| Purchase Obligations                   |       |      | 3,894,949  |                 |       | 3,894,949     |       | -0-           |       | -0-                    |       | -0- |   |
| **Total Contractual Cash Obligations** |       | $         | 28,376,968 |                 | $          | 7,893,872     |       | $             | 1,296,258  |                   | $          | 17,502,625 |   | $ | 1,594,213 |   |
|                                        |            |           |            |                      |            |               |            |               |            |                        |            |  |  |  |  |  |  |  |  |  |

 

We have a contractural obligation with the manufacturer of the PHDSystem to purchase additional parts at a total cost of approximately $3.9million.  We have placed a deposit withthe vendor for $3.4 million as of December 31, 2004.

 

**Off-Balance Sheet Arrangements**

 

We do not have any off-balance sheet arrangements, as such term isdefined in applicable SEC rules, that have or are reasonably likely to have acurrent or future effect on our financial condition, changes in financialcondition, revenues or expenses, results of operations, liquidity, capitalexpenditures or capital resources that are material to investors.

 

**Note on Forward-Looking Information**

 

Certain statements in this Annual Report on Form 10-K and in futurefilings made by us with the Securities and Exchange Commission and in ourwritten and oral statements made by or with the approval of an officer of oursconstitute “forward-looking statements” within the meaning of Section 27A ofthe Securities Act of 1933 and Section 21E of the Securities Exchange Act of1934, and we intend that such forward-looking statements be subject to the safeharbors created thereby.  The words “believes,”“expects,” “estimates,” “anticipates,” and “will be,” and similar

 

30

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words or expressions identifyforward-looking statements made by us or on our behalf.  These forward-looking statements reflect ourviews as of the date they are made with respect to future events and financialperformance, but are subject to many uncertainties and factors that may causeour actual results to be materially different from any future results expressedor implied by such forward-looking statements. Factors that could cause such a difference include, but are not limitedto, the following: (i) uncertainty about the acceptance of the PHD System byboth potential users and purchasers, including without limitation patients,clinics and other health care providers; (ii) risks related to uncertain unitpricing and product cost, which may not be at levels that permit us to beprofitable; (iii) market, regulatory, reimbursement and competitive conditions;(iv) risks related to a failure to meet additional development andmanufacturing milestones, including, without limitation, cost reductionefforts, for the PHD System on a timely basis, (v) our  ability to obtain sufficient capital on acceptableterms to run our business; (vi) risks inherent in relying on a third party tomanufacture the PHD System; (vii) changes in QSR requirements; and (viii) risksrelated to the disposition of our common stock by Durus Life Sciences MasterFund, Ltd. and its affiliates.

 

The forward –looking statements made in this report speak only as ofthe date that they are made.  We do notundertake to publicly update or revise our forward-looking statements even ifexperience or future changes make it clear that any projected results or eventsexpressed or implied therein will not be realized.

 

**Results of Operations**

 

***Year Ended December 31, 2004 Compared to Year Ended December31, 2003***

*** ***

Net loss for the year ended December 31, 2004 was $27.7 million ($0.93per share), compared with $22.3 million ($0.79 per share), for the year endedDecember 31, 2003.

 

Our cost to manufacture the PHD system exceeds its selling price, andour cost to service and supply active machines on a per-unit basis exceeds theper-unit revenue generated by those machines. The first full year in which we recorded sales was 2003.  As volumes increased from seven activemachines at year-end 2002, to 67 active machines at year-end 2003 and 118active machines at year-end 2004, our net loss has also increased.  We expect to rely primarily on reductions inthe production and service costs of the PHD System in order to realize apositive gross margin on sales.  Wecompleted cost reductions to the PHD System in late 2003 that reduced the costof the machine from approximately $60,000 to approximately $45,000.  We plan to redesign the PHD system, and whenthe new design is manufactured, we anticipate it will have a cost below thecurrent selling price.  We continue towork diligently to achieve manufacturing and service cost reductions on the PHDSystem.  However, these cost reductionplans and efforts may not be successful, and we may not be able to achieve apositive gross margin on product sales or service of the PHD System in thefuture.

 

Additional details as to our financial performance are discussed below.

 

Clinic Partnership Agreements.  We added 14 clinic partnership agreementsin the year ended December 31, 2004, bringing the total number of signedpartnership agreements to 44.  A typicalagreement provides for an initial market assessment and allows a clinic topurchase or lease on a long-term basis multiple units over time, with theoption to purchase service and supplies at an additional charge.  A customer may also enter into a short-termrental agreement.  In order to qualifyfor Medicare reimbursement, the customer is required to become homecertified.  We provide training to theclinics, which then provide training to patients.  We are available to support clinics orpatients 24 hours a day, seven days a week.

 

Revenue.  For the year ended December 31, 2004, revenuewas $2.4 million, a 60% increase from revenue of $1.5 million for the yearended December 31, 2003.  Product revenueof $1.5 million resulted from the sale of 27 PHD Systems and rental revenue on71 units.  This is an increase of $0.3million, or 25%, over 2003 when 28 machines were sold and there were 31 rentalunits and product revenue was $1.2 million.

 

Twenty-one of the product sales recorded in fiscal 2004 were for PHDSystems sold in the United States.  Sixsales were made in the United Kingdom. The sales recorded were made pursuant to an agreement with a third partyleasing provider who leases directly to the dialysis provider.

 

31

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We also recognized revenue under short-term and long-term operatingleases in 2004. We placed 39 units under operating leases, 38 in the UnitedStates and one in the United Kingdom.  Wemaintain ownership of the units and classify them as fixed assets.  Depreciation expense is recorded monthly.Revenue from product sales and rentals in the United States and United Kingdomfor the year ended December 31, 2004 was $1.2 million and $0.3 million,respectively. For the year ended December 31, 2003 revenue from product salesand rentals in the United States and United Kingdom was $1.1 million and $0.1million, respectively.

 

Our largest customers, the Northwest Kidney Center, Dialysis Centers ofLincoln and Berkshire Dialysis Center, accounted for 24%, 10% and 9%,respectively of our revenues (by dollar volume) for fiscal year 2004.

 

Service and supplies sold during fiscal 2004 specifically relate to thePHD Systems in use.  Service and supplyrevenue is contracted under a separate agreement with a dialysis center at anestablished monthly amount.  Supplies,such as blood tubing sets, dialyzers and acid and bicarbonate preparations, arerequired to perform dialysis treatments. Service on the PHD System is for scheduled and unscheduled maintenanceand repairs, and is provided by our service technicians 24 hours a day, sevendays a week.  Service and suppliesrevenue totaled $958,000 for fiscal 2004, an increase of $659,000, or 220%,from $299,000 in 2003.  The increase inrevenue is attributed to the growth in product placement and service and supplyagreements. Service and supplies revenue in the United States and UnitedKingdom for the year ended December 31, 2004 was $851,000 and $107,000,respectively. For the year ended December 31, 2003 service and supplies revenuein the United States and United Kingdom was $275,000 and $24,000, respectively.

 

We are not dependent upon reimbursement from insurance providers as asource of revenue.  Rather, we generaterevenue from dialysis centers, which provide dialysis services through the useof the PHD System.  The dialysis centeris reimbursed on a per treatment basis by the insurance provider.  Accordingly, reimbursement rates mayinfluence customers’ demand for our product and our pricing of the PHD Systemand related supplies and service.

 

Cost of sales. Total cost of sales for fiscal 2004 was $10.7 million compared to $7.7million in fiscal 2003, an increase of $3.0 million or 39%.  Product cost of sales for 2004 were $4.8 millioncompared to $4.3 million in 2003, an increase of $0.5 million or 12%.  Included in product cost of sales for 2004 isan inventory adjustment in the amount of $0.6 million, in order to value thePHD machines in inventory at the lower of cost or market. The 2003 inventorycost adjustment was $1.4 million.  Thenumber of units manufactured decreased from 127 in 2003 to 83 in 2004.  During 2004 we determined that we hadsufficient inventory on hand to meet demand and reduced productionaccordingly.   Depreciation expense onrental machines increased to $0.5 million for the year ended December 31, 2004from $0.1 million in 2003, an increase of $0.4 million or 400%.  Six finished machines that will be used in afuture research study were expensed to product cost of sales in the quarterended December 31, 2004 at a cost of $0.2 million.  Other product cost of sales increased by $0.9million in 2004 compared to 2003, to $2.5 million from $1.6 million.  A portion of the increase, $0.1 million, isdue to potential obsolescence of parts purchased by the manufacturer of the PHDsystem. An additional $0.7 million is due to a reserve established in thequarter ended December 31, 2004 for replacement of major components of machinesalready produced.  The remainder of theincrease is due to increases in freight and royalties.

 

Service and supplies costs were $5.9 million in 2004, a $2.6 million or79% increase from $3.3 million in 2003. The increase is due to additional units in service during the currentyear compared to the prior year. The cost of consumable supplies andreplacement parts increases with additional units in service. The cost of fieldservice personnel to install and service the PHD machines and for clinicalsupport staff necessary to train the customers’ nursing staff is also relatedto the number of units in service.  Thesepersonnel costs increased $1.1 million during the year ended December 31, 2004compared to 2003. In addition, a $0.3 million reserve for potentially obsoletesupplies was recorded during the year ended December 31, 2004.

 

Research and development expenses.   For the year ended December 31, 2004,research and development expenses increased 22% to $6.7 million from  $5.5 million forthe year ended December 31, 2003. The increase of $1.2 million in 2004 wasprimarily attributable to product enhancement and improvement, and new productdevelopment of the next generation of home dialysis machines.

 

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Sales and marketing expenses.   During 2004, sales and marketing expensesincreased 14% or $0.6 million, to $4.8 million in 2004, from $4.2 million in2003.  The increase is attributable topersonnel additions, advertising and marketing promotions in 2004 associatedwith the scaling up of the commercialization of the PHD System.

 

Advertising costs are expensed as incurred. Advertising expense for theyears ended December 31, 2004, 2003, and 2002 was $720,000, $608,000 and$223,000, respectively.

 

***General and administrative expenses.***  For the yearended December 31, 2004, general and administrative expenses increased $0.7million to $7.4 million, a 10% increase from $6.7 million for the year endedDecember 31, 2003.  The increase isprimarily a result of the costs incurred to comply with Sarbanes-Oxley.  We also experienced an increase in insuranceexpenses in 2004 compared to 2003.

*** ***

Interest income and expense.  For the year ended December 31, 2004,interest income was $0.7 million, an increase of $0.4 million or 133% from theyear ended December 31, 2003.  Theincrease is due to higher cash and investment balances in 2004 than 2003.Interest expense was $1.1 million for the year ended December 31, 2004,compared with no interest expense in 2003. Interest expense consisted primarily of the amortization of debtdiscount on the Durus notes payable.

 

**Results of Operations**

 

***Year Ended December 31, 2003 Compared to Year Ended December31, 2002***

*** ***

Net loss for the year ended December 31, 2003 was $22.3 million ($0.79per share), compared with $15.7 million ($0.65 per share), for the year endedDecember 31, 2002.  The factorscontributing to the decrease in net loss are explained below.

 

Revenue.  For the year ended December 31, 2003, revenuewas $1.5 million, a 400% increase from revenue of $0.3 million for the yearended December 31, 2002.  Product revenueof $1.2 million resulted primarily from the sale or lease of 28 PHDSystems.  This is an increase of $0.9million, or 300%, over 2002 when seven machines were sold.

 

Twenty-six of the product sales recorded in fiscal 2003 were for PHDSystems sold in the United States.  Twosales were made in the United Kingdom. The sales recorded were made pursuant to an agreement with a third partyleasing provider or through direct sales to customers.

 

We also recognized revenue under short-term and long-term operatingleases in 2003.  We placed 24 units underoperating leases, 23 in the United States and one in the United Kingdom.

 

Our largest customers, the Northwest Kidney Center, Dialysis Centers ofLincoln, Berkshire Medical Dialysis Center and Satellite Healthcare, Inc.accounted for 31%, 13%, 12%, and 11% respectively of our revenues (by dollarvolume) for fiscal 2003.

 

Service and Supplies revenue totaled $299,000 for fiscal 2003, anincrease of $277,000, or 1259%, from $22,000 in 2002.  The increase in revenue is attributed to thegrowth in product placement and service and supply agreements.

 

Cost of sales.   Total cost of sales for fiscal 2003 was $7.7million compared to $2.8 million  in fiscal 2002, an increase of175%.  Product cost of sales for 2003were $4.3 million compared to $2.0 million in 2002, an increase of $2.3 millionor 115%.  The increase is due toadditional machines produced and sold during 2003.  Specifically, 127 machines were produced in2003 and 71 machines were produced during 2002. Included in product cost of sales is an inventory adjustment in theamount of $1.4 million, in order to value the PHD machines in inventory at thelower of cost or market. The 2002 inventory cost adjustment was $1.3million.  While the number of unitsproduced has increased, the production cost per unit decreased during 2003.

 

Service and supplies costs were $3.3 million in 2003, a $2.5 million or313% increase from $0.8 million in 2002. The increase is due to additional units in service during the currentyear compared to the prior year.  Themajority of

 

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these costs are for field service personnelto install and service the PHD machines and for clinical support staffnecessary to train the customers’ nursing staff.

 

Research and development expenses.   For the year ended December 31, 2003,research and development expenses were unchanged at $5.5 million compared tothe year ended December 31, 2002. There was a slight increase of $0.9 millionin 2003 primarily attributable to the donation of two PHD units to be used forclinical research, offset by lower new product development costs.

