<PAGE>   1
 
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                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                              WASHINGTON, DC 20549

                            ------------------------
 
                                   FORM 10-K
(MARK ONE)
 
      [X]   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
            SECURITIES EXCHANGE ACT OF 1934

                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
                                       OR
 
      [ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
           SECURITIES EXCHANGE ACT OF 1934

   FOR THE TRANSITION PERIOD FROM                     TO
 
                         COMMISSION FILE NUMBER 0-27588
                                 VITALCOM INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
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               DELAWARE                                 3662                                33-0538926
   (STATE OR OTHER JURISDICTION OF          (PRIMARY STANDARD INDUSTRIAL         (I.R.S. EMPLOYER IDENTIFICATION
     INCORPORATION OR ORGANIZATION)         CLASSIFICATION CODE NUMBER)                      NUMBER)
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                              15222 DEL AMO AVENUE
                            TUSTIN, CALIFORNIA 92780
                                 (714) 546-0147
         (ADDRESS AND TELEPHONE NUMBER OF PRINCIPAL EXECUTIVE OFFICES)
 
     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

                                Yes [X]  No [ ]
 
     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
 
     The aggregate market value of the stock held by non-affiliates of the
Registrant, based upon the closing sale price of the Common Stock on March 20,
1998 as reported on the Nasdaq National Market, was approximately $9,353,646.
Shares of Common Stock held by each officer and director and by each person who
owns 5% or more of the outstanding Common Stock have been excluded in that such
persons may be deemed to be affiliates. This determination of affiliate status
is not necessarily a conclusive determination for other purposes.
 
APPLICABLE ONLY TO CORPORATE ISSUERS:
 
     As of March 20, 1998, there were 8,046,797 shares outstanding of the
issuer's common stock.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
     Certain information required by Part III of this Form 10-K is incorporated
by reference to portions of the registrant's Proxy Statement for the 1998 Annual
Meeting of Stockholders to be filed pursuant to Regulation 14A under the
Securities Exchange Act of 1934, as amended.
 
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<PAGE>   2
 
                                     PART I
 
ITEM 1. BUSINESS
 
                                    BUSINESS
 
  General
 
   
     VitalCom (the "Company"), provides computer networks and related
communications products that acquire, interpret and distribute real time patient
monitoring information. The Company's computer and radio networks acquire
physiologic data generated by the Company's own proprietary ECG monitors and
other manufacturers' bedside equipment located throughout a healthcare facility.
The Company's networks consist of proprietary radio frequency ("RF")
communications components, clinical analysis software and display and networking
software to provide personal computer-based central station surveillance of
physiologic data from patients throughout a healthcare facility. The Networked
Monitoring(TM) systems sold to acute care hospitals and integrated health
delivery networks ("IHDNs") through the Company's direct sales force are
networked systems designed for facility-wide coverage that provide access to
real-time information at remote displays as well as at the central monitor,
remote access through a wide area network ("WAN") as well as local area network
("LAN"), offer the capability to acquire data from the Company's own ambulatory
ECG monitors as well as a variety of other manufacturers' bedside monitors and
are typically located in multiple departments throughout the healthcare
facility. The Company's Original Equipment Manufacturer ("OEM") customers
purchase central monitoring systems as well as individual components for use in
their monitoring products, which are generally for smaller departments that
require customized systems. OEM products offered by the Company acquire data
from the Company's ambulatory ECG monitor and from the OEM customer's bedside
monitoring devices or life support equipment. The central monitoring system and
display software for each OEM customer is developed specifically to meet the
specifications of a particular department specialty.
    
 
   
     The Company's Networked Monitoring system collects patient monitoring or
life support data from the Company's proprietary ECG monitors and other
manufacturers' bedside devices, sending the data over a RF network to a central
surveillance station. Technicians at the central surveillance station evaluate
information acquired from ambulatory and point-of-care monitors and, in the case
of a patient emergency or other significant event, respond by initiating
immediate contact with the appropriate caregiver through standard pager
technology. Because the networks continuously distribute real-time patient
information to remote displays located throughout the healthcare facility, the
caregivers can gain immediate access to critical patient status information. The
Company believes that its Networked Monitoring system enables hospitals to
shorten patient stays in costly intensive care units, increase medical staff
productivity, reduce costly patient transfers, leverage the use of existing
equipment and improve facility utilization. Since their introduction in 1991,
the Company's Networked Monitoring systems have been installed in almost 100
acute care facilities, with the largest network providing central surveillance
of up to 192 patients located in five adjacent buildings.
    
 
INDUSTRY BACKGROUND
 
     Market-driven and governmental reform initiatives have produced significant
pressures on healthcare providers to control costs, resulting in managed care
and provider capitation arrangements that shift the economic risk of healthcare
delivery from payors to providers. In order to manage this risk, healthcare
providers are changing the way in which they operate and are increasingly
focusing on controlling the cost of delivering care.
 
   
     These cost control pressures are forcing hospitals to find ways to deliver
care with fewer resources and are encouraging provider consolidation and the
emergence of IHDNs. Additionally, as the overall population ages and an
increasing number of patients receive care in lower-cost, outpatient settings,
the overall acuity level of the remaining hospital patients increases.
Consequently, acute care hospitals and IHDNs are faced with delivering quality
care to more acutely ill patients using fewer resources. In response, hospitals
have increasingly turned to technological innovation for assistance.
    
 
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     Historically, specific technological solutions have included patient
bedside monitors and life support equipment to assist in caring for acutely ill
patients. In high-acuity departments such as intensive care units ("ICUs"),
coronary care units ("CCUs") or "step-down" units, this equipment is typically
hard-wired to a central monitoring station. This departmental approach can be
very costly to establish and maintain, and dedicating equipment to individual
departments necessitates that patients be transferred in and out of monitored
beds, creating additional transfer costs and disrupting the continuity of
patient care.
 
     Outside of these specialty departments, remote bedside equipment is used to
monitor and support patients. In this setting, a patient's physiologic
information is only available at the patient bedside, rather than where that
information can be readily available to caregivers. Additionally, caregivers in
these areas are subject to high patient/caregiver ratios, have limited time to
observe patient monitors and are often required to respond to false alarms that
result in the unproductive and costly use of the medical staff's time. The
Company believes that these existing patient monitoring solutions do not
sufficiently address the needs of hospitals to manage their increasing patient
acuity in a cost-effective manner.
 
THE VITALCOM SOLUTION
 
     The Company's Networked Monitoring systems enable acute care hospitals and
IHDNs to respond to cost control pressures in the healthcare industry by
reengineering labor-intensive care delivery processes to reduce costs. Principal
benefits of the Company's solution include:
 
     - reducing patient stays in costly ICU and CCU departments through central
       surveillance of patients in less labor-intensive settings.
 
     - increasing productivity of medical staff through centralized surveillance
       of up to 48 patients by one technician, who can notify caregivers when
       patients experience a medically significant event, through standard
       paging technology.
 
     - distributing patient physiologic information to remote displays
       throughout the facility for convenient and immediate access by
       caregivers.
 
     - reducing costly patient transfers and improving overall facility
       utilization by allowing flexible bed configurations using wireless
       technology.
 
   
     - improving asset utilization with the Company's OpenNet application which
       interfaces to third-party products through programmable interfaces. The
       Company's OpenNet application currently includes interfaces with
       monitoring devices from Protocol Systems, Inc., ("Protocol") Datascope
       Corporation ("Datascope") and Johnson & Johnson Medical, Inc. ("JJMI")
       and life support equipment from Nellcor Puritan Bennett Incorporated
       ("Nellcor PB").
    
 
     - implementation of telemedicine with the Company's SiteLink(TM)
       application which allows a tertiary hospital to link its Networked
       Monitoring system to a Networked Monitoring system at a remote facility,
       even hundreds of miles away.
 
PRODUCTS
 
  Networked Monitoring Solutions
 
   
     The Company's Networked Monitoring system provides the basic architecture
for current and future product offerings. In 1991, the Company introduced its
computer network for ECG data providing acquisition, interpretation and
distribution of patient ECG information. The OpenNet application introduced in
the first half of 1996 expanded the Company's network capability to
multi-parameter applications by using other manufacturers' patient monitoring
and life support equipment. In November 1997, the Company introduced its
SiteLink application, which allows a tertiary hospital to link its Networked
Monitoring system to one at a remote facility via a dedicated T-1 phone line.
    
 
     The Company's Networked Monitoring system utilizes the following key
components: RF technology; personal computer-based central station and
proprietary display software; proprietary clinical analysis software
 
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and a proprietary network including real-time remote display and paging. The
Company's RF technology collects patient physiologic data from the Company's
proprietary ECG ambulatory transmitters, other manufacturers' multi-parameter
bedside monitoring equipment and other manufacturers' life support equipment and
transmits that data in real-time to the central surveillance station for
interpretation and distribution. A central surveillance station consists of
multiple, networked personal computers and color touch-screens. The central
surveillance station is capable of simultaneously displaying up to several
hundred patients' physiologic data. One trained technician is capable of
monitoring up to six personal computers, each of which receives, interprets and
displays real-time physiologic patient data, alarm settings and equipment status
for up to eight patients using the Company's proprietary software. In the event
that the Company's proprietary software detects a medically significant event,
it responds with an audio or visual alarm and prompts the technician to issue a
pager call to the responsible caregiver. The Company's proprietary software also
stores up to 24 hours of real-time physiologic patient information for
subsequent review.
    
 
     The Company's Networked Monitoring system provides for the simultaneous
distribution of real-time physiologic patient information to multiple remote
color touch-screen displays located throughout the facility by employing
proprietary real-time distribution software and industry-standard Ethernet
protocols. Remote viewing stations are located throughout the hospital, allowing
caregivers to view patient physiologic data, alarm settings and equipment status
for any patient connected to the network.
 
     ECG Applications. The Company's Networked Monitoring system interprets and
distributes patient information acquired from an ambulatory digital telemetry
transmitter, approximately the size of a television remote control that collects
the information through sensors attached to the patient's chest. The Company's
proprietary analysis software displays patient ECG information, including
heartrate and waveform, alarm settings and equipment status for interpretation
by a trained technician. In addition, the Company's proprietary clinical
analysis software includes algorithms to analyze patient cardiac arrhythmias,
such as asystole and ventricular fibrillation. The most recent version of the
Company's analysis software received FDA clearance in January 1995.
 
   
     Multi-Parameter OpenNet Applications. The Company's OpenNet application
uses programmable interfaces and wireless technology to acquire, interpret and
distribute multi-parameter physiologic patient information, such as blood/oxygen
saturation, respiration, temperature, end-tidal CO2 and blood pressure from
patient monitoring and life support equipment of other vendors. The software and
wireless component of the OpenNet technology have been available since March
1996. The Company's OpenNet application currently includes interfaces with
bedside monitoring devices from Protocol, Datascope and JJMI. In November 1997
the Company received its 510(k) clearance for additional OpenNet connections to
other bedside monitors and to ventilators. The ventilator feature allows
clinicians to receive, display, interpret, distribute and archive respiratory
data of ventilated patients, with the first interface to Nellcor PB's Series
7200 Ventilator.
    
 
   
     SiteLink(TM) Telemedicine Application. The Company's SiteLink application
allows a tertiary hospital to link its Networked Monitoring system to a
Networked Monitoring system at a remote facility, even hundreds of miles away,
in real time, via a dedicated T-1 phone line. Monitoring technicians at the
tertiary facility provide 24-hour surveillance for the remote site, paging
caregivers at the remote site if a patient at the remote facility is in
distress. The Company received FDA clearance in November 1997 for its SiteLink
application, which currently is installed and running in two different
locations.
    
 
   
     VitalAccess(TM) Application. During 1997 the Company introduced an
application which permits multiple caregivers simultaneous access to individual
patients' static patient monitoring information on the Company's Networked
Monitoring system from any remote Windows 95(TM) or NT workstation. Access is
routed through the Company's V-Gate server which is sold as a separate component
to a Networked Monitoring system.
    
 
  OEM Products
 
     The Company's OEM products are sold on a private-label basis to equipment
manufacturers and integrators, all of which manufacture patient monitoring or
medical devices and have multi-year working
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relationships with the Company. The Company's OEM products are typically used in
the emergency room, post-surgical, cardiac rehabilitation and other discrete
care units within a hospital. These departmental products are custom programmed
to provide specialized analysis or display formats required by a particular
department specialty and to allow equipment manufacturers and integrators to
deliver a product that satisfies the patient monitoring and reporting
requirements of their customers. The OEM products use many of the same
components that are used in the Company's Networked Monitoring systems, allowing
for economies of scale in development, manufacturing and inventory management.
When the Company's OEM customers offer networks, they are typically smaller in
size than the Networked Monitoring system networks sold by the Company's direct
sales force.
    
 
   
     The OEM products include central workstations, proprietary analysis
software and RF products, but currently do not include hardware or software for
real-time distribution on a facility-wide basis and larger networks, nor can
they accept multiparameter information from other vendors' systems. The Company
may in the future elect to incorporate in its OEM products the hardware and
software for larger networks and real-time redistribution of information to
remote viewing stations for use in specialty departments of hospitals for which
the Company's OEM customers design and sell their products. In the event the
Company incorporates these or other features into its OEM products, the Company
believes that its OEM customers would not compete with its Networked Monitoring
systems because the Networked Monitoring systems are sold to hospitals and IHDNs
who elect to install larger, more dispersed systems. However, the Company could
face competition with its OEM customers to the extent hospitals forego
purchasing the Company's facility-wide Networked Monitoring systems for the
smaller departmental systems of its OEM customers. In addition, the Company
believes that its work with OEM customers helps it better understand the
clinical procedures and technical protocols used to create the OpenNet
connections with its OEM customers' and other vendors' patient monitoring and
ventilator equipment.
    
 
CUSTOMERS
 
   
     The Company sells its Networked Monitoring systems to acute care hospitals
and IHDNs throughout the United States through its direct sales force. The
Company estimates that its potential customer base includes more than 5,200
acute care hospitals in the United States. As of December 31, 1997, the Company
had direct sale installations of its Networked Monitoring systems in almost 100
such hospitals and IHDNs. In addition, the Company sells its OEM products to
leading patient monitoring device companies. In 1996, Quinton and Datascope
accounted for approximately 18.4% and 17.7%, respectively, of the Company's
total revenues and in 1997 Quinton and Datascope accounted for approximately
12.7% and 25.0%, respectively, of the Company's total revenues. The loss of, or
a significant reduction in sales to any such customer would have a material
adverse effect on the Company's business, operating results and financial
condition.
    
 
SALES AND MARKETING
 
   
     The Company sells its Networked Monitoring systems to acute care hospitals
and IHDNs through its direct sales force. The Company's sales force is organized
by region and targets key hospitals and IHDNs within each region. The sales
cycle for Networked Monitoring systems has typically been nine to 18 months from
initial contact to receipt of a purchase order and generally involves multiple
sales calls on hospital purchasing, information technology, administrative and
clinical personnel, product demonstrations at select reference sites and on-site
evaluations. The Company markets its Networked Monitoring systems through direct
sales calls, product demonstrations at select reference sites, on-site product
evaluations, participation in trade shows and general industry advertising.
    
 
     Due to the long sales cycle and the fixed costs related to direct sales
expenses, a failure of such direct sales efforts to create an offsetting
increase in revenues and earnings would have a material adverse effect on the
Company's business, operating results and financial condition. In addition,
during the Company's long sales cycle for Networked Monitoring systems, it may
expend substantial time, effort and funds preparing a contract proposal or
negotiating a purchase order without any guarantee that it will complete the
transaction. Any significant or ongoing failure to reach definitive agreements
with direct sales customers would have a
 
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material adverse effect on the Company's business, operating results and
financial condition. See Management's Discussion and Analysis of Financial
Condition and Results of Operations -- General.
 
   
     The Company sells its OEM products to leading patient monitoring device
companies, many of whom have had long-term working relationships with the
Company. The Company's OEM sales team has significant experience in the
healthcare industry. The Company markets its OEM products to its customers
through expansion of existing product offerings, sales calls and participation
in trade shows.
    
 
CUSTOMER SUPPORT
 
     The Company provides a wide range of support services to purchasers of its
Networked Monitoring system. The Company's support program includes
pre-installation assistance in network design and planning; a training and
maintenance program for clinical and other hospital staff prior to installation
and follow-up on-site training after installation; 24-hour telephone technical
support and a consignment program during the product warranty period for systems
of 24 channels or more providing for the consignment of one central station,
including one spare transmitter per eight beds, at no charge. The Company
provides a one-year warranty on the equipment and software components of its
Networked Monitoring system. The Company will repair or replace at no charge any
device or software which it finds to be defective during the warranty period.
The Company offers extended hardware and software warranty programs to its
customers for an annual fee.
 
