##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549
   FORM 10-K
 FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934 (Mark One) þ
    
    ANNUAL
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
 For the fiscal year ended December 31, 2004 OR o
    

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: 0-18338 I-FLOW CORPORATION 
  Delaware
    
    33-0121984(State or Other Jurisdiction
of Incorporation or Organization)
    
    (IRS Employer Identification No.)20202 Windrow Drive, Lake Forest, CA
    
    92630(Address of Principal Executive Offices)
    
    (Zip Code)
 Registrants telephone number, including area code: (949) 206-2700 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $0.001 per
share Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days.
Yes þ No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is
not contained herein, and will not be contained, to the best of registrants knowledge, in
definitive proxy or information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. o Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act
Rule 12b-2).
Yes þ No o The aggregate market value of the common stock of the registrant held by non-affiliates as of June
30, 2004 (the last trading day of the second fiscal quarter) was $254,224,900, based on a closing
price of $11.86 on the Nasdaq Stock Market on such day. The number of shares of the registrants
common stock outstanding at March 5, 2005 was 22,296,503. DOCUMENTS INCORPORATED BY REFERENCE The information required by Part II, Item 5 and Part III of this annual report on Form 10-K is
incorporated by reference to portions of the registrants proxy statement for its annual meeting of
stockholders to be held on May 26, 2005, which proxy statement will be filed with the Securities
and Exchange Commission no later than 120 days after the end of the registrants fiscal year ended
December 31, 2004.




---



TABLE OF CONTENTS  PART IItem 1. BusinessItem 2. PropertiesItem 3. Legal ProceedingsItem 4. Submission of Matters to a Vote of Security HoldersPART IIItem 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesItem 6. Selected Financial DataItem 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsItem 7A. Quantitative and Qualitative Disclosures about Market RiskItem 8. Financial Statements and Supplementary DataItem 9. Changes in and Disagreements with Accountants on Accounting and Financial DisclosureItem 9A. Controls and ProceduresItem 9B. Other InformationPART IIIItem 10. Directors and Executive Officers of the RegistrantItem 11. Executive CompensationItem 12. Security Ownership of Certain Beneficial Owners and ManagementItem 13. Certain Relationships and Related TransactionsItem 14. Principal Accounting Fees and ServicesPART IVItem 15. Exhibits, Financial Statement Schedules.SIGNATURESINDEX TO EXHIBITSEXHIBIT 10.9EXHIBIT 10.10EXHIBIT 21.1EXHIBIT 23.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1    Table of Contents  
 PART I 
 Item 1. Business The Company I-Flow Corporation (the Company or I-Flow) designs, develops, manufactures and markets
technically advanced, low-cost ambulatory drug delivery systems that seek to redefine the standard
of care by providing life enhancing, cost effective solutions for pain management and infusion
therapy. The Companys products are used in hospitals and other settings, including free-standing
surgery centers and physicians offices. Since it began in 1985, I-Flow Corporation has established a reputation in the medical and health
care industry as an innovator in drug delivery technology. Through product innovation and
strategic acquisitions, the Company has emerged as a leader in pain management, offering highly
effective therapeutic delivery systems for physicians and their patients. I-Flows suite of pain
management products provides reliable and simple regional anesthesia techniques that eliminate many
of the side effects customarily associated with narcotics and general anesthesia. Patients who use
I-Flows pain management products generally recover more rapidly after surgery, which results in
shorter hospital stays and reduced costs. I-Flow currently manufactures a line of compact, portable infusion pumps, catheters and pain kits
that administer medication directly to the wound site as well as administer local anesthetics,
chemotherapies, antibiotics, diagnostic agents, nutritional supplements and other medications. The
Company has continued to introduce into the market reliable, lightweight, portable infusion pumps
which enable patients to live ambulatory and, therefore, more productive lifestyles. I-Flow sells
and distributes its products throughout the United States, Canada, Europe, Asia, Mexico, Brazil,
Australia, New Zealand and the Middle East. InfuSystem, Inc., a wholly owned subsidiary of
I-Flow Corporation (InfuSystem), is primarily engaged in the rental of infusion pumps on a
month-to-month basis for the treatment of cancer. The Company was incorporated in the State of California in July 1985. On July 30, 2001, the
Company changed its state of incorporation to Delaware by merging into a wholly owned subsidiary
incorporated in Delaware. The Companys corporate offices are located at 20202 Windrow Drive, Lake
Forest, California 92630. I-Flows telephone number is (949) 206-2700 and its website is
www.iflo.com. Recent Developments On November 9, 2004, the Company announced the first payment by Medicare for the ON-Q® PainBuster®.
This result arose out of a specific case in which the ON-Q PainBuster was used on a patient
following surgery. Historically, all of Medicares regional carriers enforced policies that denied
payments for the use of the ON-Q PainBuster. The decision that ON-Q was medically necessary, and
therefore payable by Medicare, was made by an administrative law judge based upon the law and
clinical evidence submitted by the Company in the course of the Companys appeal of the initial
decision to deny coverage. With this decision, the Company intends to request that each Medicare
carrier revise its coverage policy so that contractors will begin to provide payment for the ON-Q
PainBuster when it is used to treat post-operative pain. Additionally, private payer systems
commonly establish coverage decisions based upon Medicare policy. Accordingly, the Company plans
to use this coverage decision to seek to influence private insurers as well. There is no
guarantee, however, that insurance coverage by Medicare or by private insurers will increase as a
result of these or other developments. Acquisitions On January 14, 2000, the Company acquired all of the outstanding stock of Spinal Specialties, Inc.
(Spinal Specialties), a designer and manufacturer of custom spinal, epidural and nerve block
infusion kits based in San Antonio, Texas. Spinal Specialties provides a line of custom,
disposable products for chronic and acute pain management that are tailored to the specific needs
of a particular hospital, anesthesiologist or pain clinic. I-Flow sold Spinal Specialties on
November 1, 2003. 2




---



##### Table of Contents



Divestitures On November 1, 2003, the Company sold Spinal Specialties to Integra LifeSciences Holdings
Corporation for approximately $6,000,000 in cash, with net cash proceeds to the Company of
approximately $5,044,000. The business of Spinal Specialties is discussed above. The Companys Products I-Flow offers health care professionals an array of cost-effective drug delivery devices designed
to meet the needs of todays managed care environment in both hospital and alternate site settings.
The I-Flow family of products is focused on three primary market segments  Regional Anesthesia,
Intravenous (IV) Infusion Therapy and Oncology Infusion Services. Regional Anesthesia Acute Pain Kits I-Flows acute pain kit product line includes the ON-Q® PainBuster®Post-Operative Pain Relief System, the SoakerTM Catheter and the
C-blocTM Continuous Nerve Block System. I-Flows ON-Q systems offer continuous wound
site pain management, which is considered to be one of the most ideal treatments for post-operative
pain. This approach represents a significant improvement over traditional methods of
post-operative pain management because fewer narcotics, which have negative side effects, are used.
I-Flows C-bloc system combines the advantages of a custom nerve block kit with the added feature
of a disposable infusion pump. Studies have shown that ON-Q, when used for the treatment of
post-operative pain, reduced average pain scores, reduced the use of narcotics for pain control
following surgery, and decreased the average length of hospital stays. The Companys SoakerTM Catheters (2.5 and 5 versions) were granted United States Food
and Drug Administration (FDA) permission for use for pain management of large surgical incisions
in November 1999 and March 2000, respectively. The Companys 1 and 10 Soaker Catheters were
granted FDA permission for use in January 2005. The Soaker Catheter, which attaches to I-Flows
diverse line of infusion systems, provides the continuous, even infusion of a non-narcotic, local
anesthetic directly along surgical incisions for post-operative pain management. IV Infusion Therapy Elastomerics I-Flows product line of elastomeric pumps delivers medication from an elastic balloon that does
not rely on gravity for proper delivery. These pumps are small enough to fit into a patients
pocket or be clipped to a patients clothing. This easy-to-use technology provides health care
professionals with a device that is both safe and simple enough for patients to use for
self-administration of medication. These characteristics provide patients with better mobility and
a quicker transition to rehabilitation. The Companys elastomeric line of products can be used for
antibiotic therapy, pain management medications, chemotherapy and other medications. The Companys
elastomeric products include its patented Homepump Eclipse® and the Homepump Eclipse C Series. Non-Electric IV Bag Delivery Systems I-Flows non-electric products provide a safe and easy-to-use system for controlled infusion.
Pumps in this category are drug delivery systems that consist of a reusable mechanical infuser and
specially designed administration sets. The pumps provide precise delivery of medications that
require slow and continuous infusion. I-Flows products in this area include the Paragon® and
Sidekick® ambulatory infusion pumps and the Rely-A-Flow® Gravity Set. 3