 

Sales and marketing expenses.   During 2003, sales and marketing expensesincreased 83% or $1.9 million, to $4.2 million in 2003, from $2.3 million in2002.  The increase is attributable topersonnel additions and other costs in 2003 associated with the scaling up ofthe commercialization of the PHD System.

 

Advertising costs are expensed as incurred.  Advertising expense for the years endedDecember 31, 2003 and 2002 was $608,000 and $223,000, respectively.

 

***General and administrative expenses.***  For the yearended December 31, 2003, general and administrative expenses increased $1.0million to $6.7 million, an 18% increase. We incurred approximately $700,000 in legal and advisory costs relatedto the Durus situation in 2003.  Theremaining increase is primarily a result of personnel additions necessary tosupport commercialization efforts.

*** ***

Interest income.  For the year ended December 31, 2003,interest income was $0.3 million, unchanged from the year ended December 31,2002.  While average cash balances werehigher in 2003 than in 2002, average interest rates were lower during 2003.

 

**Liquidity and Capital Resources**

 

**Cash Flows**

 

We have financed our operations to date primarily through public andprivate sales of equity securities and proceeds from our settlement with theDurus fund.  At December 31, 2004, we hadcash and cash equivalents of $9.4 million, short-term investments of $21.7million, long term available for sale investments of $7.6 million andrestricted long-term investments of $0.6 million.  We believe that inflation generally has nothad a material impact on our operations or liquidity to date.

 

Net cashused in operating activities was $31.4 million in fiscal 2004 compared to $21.4million in fiscal 2003 and $16.2 million in fiscal 2002.  The increase in 2004 compared to 2003 isprimarily due to an increase in the annual net loss of $5.4 million, an increasein deposits with vendors of $3.3 million, and a decrease in accounts payableand accrued liabilities of $2.7 million partially offset by a decrease ininventory of $0.3 million.  The increasein the net loss, which includes $1.1 million in non-cash interest expense,  is due to increased units in service at aloss on each unit, increased spending to improve PHD performance and developnew products, and an increase in sales and marketing activities.  The increase in deposits with vendors relatesto a deposit of $3.4 million paid to the manufacturer of the PHD System forparts purchased on our behalf to be used in future production, pursuant to ouragreement with that vendor.  Accountspayable decreased $3.3 million in 2004 compared to 2003 due to increased PHDproduction in the last quarter of 2003. Payment for these machines was not made until 2004.  Accrued and other liabilities increased in2004 by $0.6 million compared to 2003. This increase is due to a reserve established in the quarter endedDecember 31, 2004 for replacement of major components of machines alreadyproduced.  The decrease in inventory of$0.3 million in 2004 compared to 2003 is attributable to a decrease in themarket value of finished units on hand at December 31, 2004 compared to 2003and a decrease in spare parts inventory. Other sources and uses of cash were consistent in 2004 compared to 2003.

 

Net cashused in investing activities was $27.0 million in fiscal 2004 compared to cashprovided of $4.2 million in fiscal 2003. In 2003, we used cash from investments to fund operations.  In 2004 we invested the proceeds from theDurus settlement in investment grade securities.   Net cash provided by financing activitieswas $52.4 million and

 

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$31.6 million in fiscal years 2004 and 2003, respectively. Cash provided from financing activities resulted from the Durussettlement in 2004 and issuance of common stock in 2003.

 

Net cash used in operatingactivities was $21.4 million in fiscal 2003 compared to $16.2 million in fiscal2002 and $18.3 million in fiscal 2001. The increase in 2003 compared to 2002 is primarily due to increasedexpenditures relating to commercialization and an increase in inventory inanticipation of increased sales.  Theincrease in inventory of $3.3 million in 2003 compared to 2002 is attributableto the production of Phase II PHD machines during the last quarter of 2003, andan increase throughout the year of parts and consumables inventory required toservice additional machines in use.  Accounts payable also increased $3.0 millionin 2003 compared to 2002 due to increased PHD production in the last quarter of2003.  Payment for these machines was notmade until 2004.  Accrued and otherliabilities increased in by $0.6 million compared to 2002.  This increase is due to an increase inaccrued vacation and bonuses relating to 23 additional employees at December31, 2003 compared to December 31, 2002. Other sources and uses of cash were consistent in 2003 compared to 2002.

 

Net cash provided by investingactivities was $4.2 million in fiscal 2003 compared to cash used of $9.8million in fiscal 2002.  In 2002, we hadincreased our investments in marketable securities, primarily as a result of aprivate placement of common stock in May 2002 that netted $16.5 million.  In 2003, we used cash from investments tofund operations.  Net cash provided byfinancing activities was $31.6 million and $16.7 million in fiscal years 2003and 2002, respectively.  Cash providedfrom financing activities resulted from the issuance of common stock.

 

**RecentFinancing Activities**

 

Durus Settlement.  In February 2004, we settled all ouroutstanding claims against Durus Life Sciences Master Fund Ltd. and otherdefendants for an aggregate payment to us of $48.7 million, which includes thepurchase by certain defendants of $16.1 million of unsecured subordinatedpromissory notes and an earlier $4.6 million payment to settle claims underSection 16(b) of the Securities Exchange Act of 1934.  We had filed a lawsuit in August 2003 afterlearning that Durus Life Sciences Master Fund Ltd. (the “Durus fund”), ScottSacane, Durus Capital Management, LLC (“Durus Capital”), Durus CapitalManagement (N.A.), LLC (“Durus Capital (N.A.)”) and Artal Long Biotech PortfolioLLC (the “Artal fund”) had acquired over 70% of our outstanding commonstock.  We refer to the Durus fund, Mr.Sacane, Durus Capital, Durus Capital (N.A.) and the Artal fund collectively as “defendants”and individually as a “defendant.”

 

*Background to the Litigation*.  In April 2003, we entered into an agreementwith Mr. Sacane and Durus Capital relating to shares of our common stock theythen controlled through the Durus fund (the “April 2003 Agreement”).  We entered into the April 2003 Agreement afterwe learned that certain of the defendants had accumulated a position in ourcommon stock in excess of the 15% ownership level that would potentiallytrigger our Shareholder Rights Agreement.

 

Pursuant to the terms of the April 2003 Agreement, Mr. Sacane and DurusCapital represented that they:  (1) thenowned 5,238,248 shares (approximately 19.5%) of our outstanding common stock,(2) crossed the 15% ownership level inadvertently, and (3) held this investmentin the Company in the ordinary course of business and not for the purpose orwith the effect of changing or influencing the control of the Company.  In addition, they agreed to reduce theirholdings to below 15% ownership over a two-year period and not to purchase anyadditional shares of our common stock until such time as their ownership wasless than 15% of the shares then-outstanding (and thereafter not in excess of15% without the consent of our board of directors).

 

After the close of business on July 24, 2003, Mr. Sacane informed usthat he, together with the other defendants, had accumulated in excess of 19million shares of our common stock in transactions he described asinadvertent.  In a Schedule 13D filedwith the SEC on July 28, 2003, the defendants disclosed that they owned21,831,218 shares, or approximately 73%, of our then-outstanding commonstock.  The Durus fund owned 21,333,118of these shares and the Artal fund owned 498,100.

 

In August 2003, we filed a lawsuit against the defendants in the UnitedStates District Court for the District of Connecticut.  Our lawsuit sought injunctive relief anddamages arising from the defendants’ alleged violation of federal securitieslaw and the alleged breach of the April 2003 Agreement.  In addition, our lawsuit sought recovery ofshort-swing trading profits under Section 16(b) of the Securities Exchange Actof 1934.

 

In January 2004, we settled the Section 16b claim against thedefendants for $4.6 million.  In February2004, we settled all other claims against the defendants, and received as partof that settlement an additional $34.1 million in cash, of which $16.1 millionwas in exchange for unsecured subordinated promissory notes. In May 2004 wereceived a final payment of $10.0 million in connection with the effectivenessof a registration statement we filed with the SEC covering the securities ownedby the Durus fund and the Artal fund.

 

*Summary of the Settlement*.  Pursuant to the settlement agreement, theDurus fund, among other things, agreed to pay us $28 million in cash (inaddition to the $4.6 million paid by the Durus fund in respect of the Section16b claim) to settle the remaining claims in our lawsuit and release any otherpotential claims against the defendants. In addition, the defendants agreed that they would not seek to exercise controlover the Company and that they would not hold the shares of our common stockwith the purpose or intent of changing or influencing the control or managementof the Company.  In furtherance of thisagreement, the Durus fund and the Artal fund agreed to execute irrevocableproxies directing that the shares of our common stock that they own be voted inproportion to the votes cast by all other holders of our common stock (otherthan the defendants) in all stockholder votes after the 2004 annual

 

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meeting. The authority granted by the proxies continues until the defendants’aggregate ownership of our common stock decreases below 15%, provided that oncethe defendants’ aggregate ownership of our common stock decreases below 50% ofthe outstanding stock, the authority granted by the proxies will apply only tothose shares of common stock owned by the defendants in the aggregate in excessof 14.99% of our outstanding common stock. Based on information contained in a Schedule 13D filed by the Durus fundwith the SEC, we believe the Durus fund owns 21,498,118 shares of our commonstock (which includes 281,454 shares issuable upon exercise of immediatelyexercisable warrants), representing approximately 72% of the outstanding sharesof our common stock.  Mr. Sacane, DurusCapital and Durus Capital (N.A.) have represented to us that they do not ownany shares of our common stock, other than indirect interests in the shares ofour common stock owned by the Durus fund, and that they do not have voting ordispositive power over any of the shares owned by the Durus fund or the Artalfund.  Pursuant to the settlementagreement, a representative of the Durus fund will have the opportunity to meetwith our board of directors before or after each regular board meeting.  In addition, we have amended our RightsAgreement to conditionally exempt the defendants therefrom.

 

As part of the settlement, we entered into a registration rightsagreement with the Durus fund and the Artal fund whereby we agreed to usereasonable best efforts to register the shares held by them in one or moreshelf registration statements and to keep these registration statements(s)effective for two years (the “effective period”), subject to extension in theevent that (1) we issue a blackout notice pursuant to the terms of theagreement (in which case the effectiveness period will be extended by theduration of such blackout), (2) the SEC imposes a stop order on theregistration statement(s) or the registration statement(s) otherwise become ineffective(in which case the effectiveness period will be extended by the duration ofsuch stop order or period of ineffectiveness), (3) we experience a materialadverse event related to certain FDA matters or similar government regulatorymatters (in which case the effectiveness period will be extended for up to 180days) or (4) we effect the registration of our common stock for our own accountor the account of another third party (in which case the effectiveness periodwill be extended for up to 180 days).  Wefiled a registration statement pursuant to the registration rights agreement onApril 12, 2004.  The SEC declared thisregistration statement effective on May 17, 2004.  The Durus fund has agreed that it will reduceits ownership of our common stock over time and that its position in our commonstock will be under 15% by the end of the effective period.  During the first year of the effectiveperiod, we may not effect the registration of anyshares of our common stock without the Durus fund’s consent.  We have agreed to pay the first $500,000 ofexpenses associated with the registration of the Durus fund’s and the Artalfund’s shares.  The Durus fund and theArtal fund will pay all fees and expenses of their counsel, all underwritingdiscounts and commissions, and any of our expenses in excess of $500,000.  The registration rights agreement alsocontains customary indemnification provisions.

 

We have also entered into a note purchase agreement with the Durus fundand the Artal fund whereby the Durus fund and the Artal fund purchasedapproximately $15.8 million and $0.3 million, respectively, of unsecuredsubordinated promissory notes (the “Notes”) from us.  The Notes are subordinated and junior inright of payment to all of our creditors, including trade creditors, and do notbear interest.  We may repay the notes incash at any time.  After the later of (1)August 30, 2005 and (2) the first trading day on which the holders of the Notesown less than 10% of our then-outstanding common stock, we may repay the Notesin stock.  Any stock issued in repaymentof the Notes will be subject to registration rights pursuant to theregistration rights agreement.  The Noteswill become due and payable one year after the later of the two dates above andin no event later than February 23, 2009. If we elect to repay the Notes in stock, the number of shares that wemust deliver for payment will be determined based on the average of the closingprices of our common stock on the Nasdaq National Market over the twentytrading days preceding our election to repay in stock.  The Notes will also become due and payable incash upon a change of control.  In theevent of a change of control repayment, in addition to repayment of the then-outstandingprincipal amount of the Notes, we are required to pay to the holders of theNotes an amount equal to (1) 5% of the consideration received by (a) theCompany in the case of an asset sale transaction constituting a change ofcontrol (net of corporate taxes, transaction expenses and indebtedness of theCompany) or (b) our stockholders and the holders of the Notes in a merger orother type of transaction constituting a change of control, less (2) theprincipal amount repaid.

 

The foregoing summaries of the settlement agreement, the amendment toour Rights Agreement, the registration rights agreement and the note purchaseagreement do not purport to be complete and are subject to, and qualified in

 

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their entirety by reference to, completecopies of these documents filed as exhibits to our Current Report on Form 8-Kfiled with the SEC on February 24, 2004 and deemed to be incorporated herein intheir entirety.

 

**FinancingNeeds**

 

Weestimate that during fiscal 2005 we will spend approximately $30 to $32 millionfor operations, including U.S. and international commercialization activitiesof the PHD System. We expect to continue to invest in commercialization of thePHD System.  We believe that cash and marketableinvestments of $38.7 million as of December 31, 2004 are sufficient to financeour commercial and operating plans through December 31, 2005.  We currently have no committed sources of, orother arrangements with respect to, additional financing.