TECHNOLOGY
 
     The Company believes that it has developed expertise in the following core
technologies: R.F. communication products, real-time application software,
clinical software algorithms and networking software. The Company benefits from
the expertise of its research and development staff and its investment in these
core technologies. These core technologies allow the Company's networks to
acquire, interpret and distribute physiologic patient information throughout the
facility in real-time. The term "real-time" refers to the ability to deliver
data with minimal latency on a deterministic basis. "Latency" refers to the
interval of time between the actual event and the arrival of the data.
"Deterministic" refers to the ability to accurately predict the period of
latency. Patient physiologic information is typically shown on remote displays
less than one-half second after the actual event.
 
   
     Radio Frequency Communication Products. The Company's proprietary radio
frequency (RF) communication products transmit real-time physiologic information
from the patient to the central surveillance station. These communication
products operate in three radio bands: VHF (174 MHz to 216 MHz, shared with TV
channels 7-13); UHF (450 MHz to 470 MHz shared with land mobile users) and the
900 MHz radio band (902 MHz to 928 MHz licensed for spread spectrum operation).
    
 
     Real-time Application Software. The Company has a substantial investment in
real-time application software. This includes modules for displaying physiologic
patient information such as real-time patient wave forms, the continuous storage
of patient information, trending of physiologic parameters, event storage and
reporting, a pager interface and alarm handling.
 
   
     Clinical Software Algorithms. The Company has invested substantial efforts
in developing clinical analysis software to evaluate ECG information received
from the Company's transmitter and other patient monitors to report clinically
significant events. The heart beat detector uses three types of sophisticated
analysis techniques to differentiate the patient's heart beat from various
sources of noise. These include linear digital filtering, nonlinear transforms
and decision rule algorithms. These algorithms detect and classify each heart
beat for every patient on the system and detect cardiac arrhythmia events such
as asystole or ventricular fibrillation. The Company's clinical software has
received all required FDA clearance.
    
 
     Real-time Networking Software. The Company has invested in developing
proprietary network algorithms that enable simultaneous viewing of real-time
physiologic patient information on multiple remote viewing stations. These
algorithms provide a deterministic method of handling network data collisions as
well
 
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as providing the minimal latency required for real-time physiologic patient
information. The Company's implementation allows for the use of industry
standard network interface controllers, hubs and routers.
 
PRODUCT DEVELOPMENT
 
   
     The Company's research and development strategy is to focus on expanding
the capabilities of existing products and developing new products. In November,
1997 the Company received its 510(k) clearance for additional OpenNet connectors
to bedside monitors not covered in a previous 510(k) clearance and connections
to ventilators. The ventilator connection allows clinicians to receive, display,
interpret, distribute and archive respiratory data of ventilated patient. The
first ventilator interface is to Nellcor Puritan Bennett's Series 7200
Ventilator. The Company received FDA clearance in November, 1997 for a product
application, SiteLink, which enables the Company's Networked Monitoring systems
at a tertiary hospital to link a Networked Monitoring system at a remote
facility, even hundreds of miles away, in real-time, via a dedicated T-1 phone
line. In 1997, the Company introduced another application, VitalAccess, that
permits caregivers access to static patient monitoring information on the
Company's Networked Monitoring system from any remote Windows 95(TM) or NT
workstation. The Company also has under development technology that would enable
the Company's Networked Monitoring systems to connect with HCIS products and
computerized patient records. The Company intends to continue to expand its
OpenNet applications with interfaces to additional patient monitoring devices,
many of which require no additional FDA clearance.
    
 
   
     The Company continues to evaluate emerging technologies in the
communications industry for possible use in its products. In addition, the
Company continually evaluates trends in the healthcare industry and, based on
its perceptions of market requirements, may accelerate development of or acquire
certain products while deferring or canceling development of others. The
completion of the development of new or enhanced or acquired products will
involve significant expenditures without knowing whether such products will
achieve the intended benefits of cost reductions and productivity gains or
whether such products will receive market acceptance.
    
 
   
     For the years ended December 31, 1997, 1996 and 1995, total research and
development expenditures were approximately $4.8 million, $5.4 million and $2.7
million, respectively, and represented 22.1%, 29.6% and 11.2% of revenues,
respectively. The Company expects to continue to allocate significant resources
to these efforts. There can be no assurance, however, that such research and
development efforts will be successful. Any failure of the Company's products
under development, including HCIS connectivity products to achieve their
intended benefits or market acceptance would have a material adverse effect on
the Company's business, operating results and financial condition.
    
 
BACKLOG
 
     The Company's backlog as of December 31, 1997, 1996 and 1995 was $2.9
million, $2.0 million and $4.1 million, respectively. Backlog consists of
purchase orders for products deliverable within twelve months and primarily
represents orders from OEM customers. Purchase orders from the Company's OEM
customers are generally cancelable at any time without penalty. The Company's
backlog is not large enough to assure that its revenue targets for a particular
quarter will be met. Therefore, the Company does not consider backlog to be a
significant indication of future performance, and sales in any quarter are
dependent on orders booked and shipped during that quarter and are not
predictable with any degree of certainty.
 
MANUFACTURING
 
   
     The Company's manufacturing operations consist primarily of final assembly
and test and quality control of materials, components, subassemblies and
systems. The Company relies on subcontractors for printed circuit board and
component assembly. The Company obtained and maintains ISO 9001/EN 29001
certification and is required to operate under the Quality System Regulation
(previously called the Good Manufacturing Practices) of the Food and Drug
Administration ("FDA"). Some of the Company's products utilize components
available in the short term from only a single or limited number of sources.
Certain of these components, such as some devices manufactured by Burr-Brown
Corporation, Motorola Semiconductor
    
 
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Products, Inc. and Maxim Integrated Products, Inc., have been available only on
an allocation basis in the past and could be in scarce supply again in the
future. While such allocation restrictions have not had a significant adverse
effect on the Company to date, any inability to obtain such components on a
timely basis or at commercially reasonable prices in the future could have a
material adverse effect on the Company's business, operating results and
financial condition until alternative sources could be developed or design and
manufacturing changes could be completed. The Company does not have long-term
supply agreements with its component suppliers or subcontractors. The Company's
manufacturing facility is located at its headquarters in Tustin, California.
 
INTELLECTUAL PROPERTY
 
     The Company relies on a combination of copyright, trade secret and
trademark laws, confidentiality procedures and contractual provisions to protect
its proprietary rights. The Company seeks to protect its software, circuitry
documentation and other written materials under trade secret and copyright laws,
which afford only limited protection. The Company has one patent on certain
aspects of the transmitter technology used in its products. Accucore, AccuLink,
AccuNet, OpenNet, SiteLink, VitalAccess, Networked Monitoring and VitalCom are
trademarks of the Company. The Company cannot assure that any of its proprietary
products or technologies can be patented, that any issued patent will provide
the Company with any competitive advantages or will not be challenged by third
parties, or that the patents of others will not have an adverse effect on the
Company's ability to do business. Certain of the Company's OEM products include
900 MHz transmission technology licensed pursuant to a fully paid, five-year
agreement with a third-party. Despite the Company's efforts to protect its
proprietary rights, unauthorized parties might attempt to copy aspects of the
Company's products or to obtain and use information that the Company regards as
proprietary. Restricting unauthorized use of the Company's products is
difficult, and although the Company is unable to determine the extent to which
unauthorized copying of its software products exists, such copying could be a
potential problem. The Company believes, however, that it leads its competitors
in certain technological developments, and that this lead affords it protection
due in part to regulatory requirements related to technological advances.
Nevertheless, the Company cannot assure that its protective measures for
proprietary rights will be adequate or that the Company's competitors will not
independently develop similar or superior technology, duplicate the Company's
products or otherwise circumvent its intellectual property rights.
 
COMPETITION
 
     The Company's Networked Monitoring systems compete with systems offered by
a number of competitors, including Hewlett-Packard Company, SpaceLabs, Inc. and
Marquette Medical Systems, most of which have significantly greater financial,
technical, research and development and marketing resources than the Company. In
addition, many of these competitors have long-standing relationships with acute
care hospitals and IHDNs. Furthermore, consolidation in the healthcare industry
and the emergence of IHDNs has resulted in larger healthcare providers that
consolidate their purchasing with a small number of preferred vendors with whom
they have had long-standing relationships. There can be no assurance that the
Company will be able to sell to such hospitals or IHDNs or that the Company will
be able to compete successfully with such vendors, and any inability to do so
would have a material adverse effect on the Company's business, operating
results and financial condition.
 
     The Company's OpenNet connections will face significant competition in the
future from HCIS providers, patient monitoring companies, life support device
companies and general purpose data network providers. Such potential competitors
may elect to enter this market and compete with the Company using significantly
greater financial, technical, research and development and marketing resources
than are available to the Company. In addition, the Company's success in selling
its multi-parameter OpenNet connections to hospitals and IHDNs will depend to a
large extent on its ability to interface with patient monitoring and life
support devices of other vendors. Any action on the part of such other vendors
to make such interfacing more difficult or impossible could have a material
adverse effect on the Company's business, operating results and financial
condition.
 
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     The market for the Company's OEM products is also intensely competitive.
The Company's OEM customers are patient monitoring and life support device
companies, many of which have significantly greater financial, technical,
research and development and marketing resources than the Company. There can be
no assurance that current OEM customers will not elect to design and manufacture
patient monitoring and system components currently supplied by the Company or
elect to contract with other OEM suppliers. Any such election by one or more of
such companies would have a material adverse effect on the Company's business,
operating results and financial condition.
 
     The Company believes that the principal competitive factors in its markets
are system features, product reliability, customer service and support, FDA
regulatory compliance expertise, existing relationships with hospitals and
IHDNs, company reputation, price and effectiveness of sales and marketing
efforts. In addition, the Company believes that the ability to identify the
evolving needs of the healthcare industry and the ability to develop innovative
products to meet such needs, are important competitive factors. The Company
believes that it competes favorably with respect to these factors but there can
be no assurance that the Company will continue to compete favorably.
 
GOVERNMENT REGULATION
 
     Certain of the Company's products are regulated in the United States as
medical devices by the FDA under the Federal Food, Drug, and Cosmetic Act ("FDC
Act") and implementing regulations and require premarket clearance or approval
by the FDA prior to commercialization. In addition, certain material changes or
modifications to the intended use, labeling or manufacturing of cleared or
approved medical devices are also subject to FDA clearance or approval. Pursuant
to the FDC Act, the FDA regulates the development, testing, safety, labeling,
storage, record keeping, advertising, production and distribution of medical
devices in the United States. Noncompliance with applicable requirements can
result in civil or criminal penalties, recall or seizure of products, or total
or partial suspension of production.
 
     Generally, before a new medical device can be introduced into the market in
the United States, the manufacturer or distributor must obtain FDA clearance by
filing a 510(k) premarket notification or obtaining approval of a premarket
approval ("PMA") application. If a medical device manufacturer or distributor
can establish that a device is "substantially equivalent" to a legally marketed
device for which the FDA has not called for PMAs, the manufacturer or
distributor may seek clearance from the FDA to market the device by filing a
510(k) premarket notification. The 510(k) premarket notification may need to be
supported by appropriate data establishing the claim of substantial equivalence
to the satisfaction of the FDA.
 
     If a manufacturer or distributor of a medical device cannot establish
substantial equivalence, the proposed device must be approved through a PMA
application, which must be supported by statistical analysis of clinical data.
The PMA application approval process can be expensive, uncertain and lengthy. To
date the Company has received clearance on all of its products under the 510(k)
process and has not been required to file a PMA application. The FDA has
published a proposed rule that would require over forty devices, including those
using arrhythmia software produced by the Company and its competitors, following
a notice period, to receive PMA approvals or be discontinued for sale. A
petition has been filed by some industry participants, including the Company, in
response to the notice, to formally request that the FDA reclassify arrhythmia
software devices from Class III devices to Class II devices. This petition is
currently under FDA review. If the FDA reclassifies arrhythmia software devices
to Class II, the Company's products will not require any additional clearances
if a PMA application is not filed and approved within a specified time frame.
However, if the FDA does not reclassify the arrhythmia software devices and
publishes its final rule, such software devices would be subject to the lengthy
and expensive PMA process, which could interrupt or terminate the sales of the
Company's or its competitors' arrhythmia software devices. Any such interruption
or termination could have a material adverse effect on the Company's business,
financial condition and results of operations. The Company is required to adhere
to applicable FDA regulations including the new Quality System Regulation
(previously called the Good Manufacturing Practices), which include testing,
control, and documentation requirements and the Medical Device Reporting
Regulation. Failure to receive or delays in receipt of FDA clearance or
approvals, including the need for extensive clinical trials or additional data
as a prerequisite to clearance or approval, would have a material adverse effect
on the Company's business,
                                        8
<PAGE>   10
 
operating results and financial condition. Changes in existing regulations or
adoption of new governmental regulations or policies could prevent or delay
required regulatory approvals of the Company's products.
 
     The Company's radio frequency transmitter devices are subject to regulation
by the Federal Communication Commission ("FCC"), and applicable approvals must
be obtained before shipment of such products. The Company believes that all of
its products designated for sale in the United States meet applicable Federal
Communications Commission (FCC) regulations, including US FCC Part 15 for
electromagnetic emissions. The FCC approval process starts with the collection
of test data that demonstrates that a product meets the requirements stated in
Part 15 of the FCC regulations. This data is then included as part of a report
and application that is submitted to the FCC requesting approval. The FCC may
grant or request additional information or withhold approval. Any failure of the
Company's products to conform to governmental regulations or any delay or
failure to obtain required FCC approvals in the future, if any, could cause the
delay or loss of sales of the Company's products and therefore have a material
adverse effect on the Company's business, financial condition and result of
operations.
 
     The Company's proprietary radio frequency (RF) communication products
transmit real-time physiologic information from the patient to the central
surveillance station. These communication products currently operate in three
radio bands: VHF (174 MHz to 216 MHz, shared with TV channels 7-13); UHF (450
MHz to 470 MHz, shared with land mobile users); and the 900 MHz radio band (902
MHz to 928 MHz licensed for Spread Spectrum operation). The majority of the
Company's RF products use the vacant television frequencies in the VHF band. The
FCC is requiring all television stations to implement digital broadcasting
transmission for High Definition Television (HDTV). Major metropolitan areas
will be required to implement HDTV by December 31, 1998 and other markets by
December 31, 2006. In order to implement HDTV the FCC has granted each TV
channel an additional 6 MHz channel for digital broadcasting until the
transition period ends, at which time the broadcaster would return one of the
two channels. As TV stations use the additional 6 MHz channel for the digital
broadcasting transition, which may take years, they may overlap into the radio
spectrum which has been used for medical RF applications. Customers of the
Company's lower power RF communication products may begin seeing more
interference in the future. This interference may result in the Company's
hospital biomedical personnel having to re-tune the Company's RF transmitters to
other channels in order to reduce interference. In the event of high
interference the Company's customers may need to purchase equipment to transmit
in the UHF frequency range. The FCC also announced that they will be expanding
the usable UHF frequencies for medical RF from the licensed 450 MHz to 470 MHz
band to the unlicensed 470 MHz to 668 MHz frequency range. With VHF frequency
ranges available for medical RF use potentially becoming more limited and the
UHF frequency ranges expanding, the Company's competitors who have historically
focused their RF products in what was the more limited UHF band, may now have a
competitive advantage as compared to the Company, until such time as the Company
expands its UHF RF product offerings. Any such competitive advantage of the
Company's competitors and any additional development costs associated with
expanding the Company's UHF RF product offerings could have a material adverse
effect on the Company's business, operating results and financial condition.
Additionally, future regulatory changes could significantly affect the Company's
operations by diverting the Company's development efforts, making current
products obsolete or increasing the opportunity for additional competition which
could have a material adverse effect on the Company's business, operating
results and financial condition.
 
     If the Company were to attempt to market its products and components in
Europe and certain other foreign jurisdictions, the Company and its distributors
and agents would have to obtain required regulatory approvals and clearances and
otherwise comply with extensive regulations regarding safety and manufacturing
processes and quality. These regulations, including the requirements for
approvals or clearance to market and the time required for regulatory review
vary from country to country.
 
EMPLOYEES
 
     As of December 31, 1997, the Company had approximately 145 full-time
employees, of which 40 were in customer service, marketing and sales, 33 were in
research and development, 59 were in manufacturing, quality assurance and
regulatory affairs and 13 were in administration. None of the Company's
employees is
 
                                        9
<PAGE>   11
 
   
covered by a collective bargaining agreement, the Company has experienced no
work stoppages and the Company believes that its relationship with its employees
is good.
    
 
ITEM 2. PROPERTIES
 
PROPERTIES
 
     The Company occupies approximately 37,000 square feet of space at is
headquarters in Tustin, California under a lease expiring in October 2001, with
an option to extend through October 2006. The Company believes that this
facility will be adequate to satisfy its currently anticipated business
requirements.
 