---



##### Table of Contents



Electronic Pumps During 2004, the Company phased out its ambulatory electronic infusion products, which included the
I-Flow VIP pump and the VOICELINK® Remote Programming System. Oncology Infusion Services InfuSystem provides ambulatory infusion pump systems and supplies to oncology offices and
chemotherapy clinics. Pumps from a variety of manufacturers are offered to customers primarily on
a rental basis. InfuSystems revenues are primarily derived from billings to third party insurers. The Companys Markets The Company sells into three market segments: Regional Anesthesia, IV Infusion Therapy and
Oncology Infusion Services. During the three years the Company has been marketing the ON-Q product
line through its direct sales representatives, I-Flow has significantly expanded its product line
and distribution capabilities to establish itself as a leading participant in the regional
anesthesia market. Management believes that this expansion, coupled with the Companys innovations
in pain management and infusion technologies, has placed I-Flow in a position for future potential
growth. The Company operates in two reportable operating segments: manufacturing and marketing
medical infusion pumps and rentals of medical infusion pumps. The rental operating segment
principally consists of the activities of InfuSystem within the Oncology Infusion Services market
segment. See Note 10 in Notes to Consolidated Financial Statements. The Company believes that the hospital market for I-Flows simple, portable regional anesthesia
technologies is largely untapped at this time. The Company estimates that there are more than 70
million operative procedures performed in the United States every year. I-Flow believes that its
ON-Q PainBuster systems could be used in more than 15 million of these procedures because there is
an incision, a surgeon can visualize the insertion of a catheter and pain management is a concern
for patients. The Company estimates that the current penetration by all participants in this
market combined is less than three percent. The alternate site health care industry has generally supported the need for ambulatory infusion
devices. An ambulatory pump enables a patient to leave the hospital earlier, making it attractive
to cost-conscious hospitals and to patients who favor home treatment. I-Flows sales in the IV
Infusion Therapy market include the Companys intravenous elastomeric pumps, mechanical infusion
devices and, to a lesser extent, electronic infusion pumps and disposables products, which were
discontinued during 2004. The Company participates in the Oncology Infusion Services market through the activities of
InfuSystem which provides infusion pump rentals and related disposable products, primarily for
chemotherapy. The following table sets forth a summary of the Companys revenues by market segment, expressed as
percentages of the Companys total net revenues for each fiscal year: Net Revenues by Market Segment
    
    
    2004
    
    
    2003
    
    
    2002Regional Anesthesia
    
    
    46
    %
    
    
    34
    %
    
    
    25
    %IV Infusion Therapy
    
    
    27
    %
    
    
    38
    %
    
    
    45
    %Oncology Infusion Services
    
    
    27
    %
    
    
    28
    %
    
    
    30
    %
 Competition The drug infusion industry is highly competitive. The Company competes in this industry primarily
based on price, service and product performance. Some of the
Companys competitors are large, diversified medical products
companies with greater
name recognition and significantly greater resources than the Company for research and development,
manufacturing, marketing and sales. As a result, they may be better able to compete for market
share, even in areas in which the Companys products 4




---



##### Table of Contents



may be superior. The industry is subject to rapid technological changes and there can be no
assurance that the Company will be able to maintain any existing technological advantage long
enough to establish its products in the market or to achieve and sustain profitability. In the
Regional Anesthesia market segment, the Companys products compete primarily against the
conventional use of narcotics for the treatment of post-operative pain. The number of current known market participants, including the Company, and the Companys current
estimated competitive position in terms of revenue for each of its product lines is noted in the
table below. CompanysNumber of Known
    
    EstimatedMarket
    
    CompetitiveU.S. Market Description
    
    Participants*
    
    PositionRegional AnesthesiaAcute Pain Kits (wound site pain management)
    
    
    11
    
    
    
    1IV Infusion TherapyElastomerics
    
    
    3
    
    
    
    1Non-electric IV Bag Delivery Systems
    
    
    4
    
    
    
    2Oncology Infusion Services
    
    
    *
    *
    
    
    1
   *
    
    Includes the Company**
    
    The Oncology Infusion Services market is highly fragmented with numerous local competitors. Sales and Distribution The Company currently distributes its products in the United States through its internal sales
force as well as through a number of national and regional medical product distributors. The
Company relies on regional United States medical product distributors for approximately 5% of its
revenue. There are no distribution contracts for the entire I-Flow product line with any of these
distributors. The Company has exclusive United States distribution rights to the ON-Q PainBuster, and has been
selling the Companys products through its direct sales organization since January 1, 2002. As of
December 31, 2002, the Company had 36 people in its sales
organization. As of December 31, 2003, the Company had 99
people in its sales organization, and, as of December 31, 2004,
the Company had 230 people in its sales
organization. The Company's sales organization is comprised of inside and outside salespeople, nurses,
customer service representatives, and sales management. In 2004, the Company changed the name of
its ON-Q Post-Operative Pain Relief System and PainBuster® Pain Management System to ON-Q
PainBuster to consolidate the brand identity of its products. In 1998, the Company entered into an agreement with B. Braun Medical S.A. (France), a
manufacturer and distributor of pharmaceuticals and infusion products, to distribute I-Flows
elastomeric infusion pumps in Western Europe, Eastern Europe, the Middle East, Asia Pacific, South
America and Africa. The agreement is renewable on an annual basis. For the years ended December
31, 2004, 2003 and 2002, sales to B. Braun Medical S.A. accounted for 9%, 10% and 12% of the
Companys total revenues, respectively. The Company entered into a separate agreement with B.
Braun Medical, Inc., a national United States distributor, to distribute I-Flows elastomeric pumps
to B. Braun Medical, Inc.s IV Infusion Therapy customers in the United States. The agreement is
renewable on a bi-annual basis. For the years ended December 31, 2004, 2003 and 2002, sales to B.
Braun Medical, Inc., accounted for 5%, 7% and 6% of the Companys total revenues, respectively. The Company also sells
several of its products into the international market and has agreements with distributors in a number of countries. Currently, the Company sells its products
through distributors in Canada, Brazil, the Benelux Countries, Germany, England, Ireland, Italy,
Mexico, Spain, Korea, Australia, New Zealand and Israel. Aggregate revenues from countries outside
of the United States represented approximately 16%, 20% and 26% of the Companys total revenues for
the years ended December 31, 2004, 2003 and 2002, respectively. The Company does not have any
capital investments in any foreign operations except for its manufacturing plant in Mexico. 5




---



##### Table of Contents



Total revenues attributable to each geographic area in which the Company has sales is as follows: Sales to unaffiliated customers:
    
    2004
    
    
    2003
    
    
    2002United States
    
    $
    59,838,000
    
    
    $
    37,503,000
    
    
    $
    25,697,000Europe
    
    
    9,214,000
    
    
    
    7,588,000
    
    
    
    7,202,000Asia / Pacific Rim
    
    
    1,365,000
    
    
    
    969,000
    
    
    
    1,095,000Other
    
    
    728,000
    
    
    
    983,000
    
    
    
    669,000All Foreign Countries in the Aggregate
    
    
    11,307,000
    
    
    
    9,540,000
    
    
    
    8,966,000
 Backlog The Company did not have a significant backlog of unfilled orders as of December 31, 2004 or
December 31, 2003. Manufacturing and Operations A majority of the Companys products are manufactured by its Mexican subsidiary, Block Medical de
Mexico, S.A. de C.V. (Block Medical). This plant has been in operation since 1994 and has
historically manufactured, and is currently manufacturing, all of the Companys disposable IV
Infusion Therapy devices and elastomeric Regional Anesthesia products. The Company currently
intends to maintain the plant in Mexico and to manufacture a substantial portion of its products
there. The Company regularly reviews the use of outside vendors for production versus internal
manufacturing, and considers factors such as the quality of the products received from outside
vendors, the costs of the products, timely delivery and employee utilization. Product Development The Company has focused its product development efforts on products in post-operative pain relief
and ambulatory infusion systems markets. In each of the years ended December 31, 2004, 2003 and
2002, the Company incurred expenses of approximately $2,779,000, $2,361,000 and $2,104,000,
respectively, for product development. Patents and Trademarks The Company has filed patent applications in the United States for substantially all of its
products. The Company currently holds approximately 40 patents, including patents that relate to
both the ON-Q PainBuster and the Soaker Catheter. The Companys patents generally expire between
2009 to 2015, with significant patents expiring in 2009. The Company has also filed for
intellectual property right protection in all foreign countries from which it derives significant
revenue. In the opinion of management, there are no limitations on the Companys intellectual
property that would have a material adverse effect on the Company. All of the Companys product names are either registered trademarks or have trademark applications
pending. There can be no assurance that pending patent or trademark applications will be approved or that
any patents will provide competitive advantages for the Companys products or will not be
challenged or circumvented by competitors or others. Government Regulation The testing, manufacture and commercialization of the Companys products are subject to regulation
by numerous governmental authorities, principally the FDA and corresponding state and foreign
regulatory agencies. Pursuant to the Federal Food, Drug, and Cosmetic Act and the regulations
promulgated thereunder, the FDA regulates the preclinical and clinical testing, manufacture,
labeling, distribution and promotion of medical devices. Noncompliance with applicable
requirements can result in, among other matters, fines, injunctions, civil penalties, recall or
seizure of products, total or partial suspension of production, failure of the FDA to grant
pre-market 6