 

Our future funding needs will depend on many factors, including thetiming and costs associated with continued progress in research anddevelopment, manufacturing scale-up, increased sales and marketing activities,the cost involved in filing and enforcing patent claims and the status ofcompetitive products.  In the event thatour plans change, our assumptions change or prove inaccurate or we are unableto obtain financing on commercially reasonable terms, we could be required toseek additional financing.  Theadditional capital required may not be available on acceptable terms or may notbe available at all.

 

We have not generated taxable income to date.  At December 31, 2004, the net operatinglosses available to offset future taxable income were approximately $129.7million.  Because we have experiencedownership changes, future utilization of the carryforwards may be limited inany one fiscal year pursuant to Internal Revenue Code regulations.  The carryforwards expire at various datesbeginning in 2012.  As a result of theannual limitation, a portion of these carryforwards may expire before becomingavailable to reduce federal income tax liabilities.   Given our historical losses and uncertaintywith respect to our ability to generate taxable income, management hasestablished a full valuation allowance at December 31, 2004 and 2003,respectively.

 

**Recent Accounting Pronouncements**

 

In December 2004, the Financial Accounting Standards Board (FASB)issued SFAS No. 123 (revised 2004), *Share-Based Payment*(SFAS123(R)). SFAS 123(R) requires that the fair value of stock options be recordedin the results of operations beginning no later than July 1, 2005.  The FASB has concluded that companies couldadopt the new standard in one of two ways: the modified prospective transitionmethod and the modified retrospective transition method.  Using the modified prospective transitionmethod, a company would recognize share-based employee compensation cost fromthe beginning of the fiscal period in which the recognition provisions arefirst applied as if the fair-value-based accounting method had been used toaccount for all employee awards granted, modified or settled after theeffective date and to any awards that were not fully vested as of the effectivedate.  Using the modified retrospectivemethod, a company would recognize employee compensation cost for periodspresented prior to the adoption of the proposed standard in accordance with theoriginal provisions of SFAS No. 123; that is, an entity would recognize employeecompensation cost in the amounts reported in the pro forma disclosures providedin accordance with SFAS No. 123.  Acompany would not be permitted to make any changes to those amounts uponadoption of the proposed standard unless those changes represent a correctionof an error (and are disclosed accordingly). For periods after the date of adoption of the proposed standards, themodified prospective transition method described above would be applied. Aksyshas not determined the effect of the new standard on earnings; however, expenseunder the new standard could be higher. The effect of adopting the new rules on reported diluted earnings pershare is dependent on the number of options granted in the future, the terms ofthose awards and their fair values, and therefore the effect on dilutedearnings per share could change. Aksys has not determined an adoption date andhas not determined whether it would adopt prospectively, or retrospectively toJanuary 1, 2005.

 

In May 2003, the FASB issued SFAS No. 150, *Accountingfor Certain Financial Instruments with Characteristics of both Liability andEquity.* SFAS No. 150 establishes standards for how an issuerclassifies and measures certain financial instruments with characteristics ofboth liabilities and equity. It also requires that an issuer classify afinancial instrument that is within its scope as a liability (or an asset insome circumstances). Many of those instruments were previously classified asequity. SFAS No. 150 is effective for financial instruments entered into or

 

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modified after May 31, 2003, and otherwiseis effective at the beginning of the first interim period beginning after June15, 2003, except for mandatorily redeemable financial instruments.  For certain mandatorily redeemable financialinstruments, the Statement will be effective on January 1, 2005.  The effective date has been deferredindefinitely for certain other types of mandatorily redeemable financialinstruments.  The adoption of SFAS No.150 did not have a significant impact on our consolidated financial position orresults from operations.

 

**Item 7A.****  Quantitative and QualitativeDisclosure About Market Risk.**

 

**Interest Rate Risk**

 

Our investments are not made for trading purposes.  Our investments are generally made in U.S.government and federal agency bonds and high-grade commercial paper andcorporate bonds.   Interest rate riskwith respect to our investments is not significant as substantially all of suchinvestments are in short-term U.S. dollar cash equivalents, which are by theirnature less sensitive to interest rate movements, or invested in short-termsecurities that are held to maturity. The one security that is classified asavailable for sale has an interest rate that is reset monthly.  Therefore, the market value of the securitydoes not experience significant fluctuations. Imputed interest on the long-term notes payable was calculated using anestimated interest rate for a similar instrument, since no objective marketexists for this particular obligation.  We have a line of credit facility with a commercial bank with interestpayable monthly at 75 basis points above the bank’s prime rate or LIBOR.  Because of our current cash position andability to repay the balance on the line of credit we are not subject tofinancial risk on this obligation if interest rates in the market changesignificantly.  A 1% change in interestrates would not have a material effect on our results of operations.

 

**Exchange Rate Risk**

 

We have a sales office in the United Kingdom, and therefore transact aportion of our business in British pounds.   A 10% change in the exchange rate of the U.S. dollar with respect to theBritish pound would not have a material effect on our financial condition orresults of operations.  We do not use anyhedges or other derivative financial instruments to manage or reduce exchangerate risk.

 

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**Item 8.****  FinancialStatements and Supplementary Data.**

 
| Management’s Report on Internal Control  over Financial Reporting |
|------------------------------------------------------------------------|
| Reports of Independent Registered Public  Accounting Firm              |
| Consolidated Financial Statements and Schedules:                       |
| •                                                                 |   | Consolidated Balance  Sheets at December 31, 2004 and 2003 |
| •                                                                 |   | Consolidated  Statements of Operations for the Fiscal Years Ended December 31, 2004, 2003  and 2002 |
| •                                                                 |   | Consolidated Statements of Stockholders’  Equity for the Fiscal Years Ended December 31, 2004, 2003 and 2002 |
| •                                                                 |   | Consolidated Statements of Cash Flows for  the Fiscal Years Ended December 31, 2004, 2003 and 2002 |
| •                                                                 |   | Notes to Consolidated Financial Statements |

 

**Management’s Report on Internal Control overFinancial Reporting**

 

The management of Aksys, Ltd. is responsible for establishing andmaintaining adequate internal control over financial reporting. Aksys Ltd.’sinternal control system was designed to provide reasonable assurance to theCompany’s management and board of directors regarding the preparation and fairpresentation of published financial statements.

 

All internal control systems, no matter how well designed, haveinherent limitations. Therefore, even those systems determined to be effectivecan provide only reasonable assurance with respect to financial statementpreparation and presentation.

 

Aksys, Ltd. management assessed the effectiveness of the Company’sinternal control over financial reporting as of December 31, 2004. In makingthis assessment, it used the criteria set forth by the Committee of SponsoringOrganizations of the Treadway Commission (COSO) in **Internal Control—Integrated Framework.**Basedon our assessment we believe that, as of December 31, 2004, the Company’sinternal control over financial reporting is effective based on those criteria.

 

Aksys, Ltd.’s independent registered public accounting firm, KPMG LLPhas issued an audit report on our assessment of the Company’s internal controlover financial reporting. This report appears below.

 

March 16, 2005

 

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# **Report of Independent Registered Public AccountingFirm**

 

 

The Board of Directors and Stockholders

Aksys, Ltd.:

 

We have audited management’s assessment, included in the accompanyingManagement’s Report on Internal Control Over Financial Reporting,**that Aksys, Ltd. and subsidiaries maintainedeffective internal control over financial reporting as of December 31, 2004,based on criteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).**Aksys, Ltd.’s management is responsible for maintainingeffective internal control over financial reporting and for its assessment ofthe effectiveness of internal control over financial reporting. Ourresponsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of Aksys, Ltd. and subsidiaries’ internal controlover financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects. Our audit included obtaining an understanding of internalcontrol over financial reporting, evaluating management’s assessment, testingand evaluating the design and operating effectiveness of internal control, andperforming such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinion.

 

Acompany’s internal control over financial reporting is a process designed toprovide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordancewith generally accepted accounting principles. A company’s internal control over financial reporting includes thosepolicies and procedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonable assurancethat transactions are recorded as necessary to permit preparation of financialstatements in accordance with generally accepted accounting principles, andthat receipts and expenditures of the company are being made only in accordancewith authorizations of management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements.

 

Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that Aksys, Ltd. andsubsidiaries maintained effective internal control over financial reporting asof December 31, 2004, is fairly stated, in all material respects, based oncriteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). Also, in our opinion, Aksys,Ltd. and subsidiaries maintained, in all material respects, effective internalcontrol over financial reporting as of December 31, 2004, based on criteriaestablished in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO).

 

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We also have audited, in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the consolidated balancesheets of Aksys, Ltd. and subsidiaries as of December 31, 2004 and 2003, andthe related consolidated statements of operations, stockholders’ equity, andcash flows for each of the years in the three-year period ended December 31,2004, and our report dated March 16, 2005**expressedan unqualified opinion on those consolidated financial statements*.*

 

 
| KPMG LLP          |
|-------------------|
|              |
|              |
| Chicago, Illinois |
| March 16, 2005    |

 

Report of IndependentRegistered Public Accounting Firm

 

 

TheBoard of Directors and Stockholders

Aksys,Ltd.:

 

Wehave audited the accompanying consolidated balance sheets of Aksys, Ltd. andsubsidiaries as of December 31, 2004 and 2003, and the related consolidatedstatements of operations, stockholders’ equity, and cash flows for each of theyears in the three-year period ended December 31, 2004. These consolidated financialstatements are the responsibility of Aksys Ltd.’s management. Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audits.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In ouropinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of Aksys, Ltd. andsubsidiaries as of December 31, 2004 and 2003, and the results of theiroperations and their cash flows for each of the years in the three-year periodended December 31, 2004, in conformity with U.S. generally accepted accountingprinciples.

 

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of Aksys, Ltd.’sinternal control over financial reporting as of December 31, 2004, based oncriteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO), and our report dated March 16,2005 expressed an unqualified opinion on management’s assessment of, and theeffective operation of, internal control over financial reporting*.*

 

 
| KPMG LLP          |
|-------------------|
|              |
|              |
| Chicago, Illinois |
| March 16, 2005    |

 

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** **

**AKSYS, LTD.AND SUBSIDIARIES**

 

**ConsolidatedBalance Sheets**

 

December 31, 2004 and 2003

 
| ** **                                                                                                                                                     | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------|------------|--------------|------------|
| **Assets**                                                                                                                                                     |       |         |       |         |       |
| Current assets:                                                                                                                                                |       |         |       |         |       |
| Cash and cash  equivalents                                                                                                                                     |       | $            | 9,419,324  |         | $          | 15,397,453 |   |
| Short-term  investments                                                                                                                                        |       | 15,030,779   |       | 4,777,644    |       |
| Restricted  short-term investments                                                                                                                             |       | 6,666,666    |       | —       |       |
| Accounts  receivable, less allowance for doubtful accounts of $14,739 at December 31,  2004 and 2003                                                           |       | 233,406      |       | 338,432      |       |
| Other  receivables                                                                                                                                             |       | 125,373      |       | 5,076        |       |
| Inventories                                                                                                                                                    |       | 5,716,320    |       | 5,995,438    |       |
| Prepaid expenses                                                                                                                                               |       | 134,739      |       | 101,614      |       |
| Deposits with  vendors                                                                                                                                         |       | 3,467,785    |       | 109,541      |       |
| Total current  assets                                                                                                                                          |       | 40,794,392   |       | 26,725,198   |       |
|                                                                                                                                                           |       |         |       |         |       |
| Long-term  investments                                                                                                                                         |       | 7,568,475    |       | —       |       |
| Restricted  long-term investments                                                                                                                              |       | 600,000      |       | 600,000      |       |
| Leased assets,  net                                                                                                                                            |       | 2,390,831    |       | 1,132,533    |       |
| Property and  equipment, net                                                                                                                                   |       | 1,533,091    |       | 1,139,774    |       |
| Other assets                                                                                                                                                   |       | 58,652       |       | 40,646       |       |
| Total assets                                                                                                                                                   |       | $            | 52,945,441 |         | $          | 29,638,151 |   |
|                                                                                                                                                           |       |         |       |         |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                  |       |         |       |         |       |
| Current  liabilities:                                                                                                                                          |       |         |       |         |       |
| Accounts payable                                                                                                                                               |       | $            | 1,635,050  |         | $          | 4,940,329 |   |
| Accrued  liabilities                                                                                                                                           |       | 2,853,257    |       | 1,298,008    |       |
| Deferred revenue                                                                                                                                               |       | 253,575      |       | 65,813       |       |
| Short-term line  of credit                                                                                                                                     |       | 3,400,000    |       | —       |       |
| Other  liabilities                                                                                                                                             |       | 41,344       |       | 28,686       |       |
| Total current  liabilities                                                                                                                                     |       | 8,183,226    |       | 6,332,836    |       |
|                                                                                                                                                           |       |         |       |         |       |
| Other long-term  liabilities                                                                                                                                   |       | 117,014      |       | 177,253      |       |
| Notes payable                                                                                                                                                  |       | 13,637,770   |       | —       |       |
| Total  liabilities                                                                                                                                             |       | 21,938,010   |       | 6,510,089    |       |
|                                                                                                                                                           |       |         |       |         |       |
| Stockholders’  equity:                                                                                                                                    |       |         |       |         |       |
| Preferred stock,  par value $.01 per share, 1,000,000 shares authorized, 0 shares issued and  outstanding in 2004 and 2003                                     |       | —       |       | —       |       |
| Common stock,  par value $.01 per share, 50,000,000 shares authorized, 29,891,537 and 29,800,904  shares issued and outstanding in 2004 and 2003, respectively |       | 298,915      |       | 298,009      |       |
| Additional  paid-in capital                                                                                                                                    |       | 187,248,679  |       | 151,738,776  |       |
| Accumulated  other comprehensive income                                                                                                                        |       | 72,326       |       | 20,277       |       |
| Accumulated  deficit                                                                                                                                           |       | (156,612,489 | )          | (128,929,000 | )          |
| Total  stockholders’ equity                                                                                                                               |       | 31,007,431   |       | 23,128,062   |       |
|                                                                                                                                                           |       | $            | 52,945,441 |         | $          | 29,638,151 |   |

 

See accompanying notes toconsolidated financial statements.