ITEM 3. LEGAL PROCEEDINGS
 
     The Company is not a party to any material legal proceedings.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
   
     The Company held a Special Meeting of the Stockholders on December 9, 1997.
At the Special Meeting, the following votes were cast for the ratification and
approval of an amendment to the Company's 1993 Stock Option Plan to increase the
shares reserved for issuance under the plan by 750,000:
    
 
<TABLE>
<S>                 <C>
For                 4,907,257
Against             1,195,432
Abstain                 1,000
Broker Non-Votes    1,933,359
</TABLE>
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
     Market and Market Price for Common Stock. VitalCom Inc. common stock,
$0.0001 par value per share, is traded over the counter under the symbol VCOM
and is an authorized security for quotation on the Nasdaq National Market
("Nasdaq").
 
     The market prices of a share of VitalCom Inc. common stock are set forth
below. The prices reflect the high and low trading prices for each quarter and
the year ended December 31, 1997, since the Company's initial public offering in
February 1996, as reported by Nasdaq.
 
   
<TABLE>
<CAPTION>
                                      THREE MONTHS ENDED                   YEAR ENDED     YEAR ENDED
                        -----------------------------------------------   DECEMBER 31,   DECEMBER 31,
                        MARCH 31   JUNE 30   SEPTEMBER 30   DECEMBER 31       1996           1997
                        --------   -------   ------------   -----------   ------------   ------------
<S>                     <C>        <C>       <C>            <C>           <C>            <C>
1996
  High................  $20.000    $23.250     $16.813        $6.000        $23.250
  Low.................   12.625     12.875       4.375         5.125          4.375
1997
  High................    5.750      5.625       5.063         5.563                        $5.750
  Low.................    4.375      4.500       4.000         3.875                         3.875
1998
  High (through
     3/20/98).........    5.000
  Low (through
     3/20/98).........    4.063
</TABLE>
    
 
   
     Holders. The approximate number of holders of record of VitalCom Inc.
common stock, as recorded on the books of VitalCom's Registrar and Transfer
Agent, as of March 20, 1998 was 40.
    
 
     Dividends. VitalCom has not paid cash dividends on its common stock and
does not currently have any plans to pay such dividends in the foreseeable
future. The dividend policy of VitalCom is reviewed from time
                                       10
<PAGE>   12
 
to time by the Company's Board of Directors in light of its earnings and
financial condition and such other business considerations as the Board of
Directors considers relevant.
 
UNREGISTERED SALES OF THE REGISTRANT'S EQUITY SECURITIES DURING LAST FISCAL YEAR
 
     The Note Purchase Agreement. In February 1997, the Company issued an
aggregate of 40,000 shares of its Common Stock, $.0001 par value, to two
consultants of the Company for a purchase price of $4.875 per share. The
aggregate purchase price was paid in cash in the amount of $40 with the balance
of the aggregate purchase price paid through the issuance of non-recourse
promissory notes secured by a pledge of the shares to the Company. The issuance
of the shares was deemed to be exempt from registration under the Securities Act
in reliance on Section 4(2) of the Securities Act as a transaction by an issuer
not involving any public offering. In addition, the recipients of the shares in
the transactions represented their intentions to acquire the shares for
investment only and not with a view to or for sale in connection with any
distribution thereof and appropriate legends were affixed to the share
certificates issued in such transactions.
 
                                       11
<PAGE>   13
 
ITEM 6. SELECTED FINANCIAL DATA
 
                            SELECTED FINANCIAL DATA
 
     The following information should be read in conjunction with the financial
statements and related notes.
 
   
<TABLE>
<CAPTION>
                                                         YEAR ENDED DECEMBER 31,
                                           ---------------------------------------------------
                                            1993       1994       1995       1996       1997
                                           -------    -------    -------    -------    -------
<S>                                        <C>        <C>        <C>        <C>        <C>
STATEMENT OF OPERATIONS DATA:
Total revenues...........................  $14,191    $17,092    $23,964    $18,372    $21,794
                                           -------    -------    -------    -------    -------
Cost of sales............................    6,754      7,956     10,299      9,680     11,477
                                           -------    -------    -------    -------    -------
Gross profit.............................    7,437      9,136     13,665      8,692     10,317
                                           -------    -------    -------    -------    -------
Operating expenses:
  Sales and marketing....................    3,211      3,643      6,442      9,515      8,562
  Research and development...............    1,609      1,852      2,673      5,434      4,816
  General and administrative.............      978      1,072      1,644      2,507      2,536
  Restructuring charges..................                                       481
                                           -------    -------    -------    -------    -------
          Total operating expenses.......    5,798      6,567     10,759     17,937     15,914
                                           -------    -------    -------    -------    -------
Operating income (loss)..................    1,639      2,569      2,906     (9,245)    (5,597)
                                           -------    -------    -------    -------    -------
Other income (expense), net..............     (546)      (174)      (130)       975        973
                                           -------    -------    -------    -------    -------
Income (loss) before provision (benefit)
  for income taxes.......................    1,093      2,395      2,776     (8,270)    (4,624)
Provision (benefit) for income taxes.....      484        971      1,193     (1,902)        26
                                           -------    -------    -------    -------    -------
Net income (loss)........................  $   609    $ 1,424    $ 1,583    $(6,368)   $(4,650)
                                           =======    =======    =======    =======    =======
Net income (loss) per basic common
  share(1)...............................                        $  0.30    $ (0.90)   $ (0.58)
                                                                 =======    =======    =======
Net income (loss) per diluted common
  share(1)...............................                        $  0.28    $ (0.90)   $ (0.58)
                                                                 =======    =======    =======
Weighted average basic common
  shares (1).............................                          5,313      7,084      8,001
                                                                 =======    =======    =======
Weighted average diluted common
  shares(1)..............................                          5,671      7,084      8,001
                                                                 =======    =======    =======
</TABLE>
    
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                           ---------------------------------------------------
                                            1993       1994       1995       1996       1997
                                           -------    -------    -------    -------    -------
                                                             (IN THOUSANDS)
<S>                                        <C>        <C>        <C>        <C>        <C>
BALANCE SHEET DATA:
Cash equivalents, short-term
  investments............................  $   634    $ 1,223    $ 2,164    $20,120    $18,157
Working capital..........................    2,341      3,009      6,236     23,980     19,965
Total assets.............................    6,670      7,998     13,353     31,921     26,708
Long-term debt, excluding current
  portion................................    2,042      1,542      1,042         82         60
Total stockholders' equity (deficit).....   (4,482)    (3,606)    (2,973)    26,973     22,521
</TABLE>
 
---------------
(1) See Note 1 to Financial Statements for a description of shares used in
    calculating net income (loss) per share.
 
                                       12
<PAGE>   14
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
 
                      MANAGEMENT'S DISCUSSION AND ANALYSIS
                OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
     Certain statements contained in this Annual Report on Form 10-K, including
the information set forth in Part I, Item 1  -- Business, this Management's
Discussion and Analysis of Financial Condition and Results of Operations and
elsewhere in this Report, may constitute forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended. Such forward-looking
statements include those regarding the Company's ability to shorten patient
stays in costly intensive care (ICU) and cardiac care (CCU) units, increase
medical staff productivity, reduce costly patient transfers, leverage the use of
existing equipment, improve facility utilization, healthcare providers changing
operations and increasingly focusing on controlling the cost of delivering care,
implementing telemedicine with the Company's SiteLink application, the Company's
possible election in the future to incorporate in its OEM products the hardware
and software for larger networks and real-time redistribution of information to
remote viewing stations, the Company's intention to expand its OpenNet
application with interfaces to additional patient monitoring or ventilator
devices, the Company's development of technology that would enable the Company's
Networked Monitoring systems to connect with HCIS products and computerized
patient records, potential new products, the status of certain products under
development, the Company's development or acquisition of new products,
rebuilding of the Company's funnel of potential new Networked Monitoring systems
sales, sequential growth in Networked Monitoring sales, the Company's working
capital position, the Company's estimated expenditures for Year 2000 compliance,
the expected effect of Year 2000 compliance on the Company and the effect of
Year 2000 compliance on the Company's customers. Actual results may vary
substantially from these forward-looking statements for many reasons, including
but not limited to those set forth in "Management's Discussion and Analysis of
Financial Condition and Result of Operations -- Factors that May Affect Future
Operating Results". Additional information is available in the Company's reports
and other documents filed with the Securities and Exchange Commission.
 
GENERAL
 
     VitalCom provides computer networks and related radio communications
products that acquire, interpret and distribute real-time monitoring
information. The Company's computer and radio networks acquire physiologic data
generated by the Company's own proprietary ECG monitors and other manufacturers'
bedside equipment located throughout a healthcare facility. The Company's
products are sold through a direct sales force to acute care hospitals and
integrated healthcare delivery networks ("IHDNs") and on an Original Equipment
Manufacturer ("OEM") basis to patient monitoring equipment manufacturers.
 
     Revenues from sales of Networked Monitoring systems sold by the Company's
direct sales force are recognized upon shipment. The sales cycle for Networked
Monitoring systems has typically been from nine to 18 months. The Company has
experienced seasonal variations in sales of its Networked Monitoring systems,
with sales in the first quarter typically lower than the preceding fourth
quarter's sales due to customer budget cycles and sales remaining relatively
flat during the third quarter. Furthermore, a large percentage of a particular
quarter's shipments of Networked Monitoring systems has historically been booked
in the last weeks of the quarter.
 
     Revenues from sales of OEM products are recognized upon shipment. The
selling cycle for OEM products varies depending upon product mix and the extent
to which the Company develops customized operating software for a particular OEM
customer. In addition, the Company has experienced seasonal variations in sales
of its departmental products, with sales in the first quarter typically lower
than the preceding fourth quarter's sales and third quarter sales of OEM
products generally being lower than other quarters.
 
     The Company's products are generally shipped as orders are received and,
accordingly, the Company typically operates with limited backlog. As a result,
sales in any quarter are dependent on orders booked and shipped in that quarter.
 
                                       13
<PAGE>   15
 
   
     To date the Company has not capitalized software development expenses.
However, the development of new products or the enhancement of existing products
may require capitalization of such expenses in the future. See Note 1 of Notes
to Financial Statements.
    
 
ANNUAL RESULTS OF OPERATIONS
 
     The following table sets forth the percentage of total revenues represented
by certain statements of operations data for the periods indicated:
 
<TABLE>
<CAPTION>
                                                              YEAR ENDED DECEMBER 31,
                                                              -----------------------
                                                              1995     1996     1997
                                                              -----    -----    -----
<S>                                                           <C>      <C>      <C>
Total revenues..............................................  100.0%   100.0%   100.0%
                                                              -----    -----    -----
Cost of sales...............................................   43.0     52.7     52.7
                                                              -----    -----    -----
Gross profit................................................   57.0     47.3     47.3
                                                              -----    -----    -----
Operating expenses:
  Sales and marketing.......................................   26.9     51.8     39.3
  Research and development..................................   11.1     29.6     22.1
  General and administrative................................    6.9     13.6     11.6
  Restructuring charges.....................................     --      2.6       --
                                                              -----    -----    -----
          Total operating expenses..........................   44.9     97.6     73.0
                                                              -----    -----    -----
Operating income (loss).....................................   12.1    (50.3)   (25.7)
Other income (expense), net.................................   (0.5)     5.3      4.5
                                                              -----    -----    -----
Income (loss) before provision (benefit) for income taxes...   11.6    (45.0)   (21.2)
Provision (benefit) for income taxes........................    5.0    (10.4)    0.01
                                                              -----    -----    -----
Net income (loss)...........................................    6.6%   (34.6)%  (21.3)%
                                                              =====    =====    =====
</TABLE>
 
COMPARISON OF THE YEARS ENDED 1997, 1996 AND 1995
 
     Total Revenues. Total revenues consist of revenue from sales of Networked
Monitoring systems and OEM products, together with fees for installation and
servicing of products. Total revenues increased 18.6% to $21.8 million in 1997
from $18.4 million in 1996. Total revenues decreased 23.3% to $18.4 million in
1996 from $24.0 million in 1995. Revenues from Networked Monitoring systems
sales increased 12.8% to $9.3 million from $8.2 million in 1996. Revenues from
Networked Monitoring systems sales decreased 37.9% to $8.2 million in 1996 from
$13.1 million in 1995. Revenues from OEM product sales increased 19.6% to $12.2
million from $10.2 million in 1996. Revenues from OEM product sales decreased
5.7% to $10.2 million in 1996 from $10.8 million in 1995. The increase in
Networked Monitoring systems sales in 1997 from 1996 was due to a rebuilding of
the Company's funnel of potential new Networked Monitoring systems sales. The
decrease in sales of Networked Monitoring systems in 1996 from 1995 was due to a
reduction in sales that resulted from a shift to a new selling method made
during 1996 and changes made to the sales force to implement this new sales
strategy. The increase in OEM product sales in 1997 from 1996 reflects the
increased demand for central monitoring systems sold by two of the Company's OEM
customers, including those sold by the Company's largest OEM customer. In 1996,
OEM product sales decreased from 1995 due to the expected reduction of sales
from an existing customer which was not offset by increased revenues from either
present or new OEM customers.
 
     Gross Margins. Cost of goods sold generally includes material, direct
labor, overhead and, for Networked Monitoring systems, installation expenses.
Cost of sales increased 18.6% to $11.5 million from $9.7 million in 1996, on a
18.6% increase in revenues in 1997. Cost of sales decreased 6.0% to $9.7 million
in 1996 from $10.3 million in 1995, on a 23.3% revenue decrease in 1996. Gross
margins were 47.3%, 47.3% and 57.0% in 1997, 1996 and 1995, respectively. Gross
margin in 1997 was identical to 1996 as the absorption of fixed costs remained
consistent from year to year. The decrease in gross margin in 1996 as compared
to 1995 was due to lower revenues in 1996 with fixed costs in overhead a higher
percentage of revenues.
 
                                       14
<PAGE>   16
 
   
     Sales and Marketing Expenses. Sales and marketing expenses include payroll,
commissions and related costs attributable to direct and OEM sales and marketing
personnel, travel and entertainment expenses, and other promotional expenses.
Sales and marketing expenses decreased 10.0%, to $8.6 million in 1997 from $9.5
million in 1996. Sales and marketing expenses increased 47.7% to $9.5 million in
1996 from $6.4 million in 1995. The decrease in sales and marketing expenses in
1997 was primarily attributable to a decrease in customer relations expenses as
1996 expenses included voluntary upgrades to selected Networked Monitoring
systems customers to provide an upgrade path for future expansions and sales to
these customers. The increase in sales and marketing expenses in 1996 compared
to 1995 was primarily attributable to an increase in increased customer
relations expense, direct sales payroll and related support, training,
recruitment, and travel and entertainment expenses associated with an increased
number of sales professionals.
    
 
     Research and Development Expenses. Research and development expenses
include payroll and related costs attributable to research and development
personnel, prototyping expenses and other costs. Research and development
expenses decreased 11.4% to $4.8 million in 1997 from $5.4 million in 1996.
Research and development expenses increased 103.3% to $5.4 million in 1996 from
$2.7 million in 1995. Research and development expenses decreased in 1997 from
1996 due primarily to a lower number of research and development personnel and
reduced spending for prototype and test equipment. The increase in research and
development expenses in 1996 compared to 1995 was due primarily to an increase
in the number of research and development personnel, increased recruitment fees
and the costs associated with the increased number of projects.
 
     General and Administrative Expenses. General and administrative expenses
includes accounting, finance, MIS, human resources, general administration,
executive officers and professional fee expenses. General and administrative
expenses increased 1.1% to $2.5 million in 1997 from $2.5 million in 1996.
General and administrative expenses increased 52.5% to $2.5 million in 1996 from
$1.6 million in 1995. The increase in spending in 1997 and 1996 is attributable
to headcount increases, related recruiting and relocation expenses and during
1996 and the legal, compliance and investor relations expenses associated with
being a public company.
 
     Restructuring Charge. Restructuring charges of approximately $461,000
resulted from the Company's November 1996 restructuring of operations and an
executive reorganization and include severance and other employee termination
costs. The total restructuring costs were all paid by September 24, 1997.
 
     Other Income (Expense), Net. Other income (expense), net consists primarily
of interest income earned on proceeds from the Company's initial public
offering, net of payments made in respect of outstanding indebtedness. Other
income (expense), net, in 1997 decreased slightly to $972,968 in income as
compared to income of $975,341 in 1996. Other income (expense), net in 1996
increased to $975,341 from $(129,537) in 1995. Other income, net in 1997 and
1996 was derived from interest earned on the proceeds from the Company's
February 1996 initial public offering, while interest payments on the Company's
long term debt were eliminated as the loan was paid off in February 1996.
 
   
     Provision (Benefit) for Income Taxes. The Company paid minimal state taxes
in 1997 due to its net loss position. In 1996 the Company recognized a benefit
for the amount of refundable federal taxes of $2.7 million as a result of the
carryback of its net operating loss, offset by the establishment of a valuation
allowance of $748,000 against previously deferred tax assets, for a net tax
benefit of $1.9 million. The Company's effective tax rate was 43.0% in 1995. The
Company's utilization of its credit carryforwards depends upon future income and
may be subject to an annual limitation, required by the Internal Revenue Code of
1986 and similar state provisions (see Note 8 of Notes to Financial Statements).
    