---



##### Table of Contents



clearance or pre-market approval for devices, withdrawal of marketing clearances or approvals and
criminal prosecution. The FDA also has the authority to request a recall, repair, replacement or
refund of the cost of any device manufactured or distributed in the U.S. if the device is deemed to
be unsafe. The Company had no product recalls, field corrections or market withdrawals in 2004. In the United States, devices are classified into one of three classes (Class I, II or III) on the
basis of the controls deemed necessary by the FDA to reasonably ensure their safety and
effectiveness. Class I and II devices are subject to general controls, and in some cases, special
controls including, but not limited to, performance standards, pre-market notification (510(k))
and post-market surveillance. Class III devices generally pose the highest risk to the patient and
are typically subject to pre-market approval to ensure their safety and effectiveness. The
Companys products are all Class I or II. Prior to commercialization in the United States market, manufacturers must obtain FDA clearance
through a pre-market notification or pre-market approval process, which can be a lengthy, expensive
and uncertain process. The FDA has been requiring more rigorous demonstration of product
performance as part of the 510(k) process, including submission of extensive clinical data. It
generally takes from two to six months to obtain clearance, but may take longer. For example, the
FDA may determine that additional information is needed before a clearance determination can be
made which could prevent or delay the introduction of new products into the market. A pre-market
approval application must be supported by valid scientific evidence to demonstrate the safety and
effectiveness of the device, typically including the results of clinical investigations, bench
tests, laboratory and animal studies. The pre-market approval process can be expensive, uncertain
and lengthy. It generally takes from six to 18 months to obtain approval, but may take longer. In
addition, modifications or enhancements that could significantly affect safety or effectiveness, or
constitute a major change in the intended use of the device, will require new submissions to the
FDA, and there can be no assurance that the FDA will grant approval. The Company may not be able to obtain the necessary regulatory pre-market approvals or clearances
for its products on a timely basis, if at all. Delays in receipt of or failure to receive such
approvals or clearances, or failure to comply with existing or future regulatory requirements,
would have a material adverse effect on the Companys business, financial condition and results of
operations. Any devices the Company manufactures or distributes pursuant to FDA clearance or approvals are
subject to continuing regulation by the FDA and certain state agencies, including adherence to FDA
Quality System Regulations, relating to the testing, control, documentation and other quality
assurance requirements. The Company must also comply with Medical Device Reporting requirements
mandating reporting to the FDA of any incident in which a product may have caused or contributed to
a death or serious injury, or in which a product malfunctioned and, if the malfunction were to
recur, would be likely to cause or contribute to a death or serious injury. Labeling and
promotional activities are also subject to scrutiny by the FDA and, in certain circumstances, by
the Federal Trade Commission. Current FDA enforcement policy prohibits the marketing of approved
medical devices for unapproved uses. The Company is subject to routine inspection by the FDA and other state agencies for compliance
with applicable federal, state and local regulations. Changes in existing requirements or adoption
of new requirements could have a material adverse effect on the Companys business, financial
condition and results of operations. The Company may also incur significant costs in complying
with any applicable laws and regulations in the future, resulting in a material adverse effect on
its business, financial condition and results of operations. The Companys research and development and manufacturing activities may involve the controlled use
of hazardous materials. Federal, state and local laws and regulations govern the use, manufacture,
storage, handling and disposal of hazardous materials. These regulations include federal statutes
popularly known as CERCLA, RCRA and the Clean Water Act. Compliance with these laws and
regulations is expensive. If any governmental authorities were to impose new environmental
regulations requiring compliance in addition to that required by existing regulations, these future
environmental regulations could impose substantial costs on the Companys business. In addition,
because of the nature of the penalties provided for in some of these environmental regulations, the
Company could be required to pay substantial fines, penalties or damages in the event of
noncompliance with environmental laws or the exposure of individuals to hazardous materials. Any
environmental violation or remediation requirement could 7




---



##### Table of Contents



also partially or completely shut down the Companys research and manufacturing facilities and
operations, which would have a material adverse effect on its business. Products intended for export are subject to additional regulations, including compliance with ISO
9001 and ISO 13485. The Company received ISO 9001 certification in May 1995 and ISO 13485
certification in July 2000, which indicate that I-Flows products meet specified uniform standards
of quality and testing. The Company was also granted permission to use the CE mark on its
products, which reflects approval of the Companys products for export into the 28 member countries
of the European Community. In December 1996, the Block Medical operations, including its Mexico
facility, were added to the Companys ISO certification and the Company received permission to use
the CE mark on the products manufactured by Block Medical. Employees As of March 1, 2005, the Company and its subsidiaries had a total of 389 full-time employees in the
United States and an additional 304 employees in Mexico. None of the Companys employees in the
United States or Mexico are covered by a collective bargaining agreement. The Company considers
its relationship with its employees to be good. From time to time, the Company also uses temporary
employees. These temporary employees are usually engaged to manufacture the Companys products. Available Information Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and
amendments to those reports filed with or furnished to the Securities and Exchange Commission
pursuant to Section 13(a) or 15(d) of the Exchange Act of 1934, as amended, are available free of
charge through our web site at www.iflo.com as soon as reasonably practicable after we
electronically file or furnish the reports with or to the Securities and Exchange Commission. 
 Item 2. Properties The Companys headquarters are located in Lake Forest, California, where the Company leases a
51,000 square foot building. The Company entered a lease for the building in 1997 and it has a
term of 10 years. The Company has the option to extend the lease for an additional five years,
which the Company currently intends to exercise. The Company also leases a 26,000 square foot
plant in Tijuana, Mexico for the manufacture of its disposable IV Infusion Therapy devices and
elastomeric Regional Anesthesia products. The plant lease was entered into in 2000 and had an
original term of five years. The term of the lease has been extended through 2008, and the Company
has two renewal options of four years each. The plant currently operates at approximately 60% of
capacity. Additionally, the Companys Infusystem subsidiary entered into leases in July 2002 for
8,120 square feet of general office space and 3,000 square feet of warehouse space in Madison
Heights, Michigan. Both leases have a term of five years. The Company believes that its
facilities are adequate to meet its current needs. 
 Item 3. Legal Proceedings As of March 1, 2005, the Company was involved in legal proceedings in the normal course of
operations. Although the ultimate outcome of the proceedings cannot be currently determined, in
the opinion of management any resulting future liability will not have a material adverse effect on
the Company and its subsidiaries, taken as a whole. 8




---



##### Table of Contents



Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of security holders during the three months ended
December 31, 2004. EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth information concerning the executive officers of the Company as
March 1, 2005. There are no family relationships between any of the executive officers or
directors of the Company. The executive officers are chosen annually at the first meeting of the
board of directors following the annual meeting of stockholders and, subject to the terms of any
employment agreement, serve at the will and pleasure of the board of directors. Name
    
    Age
    
    PositionDonald M. Earhart
    
    
    60
    
    
    President, Chief Executive Officer and
Chairman of the BoardJames J. Dal Porto
    
    
    51
    
    
    Executive Vice President, Chief Operating
Officer, Director and SecretaryJames R. Talevich
    
    
    54
    
    
    Chief Financial Officer and Treasurer
 Donald M. Earharthas been Chairman of the board of directors since March 1991 and Chief Executive
Officer since July 1990. Mr. Earhart joined the Company as President and Chief Operating Officer
in June 1990. Mr. Earhart, who holds a Bachelor of Engineering degree from Ohio State University
and a Masters Degree in Business Administration from Roosevelt University, has over 25 years
experience in the medical products industry. Prior to joining the Company, from 1986 to 1990, Mr.
Earhart was a corporate officer and the President of the Optical Division of Allergan, Inc. Prior
to his employment at Allergan, he was a corporate officer and Division President of Bausch and Lomb
and was an operations manager of Abbott Laboratories. He has also served as an engineering
consultant at Peat, Marwick, Mitchell & Co. and as an engineer with Eastman Kodak Company. James J. Dal Portojoined the Company as Controller in October 1989. Mr. Dal Porto was promoted to
Treasurer in October 1990, to Vice President of Finance and Administration in March 1991, to
Executive Vice President and Chief Financial Officer in March 1993 and to Chief Operating Officer
in February 1994. Mr. Dal Porto was appointed secretary in 2004. Mr. Dal Porto served as
Financial Planning Manager and Manager of Property Accounting and Local Taxation at CalComp, a high
technology manufacturing company, from 1984 to 1989. Mr. Dal Porto holds a B.S. in Economics from
the University of California, Los Angeles and a M.B.A. from California State University,
Northridge. James R. Talevichjoined the Company as Chief Financial Officer in August 2000. Prior to joining
the Company, he was Chief Financial Officer of Gish Biomedical, Inc., a publicly held medical
device company, from 1999 to 2000 and Chief Financial Officer of Tectrix Fitness Equipment, Inc., a
privately held manufacturing company, from 1995 to 1999. Prior to 1995, he held financial
management positions with Mallinckrodt Medical, Inc., Sorin Biomedical, Inc., a medical products
subsidiary of Fiat S.p.A., Pfizer, Inc., Sensormedics Corporation, a privately held medical device
company, Baxter Travenol Laboratories, Inc. and KPMG Peat Marwick. Mr. Talevich holds a B.A. in
Physics from California State University, Fullerton and a M.B.A. from the University of California
at Los Angeles, and is a Certified Public Accountant. 9