 

42

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**AKSYS, LTD.AND SUBSIDIARIES**

 

**Consolidated Statements of Operations**

 

Years ended December 31,2004, 2003 and 2002

 
| ** **                             | ** ** | **2004**    | ** **  | **2003**    | ** ** | **2002**    | ** ** |
|----------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|
| Revenue:                               |       |        |        |        |       |        |       |
| Product                                |       | $           | 1,457,704   |        | $          | 1,192,706   |       | $ | 276,680 |   |
| Service and  supplies                  |       | 958,355     |        | 298,757     |       | 21,986      |       |
| Total revenue                          |       | 2,416,059   |        | 1,491,463   |       | 298,666     |       |
|                                   |       |        |        |        |       |        |       |
| Cost of sales:                         |       |        |        |        |       |        |       |
| Product                                |       | 4,795,181   |        | 4,349,091   |       | 1,996,654   |       |
| Service and  supplies                  |       | 5,867,759   |        | 3,343,102   |       | 774,274     |       |
| Total cost of  sales                   |       | 10,662,940  |        | 7,692,193   |       | 2,770,928   |       |
|                                   |       |        |        |        |       |        |       |
| Operating  expenses:                   |       |        |        |        |       |        |       |
| Research and  development              |       | 6,684,465   |        | 5,474,220   |       | 5,522,772   |       |
| Sales and  marketing                   |       | 4,791,684   |        | 4,188,939   |       | 2,305,110   |       |
| General and  administrative            |       | 7,388,863   |        | 6,676,665   |       | 5,699,356   |       |
| Total operating  expenses              |       | 18,865,012  |        | 16,339,824  |       | 13,527,238  |       |
|                                   |       |        |        |        |       |        |       |
| Operating loss                         |       | (27,111,893 | )           | (22,540,554 | )          | (15,999,500 | )          |
|                                   |       |        |        |        |       |        |       |
| Other income and  expense:             |       |        |        |        |       |        |       |
| Interest income                        |       | 664,454     |        | 258,076     |       | 294,956     |       |
| Interest expense                       |       | (1,130,538  | )           | —      |       | —      |       |
| Total other  income and expense        |       | (466,084    | )           | 258,076     |       | 294,956     |       |
| Net loss before  income tax expense    |       | (27,577,977 | )           | (22,282,478 | )          | (15,704,544 | )          |
| Income tax  expense                    |       | (105,512    | )           | —      |       | —      |       |
|                                   |       |        |        |        |       |        |       |
| Net loss                               |       | $           | (27,683,489 | )           | $          | (22,282,478 | )          | $ | (15,704,544 | ) |
|                                   |       |        |        |        |       |        |       |
| Net loss per  share, basic and diluted |       | $           | (0.93       | )           | $          | (0.79       | )          | $ | (0.65 | ) |
|                                   |       |        |        |        |       |        |       |
| Weighted average  shares outstanding   |       | 29,825,659  |        | 28,218,819  |       | 24,301,029  |       |

 

Seeaccompanying notes to consolidated financial statements.

 

43

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**AKSYS, LTD.AND SUBSIDIARIES**

 

**Consolidated Statements of Stockholders’ Equity**

 

Years ended December 31, 2004, 2003 and 2002

 
| ** **                                          | ** ** | **Common stock** | ** ** | **Additional  paid-in  capital** | ** ** | **Accumulated  other  comprehensive  income(loss)** | ** ** | **Accumulated  deficit** | ** ** | **Comprehensive  income(loss)** | ** ** | **Total  stockholders’  equity** | ** ** |
|-----------------------------------------------------|------------|------------------|------------|----------------------------------|------------|-----------------------------------------------------|------------|--------------------------|------------|---------------------------------|------------|---------------------------------------|------------|
| **Shares**                                          | ** ** | **Amount**       |
|                                                |       |             |       |                             |       |                                                |       |                     |       |                            |       |                                  |       |   |   |
| Balance at  December 31, 2001                       |       | 22,097,524       |       | 220,975                          |       | 103,313,209                                         |       | 11,423                   |       | (90,941,978                     | )          |                                  |       | 12,603,629 |   |
|                                                |       |             |       |                             |       |                                                |       |                     |       |                            |       |                                  |       |   |   |
|                                                |       |             |       |                             |       |                                                |       |                     |       |                            |       |                                  |       |   |   |
| Comprehensive  loss:                                |       |             |       |                             |       |                                                |       |                     |       |                            |       |                                  |       |   |   |
| Net loss                                            |       |             |       |                             |       |                                                |       |                     |       | (15,704,544                     | )          | (15,704,544                           | )          | (15,704,544 | ) |
| Foreign currency  translation adjustment            |       |             |       |                             |       |                                                |       | (2,920                   | )          |                            |       | (2,920                                | )          | (2,920 | ) |
| Comprehensive  loss                                 |       |             |       |                             |       |                                                |       |                     |       |                            |       | (15,707,464                           | )          |   |   |
|                                                |       |             |       |                             |       |                                                |       |                     |       |                            |       |                                  |       |   |   |
| Issuance of  common stock                           |       | 3,325,636        |       | 33,257                           |       | 16,507,779                                          |       |                     |       |                            |       |                                  |       | 16,541,036 |   |
| Exercise of stock  options                          |       | 52,098           |       | 521                              |       | 85,135                                              |       |                     |       |                            |       |                                  |       | 85,656 |   |
| Issuance of shares  to Employee Stock Purchase Plan |       | 24,839           |       | 248                              |       | 124,524                                             |       |                     |       |                            |       |                                  |       | 124,772 |   |
|                                                |       |             |       |                             |       |                                                |       |                     |       |                            |       |                                  |       |   |   |
| Balance at  December 31, 2002                       |       | 25,500,097       |       | 255,001                          |       | 120,030,647                                         |       | 8,503                    |       | (106,646,522                    | )          |                                  |       | 13,647,629 |   |
|                                                |       |             |       |                             |       |                                                |       |                     |       |                            |       |                                  |       |   |   |
| Comprehensive  loss:                                |       |             |       |                             |       |                                                |       |                     |       |                            |       |                                  |       |   |   |
| Net loss                                            |       |             |       |                             |       |                                                |       |                     |       | (22,282,478                     | )          | (22,282,478                           | )          | (22,282,478 | ) |
| Foreign currency  translation adjustment            |       |             |       |                             |       |                                                |       | 11,774                   |       |                            |       | 11,774                                |       | 11,774 |   |
| Comprehensive  loss                                 |       |             |       |                             |       |                                                |       |                     |       |                            |       | (22,270,704                           | )          |   |   |
|                                                |       |             |       |                             |       |                                                |       |                     |       |                            |       |                                  |       |   |   |
| Issuance of  common stock                           |       | 4,133,529        |       | 41,335                           |       | 30,879,499                                          |       |                     |       |                            |       |                                  |       | 30,920,834 |   |
| Exercise of stock  options                          |       | 148,310          |       | 1,483                            |       | 700,319                                             |       |                     |       |                            |       |                                  |       | 701,802 |   |
| Issuance of  shares to Employee Stock Purchase Plan |       | 18,968           |       | 190                              |       | 128,311                                             |       |                     |       |                            |       |                                  |       | 128,501 |   |
|                                                |       |             |       |                             |       |                                                |       |                     |       |                            |       |                                  |       |   |   |
| Balance at  December 31, 2003                       |       | 29,800,904       |       | $                                | 298,009    |                                                | $          | 151,738,776              |       | $                               | 20,277     |                                  | $          | (128,929,000 | ) |   |   | $ | 23,128,062 |   |
|                                                |       |             |       |                             |       |                                                |       |                     |       |                            |       |                                  |       |   |   |
| Comprehensive  loss:                                |       |             |       |                             |       |                                                |       |                     |       |                            |       |                                  |       |   |   |
| Net loss                                            |       |             |       |                             |       |                                                |       |                     |       | (27,683,489                     | )          | (27,683,489                           | )          | (27,683,489 | ) |
| Unrealized gain  on investments                     |       |             |       |                             |       |                                                |       | 12,219                   |       |                            |       | 12,219                                |       | 12,219 |   |
| Foreign currency  translation adjustment            |       |             |       |                             |       |                                                |       | 39,830                   |       |                            |       | 39,830                                |       | 39,830 |   |
| Comprehensive  loss                                 |       |             |       |                             |       |                                                |       |                     |       |                            |       | (27,631,440                           | )          |   |   |
|                                                |       |             |       |                             |       |                                                |       |                     |       |                            |       |                                  |       |   |   |
| Contribution from  legal settlement                 |       |             |       |                             |       | 35,148,669                                          |       |                     |       |                            |       |                                  |       | 35,148,669 |   |
| Issuance of  common stock                           |       | 56,308           |       | 563                              |       | 182,438                                             |       |                     |       |                            |       |                                  |       | 183,001 |   |
| Exercise of stock  options                          |       | 2,254            |       | 23                               |       | 15,440                                              |       |                     |       |                            |       |                                  |       | 15,463 |   |
| Issuance of  shares to Employee Stock Purchase Plan |       | 32,071           |       | 320                              |       | 163,356                                             |       |                     |       |                            |       |                                  |       | 163,676 |   |
|                                                |       |             |       |                             |       |                                                |       |                     |       |                            |       |                                  |       |   |   |
| Balance at  December 31, 2004                       |       | 29,891,537       |       | $                                | 298,915    |                                                | $          | 187,248,679              |       | $                               | 72,326     |                                  | $          | (156,612,489 | ) |   |   | $ | 31,007,431 |   |

 

See accompanyingnotes to consolidated financial statements.

 

44

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**AKSYS, LTD.AND SUBSIDIARIES**

 

**Consolidated Statements of Cash Flows**

 

Years ended December 31,2004, 2003 and 2002

 
| ** **                                                                      | ** ** | **2004**    | ** **  | **2003**    | ** ** | **2002**    | ** ** |
|---------------------------------------------------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|
|                                                                            |       |        |        |        |       |        |       |
| Cash flows from  operating activities:                                          |       |        |        |        |       |        |       |
| Net loss                                                                        |       | $           | (27,683,489 | )           | $          | (22,282,478 | )          | $ | (15,704,544 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:    |       |        |        |        |       |        |       |
| Depreciation and  amortization                                                  |       | 829,955     |        | 565,006     |       | 566,285     |       |
| Non-cash  interest expense                                                      |       | 1,086,082   |        | —      |       | —      |       |
| Issuance of  stock in exchange for services received                            |       | —      |        | 154,570     |       | 35,007      |       |
| Changes in  assets and liabilities:                                             |       |        |        |        |       |        |       |
| Accounts  receivable                                                            |       | 105,026     |        | (211,621    | )          | (126,811    | )          |
| Other  receivables                                                              |       | (120,297    | )           | 125,053     |       | 101,759     |       |
| Inventories                                                                     |       | 279,118     |        | (3,313,747  | )          | (2,681,691  | )          |
| Prepaid expenses  and other assets                                              |       | (51,131     | )           | 8,877       |       | (67,786     | )          |
| Deposits with  vendors                                                          |       | (3,358,244  | )           | (97,543     | )          | 688,002     |       |
| Accounts payable                                                                |       | (3,305,279  | )           | 2,968,973   |       | 913,447     |       |
| Deferred revenue                                                                |       | 187,762     |        | 64,487      |       | 1,326       |       |
| Accrued and  other liabilities                                                  |       | 647,498     |        | 626,540     |       | 93,295      |       |
| Net cash used in  operating activities                                          |       | (31,382,999 | )           | (21,391,883 | )          | (16,181,711 | )          |
|                                                                            |       |        |        |        |       |        |       |
| Cash flows from  investing activities:                                          |       |        |        |        |       |        |       |
| Purchases of  investments                                                       |       | (47,253,385 | )           | (17,659,774 | )          | (25,406,457 | )          |
| Proceeds from maturities  of investments                                        |       | 22,777,328  |        | 23,438,108  |       | 16,040,000  |       |
| Purchases of  equipment leased to others                                        |       | (1,609,880  | )           | (959,125    | )          | (280,000    | )          |
| Purchases of  property and equipment                                            |       | (871,690    | )           | (580,219    | )          | (174,924    | )          |
| Net cash  provided by (used in) investing activities                            |       | (26,957,627 | )           | 4,238,990   |       | (9,821,381  | )          |
|                                                                            |       |        |        |        |       |        |       |
| Cash flows from  financing activities:                                          |       |        |        |        |       |        |       |
| Proceeds from  short-term line of credit                                        |       | 3,400,000   |        | —      |       | —      |       |
| Proceeds from  issuance of notes payable                                        |       | 16,100,000  |        | —      |       | —      |       |
| Proceeds from  issuance of common stock                                         |       | 362,140     |        | 31,596,567  |       | 16,716,457  |       |
| Proceeds from  Durus settlement                                                 |       | 32,500,357  |        | —      |       | —      |       |
| Net cash  provided by financing activities                                      |       | 52,362,497  |        | 31,596,567  |       | 16,716,457  |       |
|                                                                            |       |        |        |        |       |        |       |
| Net increase  (decrease) in cash and cash equivalents                           |       | (5,978,129  | )           | 14,443,674  |       | (9,286,635  | )          |
| Cash and cash  equivalents at beginning of year                                 |       | 15,397,453  |        | 953,779     |       | 10,240,414  |       |
| Cash and cash  equivalents at end of year                                       |       | $           | 9,419,324   |        | $          | 15,397,453  |       | $ | 953,779 |   |
|                                                                            |       |        |        |        |       |        |       |
| Supplemental  information relating to net cash flows from operating activities: |       |        |        |        |       |        |       |
| Cash paid for  interest expense                                                 |       | $           | 44,455      |        | $          | —      |       | $ | — |   |
| Cash paid for  income taxes                                                     |       | 105,512     |        | —      |       | —      |       |

 

See accompanyingnotes to consolidated financial statements.