 
LIQUIDITY AND CAPITAL RESOURCES
 
   
     The Company has financed its operations (including capital expenditures)
through net proceeds from the Company's February 1996 initial public offering,
cash flow from operations, cash and cash equivalent balances, a bank line of
credit and long-term debt. During 1995, the Company raised net proceeds of
approximately $2.8 million from the issuance of common and preferred stock.
During the year ended December 31, 1996 the Company issued 2,300,000 shares of
common stock in its February 1996 initial public
    
                                       15
<PAGE>   17
 
offering, raising $25.6 million, net of expenses. At December 31, 1997, the
Company had $18.2 million in cash, cash equivalents and short-term investments
as compared to $20.1 million at December 31, 1996.
 
     The Company used $1.7 million of cash for operating activities in 1997,
compared to $5.0 million and $0.02 million in 1996 and 1995, respectively. The
1997 net loss of $4.6 million and the $1.6 million increase in accounts
receivable was partially offset by decreases in inventories and income tax
receivable of $1.4 million and $2.9 million, respectively. Accounts receivable
increased primarily as a result of the increased business volume at the end of
1997, as compared to 1996.
 
     The Company used $6.4 million for investing activities in 1997, compared to
$1.4 million and $0.8 million in 1996 and 1995, respectively. Cash used for
investing activities in 1997, 1996 and 1995 was primarily for purchases of
equipment.
 
     The Company generated $0.2 million from financing activities in 1997,
compared to $24.4 million and $1.7 million in 1996 and 1995, respectively. The
primary source of cash from financing activities in 1997 was the net proceeds
from the issuance of common stock under the Company's employee stock purchase
plan. The primary source of cash from financing activities in 1996 was the sale
of 2,300,000 shares of common stock in the Company's initial public offering
which net the Company approximately $25.6 million. The primary source of cash
from financing activities in 1995 was from the issuance of preferred and common
stock which was partially offset by the repayment of long-term debt.
 
     At December 31, 1997, the Company's principal sources of liquidity
consisted of $18.2 million of cash, cash equivalents and short-term investments
and $5.0 million of available credit facilities. In August 1997, the Company
renewed a secured lending arrangement (the "Agreement") with Silicon Valley
Bank, providing for a $5.0 million revolving line of credit bearing interest at
the bank's prime rate. The bank does not have security interest in any of the
Company's assets unless the Company is borrowing under the line of credit and
fails to comply with certain financial covenants. The Agreement expires in
August 1998. At December 31, 1997, there were no borrowings outstanding under
the Agreement and the Company was in compliance with all covenants. The
financial covenants require that the Company maintain a quick assets ratio of
not less than 2 to 1, maintain tangible net worth of not less than $20,000,000,
maintain a ratio of total liabilities to tangible net worth of not more than 1
to 1 and maintain an aggregate total of cash and marketable securities in an
amount at least equal to the product of two times the maximum amount of the
Credit Line. As such, the bank held no security interest in any of the Company's
assets (see note 3 of Notes to Financial Statements).
 
     At December 31, 1995, the Company had a secured promissory note in the
amount of $1,541,667 due to Silicon Valley Bank which bore interest at the
bank's prime rate plus 3.0% (11.75% at December 31, 1995) per annum, payable
monthly in arrears. In February 1996 the Company paid the loan off in full,
without pre-payment penalty.
 
     The Company's principal commitment at December 31, 1997 consisted of a
lease on its office and manufacturing facility. The Company expects to spend
approximately $1.0 million for capital expenditures during 1998.
 
     The Company believes that existing cash resources, cash flows from
operations, if any, and line of credit facilities will be sufficient to fund the
Company's operations for at least the next twelve months.
 
     Year 2000 Compliance. In the next two years, many companies will face a
potentially serious information systems (computer) problem because many software
application and operational programs written in the past may not properly
recognize calendar dates beginning in the Year 2000. This problem could force
computers to either shut down or provide incorrect data or information. The
Company is presently in the process of examining its computer systems and
contacting its software providers to determine whether the Company's software
applications are compliant with the Year 2000. As of December 31, 1997, the
Company's enterprise resource planning system has been validated to be Year 2000
compliant. While it is difficult to quantify the anticipated cost involved, the
Company's best estimate of expenditures is between $50,000 to $200,000 for such
upgrades since they were part of the software and hardware provides normal
upgrades to the Company. While the Company believes that its systems are fully
Year 2000 compliant, the Company intends to continue to review its information
systems for any possible problems as well as monitor its key customers

                                       16
<PAGE>   18
 
and suppliers for any impact that the Year 2000 may have on their information
systems which could then impact the Company. Although the Company believes that
its products are Year 2000 compliant, customers may be affected by Year 2000
requirement issues as they could expend significant resources to correct or
patch other software systems for Year 2000 compliance. These expenditures may
result in reduced capital equipment budgets for other products, such as products
offered by the Company, which could result in a material adverse effect on the
Company's business, operating results and financial condition.
 
     Recent Accounting Pronouncements -- In June 1997, the FASB issued Statement
of Financial Accounting Standard No. 130 (SFAS 130), Reporting Comprehensive
Income, and No. 131 (SFAS 131), Disclosures About Segments of an Enterprise and
Related Information. These statements are effective for fiscal years commencing
after December 15, 1997. While the Company is required to comply with the
provisions of these statements in fiscal 1998, it has been determined that the
effect that these new standards will have on its consolidated financial
statements and disclosures is not material.
 
     In October 1997, the American Institute of Certified Public Accountants
issued SOP 97-2, Software Revenue Recognition, which supercedes SOP 91-1. The
provisions of SOP 97-2 are effective for fiscal years beginning after December
15, 1997. The Company is reviewing the impact of the statement on its financial
statements.
 
FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS
 
     Dependence on Increased Market Acceptance of Networked Monitoring
Systems. In 1997, sales of the Company's Networked Monitoring systems increased
12.8% to $9.3 million from $8.2 million in 1996. In 1996, sales of the Company's
Networked Monitoring systems decreased 37.9% to $8.2 million from $13.1 million
in 1995. Although the Company has experienced sequential revenue growth in 1997,
sales of the Company's Networked Monitoring systems have not returned to 1995
sales levels and the Company's operating results since 1995 have been affected
by the lower sales levels. If the Company is not successful in marketing and
selling its Networked Monitoring systems, the Company's business, operating
results and financial condition would be materially adversely affected. In
addition, although the Company's Networked Monitoring products have been
installed in almost 100 hospitals, there is no assurance that the Company's
products will achieve the hospital penetration which the Company anticipates.
 
     Fluctuations in Quarterly Results. The Company's quarterly operating
results have fluctuated in the past and may fluctuate significantly from quarter
to quarter in the future as a result of a number of factors, including, but not
limited to the size and timing of orders; the length of the sales cycle; the
Company's success in expanding its sales and marketing programs and the effects
of changes in sales force alignment; the ability of the Company's customers to
obtain budget allocations for the purchase of the Company's products; changes in
pricing policies or price reductions by the Company or its competitors; mix of
sales between Networked Monitoring systems and OEM products; the timing of new
product announcements and introductions by the Company or its competitors;
deferrals of customer orders in anticipation of new products or product
enhancements; the Company's ability to develop, introduce and market new
products and product enhancements; market acceptance of new products or product
enhancements; the Company's ability to control costs; the availability of
components; costs associated with responding software "bugs" or errors;
regulatory compliance and timing of regulatory clearances and general economic
factors.
 
     The Company's products are generally shipped as orders are received and,
accordingly, the Company has historically operated with limited backlog. As a
result, sales in any quarter are dependent on orders booked and shipped in that
quarter and are not predictable with any degree of certainty. Further, a large
percentage of any quarter's shipments have historically been booked in the last
weeks of the quarter. In addition, a significant portion of the Company's
expenses are relatively fixed, and the amount and timing of increases in such
expenses are based in large part on the Company's expectations for future
revenues. If revenues are below expectations in any given quarter, the adverse
effect may be magnified by the Company's inability to maintain gross margins and
to decrease spending to compensate for the revenue shortfall. Further, the
Company has sometimes experienced seasonal variations in operating results, with
sales in the first quarter being lower than
 
                                       17
<PAGE>   19
 
in the preceding fourth quarter's sales due to customer budget cycles and sales
remaining relatively flat during the third quarter.
 
     Lengthy Sales Cycle. The decision by a healthcare provider to replace or
substantially upgrade its clinical information systems typically involves a
major commitment of capital and an extended review and approval process, and
this review and approval process is becoming more complex, more financially
oriented and increasingly subject to overall integration into the hospital's
information systems planning. The sales cycle for the Company's Networked
Monitoring systems has typically been nine to 18 months from initial contact to
receipt of a purchase order. During this period, the Company expends substantial
time, effort and funds preparing a contract proposal and negotiating a purchase
order without any guarantee that the Company will complete the transaction. Any
significant or ongoing failure to reach definitive agreements with customers has
in the past and may in the future have a material adverse effect on the
Company's business, operating results and financial condition.
 
   
     Competition. The Company's Networked Monitoring systems compete with
systems offered by a number of competitors, including Hewlett-Packard Company,
SpaceLabs, Inc. and Marquette Electronics, Inc., most of which have
significantly greater financial, technical, research and development and
marketing resources than the Company. In addition, many of these competitors
have longstanding relationships with acute care hospitals and IHDNs. There can
be no assurance that the Company will be able to sell to such hospitals or IHDNs
or that the Company will be able to compete successfully with such vendors, and
any inability to do so could have a material adverse effect on the Company's
business, operating results and financial condition. The Company's OpenNet
applications may face significant competition in the future from HCIS providers,
patient monitoring companies, life support device companies and general purpose
data network providers. Such potential competitors may elect to enter this
market and compete with the Company using significantly greater financial,
technical, research and development and marketing resources than are available
to the Company. In addition, the Company's success in selling its
multi-parameter OpenNet networks to hospitals and IHDNs will depend to a large
extent on its ability to interface with patient monitoring and life support
devices of other vendors. Any action on the part of such other vendors to make
such interfacing more difficult or impossible could have a material adverse
effect on the Company's business, operating results and financial condition. The
market for the Company's OEM products is also intensely competitive. The Company
sells to a range of patient monitoring and life support device companies, many
of which have significantly greater financial, technical, research and
development and marketing resources than the Company. There can be no assurance
that current OEM customers will not elect to design and manufacture patient
monitoring and system components currently supplied by the Company or elect to
contract with other OEM suppliers. Any such election by one or more of such
companies could have a material adverse effect on the Company's business,
operating results and financial condition.
    
 
   
     In addition, the Company may in the future elect to incorporate in its OEM
products the hardware and software for larger networks and real-time
redistribution of information to remote viewing stations for use in specialty
departments of hospitals for which the Company's OEM customers design and sell
their products. In the event the Company incorporates these or other features
into its OEM products, the Company believes that its OEM customers would not
compete with its Networked Monitoring systems because the Networked Monitoring
systems are sold to hospitals and IHDNs who elect to install larger, more
dispersed systems. However, the Company could face competition with its OEM
customers to the extent hospitals forego purchasing the Company's facility-wide
Networked Monitoring systems for the smaller departmental systems of its OEM
customers.
    
 
     Customer Concentration; Dependence on Departmental Products. The Company's
OEM product sales, which represented approximately 55.6% and 53.7% of the
Company's total net revenues in 1996 and 1997, respectively, have historically
been to a small number of OEM customers. In 1996, Quinton Instrument Company
("Quinton") and Datascope Corporation ("Datascope") accounted for approximately
18.4% and 17.7%, respectively, of the Company's total revenues and in 1997
Quinton and Datascope accounted for approximately 12.7% and 25.0%, respectively,
of the Company's total revenues. The loss of, or a reduction in sales to, any
such OEM customer would have a material adverse effect on the Company's
business, operating results and financial condition.
                                       18
<PAGE>   20
 
     Technological Change; Need to Develop New Products. Many aspects of the
medical equipment industry are undergoing rapid technological change, changing
customer needs, frequent new product introductions and evolving industry
standards. Historically, the Company derived substantially all of its revenue
from sales of its Networked Monitoring systems and OEM products. The Company
believes that as the market for these products matures, VitalCom's future
success will depend upon its ability to develop and introduce on a timely basis
new products and product enhancements that keep pace with technological
developments and that address the increasingly sophisticated needs of acute care
hospitals and IHDNs. In addition, the introduction of competing products
embodying new technologies and the emergence of new industry standards could
render the Company's existing products unmarketable or obsolete. If the Company
is unable to develop and introduce product enhancements and new products in a
timely and cost-effective manner in response to changing market conditions or
customer requirements, or if the Company's new products or product enhancements,
such as SiteLink, do not achieve market acceptance, the Company's business,
operating results and financial condition will be materially adversely affected.
 
     Uncertainty and Consolidation in Healthcare Industry. The healthcare
industry is subject to changing political, economic and regulatory influences
that may affect the procurement practices and operation of healthcare providers.
Many healthcare providers are consolidating to create larger hospitals and
IHDNs. This consolidation reduces the number of potential customers for the
Company's products, and the increased bargaining power of these organizations
could lead to reductions in the amounts paid for the Company's products. These
larger hospitals and IHDNs may concentrate their purchases on a small number of
preferred vendors with whom they have had longstanding relationships. There can
be no assurance that the Company will be able to sell to such hospitals or IHDNs
or that the Company will be able to compete successfully with such vendors. The
impact of these developments in the healthcare industry is difficult to predict
and could have a material adverse effect on the Company's business, operating
results and financial condition.
 
     Limited Intellectual Property Protection. The Company relies on a
combination of copyright, trade secret and trademark laws, confidentiality
procedures and contractual provisions to protect its intellectual property. The
Company seeks to protect its software, circuitry documentation and other written
materials under trade secret and copyright laws, which afford only limited
protection. The Company cannot assure that its protective measures for
proprietary rights will be adequate or that the Company's competitors will not
independently develop similar or superior technology, duplicate the Company's
products or otherwise circumvent its intellectual property rights. Although the
Company has never received a claim that its products infringe a third party's
intellectual property rights, there can be no assurance that third parties will
not in the future claim infringement by the Company with respect to current or
future products or proprietary rights. Any such claims, regardless of their
merit, could be time consuming, result in costly litigation, delay or prevent
product shipments or require the Company to enter into costly royalty or
licensing agreements. The impact of any of these developments could have a
material adverse effect on the Company's business, operating results and
financial condition.
 
     Risk of Product Liability Claims. Certain of the Company's products provide
applications that relate to patient physiologic status or other clinically
critical information. Any failure by the Company's products to provide accurate
and timely information could result in product liability and warranty claims
against the Company by its customers or their patients. The Company maintains
insurance against claims associated with the use of its products, but there can
be no assurance that its insurance coverage would adequately cover any claim
asserted against the Company. A successful claim brought against the Company in
excess of its insurance coverage or outside the scope of the Company's insurance
coverage could have a material adverse effect on the Company's business,
operating results and financial condition. Even unsuccessful claims could result
in the expenditure of funds in litigation and diversion of management time and
resources.
 
     Year 2000 Compliance. In the next two years, many companies will face a
potentially serious information systems (computer) problem because many software
application and operational programs written in the past may not properly
recognize calendar dates beginning in the Year 2000. This problem could force
computers to either shut down or provide incorrect data or information. The
Company is presently in the process of examining its computer systems and
contacting its software providers to determine whether the Company's software
applications are compliant with the Year 2000. As of December 31, 1997, the
Company's
                                       19
<PAGE>   21
 
enterprise resource planning system has been validated to be Year 2000
compliant. While it is difficult to quantify the anticipated cost involved, the
Company's best estimate of expenditures is between $50,000 to $200,000 for such
upgrades since they were part of the software and hardware provides normal
upgrades to the Company. While the Company believes that its systems are fully
Year 2000 compliant, the Company intends to continue to review its information
systems for any possible problems as well as monitor its key customers and
suppliers for any impact that the Year 2000 may have on their information
systems which could then impact the Company. Although the Company believes that
its products are Year 2000 compliant, customers may be affected by Year 2000
requirement issues as they could expend significant resources to correct or
patch other software systems for Year 2000 compliance. These expenditures may
result in reduced capital equipment budgets for other products, such as products
offered by the Company, which could result in a material adverse effect on the
Company's business, operating results and financial condition.
 
     Dependence on Sole Source Components. Certain of the Company's products
utilize components that are available in the short term only from a single or a
limited number of sources, have been available only on an allocation basis in
the past and could be in scarce supply again in the future. Any inability to
obtain components in the amounts needed on a timely basis or at commercially
reasonable prices could result in delays in product introductions, interruption
in product shipments or increases in product costs, which could have a material
adverse effect on the Company's business, operating results and financial
condition until alternative sources could be developed or design and
manufacturing changes could be completed.
 