---



##### Table of Contents



RISK FACTORS I. Risk Factors Relating to Our Business and the Industry in Which We Operate We have experienced net losses in prior years and have an accumulated deficit. Future losses are
possible. As of December 31, 2004, our accumulated deficit was approximately $32,194,000. We had net income
(losses) of ($3,035,000), $457,000 and ($17,110,000) for the years ended December 31, 2002, 2003
and 2004, respectively. We may not achieve or maintain profitability in the future, and further
losses may arise. For example, during the year ended December 31, 2004, our total costs and expenses increased by an
amount greater than the increase in revenues, compared to the year ended December 31, 2003. There
can be no assurance that our future revenue growth, if any, will be greater than the growth of our
costs and expenses. If the increase in our total costs and expenses continues to be greater than
any increase in our revenues, we will not be profitable. We have invested substantial resources into the sales and marketing of the ON-Q PainBuster. If
this product does not achieve significant clinical acceptance or if our direct sales strategy is
not successful, our financial condition and operating results will be adversely affected. Our current strategy assumes that the ON-Q PainBuster will be used in a significant number of
surgical cases, ultimately becoming the standard of care for many common procedures. We have
invested, and continue to invest, a substantial portion of our resources into the establishment of
a direct sales force for the sales and marketing of ON-Q. During the year ended December 31, 2004, we invested approximately $39,500,000 in the sales
and marketing of ON-Q. A failure of ON-Q to achieve and maintain a significant market presence, or
the failure to successfully implement our direct sales strategy, will have a material adverse
effect on our financial condition and results of operations. Our customers frequently receive reimbursement from private insurers and governmental agencies.
Any change in the overall reimbursement system may adversely impact our business. The health care reimbursement system is in a constant state of change. Changes often create
financial incentives and disincentives that encourage or discourage the use of a particular type of
product, therapy or clinical procedure. Market acceptance and sales of our products may be
adversely affected by changes or trends within the reimbursement system. Changes to the health
care system that favor technologies other than ours or that reduce reimbursements to providers or
treatment facilities that use our products may adversely affect our ability to sell our products
profitably. Hospitals, alternate care site providers and physicians are heavily dependent on payment for their
services by private insurers and governmental agencies. Changes in the reimbursement system could
adversely affect our participation in the industry. Our products fall into the general category of
infusion devices and related disposable products with regard to reimbursement issues. Except for
payments made to our InfuSystem subsidiary, the majority of reimbursements are not paid directly to
us. Rather, healthcare providers will often request that their patients health insurance
providers provide them with some form of reimbursement for the disposables that are consumed in the
patients therapy. We believe that the current trend in the insurance industry (both private and governmental) has
been to eliminate cost-based reimbursement and to move towards fixed or limited fees for service,
thereby encouraging healthcare providers to use the lowest cost method of delivering medications.
This trend may discourage the use of our products, create downward pressure on our average prices,
and, ultimately, negatively affect our revenues. Changes in reimbursement
rates may adversely impact InfuSystems revenues. InfuSystem depends primarily on third-party reimbursement for the collection of its revenues.
InfuSytem is paid directly by private insurers and governmental agencies, often on a fixed fee
basis, for infusion services provided by InfuSystem to patients. InfuSystems revenues comprised
27% of our consolidated revenues for the year ended 10




---



##### Table of Contents



December 31, 2004. If the average fees allowable by private insurers or governmental agencies were
reduced, the negative impact on revenues of InfuSystem could have a material adverse effect on our
financial condition and results of operations. Changes in reimbursement rates may adversely impact the revenue that we earn from our developing
billing strategy for ON-Q. Historically, we have charged healthcare providers for each ON-Q unit that they purchase from us.
Recently, we, through our InfuSystem subsidiary, have begun to bill private insurers for the use
of ON-Q in ambulatory surgery centers, rather than charging these centers for the purchase price of
each ON-Q unit. If this sales strategy is successful, we expect to increase our use of this sales
strategy for ambulatory surgery centers. Any reduction in the average fees allowable by private
insurers for the use of ON-Q in ambulatory surgery centers could negatively affect our ability to
generate revenue from the centers and this could have a material adverse effect on our financial
condition and results of operations. We may need to raise additional capital in the future to fund our operations. We may be unable to
raise funds when needed or on acceptable terms. During the year ended December 31, 2004, our operating activities used cash of $8,820,000 and our
investing activities used cash of $41,242,000. As of December 31, 2004, we had
cash on hand of $10,021,000, short-term investments of $34,087,000 and net accounts receivable of $15,765,000. We believe our current
funds, together with possible additional borrowings on our existing lines of credit and other bank
loans, are sufficient to provide for our projected needs to maintain operations for at least the
next 12 months. This estimate, however, is based upon assumptions that may prove to be wrong. If
our assumptions are wrong or if we experience further losses, we may
be required to reduce our
operations and to seek additional financing. Any additional equity financings may be dilutive to our existing stockholders and involve the
issuance of securities that may have rights, preferences or privileges senior to those of our
current stockholders. A debt financing, if available, may involve restrictive covenants on our
business that could limit our operational and financial flexibility, and the amount of debt
incurred could make us more vulnerable to economic downturns or operational difficulties and limit
our ability to compete. Furthermore, financing may not be available when needed and may not be on
terms acceptable to us. Our products are highly regulated by a number of governmental agencies. Any changes to the
existing rules and regulations of these agencies may adversely impact our ability to manufacture
and market our products. Our activities are regulated by the Food, Drug and Cosmetic Act. Under the Food, Drug and Cosmetic
Act, we are required, among other matters, to register our facilities and to list our devices with
the FDA, to file notice of our intent to market certain new products under Section 510(K) of the
Food, Drug and Cosmetic Act, to track the location of certain of our products, and to report any
incidents of death or serious injury relating to our products. If we fail to comply with any of
these regulations, or if the FDA subsequently disagrees with the manner in which we sought to
comply with these regulations, we could be subjected to substantial civil and criminal penalties
and a recall, seizure, or injunction with respect to the manufacture or sale of our products. Each state also has similar regulations. For example, in California, we are subject to annual
production-site inspections in order to maintain our manufacturing license. State regulations also
specify standards for the storage and handling of certain chemicals and disposal of their wastes.
We are also required to comply with federal, state, and local environmental laws. Our failure to
comply with any of these laws could expose us to material liabilities. Products intended for export are subject to additional regulations, including compliance with ISO
9001 and ISO 13485. The Company received ISO 9001 certification in May 1995 and ISO 13485
certification in July 2000, which indicate that I-Flows products meet specified uniform standards
of quality and testing. The Company was also granted permission to use the CE mark on its
products, which reflects approval of the Companys products for export into the 28 member countries
of the European Community. In December 1996, the Block Medical 11




---



##### Table of Contents



operations, including its Mexico facility, were added to the Companys ISO certification and the
Company received permission to use the CE mark on the products manufactured by Block Medical. Furthermore, federal, state, local or foreign governments may enact new laws, rules and regulations
that may adversely impact our ability to manufacture and market infusion devices by, for example,
increasing our costs. Any impairment of our ability to market our infusion devices or other
products could have a material adverse effect on our financial condition and results of operations. Our compliance with laws frequently involves our subjective judgment. If we are wrong in any of
our interpretations of the laws, we could be subjected to substantial penalties for noncompliance. In the ordinary course of business, management frequently makes subjective judgments with respect
to complying with the Food, Drug and Cosmetic Act, as well as other applicable state, local and
foreign laws. If any of these regulatory agencies disagrees with our interpretation of, or objects
to the manner in which we have attempted to comply with, the applicable law, we could be subjected
to substantial civil and criminal penalties and a recall, seizure or injunction with respect to the
manufacture or sale of our products. These types of actions against us or our products could have
a material adverse effect on our financial condition and results of operations. Our intangible assets are subject to potential impairment charges that could adversely affect our
results of operations. As of December 31, 2004, $2,639,000 of our assets consisted of goodwill, an intangible asset
acquired through the acquisition of our wholly owned subsidiary, InfuSystem, Inc. (InfuSystem).
The determination of the value of such intangible assets requires management to make estimates and
assumptions that affect our financial statements. For example, we review the recoverability of the
carrying value of goodwill on an annual basis or more frequently if an event occurs or
circumstances change to indicate that an impairment of goodwill has possibly occurred. We compare
fair value of our reporting units to book value, as well as consider other factors, to determine
whether or not any potential impairment of goodwill exists. In fiscal year 2002, and as a result
of the adoption of Statement of Financial Accounting Standards No. 142, Goodwill and Other
Intangible Assets(SFAS 142) effective January 1, 2002, we wrote-off $3,474,000 of goodwill
related to past acquisitions other than InfuSystem. We cannot guarantee that there will be no
additional impairment in the future related to InfuSystem or other acquisitions we may make in the
future. Any impairment charge will adversely affect our results of operations. Our industry is intensely competitive and changes rapidly. If we are unable to maintain a
technological lead over our competitors, our business operations will suffer. The drug infusion industry is highly competitive. We compete in this industry based primarily on
price, service and product performance. Some of our competitors have significantly greater
resources than we do for research and development, manufacturing, marketing and sales. As a
result, they may be better able to compete for market share, even in areas in which our products
may be superior. We continue our efforts to introduce clinically effective, cost-efficient
products into the market, but the industry is subject to technological changes and we may not be
able to maintain any existing technological advantage long enough to establish our products and to
sustain profitability. If we are unable to effectively compete in our market, our financial
condition and results of operations will materially suffer. We rely on independent suppliers for parts and materials necessary to assemble our products. Any
delay or disruption in the supply of parts may prevent us from manufacturing our products and
negatively impact our operations. Although we perform final assembly and testing of our completed infusion systems, certain component
parts, as well as molded products, are obtained from outside vendors based on our specifications.
The loss or breakdown of our relationships with these outside vendors could subject us to
substantial delays in the delivery of our products to customers. Significant delays in the
delivery of our products could result in possible cancellation of orders and the loss of customers.
Furthermore, we have numerous suppliers of components and materials that are sole-source
suppliers. Because these suppliers are the only vendors with which we have a relationship for that
particular 12