 

45

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**December 31, 2004, 2003 and 2002**

 

**(1)****                                ****Summary ofSignificant Accounting Policies**

 

***Organization and Nature of Business***

 

Aksys,Ltd. (the Company) was originally incorporated in Illinois on January 18,1991.  In March 1993, the Companymerged into a Delaware corporation. During the quarter ended September 30, 2002, the Company commencedcommercial activities and was no longer considered to be in the developmentstage.  The Company is involved in thesale and marketing of its sole product, the PHD System.  In addition, the Company continues devotingsome of its efforts to product development. The Company operates in one industry segment and substantially all ofits long-lived assets are located in the United States.

 

Certainreclassifications have been made to the 2002 and 2003 consolidated financialstatements in order to conform to the 2004 presentation.

 

Asummary of the significant accounting policies applied in the preparation ofthe accompanying consolidated financial statements of the Company follows:

 

***(a) Principles of Consolidation***

 

OnApril 18, 1996 the Company established a subsidiary in Tokyo, Japan, andon August 8, 1998, the Company established a subsidiary in the UnitedKingdom.  The consolidated financialstatements include the financial statements of the Company and its wholly ownedsubsidiaries.  All significantintercompany transactions and balances have been eliminated in consolidation.

 

***(b) Use of Estimates***

 

Preparationof the consolidated financial statements requires management of the Company tomake estimates and assumptions relating to the reported amount of assets andliabilities and the disclosure of contingent assets and liabilities at the dateof the consolidated financial statements, and the reported amounts of revenueand expenses during the period. Significant items subject to such estimates andassumptions include the carrying amount of property, equipment and intangibleassets and valuation allowances for receivables, inventories and deferredincome tax assets.  Actual results coulddiffer from those estimates.

 

***(c) Cash Equivalents***

 

Cashequivalents of $8,331,692 and $15,247,962 at December 31, 2004 and 2003,respectively, consist of certain highly liquid investments with maturities ofless than three months when purchased.

 

(***d) Investment Securities***

 

As of December 31, 2004and 2003 all investments consisted of certificates of deposit, U.S. governmentsecurities, U.S. government agency securities and investment grade corporatedebt securities, each with a term less than or equal to five years.

 

The Company accounts forits investments using Statement of Financial Accounting Standards No. 115, “Accountingfor Certain Investments in Debt and Equity Securities”.  This standard requires that certain debt andequity securities be adjusted to market value at the end of each accountingperiod.  Unrealized holding gains andlosses, net of the related tax effect, on available-for-sale securities areexcluded from earnings and are reported as a separate component of othercomprehensive income until realized.

 

46

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The Company classifiesits debt securities in one of two categories: held-to-maturity oravailable-for-sale.  Held-to-maturitydebt securities are those securities in which the Company has the ability andintent to hold the security until maturity. All other securities are classified as available-for-sale.

 

Held-to-maturity debtsecurities are recorded at amortized cost, adjusted for the amortization oraccretion of premiums or discounts. Unrealized holding gains and losses, net of the related tax effect, onavailable-for-sale securities are excluded from earnings and are reported as aseparate component of other accumulated comprehensive income untilrealized.  Realized gains and losses fromthe sale of available-for-sale securities are determined on aspecific-identification basis.

 

A decline in the marketvalue of any available-for-sale or held-to-maturity security below cost that isdeemed to be other-than-temporary results in a reduction in carrying amount tofair value.  The impairment is charged toearnings and a new cost basis for the security is established. To determinewhether an impairment is other-than-temporary, the Company considers whether ithas the ability and intent to hold the investment until a market price recoveryand considers whether evidence indicating the cost of the investment isrecoverable outweighs evidence to the contrary.

 

Premiums and discountsare amortized or accreted over the life of the related held-to-maturity oravailable-for-sale security as an adjustment to yield using theeffective-interest method.  Dividend andinterest income are recognized when earned.

 

The majority of short andlong-term investments are classified as held-to-maturity because the Companyhas the ability and intent to hold these securities until maturity. At December31, 2004, the one exception is a long-term U.S. government agency security witha market value of approximately $7.6 million that is classified asavailable-for-sale. Monthly changes to the market value of this security areincluded in other accumulated comprehensive income for this investment.  As of December 31, 2003 there were noinvestments classified as available-for-sale.

 

***(e) Inventories***

 

Inventories are stated at the lower of weightedaverage cost or market. The weighted average cost of inventory approximates thefirst-in, first-out method (FIFO) for all inventories.

 

***(f) Long-Lived Assets***

 

Property,equipment and leased assets are recorded at cost and depreciated using thestraight-line method over the estimated useful lives of the assets, rangingfrom three to seven years.  Leaseholdimprovements are amortized over the shorter of the lease term or estimateduseful life of the asset.  The Companyleases PHD Systems to customers on a short-term basis (12 months or less) orlong-term basis (up to 24 months). Leased assets include PHD Systems currently under operating leases andmachines held for future leases.  Additionsand improvements are capitalized, and expenditures for repairs and maintenanceare charged to operations as incurred. PHD machines used as sales demonstrationmodels or for internal training are transferred from inventory to equipment anddepreciated over their useful life.

 

The Company accounts forlong-lived assets in accordance with Statement of Financial AccountingStandards Board Statement 144, *Accounting for theImpairment of Long-Lived Assets*. In accordance with Statement 144, long lived assets, such as property,plant, and equipment, and purchased intangibles subject to amortization, arereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. Recoverability ofassets to be held and used is measured by a comparison of the carrying amountof an asset to estimated undiscounted future cash flows expected to begenerated by the asset. If the carrying amount of an asset exceeds itsestimated future cash flows, an impairment charge is recognized by the amountby which the carrying amount of the asset exceeds the fair value of the asset.Assets to be disposed of would be separately presented in the balance sheet andreported at the lower of the carrying amount or fair value less costs to sell,and are no longer depreciated. The assets and

 

47

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liabilities of a disposedgroup classified as held for sale would be presented separately in theappropriate asset and liability sections of the balance sheet.

 

***(g) Revenue Recognition***

 

TheCompany recognizes revenue in accordance with Staff Accounting Bulletin (SAB)No. 104, *Revenue Recognition*, and its relatedinterpretations.  Revenue is recognizedwhen the following conditions exist: (1) there is persuasive evidence of anarrangement, (2) the product has been delivered and accepted or services andsupplies have been provided to the customer, (3) the sales price is fixed ordeterminable and (4) collectability is reasonably assured.

 

Duringthe quarter ended September 30, 2003, the Company adopted Emerging Issues TaskForce (EITF) Issue No. 00-21, *Accounting for RevenueArrangements with Multiple Deliverables*, which did not have animpact on financial position, results of operations or cash flows. The Companyrecognizes revenue from product sales at the time of installation of the PHDSystem. Services and supplies are sold to customers in a monthly serviceagreement, not dependent on service time incurred or materials used.   Services and supplies revenue is recognizeduniformly over the term of the agreement.

 

TheCompany also leases the PHD System to customers on a short-term basis (12months or less) and long-term basis (up to 24 months) and recognizes revenue onthese operating system contracts on a straight-line basis over the leaseterm.  The Company has no contracts withdistributors and sells its product directly to its customers through its ownsales force.

 

Ourlargest customers, the Northwest Kidney Center, Dialysis Center of Lincoln andBerkshire Medical Dialysis Center accounted for 24%, 10% and 9%, respectively,of our revenues (by dollar volume) for fiscal year 2004.

 

***(h) Research and Development Costs***

 

Researchand development costs are charged to expense when incurred.

 

***(i) Income Taxes***

 

Deferredtax assets and liabilities are recognized for the future tax consequencesattributable to the difference between the financial statement carrying amountof existing assets and liabilities and their respective tax bases and operatingloss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax ratesexpected to apply to taxable income in the years in which those temporarydifferences are expected to be recovered or settled.  The effect on deferred tax assets andliabilities of a change in tax rates is recognized in income in the period thatincludes the enactment date.

 

***(j) Computation of Net Loss per Share***

 

Netloss per share is based on the weighted average number of shares outstandingwith common equivalent shares from stock options and warrants excluded from thecomputation because their effect is antidilutive. At December 31, 2004, 2003and 2002, the number of common equivalent shares from stock options andwarrants excluded from the computation were 2,800,111, 2,239,088 and 1,800,653,respectively.

 

48

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***(k) Stock-Based Compensation***

 

TheCompany applies the intrinsic value based method of accounting prescribed byAccounting Principles Board (APB) Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related interpretations includingFASB Interpretation No. 44, *Accounting for CertainTransactions involving Stock Compensation*, an interpretation of APBOpinion No. 25, to account for its fixed plan stock options. Under this method,compensation expense is recorded on the date of grant only if the currentmarket price of the underlying stock exceeded the exercise price. SFAS No. 123,*Accounting for Stock Based Compensation*and SFAS No. 148, *Accounting for Stock-Based Compensation –Transition and Disclosure*, an amendment of FASB Statement No. 123,established accounting and disclosure requirements using a fair value basedmethod of accounting for stock based employee compensation plans. As permittedby existing accounting standards, the Company has elected to continue to applythe intrinsic value based method of accounting described above, and has adoptedonly the disclosure requirements of SFAS No. 123, as amended. The following tableillustrates the effect on net losses if the fair value based method had beenapplied to all outstanding and unvested awards in each period.

 
| ** **                  | ** **                                                                                                | **2004** | ** **  | **2003** | ** ** | **2002**    | ** ** |
|-----------------------------|-----------------------------------------------------------------------------------------------------------|----------|-------------|----------|------------|-------------|------------|
| Net loss as  reported       |                                                                                                      | $        | (27,683,489 | )        | $          | (22,282,478 | )          | $ | (15,704,544 | ) |
| Add:                        | Total stock-based  employee compensation expense determined under fair value based method for  all awards |     | (2,129,274  | )        | (1,779,380 | )           | (1,947,769 | ) |
|                        |                                                                                                      |     |        |     |       |        |       |
| Pro forma net  loss         |                                                                                                      | $        | (29,812,763 | )        | $          | (24,061,858 | )          | $ | (17,652,312 | ) |
| Loss per share  as reported |                                                                                                      | $        | (0.93       | )        | $          | (0.79       | )          | $ | (0.65 | ) |
| Pro forma loss  per share   |                                                                                                      | $        | (1.00       | )        | $          | (0.85       | )          | $ | (0.73 | ) |
|                             |                                                                                                           |          |             |          |            |             |            |  |  |  |  |

*** ***

***(l) Recently Issued Accounting Pronouncements***

*** ***

In December 2004, the FASBissued SFAS No. 123 (revised 2004), *Share-Based Payment*(SFAS123(R)). SFAS 123(R) requires that the fair value of stock options be recordedin the results of operations beginning no later than July 1, 2005.  The FASB has concluded that companies couldadopt the new standard in one of two ways: the modified prospective transitionmethod and the modified retrospective transition method.  Using the modified prospective transitionmethod, a company would recognize share-based employee compensation cost fromthe beginning of the fiscal period in which the recognition provisions arefirst applied as if the fair-value-based accounting method had been used toaccount for all employee awards granted, modified or settled after theeffective date and to any awards that were not fully vested as of the effectivedate.  Using the modified retrospectivemethod, a company would recognize employee compensation cost for periodspresented prior to the adoption of the proposed standard in accordance with theoriginal provisions of SFAS No. 123; that is, an entity would recognizeemployee compensation cost in the amounts reported in the pro forma disclosurescurrently required by SFAS No. 123.  Acompany would not be permitted to make any changes to those amounts uponadoption of the proposed standard unless those changes represent a correctionof an error (and are disclosed accordingly). For periods after the date of adoption of the proposed standards, themodified prospective transition method described above would be applied. TheCompany has not determined the effect of the new standard on earnings; however,expense under the new standard could be higher. The effect of adopting the new rules on reported diluted earnings pershare is dependent on the number of options granted in the future, the terms of

 

49

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those awards and theirfair values, and therefore the effect on diluted earnings per share couldchange. Aksys has not determined an adoption date and has not determinedwhether it would adopt prospectively, or retrospectively to January 1, 2005.

 

In May 2003, the FASBissued SFAS No. 150, *Accounting for CertainFinancial Instruments with Characteristics of both Liability and Equity.*SFAS No. 150 establishes standards for how an issuer classifies and measurescertain financial instruments with characteristics of both liabilities and equity.It also requires that an issuer classify a financial instrument that is withinits scope as a liability (or an asset in some circumstances). Many of thoseinstruments were previously classified as equity. SFAS No. 150 is effective forfinancial instruments entered into or modified after May 31, 2003, andotherwise is effective at the beginning of the first interim period beginningafter June 15, 2003, except for mandatorily redeemable financial instruments.For certain mandatorily redeemable financial instruments, the Statement will beeffective for the Company on January 1, 2005. The effective date has been deferred indefinitely for certain othertypes of mandatorily redeemable financial instruments. The adoption of SFAS No.150 did not have a significant impact on the Company’s consolidated financialposition or results from operations.