     Risks Associated With Recent Management Changes. During 1997, the Company
had a number of changes in its management team. Effective January 1, 1997, David
L. Schlotterbeck stepped down as the Company's Chief Executive Officer, and
Donald J. Judson, the Company's Chairman of the Board, assumed such
responsibilities. In March 1997, the Company hired a new Vice President, Direct
Sales and in July 1997 hired a new Vice President, Research and Development. In
October 1997, the Company hired Frank T. Sample as its new President and Chief
Executive Officer, with Mr. Judson stepping down as such. The addition of new
senior management has involved increased salary levels which the Company
anticipates will result in increased administrative expenses in future periods.
Such management changes can also involve disruptions in the Company's day-to-day
operations, can interrupt continuity in customers relationships and create
delays in sales the cycles or product release schedules. Although the Company
believes that its new senior management will be successful in improving the
Company's business, operating results and financial condition, there can be no
assurance that such changes will not have a material adverse effect on the
Company's business, operating results and financial condition in future periods.
 
     Dependence on Key Personnel. The Company's success depends to a large
extent on its ability to attract and retain key personnel. The loss of the
services, either temporarily or permanently, of any of the members of senior
management or other key employees, particularly in sales and marketing and
research and development, could have a material adverse effect on the Company's
business, operating results and financial condition. In addition, the Company's
future success depends to a large extent on its ability to attract and retain
additional key management, sales and marketing and research and development
personnel. Competition for such personnel is intense. There can be no assurance
that the Company will be successful in attracting and retaining such personnel,
and the failure to do so could have a material adverse effect on the Company's
business, operating results and financial condition.
 
     Government Regulation. The manufacture and sale of medical devices,
including the Company's products, is subject to extensive regulation by numerous
governmental authorities. In the United States, the Company's products are
regulated as medical devices and are subject to the FDA's pre-clearance or
approval requirements. The Company has received clearance from the FDA to market
its current products through the 510(k) premarket notification process. There
can be no assurance that a similar 510(k) clearance for any future product or
enhancement of an existing product will be granted or that the process will not
be lengthy. If the Company cannot establish that a product is "substantially
equivalent" to certain legally marketed devices, or if FDA regulatory changes
currently under consideration with respect to arrhythmia software are adopted,
the 510(k) clearance procedure will be unavailable and Company will be required
to utilize the longer and more expensive premarket approval ("PMA") process.
Failure to receive or delays in receipt of FDA clearances or approvals,
including the need for extensive clinical trials or additional data as a
prerequisite to
                                       20
<PAGE>   22
 
clearance or approval, could have a material adverse effect on the Company's
business, operating results and financial condition. Sales of medical devices
and components outside of the United States are subject to international
regulatory requirements that vary from country to country. There can be no
assurance that the Company will be able to obtain further clearance or approvals
for its products or components on a timely basis or at all, and delays in
receipt of, loss of or failure to receive such approvals or clearances could
have a material adverse effect on the Company's business, operating results and
financial condition.
 
     The Company's radio frequency transmitter devices are subject to regulation
by the Federal Communication Commission ("FCC"), and applicable approvals must
be obtained before shipment of such products. The Company believes that all of
its products designated for sale in the United States meet applicable Federal
Communications Commission (FCC) regulations, including US FCC Part 15 for
electromagnetic emissions. The FCC approval process starts with the collection
of test data that demonstrates that a product meets the requirements stated in
Part 15 of the FCC regulations. This data is then included as part of a report
and application that is submitted to the FCC requesting approval. The FCC may
grant or request additional information or withhold approval. Any failure of the
Company's products to conform to governmental regulations or any delay or
failure to obtain required FCC approvals in the future, if any, could cause the
delay or loss of sales of the Company's products and therefore have a material
adverse effect on the Company's business, financial condition and result of
operations.
 
     The Company's proprietary radio frequency (RF) communication products
transmit real-time physiologic information from the patient to the central
surveillance station. These communication products currently operate in three
radio bands: VHF (174 MHz to 216 MHz, shared with TV channels 7-13); UHF (450
MHz to 470 MHz, shared with land mobile users); and the 900 MHz radio band (902
MHz to 928 MHz licensed for Spread Spectrum operation). The majority of the
Company's RF products use the vacant television frequencies in the VHF band. The
FCC is requiring all television stations to implement digital broadcasting
transmission for High Definition Television (HDTV). Major metropolitan areas
will be required to implement HDTV by December 31, 1998 and other markets by
December 31, 2006. In order to implement HDTV the FCC has granted each TV
channel an additional 6 MHz channel for digital broadcasting until the
transition period ends, at which time the broadcaster would return one of the
two channels. As TV stations use the additional 6 MHz channel for the digital
broadcasting transition, which may take years, they may overlap into the radio
spectrum which has been used for medical RF applications. Customers of the
Company's lower power RF communication products may begin seeing more
interference in the future. This interference may result in the Company's
hospital biomedical personnel having to re-tune the Company's RF transmitters to
other channels in order to reduce interference. In the event of high
interference the Company's customers may need to purchase equipment to transmit
in the UHF frequency range. The FCC also announced that they will be expanding
the usable UHF frequencies for medical RF from the licensed 450 MHz to 470 MHz
band to the unlicensed 470 MHz to 668 MHz frequency range. With VHF frequency
ranges available for medical RF use potentially becoming more limited and the
UHF frequency ranges expanding, the Company's competitors who have historically
focused their RF products in what was the more limited UHF band, may now have a
competitive advantage as compared to the Company, until such time as the Company
expands its UHF RF product offerings. Any such competitive advantage of the
Company's competitors and any additional development costs associated with
expanding the Company's UHF RF product offerings could have a material adverse
effect on the Company's business, operating results and financial condition.
Additionally, future regulatory changes could significantly affect the Company's
operations by diverting the Company's development efforts, making current
products obsolete or increasing the opportunity for additional competition which
could have a material adverse effect on the Company's business, operating
results and financial condition.
 
                                       21
<PAGE>   23
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
     The following financial statements are filed herewith and are listed under
Item 14 of Part IV of this report.
 
                          INDEPENDENT AUDITORS' REPORT
 
To the Board of Directors of VitalCom Inc.,
 
     We have audited the accompanying balance sheets of VitalCom Inc. (the
"Company") as of December 31, 1996 and 1997, and the related statements of
operations, stockholders' equity (deficit) and cash flows for each of the three
years in the period ended December 31, 1997. Our audits also included the
financial statement schedule listed in Item 14a. These financial statements and
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements and
financial statement schedule based on our audits.
 
     We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
 
     In our opinion, such financial statements present fairly, in all material
respects, the financial position of VitalCom Inc. at December 31, 1996 and 1997,
and the results of its operations and its cash flows for each of the three years
in the period ended December 31, 1997, in conformity with generally accepted
accounting principles. Also, in our opinion, such financial statement schedule,
when considered in relation to the financial statements taken as a whole,
presents fairly, in all material respects, the information set forth therein.
 
DELOITTE & TOUCHE LLP
Costa Mesa, California
February 11, 1998
 
                                       22
<PAGE>   24
 
                                 VITALCOM INC.
 
                                 BALANCE SHEETS
 
                                     ASSETS
 
   
<TABLE>
<CAPTION>
                                                                     DECEMBER 31,
                                                              --------------------------
                                                                 1996           1997
                                                              -----------    -----------
<S>                                                           <C>            <C>
Current assets
  Cash and cash equivalents.................................  $20,120,203    $12,157,160
  Short-term investments....................................                   6,000,000
  Accounts receivable, net of allowance for doubtful
     accounts and returns of $235,566 and $270,213..........    2,299,360      3,853,066
  Inventories (Note 2)......................................    3,191,043      1,812,499
  Prepaid expenses..........................................      361,272        269,462
  Income tax refund receivable..............................    2,874,276             --
                                                              -----------    -----------
          Total current assets..............................   28,846,154     24,092,187
Property:
  Machinery and equipment...................................    1,352,898      1,464,903
  Office furniture and computer equipment...................    1,820,607      2,044,083
  Leasehold improvements....................................       67,919         87,351
                                                              -----------    -----------
                                                                3,241,424      3,596,337
  Less accumulated amortization and depreciation............     (976,328)    (1,659,939)
                                                              -----------    -----------
  Property, net.............................................    2,265,096      1,936,398
                                                              -----------    -----------
Other assets (Note 1).......................................      140,101         51,935
Goodwill, net (Note 1)......................................      669,525        627,549
                                                              -----------    -----------
          Total assets......................................  $31,920,876    $26,708,069
                                                              ===========    ===========
 
                          LIABILITIES AND STOCKHOLDERS' EQUITY
 
Current liabilities:
  Accounts payable..........................................  $ 1,085,972    $   585,744
  Accrued payroll and related costs.........................      875,344      1,198,055
  Accrued warranty costs....................................      951,381        968,245
  Accrued liabilities (Notes 5 and 6).......................    1,623,278      1,353,675
  Accrued marketing commitments.............................      309,377
  Current portion of capital lease obligations..............       21,120         21,120
                                                              -----------    -----------
          Total current liabilities.........................    4,866,472      4,126,839
                                                              -----------    -----------
Capital lease obligations, less current portion.............       81,834         60,296
Commitments and contingencies
Redeemable preferred stock, $0.001 par value, 5,000,000
  shares authorized, no shares issued and outstanding at
  December 31, 1996 and December 31, 1997
Stockholders' equity (Notes 5 and 7):
  Common stock, including paid-in capital, $0.0001 par
     value; 25,000,000 shares authorized, 7,942,688 shares
     and 8,038,547 shares issued and outstanding at December
     31, 1996 and 1997, respectively........................   36,832,936     37,226,125
Note receivable for stock sales.............................                    (194,960)
Accumulated deficit.........................................   (9,860,366)   (14,510,231)
                                                              -----------    -----------
          Total stockholders' equity........................   26,972,570     22,520,934
                                                              -----------    -----------
Total liabilities and stockholders' equity..................  $31,920,876    $26,708,069
                                                              ===========    ===========
</TABLE>
    
 
                       See notes to financial statements.
                                       23
<PAGE>   25
 
                                 VITALCOM INC.
 
                            STATEMENTS OF OPERATIONS
 
   
<TABLE>
<CAPTION>
                                                               YEAR ENDED DECEMBER 31,
                                                      -----------------------------------------
                                                         1995           1996           1997
                                                      -----------    -----------    -----------
<S>                                                   <C>            <C>            <C>
Revenues............................................  $23,964,167    $18,372,415    $21,793,555
Cost of sales.......................................   10,299,437      9,680,394     11,476,974
                                                      -----------    -----------    -----------
Gross profit........................................   13,664,730      8,692,021     10,316,581
Operating expenses:
  Sales and marketing...............................    6,442,109      9,515,482      8,562,095
  Research and development..........................    2,673,000      5,433,738      4,815,543
  General and administration........................    1,644,177      2,506,980      2,535,586
  Restructuring charges (Note 9)....................                     480,996
                                                      -----------    -----------    -----------
          Total operating expenses..................   10,759,286     17,937,196     15,913,224
                                                      -----------    -----------    -----------
Operating income (loss).............................    2,905,444     (9,245,175)    (5,596,643)
Other income (expense), net.........................     (129,537)       975,341        972,968
                                                      -----------    -----------    -----------
Income (loss) before provision (benefit) for income
  taxes.............................................    2,775,907     (8,269,834)    (4,623,675)
Provision (benefit) for income taxes................    1,192,657     (1,901,995)        26,190
                                                      -----------    -----------    -----------
Net income (loss)...................................  $ 1,583,250    $(6,367,839)   $(4,649,865)
                                                      ===========    ===========    ===========
Net income applicable to common shareholders (Note
  1)................................................  $   619,611
                                                      ===========
Net income (loss) per basic common share............  $      0.30    $     (0.90)   $     (0.58)
                                                      ===========    ===========    ===========
Net income (loss) per diluted common share..........  $      0.28    $     (0.90)   $     (0.58)
                                                      ===========    ===========    ===========
Weighted average basic common shares................    5,312,990      7,084,397      8,000,982
                                                      ===========    ===========    ===========
Weighted average diluted common shares..............    5,671,307      7,084,397      8,000,982
                                                      ===========    ===========    ===========
</TABLE>
    
 
                       See notes to financial statements.
                                       24
<PAGE>   26
 
                                 VITALCOM INC.
 
                  STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
              FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
 
   
<TABLE>
<CAPTION>
                                                                               NOTE
                                        COMMON STOCK                        RECEIVABLE         TOTAL
                                  ------------------------   ACCUMULATED    FOR COMMON     STOCKHOLDER'S
                                    SHARES       AMOUNT        DEFICIT      STOCK SALES   EQUITY (DEFICIT)
                                  ----------   -----------   ------------   -----------   ----------------
<S>                               <C>          <C>           <C>            <C>           <C>
Balances, January 1, 1995.......   5,033,652   $   506,219   $ (4,112,138)   $              $(3,605,919)
  Preferred stock dividends
     (Note 5)...................                                 (255,639)                     (255,639)
  Repurchase of common stock
     (Note 5)...................  (1,233,136)     (123,314)                                    (123,314)
  Issuance of shares in
     connection with stock
     option exercised (Note
     7).........................      26,250        25,200                                       25,200
  Contribution and retirement of
     common shares (Note 5).....     (15,544)
  Purchase and exchange of
     shares, net (Note 5).......  (3,143,097)     (319,301)                                    (319,301)
  Stock split (Note 1)..........     409,197
  Issuance of shares (Note 5)...      78,672       430,799                                      430,799
  Accretion attributable to
     preferred stock (Note 5)...                                 (708,000)                     (708,000)
  Net income....................                                1,583,250                     1,583,250
                                  ----------   -----------   ------------    ---------      -----------
Balances, December 31, 1995.....   1,155,994       519,603     (3,492,527)                   (2,972,924)
  Conversion of Series C and D
     preferred stock to common
     stock......................   4,419,629    10,348,486                                   10,348,486
  Stock issued to the public,
     net (Note 5)...............   2,300,000    25,633,607                                   25,633,607
  Stock options exercised.......      34,250        27,690                                       27,690
  Tax benefit related to stock
     options....................                   150,140                                      150,140
  Stock issued pursuant to
     employee stock purchase
     plan.......................      32,815       153,410                                      153,410
  Net loss......................                               (6,367,839)                   (6,367,839)
                                  ----------   -----------   ------------    ---------      -----------
Balances, December 31, 1996.....   7,942,688    36,832,936     (9,860,366)                   26,972,570
Stock options exercised.........       8,500         6,971                                        6,971
Note receivable for stock
  sales.........................      40,000       195,000                    (195,000)
Cash collections on note
  receivable....................                                                    40               40
Stock issued pursuant to
  employee stock purchase
  plan..........................      47,359       191,218                                      191,218
Net loss........................                               (4,649,865)                   (4,649,865)
                                  ----------   -----------   ------------    ---------      -----------
Balances, December 31, 1997.....   8,038,547   $37,226,125   $(14,510,231)   $(194,960)     $22,520,934
                                  ==========   ===========   ============    =========      ===========
</TABLE>
    
 
                       See notes to financial statements.
                                       25
<PAGE>   27
 
                                 VITALCOM INC.
 