---



##### Table of Contents



component or material, we may be unable to produce and sell products if one of these suppliers
becomes unwilling or unable to deliver components or materials meeting our specifications. Our
inability to manufacture and sell products to meet delivery schedules could have a material adverse
effect on our reputation in the industry, as well as our financial condition and results of
operations. If one of our products proves to be defective or is misused by a healthcare practitioner or
patient, we may be subject to claims of liability that could adversely affect our financial
condition and the results of our operations. A defect in the design or manufacture of our products, or a failure of our products to perform for
the use that we specify, could have a material adverse effect on our reputation in the industry and
subject us to claims of liability for injuries and otherwise. Misuse of our product by a
practitioner or patient that results in injury could similarly subject us to claims of liability.
We currently have in place product liability insurance in the amount of $10,000,000 for liability
losses, including legal defense costs. Any substantial underinsured loss would have a material
adverse effect on our financial condition and results of operations. Furthermore, any impairment
of our reputation could have a material adverse effect on our sales, revenues, and prospects for
future business. We are dependent on our proprietary technology and the patents, copyrights, and trademarks that
protect our products. If competitors are able to independently develop products of equivalent or
superior capabilities, the results of our operations could be adversely impacted. We rely substantially on proprietary technology and capabilities. We have filed patent
applications in the United States for substantially all of our products. As of December 31, 2004,
we held approximately 40 patents, including patents that relate to both the ON-Q PainBuster and the
Soaker Catheter. We have also filed for intellectual property rights protection in all foreign
countries in which we currently derive significant revenue. Our patents generally expire between
2009 and 2015, with the most significant patents expiring in 2009. Without sufficient intellectual
property protection, our competitors may be able to sell products identical to ours and cause a
downward pressure on the selling price of our products. There can be no assurance that pending patent or trademark applications will be approved or that
any patents will provide competitive advantages for our products or will not be challenged or
circumvented by competitors. Our competitors may also independently develop products with
equivalent or superior capabilities or otherwise obtain access to our capabilities. We manufacture the majority of our products in Mexico. Any difficulties or disruptions in the
operation of our plant may adversely impact our operations. The majority of our products are manufactured by Block Medical, a wholly owned subsidiary. We may
encounter difficulties as a result of the uncertainties inherent in doing business in a foreign
country, including economic, political and regulatory uncertainties. Our stockholders equity may
also be adversely affected by unfavorable translation adjustments arising from differences in
exchange rates from period to period. In addition, we have not and currently do not hedge or enter
into derivative contracts in an effort to address foreign exchange risk. If there are difficulties
or problems in our Mexico facility, or other disruptions in our production and delivery process
affecting product availability, these difficulties could have a material adverse effect on our
business, financial condition and results of operations. A significant portion of our sales is to customers in foreign countries. We may lose revenues,
market share, and profits due to exchange rate fluctuations and other factors related to our
foreign business. In the year ended December 31, 2004, sales to customers in foreign countries comprised
approximately 16% of our revenues. Our foreign business is subject to economic, political and
regulatory uncertainties and risks that are unique to each area of the world. Fluctuations in
exchange rates may also affect the prices that our foreign customers are willing to pay, and may
put us at a price disadvantage compared to other competitors. Potentially volatile shifts in
exchange rates may negatively affect our financial condition and operations. 13




---



##### Table of Contents



We currently rely on two distributors for a significant percentage of our sales. If our
relationship with these distributors were to deteriorate, our sales may materially decline. During the year ended December 31, 2004, sales to B. Braun Medical S.A. (France) and B. Braun
Medical, Inc., a national distributor in the United States, accounted
for approximately 9% and 5%,
respectively, of our net revenues. Any deterioration in our relationship with B. Braun Medical
S.A. or B. Braun Medical, Inc. could cause a material decline in our overall sales and a material
adverse effect on our business. The preparation of our financial statements in accordance with accounting principles generally
accepted in the United States requires us to make estimates, judgments, and assumptions that may
ultimately prove to be incorrect. The accounting estimates and judgments that management must make in the ordinary course of business
affect the reported amounts of assets and liabilities at the date of the financial statements and
the reported amounts of revenue and expenses during the periods presented. If the underlying
estimates are ultimately proven to be incorrect, subsequent adjustments resulting from errors could
have a material adverse effect on our operating results for the period or periods in which the
change is identified. Additionally, subsequent adjustments from
errors could require us to restate our
financial statements. Restating financial statements could result in a material decline in the
price of our stock. Failure to achieve and maintain effective internal controls in accordance with Section 404 of the
Sarbanes-Oxley Act could have a material adverse effect on the Companys business and its stock
price. Section 404 of the Sarbanes-Oxley Act requires the Company to evaluate annually the effectiveness
of its internal controls over financial reporting as of the end of each fiscal year beginning in
2004 and to include a management report assessing the effectiveness of its internal controls over
financial reporting in all annual reports beginning with this Annual Report on Form 10-K for the
fiscal year ended December 31, 2004. Section 404 also requires the Companys independent auditor
to attest to, and to report on, managements assessment of the Companys internal controls over
financial reporting. The Companys management has evaluated its internal controls over financial
reporting as of December 31, 2004 in order to comply with Section 404 and has concluded that its
disclosure controls and procedures were not effective. See item 9A of
this report for a discussion of the material weakness identified by
management. In addition, the Companys independent auditor
has reported on managements assertion with respect to the
effectiveness of the Companys internal controls
over financial reporting as of December 31, 2004. If the Company
fails to implement adequate internal controls, as such standards are modified, supplemented or amended from
time to time, the Company cannot assure you that it will be able to conclude in the future that it
has effective internal controls over financial reporting in accordance with Section 404. If the
Company fails to achieve and maintain a system of effective internal controls, it could have a
material adverse effect on the Companys business and its stock price. II. Risk Factors Related Specifically to Our Common Stock The average trading volume for our common stock is relatively low when compared to most larger
companies. As a result, there may be less liquidity and more volatility associated with our common
stock, even if our business is doing well. Our common stock has been traded publicly since February 13, 1990, and since then has had only a
few market makers. The average daily trading volume for our shares during the month of February
2005 was approximately 270,000 shares. There can be no assurance that a more active or established
trading market for our common stock will develop or, if developed, will be maintained. The market price of our common stock has been and is likely to continue to be highly volatile.
Market prices for securities of biotechnology and medical device companies, including ours, have
historically been highly volatile, and the market has from time to time experienced significant
price and volume fluctuations that appear unrelated to the operating performance of particular
companies. The following factors, among others, can have a significant effect on the market price
of our securities:  
    announcements of technological innovations, new products, or clinical studies by us or others; 14




---



##### Table of Contents




    government regulation;
    changes in the coverage of reimbursement rates of private insurers and governmental agencies;
    developments in patent or other proprietary rights;
    future sales of substantial amounts of our common stock by existing stockholders or by us; and
    comments by securities analysts and general market conditions. The realization of any of the risks described in these Risk Factors could also have a negative
effect on the market price of our common stock. In the future, our common stock may be removed from listing on the Nasdaq quotation system and may
not qualify for listing on any stock exchange, in which case it may be difficult to find a market
in our stock. If our common stock is no longer traded on a national trading market, it may be more difficult for
you to sell shares that you own, and the price of our common stock would likely be negatively
affected. Currently, our common stock is traded on the Nasdaq National Market. Nasdaq has a
number of continued listing requirements, including a minimum trading price requirement. Failure
to comply with any Nasdaq continued listing requirement could cause our common stock to be removed
from listing on Nasdaq. Should this occur, we may not be able to secure listing on other exchanges
or quotation systems, and this would have a material adverse effect on the price and liquidity of
our common stock. Future sales of our common stock by existing stockholders could negatively affect the market price
of our stock and make it more difficult for us to sell stock in the future. Sales of our common stock in the public market, or the perception that such sales could occur,
could result in a decline in the market price of our common stock and make it more difficult for us
to complete future equity financings. A substantial number of shares of our common stock and
shares of common stock subject to outstanding warrants may be resold pursuant to currently
effective registration statements. As of December 31, 2004, there were:  
    22,092,849 shares of common stock that have been issued in registered offerings and
are freely tradable in the public markets;
    225,111 shares of common stock underlying warrants which have been registered for
resale under a Registration Statement onForm S-3 (Registration No. 333-109096);
    127,000 shares of vested and unvested restricted common stock that have been issued
under our restricted stock plans; and
    an aggregate of 3,626,824 shares of common stock that may be issued on the exercise
of stock options outstanding under our equity incentive plans. We cannot estimate the number of shares of common stock that may actually be resold in the public
market because this will depend on the market price for our common stock, the individual
circumstances of the sellers, and other factors. If stockholders sell large portions of their
holdings in a relatively short time, for liquidity or other reasons, the market price of our common
stock could decline significantly. Anti-takeover devices may prevent a sale, or changes in the management, of I-Flow. We have in place several anti-takeover devices, including a stockholder rights plan, that may have
the effect of delaying or preventing a sale, or changes in the management, of I-Flow. For example,
one anti-takeover device provides for a board of directors that is separated into three classes,
with their terms in office staggered over three 15




---



##### Table of Contents



year periods. This has the effect of delaying a change in control of the board of directors
without the cooperation of the incumbent board. In addition, our bylaws do not allow stockholders
to call a special meeting of stockholders or act by written consent, and also require stockholders
to give written notice of any proposal or director nomination to us within a specified period of
time prior to any stockholder meeting. We may also issue shares of preferred stock without stockholder approval and upon terms that our
board of directors may determine in the future. The issuance of preferred stock could have the
effect of making it more difficult for a third party to acquire a majority of our outstanding
stock, and the holders of such preferred stock could have voting, dividend, liquidation, and other
rights superior to those of holders of our common stock. We do not pay dividends and this may negatively affect the price of our stock. I-Flow has not paid dividends on its common stock and does not anticipate paying dividends on its
common stock in the foreseeable future. The future price of our common stock may be depressed
because we do not pay dividends. 
 PART II 
 Item 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Common Stock Information The Companys common stock trades on The Nasdaq National Market under the symbol IFLO. Set
forth below are the high and low sales prices for the Companys common stock for each full quarter
period within the two most recent fiscal years. High
    
    
    Low20031st Quarter
    
    $
    2.90
    
    
    $
    1.552nd Quarter
    
    $
    7.75
    
    
    $
    2.473rd Quarter
    
    $
    11.49
    
    
    $
    6.504th Quarter
    
    $
    15.50
    
    
    $
    10.0020041st Quarter
    
    $
    18.17
    
    
    $
    11.252nd Quarter
    
    $
    17.54
    
    
    $
    8.993rd Quarter
    
    $
    16.00
    
    
    $
    8.944th Quarter
    
    $
    21.15
    
    
    $
    12.95
 American Stock Transfer & Trust Company is the Companys transfer agent for its common stock. As
of March 3, 2005, the Company had 294 stockholders of record. 16