 

***(m)Translation of Foreign Currency***

 

The Company follows thetranslation policy as provided by SFAS No. 52, “Foreign Currency Translation”in translating the financial statements of its operation in the United Kingdomfrom British pounds to U.S. dollars. Accordingly, assets and liabilities are translated at the rate ofexchange at the balance sheet date. Income and expenses are translated at the average exchange rateprevailing throughout the year.   Resultingcumulative translation adjustments have been recorded as a separate componentof stockholders’ equity.

 

***(n)Comprehensive Loss***

 

The Company follows SFASNo. 130 “Reporting Comprehensive Income”. Comprehensive income includes net income, foreign currency translation adjustmentsand unrealized gains or losses on available for sale securities.  Comprehensive loss is presented in theconsolidated statements of stockholders’ equity.

 

***(o)Advertising Costs***

 

Advertising costs areexpensed as incurred.  Advertisingexpense for the years ended December 31, 2004, 2003 and 2002 was $720,000,$608,000 and $223,000, respectively.

 

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**(2)****                                ****Investments**

 

Thefollowing is a summary of investments as of December 31, 2004 and 2003:

 

Longterm available-for-sale securities at December 31, 2004

 
| ** **              | ** ** | **Cost** | ** ** | **Net Unrealized Holding  Gain** | ** ** | **Fair Market Value** | ** ** |
|-------------------------|------------|----------|------------|----------------------------------|------------|-----------------------|------------|
| U.S. Government  Agency |       | $        | 7,556,256  |                             | $          | 12,219                |       | $ | 7,568,475 |   |
|                         |            |          |            |                                  |            |                       |            |  |  |  |

 

Shortterm held-to-maturity securities at December 31, 2004

 
| ** **                       | ** ** | **Amortized Cost** | ** ** | **Gross Unrealized Holding  Losses** | ** ** | **Fair Market Value** | ** ** |
|----------------------------------|------------|--------------------|------------|--------------------------------------|------------|-----------------------|------------|
| Certificates of  Deposit         |       | $                  | 75,000     |                                 | $          | 0                     |       | $ | 75,000 |   |
| U.S Treasury                     |       | 9,490,587          |       | 7,187                                |       | 9,483,400             |       |
| U.S. Government  Agency          |       | 10,507,545         |       | 34,629                               |       | 10,472,916            |       |
| Investment Grade  Corporate Debt |       | 1,624,313          |       | 12,074                               |       | 1,612,239             |       |
| Total                            |       | $                  | 21,697,445 |                                 | $          | 53,890                |       | $ | 21,643,555 |   |
|                                  |            |                    |            |                                      |            |                       |            |  |  |  |  |

 

Short-terminvestments consisted of commercial paper, corporate bonds and U.S. Treasurysecurities at December 31, 2003 with a market value of $4,777,644 and amortizedcost of $4,770,962.

 

TheCompany must maintain a minimum balance in its investment account as collateralfor the line of credit.  The amount ofcollateral required is dependant on the type of investments in theaccount.  As of December 31, 2004, 90% ofthe value of restricted securities must cover the maximum available credit of$6.0 million. As of December 31, 2004, the Company has restricted $6.7 millionof short-term investments in order to satisfy the line of credit collateralrequirement.

 

Inaddition, at December 31, 2004 and 2003 the Company is required to hold acertificate of deposit in the amount of $600,000 as a security deposit on thebuilding lease.  This certificate ofdeposit is classified as a restricted long-term investment.

 

**(3)****                                ****Inventories**

 

Inventoriesat December 31, 2004 and December 31, 2003, respectively, are as follows:

 

 
| ** **                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
| PHD machines – finished goods |       | $        | 4,504,500  |     | $          | 4,780,000 |   |
| PHD machines  spare parts          |       | 876,396  |       | 918,557  |       |
| Consumables                        |       | 330,101  |       | 252,354  |       |
| Raw materials                      |       | 5,323    |       | 44,527   |       |
|                               |       | $        | 5,716,320  |     | $          | 5,995,438 |   |

 

51

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Thecost of producing the PHD System is currently in excess of its marketprice.  During the year ended December31, 2004 and 2003, an inventory adjustment was recorded as product cost ofsales in the amount of $567,681 and $1,431,079, respectively, in order to valuethe PHD machines produced and purchased during the year in inventory at thelower of cost or market.

 

Duringthe year ended December 31, 2004, the Company established a reserve for excessand obsolete parts and consumables of $340,000.

 

**(4)****                                ****Property, Equipment and Leased Assets**

 

Property,equipment and leased assets at December 31, 2004 and 2003, respectively, are asfollows:

 
| ** **                                      | ** ** | **Estimated  useful life** | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|------------|------------|------------|------------|
| Leased assets                                   |       | 5 years                    |       | $          | 2,847,673  |       | $          | 1,237,792 |   |
| Furniture and  fixtures                         |       | 7 years                    |       | 1,238,586  |       | 1,238,586  |       |
| Leasehold  improvements                         |       | 10 years                   |       | 1,146,511  |       | 1,146,511  |       |
| Equipment                                       |       | 3-7 years                  |       | 5,272,998  |       | 4,401,309  |       |
|                                            |       |                       |       | 10,505,768 |       | 8,024,198  |       |
| Less accumulated  depreciation and amortization |       |                       |       | (6,581,846 | )          | (5,751,891 | )          |
|                                            |       |                       |       |       |       |       |       |
|                                            |       |                       |       | $          | 3,923,922  |       | $          | 2,272,307 |   |

 

Leasedassets at December 31, 2004 were 2,847,673 with related accumulateddepreciation of $456,842.  At December31, 2003 leased assets were $1,237,792 with accumulated depreciation of$105,259.

 

**(5)****                                ****Stockholders’ Equity**

 

Durus Settlement.  In February 2004, we settled all ouroutstanding claims against Durus Life Sciences Master Fund Ltd. and otherdefendants.  We had filed a lawsuit inAugust 2003 after learning that Durus Life Sciences Master Fund Ltd. (the“Durus fund”), Scott Sacane, Durus Capital Management, LLC (“Durus Capital”),Durus Capital Management (N.A.), LLC (“Durus Capital (N.A.)”) and Artal LongBiotech Portfolio LLC (the “Artal fund”) had acquired over 70% of ouroutstanding common stock.  We refer tothe Durus fund, Mr. Sacane, Durus Capital, Durus Capital (N.A.) and the Artalfund collectively as “defendants” and individually as a “defendant.”

 

*Backgoundto the Litigation*.  InApril 2003, we entered into an agreement with Mr. Sacane and Durus Capitalrelating to shares of our common stock they then controlled through the Durusfund (the “April 2003 Agreement”).  Weentered into the April 2003 Agreement after we learned that certain of thedefendants had accumulated a position in our common stock in excess of the 15%ownership level that would potentially trigger our Shareholders RightsAgreement.

 

Pursuant to the terms ofthe April 2003 Agreement, Mr. Sacane and Durus Capital represented that they:(1) then owned 5,238,248 shares (approximately 19.5%) of our outstanding commonstock, (2) crossed the 15% ownership level inadvertently, and (3) held thisinvestment in the Company in the ordinary course of business and not for thepurpose or with the effect of changing or influencing the control of theCompany.  In addition, they agreed toreduce their holdings to below 15% ownership over a two-year period and not topurchase any additional shares of our common stock until such time as theirownership was less than 15% of the shares then-outstanding (and thereafter notin excess of 15% without the consent of our board of directors).

 

After the close ofbusiness on July 24, 2003, Mr. Sacane informed us that he, together with theother defendants, had accumulated in excess of 19 million shares of our commonstock in transactions he described as inadvertent.  In a Schedule 13D filed with the SEC on July28, 2003, the defendants disclosed that they owned 21,333,118 of these sharesand the Artal fund owned 498,100.

 

In August 2003, we fileda lawsuit against the defendants in the United States District Court for theDistrict of Connecticut.  Our lawsuitsought injunctive relief and damages arising from the defendants' allegedviolation of federal securities law and the alleged breach of April 2003Agreement.  In addition, our lawsuitsought recovery of short-swing trading profits under Section 16(b) of theSecurities Exchange Act of 1934.

 

In January 2004, wesettled the Section 16b claim against the defendants for $4.6 million.  In February 2004, we settled all other claimsagainst the defendants, and received as part of that settlement an additional$34.1 million in cash, of which $16.1 million was in exchange for unsecuredsubordinated promissory notes.  In May2004 we received a final payment of $10.0 million in connection with theeffectiveness of a registration statement we filed with the SEC covering thesecurities owned by Durus fund and the Artal fund.

 

In February 2004, theCompany settled all other claims against the Durus Fund and other defendantsfor an aggregate payment to the Company of $48.7 million, which includes thepurchase by the Durus Fund and another defendant of $16.1 million of promissorynotes (“Notes”) and the earlier $4.6 million payment to settle claims underSection 16.  As of June 30, 2004, theCompany had received the full $48.7 million. Under the Registration Rights Agreement between the Company and theDurus Fund, the Company agreed to pay up to $500,000 in costs with respect toany Shelf Registration required to sell the shares held by Durus.

 

52

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During the quarter endedSeptember 30, 2004 the Company accrued $500,000 for services provided by aninvestment banking firm in relation to the Durus settlement.

 

The $10.0 millionreceived during the second quarter, and the $22.6 million cash payment receivedin the first quarter, were considered to be capital contributions and wererecorded as an increase to additional paid-in capital.  The Company also entered into a note purchaseagreement with the Durus fund and the Artal fund whereby the Durus fund and theArtal fund purchased approximately $15.8 million and $0.3 million,respectively, of unsecured subordinated promissory notes (the “Notes”) fromus.  The Notes are subordinated andjunior in right of payment to all of our creditors, including trade creditors,and do not bear interest. The Company imputed an interest rate of 10%, anddiscounted the notes to $12.6 million. The $3.5 million discount on the notes was also recorded as an increaseto additional paid-in capital.  TheCompany may repay the notes in cash at any time.  After the later of (1) August 30, 2005 and(2) the first trading day on which the holders of the Notes own less than 10%of our then-outstanding common stock, the Company may repay the Notes instock.  Any stock issued in repayment ofthe Notes will be subject to registration rights pursuant to the registrationrights agreement.  The Notes will becomedue and payable one year after the later of the two dates above and in no eventlater than February 23, 2009.  If theCompany elects to repay the Notes in stock, the number of shares that must bedelivered for payment will be determined based on the average of the closingprices of Aksys, Ltd. common stock on the Nasdaq National Market over thetwenty trading days preceding the Company’s election to repay in stock.  The Notes will also become due and payable incash upon a change of control.  In theevent of a change of control repayment, in addition to repayment of thethen-outstanding principal amount of the Notes, the Company is required to pay tothe holders of the Notes an amount equal to (1) 5% of the considerationreceived by (a) the Company in the case of an asset sale transactionconstituting a change of control (net of corporate taxes, transaction expensesand indebtedness of the Company) or (b) our stockholders and the holders of theNotes in a merger or other type of transaction constituting a change ofcontrol, less (2) the principal amount repaid.

 

OnJanuary 22, 2003, the Company entered into a $15 million equity line of creditarrangement with Kingsbridge Capital Limited (“Kingsbridge”).  This arrangement superceded a similararrangement entered into between the Company and Kingsbridge on October 15,2002.  Pursuant to the terms of theAmended and Restated Common Stock Purchase Agreement between the Company andKingsbridge, the Company could sell common stock at its sole discretion over a24-month period on a “when and if needed” basis, and Kingsbridge was requiredunder the terms of the agreement to purchase this stock, subject to thesatisfaction of certain conditions contained in the agreement.  During the year ended December 31, 2003, theCompany issued 2,489,408 shares of common stock to Kingsbridge under the equityline arrangement and received $15.0 million in proceeds.  The Company received $1,150,000 whenKingsbridge exercised 200,000 warrants to purchase common stock at $5.75 pershare in 2003.  As of December 31, 2003the Company had fully drawn the equity line with Kingsbridge and did notcurrently have a similar arrangement with Kingsbridge or any other entity.

 

OnJune 30, 2003, the Company issued 1,363,637 shares of common stock to a singleinvestor and received net proceeds of $13.8 million.  In addition, the Company issued a warrant topurchase 204,546 shares of stock at an exercise price of $13.75 per share.  This warrant had a fair value of $1,007,745using the Black Scholes pricing model. The Company also issued a warrant to purchase 136,364 shares of commonstock at an exercise price of $15.00 per share to an investment banking firmthat acted as placement agent in this transaction.  This warrant had a fair value of $622,908using the Black Scholes pricing model. The Company offered the foregoing securities in a public offering.

 

OnMay 10, 2002, the Company completed a private placement to institutional investorsof 3,319,396 shares of its common stock, at a per share price of $5.29,resulting in gross proceeds of approximately $17.6 million.  After offering costs, net proceeds to theCompany were approximately $16.5 million. The shares were sold with the assistance of U.S. Bancorp Piper Jaffray (“PiperJaffray”).  As the placement agent, PiperJaffray received fees of approximately $1.1 million.

 

During 2003 and 2002, theCompany issued 28,764 and 6,240 shares respectively of common stock at a fairvalue of $154,570 and $35,007 in exchange for services rendered.  There were no similar stock issuances in2004.