                            STATEMENTS OF CASH FLOWS
 
   
<TABLE>
<CAPTION>
                                                                 YEAR ENDED DECEMBER 31,
                                                        -----------------------------------------
                                                           1995           1996           1997
                                                        -----------   ------------   ------------
<S>                                                     <C>           <C>            <C>
Cash flows from operating activities:
  Net income (loss)...................................  $ 1,583,250   $ (6,367,839)  $ (4,649,865)
  Adjustments to reconcile net income (loss) to net
     cash used in operating activities:
  Depreciation and amortization.......................      931,773        553,754        776,807
  Provision for doubtful accounts and sales returns...      208,658       (330,123)        34,647
  Deferred income taxes...............................     (498,866)       751,127
  Loss on disposal of property........................        9,793         10,878         35,078
  Changes in operating assets and liabilities:
     Accounts receivable..............................   (3,521,924)     4,429,984     (1,588,353)
     Inventories......................................     (635,586)    (1,711,122)     1,378,544
     Income tax receivable............................                  (2,874,276)     2,874,276
     Prepaid expenses and other current assets........      (81,653)      (188,175)        91,810
     Other assets.....................................         (408)       128,600         88,166
     Accounts payable.................................      513,494        116,622       (500,228)
     Accrued payroll and related costs................      667,724       (465,696)       322,711
     Accrued warranty costs...........................       98,535        349,019         16,864
     Income taxes payable.............................      153,051       (312,127)       228,294
     Accrued marketing commitments....................      110,926        198,451       (309,377)
     Accrued liabilities..............................      437,670        699,676       (497,897)
                                                        -----------   ------------   ------------
     Net cash used in operating activities............      (23,563)    (5,011,247)    (1,698,523)
Cash flows from investing activities:
  Purchases of property and equipment.................     (751,999)    (1,434,608)      (441,661)
  Purchases of short-term investments.................                                 (6,000,000)
  Proceeds from sale of property......................                       3,550            450
                                                        -----------   ------------   ------------
     Net cash used in investing activities............     (751,999)    (1,431,058)    (6,441,211)
Cash flows from financing activities:
  Preferred stock dividends...........................     (255,639)
  Repurchase of common stock..........................     (123,314)
  Repayment of long-term debt.........................     (500,000)    (1,565,984)       (21,538)
  Net proceeds from issuance of preferred and common
     stock............................................    2,783,191     25,814,707        198,229
  Tax benefit related to stock options................                     150,140
  Deferred offering costs.............................     (188,361)
                                                        -----------   ------------   ------------
     Net cash provided by financing activities........    1,715,877     24,398,863        176,691
Net increase(decrease) in cash and cash equivalents...      940,315     17,956,558     (7,963,043)
Cash and cash equivalents, beginning of year..........    1,223,330      2,163,645     20,120,203
                                                        -----------   ------------   ------------
Cash and cash equivalents, end of year................  $ 2,163,645   $ 20,120,203   $ 12,157,160
                                                        ===========   ============   ============
Supplemental disclosures of cash flow information:
  Interest paid.......................................  $   218,291   $     69,259   $     31,382
  Income taxes paid...................................  $ 1,557,057   $    360,326   $     33,025
Supplemental schedule of noncash transactions:
  Notes receivable for stock sales....................                               $    195,000
</TABLE>
    
 
                       See notes to financial statements.
                                       26
<PAGE>   28
 
                                 VITALCOM INC.
 
                         NOTES TO FINANCIAL STATEMENTS
 
1. GENERAL AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
     General and Nature of Operations -- VitalCom provides radio communications
products and computer networks that acquire, interpret and distribute real-time
patient monitoring information. The Company's radio and computer networks
acquire physiologic data generated by its own proprietary ECG monitors and other
manufacturers' bedside equipment located throughout a healthcare facility. The
Company's products are sold through a direct sales force to acute care hospitals
and integrated healthcare delivery networks ("IHDNs") and on an Original
Equipment Manufacturer ("OEM") basis to patient monitoring equipment
manufacturers.
 
   
     During the 1994 year, New PCI, Inc. changed its name to ACCUCORE, Inc., and
in January 1996, changed its name to VitalCom Inc. (the "Company").
    
 
     Consolidation -- In December 1995, the Company and its wholly owned
subsidiary merged. The merger has been treated as a reorganization of entities
under common control and accounted for in a manner similar to that of a pooling
of interests. The Company's financial statements have been restated accordingly.
 
     Cash Equivalents -- Cash equivalents generally represent highly liquid
investments purchased with an original maturity date of three months or less.
 
     Short-Term Investments -- The Company accounts for investments in debt and
equity securities in accordance with Statement of Financial Accounting Standards
No. 115 (SFAS 115), Accounting for Certain Investments in Debt and Equity
Securities. SFAS 115 requires investment securities to be classified as trading,
available for sale, or held to maturity. Management determines the appropriate
classification of its investments at the time of purchase and reevaluates the
classification at each balance sheet date. As of December 31, 1997, all
investments in the short-term investment portfolio are classified as available
for sale. Investments classified as available for sale are required to be
recorded at fair value and any temporary difference between an investment's cost
and its fair value is recorded as a separate component of shareholders' equity.
 
     Inventories -- Inventories are stated at the lower of weighted average cost
or market.
 
     Property -- Property is stated at cost. Depreciation is provided using the
straight-line method and the double declining balance method over the estimated
useful lives of the related assets, generally three to eight years. Leasehold
improvements are amortized over the lesser of the estimated useful lives of the
related improvements or the related lease term.
 
     Goodwill -- Goodwill represents the excess purchase cost over the net
assets acquired and is amortized over 20 years using the straight-line method.
The Company periodically evaluates the recoverability of goodwill based on a
profitability analysis related to its product sales and has determined that
there was no impairment of goodwill at December 31, 1997.
 
   
     Long Lived Assets -- The Company accounts for the impairment and
disposition of long-lived assets in accordance with Statement of Financial
Accounting Standards No. 121 (SFAS 121), Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of. In accordance
with SFAS 121, long-lived assets to be held are reviewed for events or changes
in circumstances which indicate that their carrying value may not be
recoverable. The Company periodically reviews the carrying value of long-lived
assets to determine whether or not an impairment to such value has occurred and
has determined that there was no impairment at December 31, 1997.
    
 
     Revenue Recognition -- Revenues from both Networked Monitoring(TM) systems
and OEM products, which consist of both hardware and software, are recognized
upon shipment if no significant vendor obligations remain and collection of the
related receivable is probable. The Company accounts for insignificant vendor
obligations and post-contract support at the time of product delivery by
accruing such costs and recognizing them ratably on completion of performance.
There is no right of return on sales. Revenues related to service
 
                                       27
<PAGE>   29
                                 VITALCOM INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
 
contracts with customers, which are insignificant, are deferred and amortized
over the terms of the contracts, generally one year.
 
     Software Development Costs -- Development costs incurred in the research
and development of new software products and enhancements to existing software
products are expensed as incurred until technological feasibility has been
established. After technological feasibility is established, any additional
costs would be capitalized in accordance with Statement of Financial Accounting
Standards No. 86, Accounting for the Costs of Computer Software to be Sold,
Leased or Otherwise Marketed. Because the Company believes that its current
process for developing software is essentially completed concurrently with the
establishment of technological feasibility, no costs are capitalized as of
December 31, 1995, 1996 or 1997.
 
     Income Taxes -- The Company accounts for income taxes in accordance with
Statement of Financial Accounting Standard No. 109 (SFAS No. 109), Accounting
for Income Taxes. This statement requires the recognition of deferred tax assets
and liabilities for the future consequences of events that have been recognized
in the Company's financial statements or tax returns. Measurement of the
deferred items is based on enacted tax laws.
 
   
     Net Income (loss) Per Share -- Net income (loss) per share is computed by
dividing net income by the weighted average number of common and common
equivalent shares outstanding. Weighted average common and common equivalent
shares include common shares, stock options using the treasury stock method and
the assumed conversion of all outstanding shares of preferred stock into shares
of common stock. In February 1997, the Financial Accounting Standards Board
(FASB) issued Statement of Financial Accounting Standards No. 128 (SFAS 128),
Earnings Per Share, which the Company was required to adopt in the fourth
quarter of fiscal 1997. Under the provisions of SFAS 128, primary earnings per
share is replaced by basic earnings per share and the dilutive effect of stock
options will be excluded from the calculation.
    
 
   
     Net Income Applicable to Common Stockholders -- Net income applicable to
common stockholders represents net income less preferred dividends and accretion
attributable to preferred stock redemption value (See Note 5 of Notes to
Financial Statements).
    
 
     Stock Split -- In connection with the June 1, 1995 transactions discussed
in Note 5, common stockholders received an additional 409,197 shares of common
stock due to a 1.612 for 1 common stock split. Per share amounts reflect such
stock split.
 
     Recent Accounting Pronouncements -- In June 1997, the FASB issued Statement
of Financial Accounting Standard No. 130 (SFAS 130), Reporting Comprehensive
Income, and No. 131 (SFAS 131), Disclosures About Segments of an Enterprise and
Related Information. These statements are effective for fiscal years commencing
after December 15, 1997. While the Company is required to comply with the
provisions of these statements in fiscal 1998, it has been determined that the
effect that these new standards will have on its consolidated financial
statements and disclosures is not material.
 
     In October 1997, the American Institute of Certified Public Accountants
issued SOP 97-2, Software Revenue Recognition, which supercedes SOP 91-1. The
provisions of SOP 97-2 are effective for fiscal years beginning after December
15, 1997. The Company is reviewing the impact of the statement on its financial
statements.
 
     Use of Estimates -- The preparation of financial statements in conformity
with generally accepted accounting principles necessarily requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from these estimates.
 
                                       28
<PAGE>   30
                                 VITALCOM INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
 
  Significant Concentrations
 
     Customer Concentrations -- The Company's OEM revenues, which represented
55.6% and 53.7% of the Company's total revenues in 1996 and 1997 respectively,
have historically been concentrated in a small number of OEM customers.
Approximately 30.4%, 41.7% and 45.6% of 1995, 1996 and 1997 total revenues,
respectively, were to three customers. The loss of, or a reduction in sales to,
any such OEM customers would have a material adverse effect on the Company's
business, operating results and financial condition. Further, sales of the
Company's OEM products are dependent to a large extent upon the Company's OEM
customers selling patient monitoring devices that include the Company's OEM
products as necessary components. Any inability of such OEM customers to sell
such systems, or any election by such OEM customers not to include the Company's
products as components therein, could have a material adverse effect on the
Company's business, operating results and financial condition.
 
     Supplier Concentration -- Certain of the Company's products utilize
components that are available in the short term only from a single or a limited
number of sources. Certain of these components, such as semiconductor devices,
have been available only on an allocation basis in the past and could be in
scarce supply again in the future. Any inability to obtain components in the
amounts needed on a timely basis or at commercially reasonable prices could
result in delays in product introductions or interruption in product shipments
or increases in product costs, which could have a material adverse effect on the
Company's business, operating results and financial condition until alternative
sources could be developed or design and manufacturing changes could be
completed. Any such design or manufacturing changes or increased costs could
result in delayed shipments and significant expenses in a particular quarter and
therefore could materially adversely affect operating results for any such
quarter or other period.
 
     Reclassifications -- Certain reclassifications have been made to the 1995
and 1996 financial statements to conform to the 1997 presentation.
 
2. INVENTORIES
 
   
     Inventories are stated at the lower of weighted average cost or market and
consists of the following at December 31:
    
 
<TABLE>
<CAPTION>
                                         1996          1997
                                      ----------    ----------
<S>                                   <C>           <C>
Raw materials.......................  $1,402,828    $1,125,209
Work-in-process.....................     400,318       110,227
Finished goods......................   1,387,897       577,063
                                      ----------    ----------
                                      $3,191,043    $1,812,499
                                      ==========    ==========
</TABLE>
 
3. REVOLVING LINE OF CREDIT
 
     In August 1997, the Company entered into a secured lending arrangement (the
"Agreement") with Silicon Valley Bank, providing for a $5.0 million revolving
line of credit bearing interest at the bank's prime rate. The bank does not have
security interest in any of the Company's assets unless the Company is borrowing
under the line of credit and fails to comply with certain financial covenants.
The Agreement expires in August 1998 and has certain financial and other
covenants. The financial covenants required are that the Company maintain a
quick assets ratio of not less than 2 to 1, maintain tangible net worth of not
less than $20,000,000, maintain a ratio of total liabilities to tangible net
worth of not more than 1 to 1 and maintain an aggregate total of cash and
marketable securities in an amount at least equal to the product of two times
the maximum amount of the Credit Line. At December 31, 1997, there were no
borrowings outstanding under the Agreement and the Company was in compliance
with all covenants. As such, the bank held no security interest in any of the
Company's assets.
 
                                       29
<PAGE>   31
                                 VITALCOM INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
 
4. CAPITAL AND OPERATING LEASES
 
     The Company leases its facilities and certain equipment under a
noncancelable operating lease and a capital lease that expires at various dates
through 2001.
 
     Future minimum rent under such leases is as follows:
 
   
<TABLE>
<CAPTION>
                                          CAPITAL    OPERATING
                                           LEASE       LEASE
                                          -------    ---------
<S>                                       <C>        <C>
Year ending December 31:
     1998...............................  $31,815    $259,356
     1999...............................   31,815     255,780
     2000...............................   29,163     255,780
     2001...............................              170,520
                                          -------    --------
                                           92,793    $941,436
                                                     ========
Less amount representing interest.......  (11,377)
                                          -------
Present value of minimum lease
  payments..............................   81,416
Less current portion....................  (21,120)
                                          -------
Capital lease obligations due after one
  year..................................  $60,296
                                          =======
</TABLE>
    
 
     Capital leases included in Property at December 31, 1996 and 1997, net of
accumulated depreciation, were approximately $105,789 and $93,548, respectively.
 
     The Company's rent expense was $109,113, $340,127 and $356,265 for the
years ended December 31, 1995, 1996 and 1997, respectively.
 
5. STOCKHOLDERS' EQUITY
 
   
     On June 1, 1995 in a series of transactions, certain stockholders, who
owned approximately 73% of the Company, sold 3,143,097 shares of Series A and B
common stock and 7,618,392 shares of Series A and Series B preferred to new
investors who exchanged those shares for 3,982,568 shares of newly issued Series
C and Series D preferred stock. In connection with the transactions, the Company
repurchased 1,233,136 shares of its Series B common stock for $123,314 and a
stockholder contributed 15,544 shares of Series A common stock to the Company.
Such shares of common stock were subsequently retired by the Company. Holders of
the remaining shares of Series A common stock, which represented approximately
27% of the Company's ownership including shares received in the stock split
described in Note 1, then exchanged their common shares for newly issued shares
of common stock. No change in accounting basis was made as a result of this
transaction. During the year ended December 31, 1995, $516,840 and $191,160 was
accreted towards the Series C and Series D liquidation preference respectively,
using the effective interest method.
    
 
     In connection with these transactions, the Company, the new stockholders
and the other stockholders of the Company entered into a Stockholders Agreement
(the Stockholders Agreement) providing for, among other things, certain
restrictions on the transfer of shares of common stock or preferred stock,
rights of first refusal, and certain rights with respect to the repurchase of
such shares by the Company in the event of the death or total disability of the
holder thereof. Pursuant to the Stockholders Agreement, the new stockholders and
the other stockholders agree to vote their respective shares in a certain manner
in connection with the election of directors, including the directors elected
solely by the holders of the Series C convertible preferred stock. The
Stockholders Agreement terminated automatically upon the effective date of the
Company's initial public offering.
 
                                       30
<PAGE>   32
                                 VITALCOM INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
 
     The Series C preferred stockholders were entitled to receive dividends if
and when declared by the Board of Directors, were entitled to one vote for each
share of preferred stock subject to certain adjustments, had a liquidation
preference of $5.72 per share, and were convertible into shares of common stock
at the liquidation price per share subject to certain adjustments and were
mandatorily convertible upon an initial public offering of a certain size and
value. Such shares of preferred stock were mandatorily redeemable by the Company
at $5.72 per share in annual 25% increments beginning in 2001. Effective with
the Company's initial public offering in February 1996, each share of the Series
C preferred stock was converted to one share of common stock.
 
     The Series D preferred stockholders were entitled to the same rights and
privileges as the Series C stockholders except that they were not entitled to
vote, and they could convert their shares to Series C preferred shares under
certain circumstances. Such Series D shares were mandatorily convertible
ultimately into common stock upon the Company's initial public offering.
Effective with the Company's initial public offering in February 1996, each
share of the Series D preferred stock was converted to one share of common
stock.
 
     In October 1995, the Company sold 34,965 shares of common stock and 43,706
shares of Series C preferred stock to its then President and raised net proceeds
of approximately $200,000 and $249,998, respectively, under an agreement entered
into in September 1995. Also during the year ended December 31, 1995, the
Company sold 43,707, 114,054 and 279,301 shares of its common stock, preferred C
and preferred D stock to a certain employee and a shareholder and raised net
proceeds of $230,799, $602,386 and $1,474,808, respectively.
 
   
     During the year ended December 31, 1996 the Company issued 2,300,000 shares
of common stock in its initial public offering, raising approximately
$25,633,607, net of expenses. Effective with the initial public offering all
3,055,328 shares of the Company's Series C preferred stock and all 1,364,301
shares of Series D preferred stock converted to one share each of the Company's
common stock. In addition, during the year ended December 31, 1996 the Company
issued 32,815 shares of its common stock under its Employee Stock Purchase Plan
and 34,250 shares of its common stock for exercises of stock options under the
1993 Stock Option Plan, for net proceeds of $153,410 and $27,690, respectively.
    
 
   
     During the year ended December 31, 1997, the Company issued 47,359 shares
of its common stock under its Employee Stock Purchase Plan, and 8,500 shares of
its common stock for exercises of stock options under the 1993 Stock Option Plan
for net proceeds of $191,218 and $6,971, respectively. The Company also issued
40,000 shares of its common stock, under interest-bearing, nonrecourse notes in
the amount of $195,000 and received net proceeds of $40 during 1997.
    