---



##### Table of Contents



The Company has not paid, and does not currently expect to pay in the foreseeable future, cash
dividends on its common stock. Information About Our Equity Compensation Plans The information regarding the securities authorized for issuance under the Companys equity
compensation plans required by Item 5 is incorporated by reference to the Companys proxy
statement for its 2005 annual meeting of stockholders, which will be filed with the Securities and
Exchange Commission no later than 120 days after the end of the fiscal year ended December 31,
2004. 17




---



##### Table of Contents



Item 6. Selected Financial Data The following selected consolidated financial data have been derived from the Companys audited
consolidated financial statements. The information set forth below is not necessarily indicative
of the expectations of results for future operations and should be read in conjunction with the
consolidated financial statements and notes thereto appearing elsewhere in this Annual Report on
Form 10-K. (Amounts in thousands, except
    
    Years Ended December 31,per share amounts)
    
    2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000Consolidated Statements of Operations Data:(1) (2) (3)(4)Revenues:Net product sales
    
    $
    51,796
    
    
    $
    34,021
    
    
    $
    24,370
    
    
    $
    20,168
    
    
    $
    21,537Rental income and other
    
    
    19,349
    
    
    
    13,022
    
    
    
    10,293
    
    
    
    10,363
    
    
    
    8,469Total revenues
    
    
    71,145
    
    
    
    47,043
    
    
    
    34,663
    
    
    
    30,531
    
    
    
    30,006Cost of revenues:Product cost of revenues
    
    
    15,703
    
    
    
    13,192
    
    
    
    8,979
    
    
    
    8,734
    
    
    
    9,736Rental cost of revenues
    
    
    5,626
    
    
    
    4,018
    
    
    
    3,007
    
    
    
    3,182
    
    
    
    2,562Total cost of revenues
    
    
    21,329
    
    
    
    17,210
    
    
    
    11,986
    
    
    
    11,916
    
    
    
    12,298Gross Profit
    
    
    49,816
    
    
    
    29,833
    
    
    
    22,677
    
    
    
    18,615
    
    
    
    17,708Operating expenses:Selling and marketing
    
    
    44,394
    
    
    
    20,412
    
    
    
    11,760
    
    
    
    4,845
    
    
    
    4,615General and administrative
    
    
    16,391
    
    
    
    10,341
    
    
    
    8,099
    
    
    
    8,841
    
    
    
    7,736Product development
    
    
    2,779
    
    
    
    2,361
    
    
    
    2,104
    
    
    
    2,238
    
    
    
    2,001Total operating expenses
    
    
    63,564
    
    
    
    33,114
    
    
    
    21,963
    
    
    
    15,924
    
    
    
    14,352Operating income (loss)
    
    
    (13,748
    )
    
    
    (3,281
    )
    
    
    714
    
    
    
    2,691
    
    
    
    3,356Interest expense (income), net
    
    
    (525
    )
    
    
    46
    
    
    
    (6
    )
    
    
    44
    
    
    
    265Income (loss) from continuing operations before income taxes and
cumulative effect of a change in accounting principle
    
    
    (13,223
    )
    
    
    (3,327
    )
    
    
    720
    
    
    
    2,647
    
    
    
    3,091Income tax provision (benefit)
    
    
    3,887
    
    
    
    (1,173
    )
    
    
    305
    
    
    
    1,067
    
    
    
    1,262Income (loss) from continuing operations before cumulative effect
of a change in accounting principle
    
    
    (17,110
    )
    
    
    (2,154
    )
    
    
    415
    
    
    
    1,580
    
    
    
    1,829Discontinued operations:Income (loss) from discontinued operations, net of tax
    
    
    
    
    
    
    328
    
    
    
    24
    
    
    
    (313
    )
    
    
    (217
    )Gain on sale of discontinued operations, net of tax
    
    
    
    
    
    
    2,283
    
    
    
    
    
    
    
    
    
    
    
    Income (loss) before cumulative effect of a change in accounting
principle
    
    
    (17,110
    )
    
    
    457
    
    
    
    439
    
    
    
    1,267
    
    
    
    1,612Cumulative effect of a change in accounting principle for goodwill
    
    
    
    
    
    
    
    
    
    
    (3,474
    )
    
    
    
    
    
    
    Net income (loss)
    
    $
    (17,110
    )
    
    $
    457
    
    
    $
    (3,035
    )
    
    $
    1,267
    
    
    $
    1,612Per share of common stock, basic:Income (loss) from continuing operations before cumulative effect
of a change in accounting principle
    
    $
    (0.83
    )
    
    $
    (0.13
    )
    
    $
    0.03
    
    
    $
    0.10
    
    
    $
    0.12Income (loss) from discontinued operations, net of tax
    
    
    
    
    
    
    0.02
    
    
    
    
    
    
    
    (0.02
    )
    
    
    (0.01
    )Gain on sale of discontinued operations, net of tax
    
    
    
    
    
    
    0.14
    
    
    
    
    
    
    
    
    
    
    
    Income (loss) before cumulative effect of a change in accounting
principle
    
    
    (0.83
    )
    
    
    0.03
    
    
    
    0.03
    
    
    
    0.08
    
    
    
    0.11Cumulative effect of a change in accounting principle
    
    
    
    
    
    
    
    
    
    
    (0.23
    )
    
    
    
    
    
    
    Net income (loss)
    
    $
    (0.83
    )
    
    $
    0.03
    
    
    $
    (0.20
    )
    
    $
    0.08
    
    
    $
    0.11Per share of common stock, diluted:Income (loss) from continuing operations before cumulative effect
of a change in accounting principle
    
    $
    (0.83
    )
    
    $
    (0.13
    )
    
    $
    0.03
    
    
    $
    0.10
    
    
    $
    0.12Income (loss) from discontinued operations, net of tax
    
    
    
    
    
    
    0.02
    
    
    
    
    
    
    
    (0.02
    )
    
    
    (0.02
    )Gain on sale of discontinued operations, net of tax
    
    
    
    
    
    
    0.14
    
    
    
    
    
    
    
    
    
    
    
    Income (loss) before cumulative effect of a change in accounting
principle
    
    
    (0.83
    )
    
    
    0.03
    
    
    
    0.03
    
    
    
    0.08
    
    
    
    0.10Cumulative effect of a change in accounting principle
    
    
    
    
    
    
    
    
    
    
    (0.22
    )
    
    
    
    
    
    
    Net income (loss)
    
    $
    (0.83
    )
    
    $
    0.03
    
    
    $
    (0.19
    )
    
    $
    0.08
    
    
    $
    0.10Weighted-average common shares outstanding:Basic
    
    
    20,628
    
    
    
    16,384
    
    
    
    15,368
    
    
    
    15,231
    
    
    
    15,002Diluted
    
    
    20,628
    
    
    
    16,384
    
    
    
    15,879
    
    
    
    15,749
    
    
    
    15,647Consolidated Balance Sheet Data: (1) (2) (3)Working capital
    
    
    57,948
    
    
    $
    31,467
    
    
    $
    16,657
    
    
    $
    15,822
    
    
    $
    14,441Total assets
    
    
    84,430
    
    
    
    51,896
    
    
    
    33,061
    
    
    
    35,704
    
    
    
    35,215Long-term obligations
    
    
    
    
    
    
    
    
    
    
    1
    
    
    
    83
    
    
    
    1,303Total stockholders equity
    
    
    73,219
    
    
    
    44,773
    
    
    
    27,470
    
    
    
    29,769
    
    
    
    27,618
   (1)
    
    Certain amounts previously reported have been reclassified to conform with the 2004 presentation.(2)
    
    Effective January 1, 2002, the Company changed its method of accounting for goodwill and other
intangible assets as a result of adopting Statement of Financial Accounting Standards No. 142,
Accounting for Goodwill and Other Intangible Assets. The Company recognized a transitional
goodwill impairment loss of $3,474,000 as a cumulative effect of a change in accounting principle
during the six months ended June 30, 2002. The amounts previously reported for the first quarter
of 2002 have been revised to include the $3,474,000 cumulative effect of this change in accounting
principle. The effect of the change on the first quarter 2002 results was to reduce net income by
$3,474,000, or $0.22 per diluted share, for the cumulative effect of this accounting change.(3)
    
    In November 2003, the Company sold Spinal Specialties, Inc., a wholly owned subsidiary. The
operations of Spinal Specialties have been excluded from continuing operations for all periods
presented. See Note 4 of Notes to Consolidated Financial Statements.(4)
    
    The Company recorded a full valuation allowance
against its deferred tax assets in the fourth quarter of 2004. 18




---



##### Table of Contents



SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
 (Amounts in thousands, except per share amounts) 2004
    
    Mar. 31
    
    
    June 30
    
    
    Sept. 30
    
    
    Dec. 31 (2)Total revenues
    
    $
    14,169
    
    
    $
    17,167
    
    
    $
    18,688
    
    
    $
    21,121Gross profit
    
    
    9,487
    
    
    
    11,946
    
    
    
    13,311
    
    
    
    15,072Loss before income taxes
    
    
    (2,356
    )
    
    
    (2,434
    )
    
    
    (2,814
    )
    
    
    (5,619
    )Net loss
    
    
    (1,500
    )
    
    
    (1,504
    )
    
    
    (1,770
    )
    
    
    (12,336
    )Per share of
common stock - basic and diluted:Loss from continuing operations
    
    
    (0.08
    )
    
    
    (0.07
    )
    
    
    (0.08
    )
    
    
    (0.56
    )Net loss
    
    
    (0.08
    )
    
    
    (0.07
    )
    