 

53

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**(6)****                                ****Stock Option Plans**

 

TheCompany established a nonqualified stock option plan in 1993 (the “1993 StockOption Plan”), which provides for the granting of options to purchase shares ofthe Company’s common stock to the employees, scientific advisory board members,other associates, and members of the board of directors.  In March 1996, the Company established the1996 Stock Awards Plan (together with the 1993 Stock Option Plan, the “StockPlans”) to provide incentive awards to directors, employees and other keyindividuals in the form of stock options, SARs, restricted stock andperformance grants.  Options vest overvarious periods as set forth in agreements relating to a particular optiongrant and expire as determined by the board on an individual basis, but not toexceed 10 years.  At the time the 1996Stock Awards Plan was established, the 1993 Stock Option Plan was terminated,except with respect to options then outstanding.  At December 31, 2004, 3,276,150 sharesof common stock have been reserved for issuance under the Stock Plans,including 1,224,969 shares available for future grants under the 1996 StockAwards Plan.

 

Theper share weighted-average fair value of stock options granted during 2004,2003 and 2002 was $5.17, $4.63 and $5.16, respectively, on the dates of grantusing the Black Scholes option-pricing model with the following weighted-averageassumptions: 2004 – expected dividend yield of 0%, expected volatility of 97.41%,risk-free interest rate averaging 2.28% and an expected life of 5 years; 2003 –expected dividend yield of 0%, expected volatility of 65.05%, risk-freeinterest rate averaging 2.07% and an expected life of 5 years; 2002 - expecteddividend yield of 0%, expected volatility of 131%, risk-free interest rate of1.20%, and an expected life of 5 years.

 

Stock option activityduring the periods indicated is as follows:

 
| ** **                    | ** ** | **Number of  shares** | ** ** | **Weighted-average  exercise price** | ** ** |
|-------------------------------|------------|-----------------------|------------|--------------------------------------|------------|
| Balance at  December 31, 2001 |       | 1,318,916             |       | $                                    | 6.7943     |   |
| Granted                       |       | 383,882               |       | 6.0013                               |       |
| Exercised                     |       | (52,098               | )          | 1.6441                               |       |
| Canceled                      |       | (277,490              | )          | 9.5136                               |       |
|                          |       |                  |       |                                 |       |
| Balance at  December 31, 2002 |       | 1,373,210             |       | 6.2186                               |       |
| Granted                       |       | 274,000               |       | 8.2601                               |       |
| Exercised                     |       | (148,310              | )          | 4.7985                               |       |
| Canceled                      |       | (65,050               | )          | 6.7274                               |       |
|                          |       |                  |       |                                 |       |
| Balance at  December 31, 2003 |       | 1,433,850             |       | 6.7325                               |       |
| Granted                       |       | 683,035               |       | 7.0004                               |       |
| Exercised                     |       | (2,254                | )          | 7.3088                               |       |
| Canceled                      |       | (63,450               | )          | 6.9803                               |       |
|                          |       |                  |       |                                 |       |
| Balance at December  31, 2004 |       | 2,051,181             |       | $                                    | 6.8135     |   |

 

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Thefollowing table summarizes information about stock options outstanding atDecember 31, 2004:

 

 
| ** **                   | ** ** | **Options Outstanding**              | ** ** | **Options Exercisable**                              | ** ** |
|------------------------------|------------|--------------------------------------|------------|------------------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Number  Outstanding  at 12/31/04** | ** ** | **Weighted-  Average  Remaining  Contractual  Life** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Number  Exercisable at  12/31/04** | ** ** | **Weighted-  Average Exercise  Price** | ** ** |
|                         |       |                                 |       |                                                 |       |   |   |   |   |   |   |
| $0.25 to $3.99               |       | 1,150                                |       | 0.3 years                                            |       | $ | 0.2533 |   | 1,150 |   | $ | 0.2533 |   |
| $4.00 to $5.00               |       | 110,255                              |       | 5.9 years                                            |       | $ | 4.6056 |   | 81,505 |   | $ | 4.6023 |   |
| $5.01 to $6.00               |       | 762,263                              |       | 5.7 years                                            |       | $ | 5.3277 |   | 585,718 |   | $ | 5.3519 |   |
| $6.01 to $7.50               |       | 729,847                              |       | 8.3 years                                            |       | $ | 6.6356 |   | 264,466 |   | $ | 6.4619 |   |
| $7.51 to $16.75              |       | 447,666                              |       | 6.4 years                                            |       | $ | 10.1941 |   | 287,604 |   | $ | 10.0186 |   |
| $0.25 to $16.75              |       | 2,051,181                            |       |                                                 |       |   |   | 1,220,443 |   |   |   |

 

**(7)****                                ****Employee Benefit Plans**

 

In1995 the Company adopted a tax-qualified employee savings and retirement plan(the “401(k) Plan”) covering all full-time employees.  The 401(k) Plan provides a match of 100% ofthe employees’ contributions up to 2% of an employee’s salary.  Total expense for the years endedDecember 31, 2004, 2003 and 2002 was $115,201, $85,370 and $62,521,respectively.

 

OnMarch 4, 1996, the Company established the 1996 Employee Stock Purchase Plan(the “1996 Stock Purchase Plan”) covering all employees.  The 1996 Stock Purchase Plan allowedemployees to purchase Company common stock at a 15% discount to market, basedon eligible payroll deductions.

 

OnApril 26, 2001, the Company established the 2001 Employee Stock Purchase Plan(the “2001 Stock Purchase Plan”) covering all employees.  The 2001 Stock Purchase Plan superceded theCompany’s 1996 Stock Purchase Plan.  The2001 Stock Purchase Plan allows employees to purchase Company common stock at a15% discount to market, based on eligible payroll deductions.  There are four plan periods in each calendaryear, with each such plan period corresponding with a calendar quarter.  Market price is calculated as the fair marketvalue of the common stock as of the last trading day of such plan period lessthe discount to the market.  A total of250,000 shares of common stock were reserved for issuance under the 2001 StockPurchase Plan.  Total shares issued basedon payroll withholdings for the years ended December 31, 2004, 2003 and 2002were 37,738 (9,738 issued January 2005), 16,394 (4,071 issued January 2004) and24,358 (6,645 issued January 2003), respectively.  As of December 31, 2004, there are 140,807shares remaining under the 2001 Stock Purchase Plan.

 

**(8)****                                ****Stockholder Rights Plan**

 

On October 28, 1996 the Company adopted a stockholderrights plan and declared a dividend to be made to stockholders of record onNovember 8, 1996 of one preferred share purchase right on each outstandingshare of the Company’s common stock.  Thestockholder rights plan was adopted to preserve for the stockholders of theCompany the long-term value of the Company in the event of a takeover of theCompany or the purchase of a significant block of the Company’s common stockand to protect the Company and its stockholders against coercive takeovertactics.  Prior to the time the rightsbecome exercisable, the rights will be evidenced by the certificatesrepresenting shares of common stock of the Company and will be transferableonly in connection with the transfer of shares of common stock.  If a person acquires 15% of the Company’scommon stock the rights will then be exercisable, and each right will entitlethe holder thereof to

 

55

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purchase for an exercise price of $85.00 (subject toadjustment), shares of the Company’s common stock having a market value oftwice such exercise price, valued as of the date of occurrence of suchtriggering event, subject to the right of the Company to exchange the rightsfor common stock of the Company on a one-for-one basis.  The Company will be entitled to redeem therights at $0.01 per right at any time before public disclosure that a 15% positionhas been acquired.  The rights willexpire on October 28, 2006, unless previously redeemed or exercised.  As part of the settlement agreement with theDurus funds, as discussed in Note 5, the Company has amended its RightsAgreement to conditionally exempt the Durus funds therefrom.

 

**(9)****                                ****Income Taxes**

 

Asa result of the settlement with Durus, the Company will have an income taxobligation for the year ended December 31, 2004.  Net operating loss carryforwards will be usedto cover a portion of the taxable income triggered under the alternativeminimum tax. The Company has recorded income tax expense for the year of$106,000.  An estimated tax payment forthis amount was made in the quarter ended December 31, 2004.  No additional Federal or state income taxeshave been provided for in the accompanying financial statements. AtDecember 31, 2004, the Company has net operating loss and other tax creditcarryforwards for Federal income tax purposes of approximately $129.7 millionand $2.9 million.  The net operating losscarryforwards expire at various dates beginning in 2012.  As a result of the annual limitation, aportion of these carryforwards may expire before ultimately becoming availableto reduce federal income tax liabilities.  Changes in the Company’sownership would cause additional limitations on the amount of loss and creditcarryforwards that can be utilized to offset income in the future.

 

Thenet deferred tax assets are summarized at December 31 as follows:

 
| ** **                            | ** ** | **2004**    | ** ** | **2003**    | ** ** |
|---------------------------------------|------------|-------------|------------|-------------|------------|
| Deferred tax  assets:                 |       |        |       |        |       |
| Net operating  loss carryforwards     |       | $           | 51,895,000 |        | $          | 53,897,000 |   |
| Research and  other tax carryforwards |       | 2,961,000   |       | 2,870,000   |       |
| Other                                 |       | 584,000     |       | 603,000     |       |
|                                  |       |        |       |        |       |
| Total deferred  tax assets            |       | 55,440,000  |       | 57,370,000  |       |
| Less valuation  allowance             |       | (55,440,000 | )          | (57,370,000 | )          |
|                                  |       |        |       |        |       |
| Net deferred  taxes                   |       | $           | —     |        | $          | — |   |

 

Given the Company’shistorical losses and uncertainty with respect to the Company’s ability togenerate future taxable income, management has established a valuationallowance of $55,440,000 at December 31, 2004 and $57,370,000 at December 31,2003 to reduce the net deferred tax assets to zero.  The increase (decrease) in the valuationallowance was $(1,930,000) and $8,767,000 in 2004 and 2003, respectively.

 

56

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**(10)****                         ****Contractual Obligations**

 

***Purchases***

 

TheCompany has a contractual obligation with the manufacturer of the PHD System topurchase the inventory purchased by the manufacturer for scheduled productionof future PHD Systems.  At December 31,2004 the total cost of this obligation was approximately $3.9 million.  During 2004, $3.4 million was paid to themanufacturer as a deposit on inventory purchased for the scheduled productionof the PHD Systems.  In addition, areserve of $130,495 has been established for potential obsolescence of thispre-production inventory.

 

***Leases***

 

DuringSeptember 1996, the Company entered into a lease agreement, accounted for as anoperating lease, for its offices and laboratory research facilities. The termof the lease was ten years expiring in September 2006. In November 2004, theCompany amended its lease with a five year extension through December2011.  The Company also leases certainequipment under operating leases. Included in both research and development expenses and general andadministrative expenses for the years ended December 31, 2004, 2003 and 2002 was$612,357, $656,490 and $654,743, respectively, for rent expense under operatingleases for certain equipment and the Company’s offices and researchfacilities.  The Company has commitmentsfor future minimum rent payments under these lease agreements, as follows:

 

| 2005                  |   | $         | 437,256   |   |
|-----------------------|--------|-----------|-----------|--------|
| 2006                  |   | 407,094   |      |
| 2007                  |   | 389,164   |      |
| 2008                  |   | 435,750   |      |
| 2009                  |   | 466,875   |      |
| All subsequent  years |   | 1,068,625 |      |
|                  |   | $         | 3,204,764 |   |

 

***License Agreements***

 

TheCompany has been granted licenses to use certain technology in the developmentand sale of its products.  Such licenseagreements provide for royalty payments to be made by the Company based on netsales over the life of any application based on the patent rights.  Minimum required payments under theseagreements are as follows:

 

| 2005                  |   | $       | 251,667   |   |
|-----------------------|--------|---------|-----------|--------|
| 2006                  |   | 250,000 |      |
| 2007                  |   | 250,000 |      |
| 2008                  |   | 250,000 |      |
| 2009                  |   | 250,000 |      |
| All subsequent  years |   | 525,588 |      |
|                  |   | $       | 1,777,255 |   |

 

Totalroyalty expense for the years ended December 31, 2004, 2003 and 2002 was$255,000, $215,000, and $185,000, respectively.

 

57

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**(11)****                         ****Contingencies**

 

In July 2004, an allegedshort-seller of Aksys stock filed a lawsuit against the Durus funds and theCompany in the Federal District for the State of Connecticut (*Collier v. Aksys, Ltd. et al., District ofConnecticut, Civil Action No. 3:04-CV-01232*).  The lawsuit is a purported class action filedon behalf of all short-sellers of Aksys stock during the period of January 1,2003 through July 24, 2003.  Theplaintiff is alleging violations of federal securities laws in connection withthe Durus funds’ accumulation of the Company’s stock.  We believe that all the claims against theCompany are without merit.  In September2004, we entered into an agreement with counsel for plaintiffs whereby we weredismissed from the lawsuit without prejudice.

 

In May 2001, the Companysigned an engagement letter with an investment banking firm to raise fundingthrough the sale of common stock. A dispute arose as to whether a fee waspayable under this letter, and litigation ensued. In March 2003, the Companyand the investment banking firm settled this litigation.  The Company agreed to pay $75,000 uponsettlement and an additional $75,000 in November 2003.  The Company also issued the investmentbanking firm 26,500 shares of its common stock upon settlement and agreed topay the investment banking firm future advisory fees of up to $160,000 in connectionwith future financings.   All paymentsdue in 2003 were made as of December 31, 2003, and no liability was recorded inthe Company’s consolidated financial statements as of December 31, 2004 or December31, 2003.