 
6. 401(K) AND PROFIT-SHARING PLAN
 
   
     The Company has a contributory profit-sharing plan which covers
substantially all of its employees. Effective July 1, 1993, the Company amended
its profit-sharing plan to include a 401(k) provision (the "401(k) Plan"). The
401(k) provisions in the 401(k) Plan allow eligible employees to contribute up
to 15% of their income on a tax-deferred basis, subject to IRS discrimination
and maximum dollar deferral rules. The Company, at its sole election, may make
matching contributions to the 401(k) Plan. The Board of Directors approved a
discretionary employer-matching contribution of $.50 for each $1.00 the employee
contributes on the first 12% of compensation deposited as elective
contributions, subject to 401(k) Plan limitations and IRS regulations, for
calendar years 1995, 1996, and 1997. The Company's matching contributions vest
to employees at 25% per year for each full year of continuous service. The
Company's 401(k) matching expense was $228,590, $300,006 and $255,016 for the
years ended December 31, 1995, 1996 and 1997, respectively.
    
 
     The 401(k) Plan provides for an annual contribution to a self-directed
employee trust in an amount to be determined by the Board of Directors, but
limited to the amount allowable for income tax purposes.
 
                                       31
<PAGE>   33
                                 VITALCOM INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
 
Employees may make annual contributions to the 401(k) Plan of not more than 10%
of their annual compensation. The Company's contributions vest to the employees
at 20% for the first two years and 20% per year for years three through six for
each full year of continuous service, and are allocated based on employee
compensation. The Company had no profit-sharing expense for the years ended
December 31, 1995, 1996 and 1997.
 
7. STOCK BASED COMPENSATION PLANS
 
   
     At December 31, 1996 the Company had three stock options plans and an
employee stock purchase plan, which are described below. The Company accounts
for these plans in accordance with the provisions of Accounting Principles Board
Opinion No. 25, Accounting for Stock Issued to Employees, and related
Interpretations (APB 25). In October 1995, the Financial Accounting Standards
Board issued Statement of Financial Accounting Standards No. 123 (SFAS 123),
Accounting for Stock-Based Compensation. As permitted by SFAS 123, the Company
has chosen to continue to account for its stock-based compensation plans under
APB 25 and provide the expanded disclosures specified in SFAS 123. No
compensation expense has been recognized for its stock-based compensation plans.
    
 
   
     Had compensation cost been determined using the provisions of SFAS 123, the
Company's net income (loss) and income (loss) per share would have been:
    
 
   
<TABLE>
<CAPTION>
                                                1995         1996          1997
                                             ----------   -----------   -----------
<S>                            <C>           <C>          <C>           <C>
Net (loss)...................  As reported   $1,583,250   $(6,367,839)  $(4,649,865)
                                 Pro forma   $1,562,350    (6,567,038)   (5,109,243)
Net (loss) per basic share...                      0.30         (0.90)        (0.58)
Net (loss) per diluted
  share......................                      0.28         (0.90)        (0.58)
</TABLE>
    
 
     For purposes of estimating the compensation cost of the Company's option
grants and employee stock purchase plan in accordance with SFAS 123, the fair
value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model with the following assumptions used for
grants in the years 1997 and 1996, respectively: expected volatility of 52% and
67%; risk free interest rate of 6%; and expected lives of 10 years for the 1993
Stock Option Plan and the 1996 Stock Option Plan.
 
     Effective September 22, 1993, the Company adopted the 1993 Stock Option
Plan (the "Option Plan"), as amended, to permit the Company's personnel and
directors of the Company to participate in ownership of the Company. The Option
Plan is administered by a committee consisting of two or more non-employee
directors of the Company. Each option agreement includes a provision requiring
the optionee to consent to the terms of the Agreement. The Option Plan provides
for the grant of incentive stock options under the applicable provisions of the
Internal Revenue Code or nonqualified options. In October 1996 the Board of
Directors approved non-officer employees holding outstanding options to purchase
45,400 Common Shares of the Company at exercise prices equal to or in excess of
$12.87 to exchange such options for new options at $6.00 per share, with the new
options having a vesting schedule that re-started on the date of the new option
 
                                       32
<PAGE>   34
                                 VITALCOM INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
 
exchange grant. Up to 2,339,885 shares of the Company's common stock were
reserved for issuance under the Option Plan. The following table summarizes
activity under the 1993 Option Plan, as amended.
 
<TABLE>
<CAPTION>
                                                                    WEIGHTED
                                     NUMBER                         AVERAGE      NUMBER OF
                                       OF             PRICE         EXERCISE      OPTIONS
                                     SHARES         PER SHARE        PRICE      EXERCISABLE
                                    ---------    ---------------    --------    -----------
<S>                                 <C>          <C>                <C>         <C>
Balance, January 1, 1995..........    161,236    $0.60  - $ 1.28     $ 0.83
  Granted.........................    528,973     1.41  -   5.72       5.68
  Exercised.......................    (26,250)              0.60       0.60
  Canceled........................    (11,236)    0.60  -   5.72       2.74
                                    ---------
Balance, December 31, 1995........    652,723     0.60  -   5.72       4.74
  Granted.........................    131,109     6.00  -  15.75      11.22
  Exercised.......................    (34,250)    0.60  -   1.28       0.81
  Canceled........................    (89,358)    0.60  -  15.75       9.09
                                    ---------
Balance, December 31, 1996........    660,224     0.60  -  15.75       5.64       232,035
  Granted.........................  1,263,937     3.875 -   5.50       4.64
  Exercised.......................     (8,500)    0.60  -   1.28       0.82
  Canceled........................   (310,808)    1.28  -  15.75       6.33
                                    ---------
Balance, December 31, 1997........  1,604,853    $0.60  - $15.75     $ 4.74       292,017
                                    =========
</TABLE>
 
     At December 31, 1997, 649,955 options were available for grant under the
1993 Option Plan.
 
     The Company has reserved an aggregate of 100,000 shares of Common Stock for
issuance under its 1996 Stock Option Plan (the "1996 Plan") to permit employees
and consultants to the Company to participate in ownership of the Company. The
1996 Plan was adopted by the Board of Directors in October 1996. The 1996 Plan
is administered by a committee consisting of two or more non-employee directors
of the Company. Each option agreement includes a provision requiring the
optionee to consent to the terms of the 1996 Plan. The Option Plan provides for
the grant of nonqualified options. The following table summarizes activity under
the 1996 Plan.
 
<TABLE>
<CAPTION>
                                                                   WEIGHTED
                                       NUMBER                       AVERAGE      NUMBER OF
                                         OF           PRICE        EXERCISE       OPTIONS
                                       SHARES       PER SHARE        PRICE      EXERCISABLE
                                       -------    -------------    ---------    -----------
<S>                                    <C>        <C>              <C>          <C>
Balance, January 1, 1996.............
  Granted............................   60,800    $5.50 - $6.00      $5.98
  Exercised..........................
  Canceled...........................   (5,200)                       6.00
                                       -------
Balance, December 31, 1996...........   55,600     5.50 -  6.00       5.98
  Granted............................   35,500             4.97       4.97
  Exercised..........................
  Canceled...........................  (21,775)    4.97 -  6.00       5.77
                                       -------
Balance, December 31, 1997...........   69,325    $4.97 - $6.00      $5.52         9,675
                                       =======
</TABLE>
 
     At December 31, 1997, 30,675 options were available for grant under the
1996 Plan.
 
     The weighted average fair market value of options granted under the 1993
Stock Option Plan and the 1996 Stock Option plan in 1996 and 1997 was $14.77 and
$4.78, respectively.
 
                                       33
<PAGE>   35
                                 VITALCOM INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
 
     The following table summarizes information about stock options outstanding
under the 1993 Stock Option Plan and the 1996 Stock Option Plan at December 31,
1997:
 
<TABLE>
<CAPTION>
                                             OPTIONS OUTSTANDING                       OPTIONS EXERCISABLE
                              -------------------------------------------------   ------------------------------
                                            WEIGHTED AVERAGE
                                NUMBER         REMAINING       WEIGHTED AVERAGE     NUMBER      WEIGHTED AVERAGE
  RANGE OF EXERCISE PRICES    OUTSTANDING   CONTRACTUAL LIFE    EXERCISE PRICE    EXERCISABLE    EXERCISE PRICE
  ------------------------    -----------   ----------------   ----------------   -----------   ----------------
<S>                           <C>           <C>                <C>                <C>           <C>
$0.60 - $1.41...............      68,000       6.3 years            $ 0.91           58,500          $ 0.84
$3.875 - $6.00..............   1,596,219       9.3 years              4.87          233,233            5.70
$15.75......................       9,959       8.3 years             15.75            9,959           15.75
                               ---------                                            -------
                               1,674,178       9.2 years            $ 4.78          301,692          $ 5.09
                               =========                                            =======
</TABLE>
 
     The Company has reserved an aggregate of 150,000 shares of Common Stock for
issuance under its 1996 Employee Stock Purchase Plan (the "ESPP"). The ESPP was
adopted by the Board of Directors in January 1996 and approved by the Company's
stockholders prior to the consummation of the Company's initial public offering
in February 1996. The ESPP is intended to qualify under Section 423 of the
Internal Revenue Code of 1986, as amended, and permits eligible employees of the
Company to purchase Common Stock through payroll deductions of up to 10% of
their compensation provided that no employee may purchase more than $25,000
worth of stock in any calendar year. The ESPP was implemented by an offering
period commencing on February 14, 1996 and ending on the last business day in
the period ending October 31, 1996. Each subsequent offering period (an
"Offering Period") commences on the day following the end of the prior Offering
Period and has a duration of six months. The price of Common Stock purchased
under the ESPP will be 85% of the lower of the fair market value of the Common
Stock on the first or last day of each offering period. The ESPP will expire in
the year 2006. In the years ended December 31, 1996 and 1997 the Company issued
32,815 and 47,359 shares of Common Stock, respectively under the ESPP for
$153,410 and $191,218, respectively. At December 31, 1997, $45,278 had been
withheld from employee earnings for stock purchases under the ESPP.
 
     For purposes of estimating the compensation cost of employees' rights under
the ESPP in accordance with SFAS 123, the fair value of the purchase rights has
been estimated using the Black-Scholes model with the following assumptions used
for 1997; expected volatility of 52%; risk free interest rate of 6%; expected
life of six months. The weighted-average fair value of those purchase rights
granted in 1997 was $0.69.
 
     The Company has reserved an aggregate of 60,000 shares of Common Stock for
issuance under its 1996 Director Option Plan (the "Director Plan"). The Director
Plan was adopted by the Board of Directors in February 1996. The Director Plan
provides for the grant of an option to purchase a number of shares of Common
Stock (the "First Option") to be determined by the incumbent Board of Directors
to each non-employee director who first becomes a non-employee director after
the effective date of the Director Plan. Annually, each outside director shall
automatically be granted an option to purchase 4,000 shares (a "Subsequent
Option"), provided he or she is then a non-employee director and, as of such
date, he or she shall have served on the Board for at least the preceding six
months. Each non-employee director will be eligible to receive a Subsequent
Option, regardless of whether such non-employee director was eligible to receive
a First Option. First Options and each Subsequent Option will have a term of ten
years. One-quarter of the shares subject to a First Option will vest one year
after their date of grant and an additional one-quarter will vest at the end of
each year thereafter, provided that the optionee continues to serve as a
director on such dates. Similarly, one-quarter of the shares subject to a
Subsequent Option will vest one year after the date of the option grant and an
additional one-quarter will vest at the end of each year thereafter, provided
that the optionee continues to serve as a director on such date. The exercise
prices of the First Option and each Subsequent Option will be 100% of the fair
market value per share of the Company's Common Stock on the date of the grant of
the option. There was no activity in the Director Plan during the year ended
December 31,
 
                                       34
<PAGE>   36
                                 VITALCOM INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
 
   
1996. At December 31, 1996 and 1997 there were no options outstanding and 60,000
shares available for issuance.
    
 
8. INCOME TAXES
 
     The provision (benefit) for income taxes is as follows:
 
<TABLE>
<CAPTION>
                                                       YEAR ENDED DECEMBER 31,
                                               ----------------------------------------
                                                  1995          1996           1997
                                               ----------    -----------    -----------
<S>                                            <C>           <C>            <C>
Current:
  Federal....................................  $1,303,349    $(2,710,593)   $
  State......................................     388,174         31,904         26,190
                                               ----------    -----------    -----------
                                                1,691,523     (2,678,689)        26,190
                                               ----------    -----------    -----------
Deferred:
  Federal....................................    (387,031)        31,804     (1,861,315)
  State......................................    (111,834)      (782,931)       256,150
                                               ----------    -----------    -----------
                                                 (498,865)      (751,127)    (1,605,165)
                                               ----------    -----------    -----------
Change in valuation allowance................                  1,527,821      1,605,165
                                               ----------    -----------    -----------
                                               $1,192,658    $(1,901,995)   $    26,190
                                               ==========    ===========    ===========
</TABLE>
 
     A reconciliation of the provision (benefit) for income taxes to the amount
of income tax expense that would result from applying the federal statutory rate
(35%) to income before provision for income taxes is as follows:
 
<TABLE>
<CAPTION>
                                                            YEAR ENDED DECEMBER 31,
                                                           --------------------------
                                                           1995      1996       1997
                                                           ----      -----      -----
<S>                                                        <C>       <C>        <C>
Income tax expense at statutory rate.....................  35.0%     (35.0)%    (35.0)%
State tax expense, net of federal benefit................   6.6        1.4         .6
Research and development credits.........................             (2.6)
Change in valuation allowance............................             11.0       32.5
Other....................................................   0.9        2.2        2.5
                                                           ----      -----      -----
                                                           42.5%     (23.0)%      0.6%
                                                           ====      =====      =====
</TABLE>
 
                                       35
<PAGE>   37
                                 VITALCOM INC.
 
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
 
     Deferred tax assets and liabilities at December 31 are as follows:
 
<TABLE>
<CAPTION>
                                                  1995         1996           1997
                                                --------    -----------    -----------
<S>                                             <C>         <C>            <C>
Current:
  Accrued compensation and related costs......  $ 72,640    $   212,923    $   219,189
  Warranty reserves...........................   260,823        411,948        414,796
  Sales returns and bad debt allowance........   244,943        102,000        115,759
  Inventory reserves..........................   127,702        252,577        312,191
  Other.......................................    94,492       (323,552)      (227,556)
                                                --------    -----------    -----------
                                                 800,600        655,896        834,379
Long-term:
  Amortization and depreciation...............   (49,473)      (108,693)       (82,569)
  Net operating loss carryforward.............                  558,567      1,760,657
Tax credit carryforward.......................                  422,051        620,519
                                                --------    -----------    -----------
                                                  49,473        871,925      2,298,607
                                                --------    -----------    -----------
Valuation allowance...........................               (1,527,821)    (3,132,986)
                                                --------    -----------    -----------
                                                $751,127    $              $
                                                ========    ===========    ===========
</TABLE>
 
     As of December 31, 1997 a valuation allowance of $3,132,986 has been
provided based upon the Company's assessment of the future realizability of
certain deferred tax assets, as it is more likely than not that sufficient
taxable income will not be generated to realize these temporary differences.
 
     At December 31, 1997, the Company had federal and state net operating loss
carryforwards of approximately $4.3 million and $3.3 million, respectively,
which will begin expiring in the years 2013 and 2002. At December 31, 1997, the
Company had general business credit carryforwards for federal and state purposes
of $302,299 and $205,242 respectively, which will begin expiring in the years
2009 and 2012.
 
9. RESTRUCTURING CHARGES
 
     Restructuring charges of approximately $461,000 resulted from the Company's
November 1996 restructuring of operations and an executive reorganization and
include severance and other employee termination costs. The total restructuring
costs were all paid by September 24, 1997.
 
10.  NET INCOME (LOSS) PER SHARE
 
     The following table is a reconciliation of net income and share amounts
used in the calculation of net income (loss) per share and net income (loss) per
share assuming dilution.
 
<TABLE>
<CAPTION>
                                                NET                      PER SHARE
                                            INCOME(LOSS)     SHARES       AMOUNT
                                            ------------    ---------    ---------
<S>                                         <C>             <C>          <C>
Year ended December 31, 1995
  Basic net income (loss) per share.......   $1,583,250     5,312,990        .30
  Effect of dilutive stock options........                    358,317       (.02)
                                             ----------     ---------      -----
  Diluted net income (loss) per share.....   $1,583,250     5,671,307      $ .28
                                             ==========     =========      =====
</TABLE>
 
     The weighted average number of shares outstanding for 1996 and 1997 was
7,084,397 and 8,000,982 respectively. Options to purchase shares of common stock
in 1996 and 1997 were outstanding during the year but were not included in the
computation of diluted loss per share, as their effect was antidilutive.
 
                                       36
<PAGE>   38
 
                                 VITALCOM INC.
                SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
 
<TABLE>
<CAPTION>
                                                 BALANCE AT    CHARGED TO                   BALANCE
                                                 BEGINNING     COSTS AND                      END
                  DESCRIPTION                    OF PERIOD      EXPENSES     DEDUCTIONS    OF PERIOD
                  -----------                    ----------    ----------    ----------    ---------
<S>                                              <C>           <C>           <C>           <C>
Provision for Doubtful Accounts and Sales
  Returns:
  December 31, 1995............................   $357,031     $ 208,658         $         $565,689
  December 31, 1996............................    565,689      (330,123)                   235,566
  December 31, 1997............................   $235,566     $  34,647                   $270,213
</TABLE>
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
 
     There have been no changes in or disagreements with accountants on
accounting or financial disclosure matters during the Company's two most recent
fiscal years.
 