    
    (0.08
    )
    
    
    (0.56
    )Weighted-average common shares - basic and diluted
    
    
    18,282
    
    
    
    20,933
    
    
    
    21,501
    
    
    
    21,950
 2003
    
    Mar. 31
    
    
    June 30
    
    
    Sept. 30
    
    
    Dec. 31 (1)Total revenues
    
    $
    10,135
    
    
    $
    11,383
    
    
    $
    11,822
    
    
    $
    13,703Gross profit
    
    
    6,680
    
    
    
    7,351
    
    
    
    7,510
    
    
    
    8,292Loss from continuing operations before income taxes
    
    
    (76
    )
    
    
    (98
    )
    
    
    (850
    )
    
    
    (2,303
    )Loss from continuing operations
    
    
    (44
    )
    
    
    (56
    )
    
    
    (507
    )
    
    
    (1,547
    )Income from discontinued operations, net of tax
    
    
    61
    
    
    
    78
    
    
    
    121
    
    
    
    68Gain on sale of discontinued operations, net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,283Net income (loss)
    
    
    17
    
    
    
    22
    
    
    
    (386
    )
    
    
    804Per share of
common stock - basic and diluted:Loss from continuing operations
    
    
    0.00
    
    
    
    0.00
    
    
    
    (0.03
    )
    
    
    (0.09
    )Net income (loss)
    
    
    0.00
    
    
    
    0.00
    
    
    
    (0.02
    )
    
    
    0.04Weighted-average common shares - basic and diluted
    
    
    15,434
    
    
    
    15,516
    
    
    
    16,445
    
    
    
    18,037
   (1)
    
    In November 2003, the Company sold Spinal Specialties, Inc., a wholly owned subsidiary. The
operations of Spinal Specialties have been excluded from continuing operations for all
periods presented. See Note 4 of Notes to Consolidated Financial Statements.(2)
    
    The Company recorded a full valuation allowance
against its deferred tax assets in the fourth quarter of 2004. 19




---



##### Table of Contents



Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements Statements by the Company in this report and in other reports and statements released by the
Company are and will be forward-looking in nature and express the Companys current opinions about
trends and factors that may impact future operating results. Statements that use words such as
believes, anticipates, or expects or use similar expressions are intended to identify
forward-looking statements. Forward-looking statements are subject to risks and uncertainties,
which could cause actual results to differ materially from those expected, and readers are
cautioned not to place undue reliance on these forward-looking statements. The Company undertakes
no obligation to republish revised forward-looking statements to reflect the occurrence of
unanticipated or subsequent events. Readers are also urged to carefully review and consider the
various disclosures made by the Company in this report that seek to advise interested parties of
the risks and other factors that affect the Companys business. Interested parties should also
review the Companys reports on Forms 10-Q and 8-K and other reports that are periodically filed
with the Securities and Exchange Commission. The risks affecting the Companys business include,
among others: implementation of our direct sales strategy; dependence on our suppliers and
distributors; reliance on the success of the home health care industry; our continuing compliance
with applicable laws and regulations, such as the Food, Drug and Cosmetic Act, and the FDAs
concurrent with our managements subjective judgment on compliance issues; the reimbursement system
currently in place and future changes to that system; competition in the industry; economic and
political conditions in foreign countries; currency exchange rates; inadequacy of booked reserves;
technological changes; and product availability and acceptance. All forward-looking statements,
whether made in this report or elsewhere, should be considered in context with the various
disclosures made by the Company about its business. Critical Accounting Policies I-Flow prepares its consolidated financial statements in conformity with accounting principles
generally accepted in the United States. Accordingly, the Company is required to make estimates,
judgments and assumptions that the Company believes are reasonable based upon the information
available. These estimates and assumptions affect the reported amounts of assets and liabilities
at the date of the financial statements and the reported amounts of revenues and expenses during
the periods presented. The critical accounting policies which the Company believes are the most
important to aid in fully understanding and evaluating its reported financial results include the
following: Revenue Recognition The Company recognizes revenue from product sales at the time of shipment and passage of title.
The Company offers the right of return for defective products and continuously monitors and tracks
product returns. The Company records a provision for the estimated amount of future returns based
upon historical experience and any notification received of pending returns. Although such returns
have historically been insignificant, the Company cannot guarantee that it will continue to
experience the same return rates as it has in the past. Any significant increase in product
returns could have a material adverse impact on the Companys operating results for the period or
periods in which the returns materialize. The Company recognizes rental revenues from medical pumps over the term of the related agreement,
generally on a month-to-month basis. Pump rentals are billed at the Companys established rates,
which often differ from contractually allowable rates provided by third party payors such as
Medicare, Medicaid and commercial insurance carriers. The Company records net rental revenues at
the estimated realizable amounts from patients and third party payors. The Company experiences
significant delays in payment with certain of these third party payors, but it continuously
monitors reimbursement rates of the third party payors and the timing of such payments. Any change
in reimbursement or collection rates could have a material adverse impact on the Companys
operating results for the period or periods in which the change is identified. 20




---



##### Table of Contents



Accounts Receivable The Company performs various analyses to evaluate its accounts receivable balances. It records an
allowance for bad debts based upon the estimated collectibility of the accounts such that the
recorded amounts reflect estimated net realizable value. The Company applies specified percentages
to the accounts receivable agings to estimate the amount that will ultimately be uncollectible and
therefore should be reserved. The percentages are increased as the accounts age. If the actual
uncollected amounts are less than the previously estimated allowance, a favorable adjustment would
result. If the actual uncollected amounts significantly exceed the estimated allowance, the
Companys operating results would be significantly and adversely affected. Inventories The Company values inventory at the lower of the actual cost to purchase or manufacture the
inventory and the current estimated market value of the inventory. The Company regularly reviews
inventory quantities on hand and records a provision for excess and obsolete inventory on
specifically identified items based primarily upon the estimated forecast of product demand and
production requirements for the next two years. A significant increase in the demand for the
Companys products could result in a short-term increase in the cost of inventory purchases while a
significant decrease in demand could result in an increase in the amount of excess inventory
quantities on hand. Additionally, the Companys estimates of future product demand may prove to be
inaccurate and thus the Company may have understated or overstated the provision required for
excess and obsolete inventory. In the future, if inventory is determined to be overvalued, the
Company would be required to recognize such costs in cost of goods sold at the time of such
determination. Likewise, if inventory is determined to be undervalued, the Company may have
over-reported cost of goods sold in previous periods and would be required to recognize such
additional operating income at the time of sale. Therefore, although the Company seeks to ensure
the accuracy of its forecasts of future product demand, any significant unanticipated changes in
demand or technological developments could have a significant impact on the value of its inventory
and reported operating results. Deferred Taxes The Company recognizes deferred tax assets and liabilities based upon the future tax consequences
attributable to the difference between the financial statement carrying amounts and their
respective tax bases, and for operating loss and tax credit carryforwards. The Company regularly
reviews its deferred tax assets for recoverability and establishes a
valuation allowance when it is more likely than not that projected future taxable income and the expected timing of the reversals
of existing temporary differences will be insufficient to recover any
deferred tax assets. If the Company operates at a profit in the future and generates
sufficient future taxable income, it could be required to reverse the current valuation allowance
against the deferred tax assets, which would result in a substantial decrease in the provision for
income taxes in the period of reversal. Likewise, if the Company is unable to operate at a profit
and it is more likely than not that the Company will be unable to
generate sufficient future taxable income, it would be required to continue to
maintain a full valuation allowance against all of its deferred tax assets. Intangible Assets Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets(SFAS
142), required the Company to cease amortizing goodwill and indefinite life intangibles effective
January 1, 2002. The Companys business combinations have at various times resulted in the
acquisition of goodwill and other intangible assets, which may affect the amount of future period
amortization expense and impairment expense that the Company may incur. The determination of the
value of such intangible assets requires management to make estimates and assumptions that affect
its consolidated financial statements. The Company reviews the recoverability of the carrying
value of goodwill on an annual basis or more frequently if an event occurs or circumstances change
to indicate that an impairment of goodwill has possibly occurred. The Company compares the fair
value of its reporting units to their carrying value, as well as other factors, to determine
whether or not any potential impairment of goodwill exists. If a potential impairment exists, an
impairment loss is recognized to the extent the carrying value of goodwill exceeds the difference
between the fair value of the reporting unit and the fair value of its other 21