 

In theordinary course of business, the Company is party to employment and other legalactions as plaintiff or defendant.  Whilemanagement cannot determine with certainty the ultimate outcome of suchlawsuits, management believes that the Company is not involved in any currentlitigation proceedings which, should there be an unfavorable disposition,either individually or in aggregate, would have a material adverse effect onthe Company’s consolidated financial position, results of operations orliquidity.

 

**(12)****                         ****Liquidity and Capital Resources**

 

Itis the Company’s plan to raise the additional capital required to fundcommercial activities beyond 2005 through public and private equity or debtfinancings.  The additional capitalrequired for these commercial activities may not be available on termsacceptable to the Company or at all. In the event the Company cannot raisesufficient capital for these commercial activities, the Company believes thatits cash and marketable investment securities of $38.7 million as of December31, 2004 are sufficient to finance the Company’s operations through December31, 2005.

 

Asa result of the Durus Fund’s accumulation of approximately 72% of the Company’soutstanding common stock, the Company’s ability to attract additional equityfinancing has been constrained.  If Aksysis unable to obtain financing on acceptable terms for a significant period oftime, its ability to achieve its principal corporate objective, the successfullaunch of the PHD System, will be materially and adversely impacted.

 

**(13)****                          Line of Credit**

 

On June 17, 2004, theCompany entered into a Line of Credit Note (the “Line of Credit”), by and amongthe Company, as borrower thereunder (the “Borrower”), and Bank One, NA, aslender.  The Line of Credit provides foran eighteen-month credit facility consisting of an aggregate $6.0 millionrevolving line of credit which matures on December 31, 2005.  The Line of Credit bears interest at the bank’sprime rate or at LIBOR plus a margin of 0.75%. Under the Line of Credit, theCompany and its subsidiaries are subject to restrictions on selling ortransferring assets and making certain investments, includingacquisitions.  Proceeds from the Line ofCredit have been used as a deposit to the manufacturer of the PHD System forparts purchased on the Company’s behalf to be used in future production,pursuant to the agreement with that vendor. At December 31, 2004 there was $3.4 million outstanding under the Lineof Credit.  The Company must maintain aminimum balance in its investment account as collateral for the Line ofCredit.  The amount of collateralrequired is dependant on the type on investments in the account.  As of December 31, 2004, 90% of the value ofrestricted securities must cover the maximum available credit of $6.0million.  As of December 31, 2004, theCompany has restricted $6.7 million of short-term investments in order tosatisfy the Line of Credit collateral requirement.

 

Cash payments forinterest were $44,000 during the year ended December 31, 2004.

 

58

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**(14)****                          Concentrationof Credit Risk**

 

During 2004 the Companymaintained a cash balance in excess of federally insured limits.  The funds are with a major money center bank.The Company does not believe that there is a significant risk in having thisbalance in one financial institution. The cash balance with the bank at December 31, 2004 and 2003 was $1,087,632and $148,602, respectively.

 

**Item 9.  Changes in and Disagreements with Accountantson Accounting and Financial Disclosure.**

 

None.

 

**Item9A.  Controls and Procedures**

 

Disclosure Controls and Procedures.  As required by Rule 13a-15 under theSecurities Exchange Act, as of the end of the period covered by this report, wecarried out an evaluation of the effectiveness of the design and operation ofour disclosure controls and procedures. This evaluation was carried out under the supervision and with theparticipation of our management, including the President and Chief ExecutiveOfficer and the Senior Vice President and Chief Financial Officer.  Based on this evaluation, the President andChief Executive Officer and Senior Vice President and Chief Financial Officerconcluded that our disclosure controls and procedures are effective.

 

Disclosurecontrols and procedures are designed to ensure that information required to bedisclosed in our reports filed or submitted under the Securities Exchange Actis recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controlsand procedures designed to ensure that information required to be disclosed inour reports filed or submitted under the Securities Exchange Act is accumulatedand communicated to management, including the President and Chief ExecutiveOfficer and Senior Vice President and Chief Financial Officer, as appropriate,to allow timely decisions regarding required disclosure.

 

Changes in Internal Controls Over Financial Reporting.  There have been no changes in our internalcontrols over financial reporting that occurred during the period covered bythis report that have materially affected, or are reasonably likely tomaterially affect, our control over financial reporting.

 

#### **PARTIII**

#### ** **

**Item 10.  Directors and Executive Officers of theRegistrant.**

 

Information with respectto the Directors of the Company is set forth in the Proxy Statement under theheading “Election of Directors,” which information is incorporated herein byreference.  Information regarding theexecutive officers is set forth above in Part I under “Business – ExecutiveOfficers .”  Information required by Item405 of Regulation S-K is set forth in the Proxy Statement under the heading “Section16 (a) Beneficial Ownership Reporting Compliance,” which information isincorporated herein by reference.

 

59

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#### **PARTIV**

#### ** **

**Item 15.  Exhibits and Financial Statement Schedules.**

 
| (a)    | Financial Statements:                 |
|--------|---------------------------------------|
|   |                                  |   |
|   | 1.                                    | *Financial Statements.* |
|   |                                  | * * |
|   |                                  | The following financial  statements are included in Item 8 of this report: |
|   |                                  | Reports  of Independent Registered Public Accounting Firm |
|   |                                  | Consolidated Balance  Sheets as of December 31, 2004 and 2003 |
|   |                                  | Consolidated  Statements of Operations for the years ended December 31, 2004, 2003 and 2002 |
|   |                                  | Consolidated  Statements of Stockholders’ Equity for the years ended December 31, 2004,  2003 and 2002 |
|   |                                  | Consolidated  Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002 |
|   |                                  | Notes to  the Consolidated Financial Statements |
|   |                                  |   |
|   | 2.                                    | *Financial Statement Schedules.* |
|   |                                  | None. |
|   |                                  |   |
| (b)    | Exhibits.                             |
|   |                                  |   |
|   | See “Exhibit  Index” below. |

 

60

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**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, theRegistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized on the 16th day of March, 2005.

 
|   | **AKSYS, LTD.** | ** **                             |
|--------|-----------------|----------------------------------------|
|   | ** **      | ** **                             |
|   | By              | /s/ William C.  Dow                    | ** ** |
|   |            | William C. Dow                         |   |
|   |            | President and  Chief Executive Officer |   |
|   |            |                                   |
|        |                 |                                        |  |  |

 

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the Registrant in thecapacities indicated on this 16th day of March, 2005.

 
| **Signature**              | ** ** | **Capacity**                                                     |
|----------------------------|------------|------------------------------------------------------------------|
|                       |       |                                                             |
|                       |       |                                                             |
| /s/ William C.  Dow        |       | President, Chief  Executive Officer and Director                 |
| William C. Dow             |       | (Principal Executive  Officer)                                   |
|                       |       |                                                             |
|                       |       |                                                             |
| /s/ Lawrence D.  Damron    |       | Senior Vice President  and Chief Financial Officer  and Director |
| Lawrence D.  Damron        |       | (Principal Financial  Officer)                                   |
|                       |       |                                                             |
|                       |       |                                                             |
| /s/ Richard B.  Egen       |       | Chairman of the Board  of Directors                              |
| Richard B. Egen            |       |                                                             |
|                       |       |                                                             |
|                       |       |                                                             |
| /s/ Bernard R.  Tresnowski |       | Director                                                         |
| Bernard R.  Tresnowski     |       |                                                             |
|                       |       |                                                             |
|                       |       |                                                             |
| /s/ Alan R.  Meyer         |       | Director                                                         |
| Alan R. Meyer              |       |                                                             |

 

61

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**AKSYS, LTD.EXHIBIT INDEX**

 
| **Exhibit   Number** | ** ** | **Description**                                                                                                                                                                                                                                                       |
|----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                  |       | Restated Certificate of  Incorporation of Aksys, Ltd. (1)                                                                                                                                                                                                             |
| 3.2                  |       | Amended and Restated  By-Laws of Aksys, Ltd. (1)                                                                                                                                                                                                                      |
| 4.1                  |       | Form of certificate  representing shares of Common Stock, $.01 par value per share (1)                                                                                                                                                                                |
| 4.2                  |       | Rights Agreement, dated as of October 28, 1996, by  and between Aksys, Ltd. and First Chicago Trust Company of New York (2)                                                                                                                                           |
| 4.3                  |       | First Amendment to Rights Agreement, dated as of February  23, 2004, by and between Aksys, Ltd. and EquiServe Trust Company, N.A., as  successor rights agent to First Chicago Trust Company of New York (3)                                                          |
| 4.4                  |       | Note Purchase Agreement, dated as of February 23,  2004, by and among Aksys, Ltd., Durus Life Sciences Master Fund Ltd. and  Artal Long Biotech Portfolio LLC (including Form of Unsecured Subordinated  Promissory Note)  (3)                                   |
| 4.5                  |       | Registration Rights Agreement, dated as of February  23, 2004, by and among Aksys, Ltd., Durus Life Sciences Master Fund Ltd. and  Artal Long Biotech Portfolio LLC (3)                                                                                               |
| 4.6                  |       | Common Stock Purchase Warrant, dated as of June 30,  2003, issued in favor of The Riverview Group, LLC (4)                                                                                                                                                            |
| 4.7                  |       | Common Stock Purchase Warrant, dated as of June 30,  2003, issued in favor of Roth Capital Partners, LLC (4)                                                                                                                                                          |
| 10.1                 |       | Aksys, Ltd. 1993 Stock  Option Plan (1)                                                                                                                                                                                                                               |
| 10.2                 |       | Manufacturing  Agreement, dated as of January 23, 1996, between the Company and Texas  Medical Products, Inc. (1)                                                                                                                                                     |
| 10.3                 |       | License  Agreement, dated as of April 1, 1993, between the Company and Zbylut J.  Twardowski (1)                                                                                                                                                                      |
| 10.4                 |       | License  Agreement, dated as of April 1, 1993, between the Company and Cynthia P.  Walters (1)                                                                                                                                                                        |
| 10.5                 |       | Form of Indemnification  Agreement (1)                                                                                                                                                                                                                                |
| 10.6                 |       | License Agreement,  dated as of March 11, 1996, between the Company and Allergan, Inc. (1)                                                                                                                                                                            |
| 10.7                 |       | Lease for Property at  Two Marriott Drive (5)                                                                                                                                                                                                                         |
| 10.7(a)              |       | First  Amendment to Lease for Property at Two Marriott Drive                                                                                                                                                                                                          |
| 10.8                 |       | Severance,  Confidentiality and Post-Employment Restrictions Agreement, dated as of  October 4, 1999 Between the Company and William C. Dow (6)                                                                                                                       |
| 10.9                 |       | Manufacturing  Agreement, dated as of February 28, 2003, Between the Company and Peak  Industries, Inc. (7)                                                                                                                                                           |
| 10.10                |       | Aksys, Ltd. 1996 Stock  Awards Plan, as amended (8)                                                                                                                                                                                                                   |
| 10.11                |       | Aksys, Ltd. 2001  Employee Stock Purchase Plan (8)                                                                                                                                                                                                                    |
| 10.12                |       | Settlement Agreement and Mutual Release, dated as of  February 23, 2004, by and among Aksys, Ltd., Durus Life Sciences Master Fund  Ltd., Scott Sacane, Durus Capital Management, LLC, Durus Capital Management  (N.A.), LLC and Artal Long Biotech Portfolio LLC (3) |
| 10.13                |       | Codevelopment and  Licensing Agreement, dated as of June 21, 1999, between the Company and  Teijin Limited(9)                                                                                                                                                         |
| 10.14                |       | Stock Purchase  Agreement, dated as of January 7, 1998, between the Company and Teijin  Limited(9)                                                                                                                                                                    |
| 10.15                |       | Development and Licensing  Agreement, dated as of November 21, 2000, with Teijin Limited(9)                                                                                                                                                                           |
| 10.16                |       | Employment letter  between Aksys, Ltd. and Laurence Birch(11)                                                                                                                                                                                                         |
| 21                   |       | Subsidiaries of Aksys,  Ltd.(10)                                                                                                                                                                                                                                      |
| 23                   |       | Consent of Independent  Registered Public Accounting Firm                                                                                                                                                                                                             |
| 31.1                 |       | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                             |
| 31.2                 |       | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                             |

 

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| 32.1 |   | Certification pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
|------|--------|---------------------------------------------------------------------------|
| 32.2 |   | Certification pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

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(1)                      Incorporatedby reference to the Company’s Registration Statement on Form S-1 (RegistrationNo. 333-2492).

(2)                      Incorporatedby reference to the Company’s Registration Statement on Form 8A12G, filed onNovember 5, 1996.

(3)                      Incorporatedby reference to the Company’s Current Report on Form 8-K, filed on February 24,2004.

(4)                      Incorporatedby reference to the Company’s Current Report on Form 8-K, filed on July 2,2003.

(5)                      Incorporatedby reference to the Company’s Annual Report on Form 10-K for the year endedDecember 31, 1997.

(6)                      Incorporatedby reference to the Company’s Annual Report on Form 10-K for the year endedDecember 31, 1999.

(7)                      Incorporatedby reference to the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2002.

(8)                      Incorporatedby reference to the Company’s Proxy Statement for its 2004 Annual Meeting ofStockholders.

(9)                      Incorporatedby reference to the Company’s Registration Statement on Form S-3 (RegistrationNo. 102651).

(10)                Incorporated byreference to the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2003.

(11)                Incorporated byreference to the Company’s current Report on Form 8-K, filed on March 2, 2005.

 

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