                                    PART III
 
     Pursuant to Paragraph G(3) of the General Instructions to Form 10-K,
portions of the information required by Part III of Form 10-K are incorporated
by reference from the Company's Proxy Statement to be filed with the Securities
and Exchange Commission in connection with the 1997 Annual Meeting of
Stockholders (the "Proxy Statement").
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
     Information concerning the directors of the Company appears in the
Company's Proxy Statement under the caption "Election of Directors" and is
incorporated herein by this reference.
 
EXECUTIVE OFFICERS
 
     Set forth below is certain information as of February 27, 1998 with respect
to each person who is an executive officer of the Company:
 
<TABLE>
<CAPTION>
              NAME                AGE                   POSITION
              ----                ---                   --------
<S>                               <C>   <C>
Frank T. Sample.................  52    President and Chief Executive Officer,
                                        Chairman of the Board
Warren J. Cawley................  57    Vice President, Business Development
David Clare.....................  41    Vice President, Direct Sales
John R. Graham..................  52    Vice President, OEM Sales
Stanley Reese...................  47    Vice President, Research and Development
Shelley B. Thunen...............  45    Vice President, Finance, Chief Financial
                                        Officer and Corporate Secretary
</TABLE>
 
     Frank T. Sample, President and Chief Executive Officer, Chairman of the
Board -- Mr. Sample has served as a Director of the Board of the Company and
also has served as its President and Chief Executive Officer since October 1997.
In February 1998, Mr. Sample was appointed Chairman of the Board. From August
1997 to October 1997, Mr. Sample served as Executive Vice President at IDX
Systems Corporation, a leading provider of information technology to the
healthcare industry. From December 1990 to July 1997, when PHAMIS, Inc. was
merged into IDX Systems Corporation, he was President and Chief Executive
Officer at PHAMIS, Inc., a provider of patient-centered medical record
information systems. He is currently a Director of IDX Systems Corporation and
two privately held companies. Mr. Sample holds a B.B.A. in Business
Administration from Cleveland State University.
 
     Warren J. Cawley, Vice President Business Development -- Mr. Cawley has
served as Vice President, Business Development since July 1996. From 1989
through June 1996, Mr. Cawley served as Vice President, Direct Sales for the
Company. From 1985 through 1989, Mr. Cawley served as Vice President, OEM Sales
for
 
                                       37
<PAGE>   39
 
the Company. Prior to 1985, Mr. Cawley served in various sales and management
capacities at several medical device companies. Mr. Cawley holds an M.B.A.
degree and a B.S. degree from the University of Southern California.
 
     David Clare, Vice President, Direct Sales -- Mr. Clare joined VitalCom in
March 1997 as Vice President, Direct Sales. Prior to joining the company, Mr.
Clare served as Vice President and General Manager, Radiology at ADAC
Laboratories, a medical device company. From 1992 to 1995, Mr. Clare was the
Vice President, Southwest Region for HBO & Company, a healthcare information
systems company. Mr. Clare holds a B.A. in Economics from Ursinus College,
Collegville, PA.
 
     John R. Graham, Vice President OEM Sales -- Mr. Graham has served as Vice
President, OEM Sales of the Company since 1989. Prior to joining the Company in
1989, he acted as a consultant and held various positions at a number of
healthcare organizations and technology-based companies, including serving as
President and Chief Executive Officer of a medical device company. Mr. Graham
holds an M.S. degree in Bioengineering from Columbia University and a B.S.E.E.
degree from Northeastern University.
 
     Stanley Reese, Vice President, Research and Development -- Mr. Reese joined
the Company in July 1997 as Vice President, Research and Development. Prior to
joining the Company, from 1989 to 1997, Mr. Reese directed all product
development activities as Vice President, Engineering for Cubix Corp., a leading
supplier of remote access fault tolerant systems. Mr. Reese holds a B.S. in
Electrical Engineering from The Citadel, an M.S. in Electrical Engineering from
The Georgia Institute of Technology and is a graduate of the Executive
Management Program at the University of California in Irvine.
 
     Shelley B. Thunen, Vice President, Finance, Chief Financial Officer and
Corporate Secretary -- Ms. Thunen has served as Vice President, Finance and
Chief Financial Officer of the Company since August 1992. Prior to joining the
Company, Ms. Thunen served as the Vice President -- Finance of Hybrid Designs,
Inc., a manufacturer of hybrid microelectronic circuits, from August 1990 to
August 1992 and concurrently from January 1992 through August 1992 served as
General Manager of a related company. Prior to August 1990, Ms. Thunen was a
financial consultant specializing in company turnarounds and served in various
financial management capacities at several technology-based companies, including
as Chief Financial Officer of a publicly traded computer company. Ms. Thunen
holds an M.B.A. degree and a B.A. degree in Economics from the University of
California at Irvine.
 
ITEM 11. EXECUTIVE COMPENSATION
 
     Information concerning executive compensation appears in the Company's
Proxy Statement under the caption "Executive Compensation" and is incorporated
herein by this reference.
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
     Information concerning the security ownership of certain beneficial owners
and management appears in the Company's Proxy Statement under the caption
"Election of Directors" and is incorporated herein by this reference.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
     Information concerning certain relationships and related transactions
appears in the Company's Proxy Statement under "Election of Directors" and is
incorporated herein by this reference.
 
                                       38
<PAGE>   40
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
 
     (a) The following documents are filed as part of this Form 10-K:
 
        (1) Financial Statements. The following Financial Statements of VitalCom
            Inc. and Independent Auditors' Report are filed as part of this
            report.
 
            Independent Auditors' Report
 
            Balance Sheets at December 31, 1997 and 1996
 
            Statements of Operations for the years ended December 31, 1997, 1996
            and 1995
 
            Statements of Stockholders' Equity (Deficit) for the years ended
            December 31, 1997, 1996 and 1995
 
            Statements of Cash Flows for the years ended December 31, 1997, 1996
            and 1995
 
            Notes to Financial Statements
 
        (2) Financial Statement Schedules. The following financial statement
            schedule of VitalCom Inc. are filed as part of this report and
            should be read in conjunction with the Financial Statements of
            VitalCom Inc.
 
            Schedule II -- Valuation and Qualifying Accounts
 
            Schedules not filed herein are omitted because of the absence of
            conditions under which they are required or because the information
            called for is shown in the financial statements or notes thereto.
 
     (b) Reports on Form 8-K:
 
     None
 
     (c) Exhibits
 
<TABLE>
<CAPTION>
EXHIBIT
  NO.                        DESCRIPTION OF EXHIBIT
-------                      ----------------------
<S>       <C>
  3.1     Amended and Restated Certificate of Incorporation of the
          Registrant, as currently in effect.(1)
  3.2     Amended and Restated Bylaws of the Registrant, as currently
          in effect.(1)
  4.1     Specimen Common Stock Certificate.(1)
  4.2     Form of Voting Agreement among the Registrant, Warburg,
          Pincus Ventures, L.P., ABS Capital Partners, L.P. and Donald
          W. Judson.(1)
 10.1     Registrant's 1993 Stock Option Plan, as amended, and forms
          of agreement thereunder.(2)
 10.2     Registrant's 1996 Employee Stock Purchase Plan.(1)
 10.3     Lease dated July 28, 1995 between Catellus Development
          Corporation as Landlord and Registrant as Tenant.(1)
 10.4     Warburg Securities Purchase Agreement dated as of June 1,
          1995 by and among the Registrant, Warburg, Pincus Ventures,
          L.P., ABS Capital Partners, L.P., Vertical Fund Associates,
          L.P., Vertical Partners, L.P. and BT Capital Partners,
          Inc.(1)
 10.5     Form of Indemnification Agreement between the Registrant and
          its executive officers and directors.(1)
</TABLE>
 
                                       39
<PAGE>   41
 
   
<TABLE>
<CAPTION>
EXHIBIT
  NO.                        DESCRIPTION OF EXHIBIT
-------                      ----------------------
<S>       <C>
 10.6     Form of Employment Agreement between the Registrant and
          certain of its executive officers.(1)
 10.7     Form of Employee Severance Agreement with certain of the
          Registrant executive officers.(1)
 10.8     Management Bonus Plan.(1)
 10.9     Registrant's 1996 Director Option Plan.(1)
 10.10    Registrant's 1996 Stock Option Plan and related
          agreements.(7)
 10.11    Promissory Note Secured by Deed of Trust dated October 17,
          1996 of David L. Schlotterbeck in favor of the
          Registrant.(3)
 10.12    Loan Agreement between the Registrant and Silicon Valley
          Bank dated February 26, 1993, as amended through August 6,
          1996.(1)
 10.13    Second Amendment to Employment Agreement dated January 1,
          1997 between the Registrant and David L. Schlotterbeck (4)
 10.14    Consulting Agreement dated January 1, 1997 between the
          Registrant and David L. Schlotterbeck(4)
 10.15    Outside Board of Directors Agreement dated February 20, 1997
          between the Registrant and David L. Schlotterbeck(4)
 10.16    Stock Option Amendment Agreement dated February 20, 1997
          between the Registrant and David L. Schlotterbeck(4)
 10.17    Full-Recourse Promissory Note Secured by Deed of Trust
          between the Registrant and David R. Clare and Jennifer H.
          Clare(5)
 10.18    Silicon Valley Bank Amendment to Loan Agreement(6)
 10.19    Employment Agreement between VitalCom Inc. and Frank T.
          Sample.
 10.20    Employee Severance Agreement between VitalCom Inc. and Frank
          T. Sample.
 11.1     Statement regarding computation of pro forma net income
          (loss) per share.
 23.1     Independent Auditors' Consent.
 24.1     Power of Attorney (Included on page 37 hereof).
 27       Financial Data Schedule
</TABLE>
    
 
---------------
(1) Incorporated by reference to the Registrant's Registration Statement on Form
    S-1 (File No. 333-00268-LA) in the form in which it was declared effective
    on February 13, 1997.
 
   
(2) Incorporated by reference to the Registrant's Registration Statement on Form
    S-8 (File No. 333-47173).
    
 
(3) Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q
    for the quarter ended September 30, 1996.
 
(4) Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q
    for the quarter ended March 31, 1997.
 
(5) Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q
    for the quarter ended June 30, 1997.
 
(6) Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q
    for the quarter ended September 30, 1997.
 
   
(7) Incorporated by reference to the Registrant's Registration Statement on Form
    S-8 (File No. 333-33901).
    
 
                                       40
<PAGE>   42
 
                                   SIGNATURES
 
     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
 
                                          VITALCOM INC.
 
                                          By: /s/ FRANK T. SAMPLE
                                            ------------------------------------
                                            Frank T. Sample
                                            President and Chief Executive
                                              Officer
 
                               POWER OF ATTORNEY
 
     KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Frank T. Sample and Shelley B. Thunen and each of
them, jointly and severally, his or her attorneys-in-fact, each with full power
of substitution, for him or her in any and all capacities, to sign any and all
amendments to this Report on Form 10-K, and to file the same, with exhibits
thereto and other documents in connection therewith, with the Securities and
Exchange Commission, hereby ratifying and confirming all that each of said
attorneys-in-fact, or his or her substitute or substitutes, may do or cause to
be done by virtue hereof.
 
     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant on March 25, 1998 in the capacities indicated.
 
<TABLE>
<CAPTION>
                       SIGNATURE                                             TITLE
                       ---------                                             -----
<S>                                                       <C>
 
/s/ FRANK T. SAMPLE                                       Chairman of the Board, President and Chief
--------------------------------------------------------  Executive Officer (Principal Executive
Frank T. Sample                                           Officer)
 
/s/ SHELLEY B. THUNEN                                     Vice President -- Finance and Chief
--------------------------------------------------------  Financial Officer (Principal Financial and
Shelley B. Thunen                                         Accounting Officer)
 
/s/ PATRICK T. HACKETT                                    Director
--------------------------------------------------------
Patrick T. Hackett
 
/s/ JACK W. LASERSOHN                                     Director
--------------------------------------------------------
Jack W. Lasersohn
 
/s/ TIMOTHY T. WEGLICKI                                   Director
--------------------------------------------------------
Timothy T. Weglicki
</TABLE>
 
                                       41
<PAGE>   43
 
                                 EXHIBIT INDEX
 
   
<TABLE>
<CAPTION>
                                                                             SEQUENTIALLY
    EXHIBIT                                                                    NUMBERED
      NO.                         DESCRIPTION OF EXHIBIT                        PAGES
    -------                       ----------------------                     ------------
    <S>        <C>                                                           <C>
     3.1       Amended and Restated Certificate of Incorporation of the
               Registrant, as currently in effect.(1)......................
     3.2       Amended and Restated Bylaws of the Registrant, as currently
               in effect.(1)...............................................
     4.1       Specimen Common Stock Certificate.(1).......................
     4.2       Form of Voting Agreement among the Registrant, Warburg,
               Pincus Ventures, L.P., ABS Capital Partners, L.P. and Donald
               W. Judson.(1)...............................................
    10.1       Registrant's 1993 Stock Option Plan, as amended, and forms
               of agreement thereunder.(2).................................
    10.2       Registrant's 1996 Employee Stock Purchase Plan.(1)..........
    10.3       Lease dated July 28, 1995 between Catellus Development
               Corporation as Landlord and Registrant as Tenant.(1)........
    10.4       Warburg Securities Purchase Agreement dated as of June 1,
               1995 by and among the Registrant, Warburg, Pincus Ventures,
               L.P., ABS Capital Partners, L.P., Vertical Fund Associates,
               L.P., Vertical Partners, L.P. and BT Capital Partners,
               Inc.(1).....................................................
    10.5       Form of Indemnification Agreement between the Registrant and
               its executive officers and directors.(1)....................
    10.6       Form of Employment Agreement between the Registrant and
               certain of its executive officers.(1).......................
    10.7       Form of Employee Severance Agreement with certain of the
               Registrant executive officers.(1)...........................
    10.8       Management Bonus Plan.(1)...................................
    10.9       Registrant's 1996 Director Option Plan.(1)..................
    10.10      Registrant's 1996 Stock Option Plan and related
               agreements.(7)..............................................
    10.11      Promissory Note Secured by Deed of Trust dated October 17,
               1996 of David L. Schlotterbeck in favor of the
               Registrant.(3)..............................................
    10.12      Loan Agreement between the Registrant and Silicon Valley
               Bank dated February 26, 1993, as amended through August 6,
               1996.(1)....................................................
    10.13      Second Amendment to Employment Agreement dated January 1,
               1997 between the Registrant and David L.
               Schlotterbeck.(4)...........................................
    10.14      Consulting Agreement dated January 1, 1997 between the
               Registrant and David L. Schlotterbeck.(4)...................
    10.15      Outside Board of Directors Agreement dated February 20, 1997
               between the Registrant and David L. Schlotterbeck.(4).......
    10.16      Stock Option Amendment Agreement dated February 20, 1997
               between the Registrant and David L. Schlotterbeck.(4).......
    10.17      Full-Recourse Promissory Note Secured by Deed of Trust
               between the Registrant and David R. Clare and Jennifer H.
               Clare.(5)...................................................
    10.18      Silicon Valley Bank Amendment to Loan Agreement.(6).........
    10.19      Employment Agreement between VitalCom Inc. and Frank T.
               Sample......................................................
    10.20      Employee Severance Agreement between VitalCom Inc. and Frank
               T Sample....................................................
    11.1       Statement regarding computation of pro forma net income per
               share.(1)...................................................
</TABLE>
    
 
                                       42
<PAGE>   44
 
<TABLE>
<CAPTION>
                                                                             SEQUENTIALLY
    EXHIBIT                                                                    NUMBERED
      NO.                         DESCRIPTION OF EXHIBIT                        PAGES
    -------                       ----------------------                     ------------
    <S>        <C>                                                           <C>
    23.1       Independent Auditors' Consent...............................
    24.1       Power of Attorney (Included on page 40 hereof)..............
    27         Financial Data Schedule.....................................
</TABLE>
 
---------------
(1) Incorporated by reference to the Registrant's Registration Statement on Form
    S-1 (File No. 333-00268-LA) in the form in which it was declared effective
    on February 13, 1997.
 
(2) Incorporated by reference to the Registrant's Registration Statement on Form
    S-8 (file No. 333-47173).
 
(3) Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q
    for the quarter ended September 30, 1996.
 
(4) Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q
    for the quarter ended March 31, 1997.
 
(5) Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q
    for the quarter ended June 30, 1997.
 
(6) Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q
    for the quarter ended September 30, 1997.
 
(7) Incorporated by reference to the Registrant's Registration Statement on Form
    S-8 (File No. 333-33901).
 
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