---



##### Table of Contents



assets and liabilities. The Company cannot guarantee that there will be no impairment in the
future. If the Company is required to recognize an impairment of
goodwill, the Companys operating results could be significantly
and adversely affected. See Note 2 to Consolidated Financial Statements. Overview and Recent Developments The Company designs, develops and markets technically advanced, low-cost drug delivery systems and
services that provide life-enhancing, cost-effective solutions for pain relief and intravenous
infusion therapy. The Company focuses on three distinct markets: Regional Anesthesia, IV Infusion
Therapy and Oncology Infusion Services. The Companys products are used in hospitals, ambulatory
surgery centers, physicians offices and patients homes. The Companys strategic focus for future growth is on the Regional Anesthesia market and, more
specifically, on the Companys pain relief products marketed under its ON-Q brand. The Company
intends to continue to expand its sales and marketing efforts to further penetrate the United
States post-surgical pain relief market for its ON-Q products. On November 9, 2004, the Company announced the first payment by Medicare for the ON-Q PainBuster.
This result arose out of a specific case in which ON-Q PainBuster was used for a patient following
surgery. Historically, all of Medicares regional contractors enforced policies that resulted in
denied payments for the use of the ON-Q PainBuster. The decision that ON-Q was medically
necessary, and therefore payable by Medicare, was made by an administrative law judge based upon
the law and clinical evidence submitted by the Company in the course of the Companys appeal to the
initial decision to deny coverage. With this decision, the Company intends to request that each
Medicare contractor revise its coverage policy so that the contractors will begin to provide
payment for ON-Q PainBuster when it is used to treat post-operative pain. Additionally, private
payer systems commonly establish coverage decisions based upon Medicare policy. Accordingly, the
Company plans to use this coverage decision to seek to influence private insurers as well. There
is no guarantee, however, that insurance coverage by Medicare or by private insurers will increase
as a result of these or other developments. Divestiture of Spinal Specialties The Company sold Spinal Specialties, Inc., a wholly owned subsidiary, on November 1, 2003 to
Integra LifeSciences Holdings Corporation for approximately $6,000,000 in cash and net proceeds of
approximately $5,044,000. Assets and liabilities included in the sale consisted primarily of
approximately $722,000 of accounts receivable, $1,155,000 of inventory, $400,000 of fixed assets,
and $313,000 of accounts payable and accrued liabilities. The Company recorded a pretax gain on
the sale of $2,999,000 and a tax provision on the gain of $716,000,
resulting in an after-tax gain of
$2,283,000. The reported gain has been reduced by a charge of $327,000 related to the acceleration
of vesting of certain stock options upon the closing of the sale. This amount has been accounted
for as an increase in common stock. The net income of Spinal Specialties prior to divestiture is presented in the Companys
Consolidated Statements of Operations and Comprehensive Operations as income from discontinued
operations, net of tax. Reported in income from discontinued operations, net of tax, are net
product sales from Spinal Specialties of $3,795,000 and $3,454,000 in 2003 and 2002, respectively,
and income before taxes from Spinal Specialties of $532,000 and $42,000 in 2003 and 2002,
respectively. Also reported in income from discontinued operations, net of tax, is income tax
expense of $204,000 and $18,000 for 2003 and 2002, respectively. Consolidated Results of Operations for the Year Ended December 31, 2004 Compared to the Year Ended
December 31, 2003 Revenue Net revenues during the year ended December 31, 2004 were $71,145,000 compared to $47,043,000 for
the prior year, an increase of 51%. Net product revenues increased 52% in 2004 to $51,796,000
compared to $34,021,000 in 2003. Rental income, comprised of the revenues of the Companys
InfuSystem subsidiary, increased by 49% to $19,349,000 for the year ended December 31, 2004 from
$13,022,000 for the prior year. 22




---



##### Table of Contents



The Companys product revenues during 2004 and 2003 were generated in two primary market segments:
Regional Anesthesia and IV Infusion Therapy. Regional Anesthesia product revenues for 2004, which
included revenue from the ON-Q PainBuster and the Soaker Catheter, increased by 101% to $32,392,000
in 2004 compared to $16,112,000 for fiscal 2003. The increase was primarily due to increased
clinical usage of the ON-Q PainBuster by surgeons in the United States. Average selling prices
remained fairly constant throughout both years. Significant factors in the revenue increase and
trend toward the use of regional anesthesia for post-operative pain include the progressive
increase during 2004 in the size of the Companys direct sales force and the publication of
favorable results from clinical studies. IV Infusion Therapy product sales, which included the Companys intravenous elastomeric pumps,
mechanical infusion devices and electronic infusion pumps and disposables, increased 8% in 2004 to
$19,404,000 from $17,909,000 in 2003. The year-to-year increase primarily resulted from increased
sales of IV Infusion Therapy products to international distributors
including B. Braun Medical S.A. The Company has a
distribution agreement with B. Braun Medical S.A. (France), a manufacturer and distributor of
pharmaceuticals and infusion products, to distribute I-Flows elastomeric infusion pumps in Western
Europe, Eastern Europe, the Middle East, Asia Pacific, South America and Africa. Pursuant to a
separate distribution agreement, B. Braun Medical, Inc. distributes I-Flows elastomeric pumps to
B. Braun Medical Inc.s IV Infusion Therapy customers in the United States. Rental revenues provided by the Companys InfuSystem subsidiary within the Oncology Infusion
Services market increased 49% to $19,349,000 in 2004 compared to $13,022,000 in 2003. The revenue
increase is substantially due to an increased usage of new drugs and clinical protocols requiring
the use of ambulatory electronic pumps as opposed to oral application of chemotherapy drugs.
InfuSystem revenues fluctuate based upon a number of factors, including the number of client
facilities utilizing the InfuSystem pump management system, the number of contracts with managed
care organizations, the number of potential patients covered by those contracts, reimbursement
levels, and periodic fluctuations in the prevalence of continuous infusional administration of
chemotherapy as opposed to oral administration of drug therapies. Cost of Revenue Cost of revenues increased by 24% to $21,329,000 for the year ended December 31, 2004 compared to
$17,210,000 for the year ended December 31, 2003. Cost of revenues in 2003 included a write-down
of $582,000 for tooling and inventory related to the Companys declining electronic IV pump
business. The write-down consisted of $394,000 for excess and obsolete inventory and $188,000 for
tooling. The Company phased out its electronic pump products in the IV Infusion Therapy Market
during 2004. As a percentage of net product sales, product cost of revenue decreased by
approximately eight percentage points in 2004 to 30%, primarily due to the favorable change in
sales mix toward high-margin regional anesthesia products such as the ON-Q PainBuster. Rental cost
of revenues increased by $1,608,000, or 40%, to $5,626,000 primarily due to increases in operating supplies
and material costs ($729,000), and increased depreciation expense
($668,000) due to the increasing size of the Companys
rental fleet of chemotherapy pumps. As a percentage of rental revenues, however, rental cost of
revenue decreased by approximately two percentage points due to improved operational efficiency. Selling and Marketing Expenses Selling and marketing expenses for the year ended December 31, 2004 increased by $23,982,000, or
117%, compared to the prior year. This increase was primarily attributable to increases in direct
sales force salaries ($7,160,000), commissions ($5,863,000), travel ($1,507,000), entertainment
($1,029,000), non-cash stock-based compensation expense related to sales personnel ($1,287,000),
marketing expenses ($2,287,000) and other costs related to the hiring and operation of an expanded
direct sales force in the United States during fiscal 2004 to support sales and marketing of the
ON-Q PainBuster. As a percentage of total revenues, selling and marketing expenses increased by 19
percentage points, to 62%. The Company intends to continue to invest significant resources to
promote ON-Q during 2005. As of December 31, 2004, the Company employed approximately 230 people
in its sales organization in support of its ON-Q sales effort, an increase of approximately 132%
compared to December 31, 2003. 23




---



##### Table of Contents



General and Administrative Expenses General and administrative expenses for the year ended December 31, 2004 increased $6,050,000 or
59% from the prior year. The increase is primarily attributable to increases in employee
compensation ($2,251,000), provision for bad debts ($1,321,000), consulting expenses related to the
documentation of internal controls to implement Section 404 of the Sarbanes-Oxley Act of 2002
($1,198,000), legal expenses ($486,000), and other costs associated with the growth of the
business. The increase in compensation resulted from increased staffing and year-end bonuses. The
increase in the provision for bad debts includes $747,000 incremental provision for the estimated
amount of uncollectible 2004 billings by the Companys rental business, partly attributable to the
rapid growth of rental revenues. As a percentage of total revenues, general and administrative
expenses increased for fiscal 2004 by one percentage point to 23%. Product Development Expenses Product development expenses include research and development for new products and the cost of
obtaining and maintaining regulatory approvals of products and processes. Product development
expenses for the year ended December 31, 2004 increased $418,000, or 18%, as compared to fiscal
2003, primarily due to increased compensation cost. The Company will continue to incur product
development expenses as it continues its efforts to introduce new technology and cost-efficient
products into the market. Product development expense as a percentage of net product sales
decreased by approximately two percentage points to 5% during 2004 compared to 2003. Income Taxes During the year ended December 31, 2004, the Company recorded an income tax provision of
$3,887,000, compared to an income tax benefit of $1,173,000 for the year ended December 31, 2003.
The income tax provision for 2004 includes approximately $8,800,000 of incremental expense
resulting from an increase in the valuation allowance for deferred tax assets. The increase in the
valuation allowance effectively reduced the net book value of the Companys deferred tax assets to
zero. The balance sheet effect of the write-down was a decrease in net deferred tax assets of
approximately $15,949,000 and a corresponding decrease in net shareholders equity. The portion of
the write-down not charged to the 2004 provision for income taxes consisted primarily of the tax
benefit for stock options of $6,972,000 which was a direct adjustment to net shareholders equity.
The write-down was consistent with the guidance in Statement of Financial Accounting Standards No.
109, Accounting for Income Taxes (SFAS 109), which addresses the valuation of deferred tax
assets. The Company regularly reviews its deferred tax assets for
recoverability and establishes a valuation allowance when it is more
likely than not that projected future taxable income and the expected
timing of the reversals of existing temporary differences will be
insufficient to recover the deferred tax assets. Under SFAS 109, a valuation allowance is
recognized if, based upon the weight of available evidence, it is more likely than not that some
portion or all of the deferred tax asset will not be realized. The weight given to
the potential effect of negative and positive evidence should be commensurate with the extent to
which it can be objectively verified, and a cumulative loss in recent years is considered a
significant piece of negative evidence. Currently, management believes that based upon the criteria
specified by SFAS 109, it is more likely than not that the Company will not realize the benefits of
the existing net deferred tax asset at December 31, 2004. The Companys effective tax rate for the year ended December 31, 2004 was a tax expense rate of
29.4% compared to tax benefit rate of 35.3% in 2003. The change in the effective tax rate is
primarily the result of the increase in the provision for income taxes in 2004 resulting from the
increase in the valuation allowance for deferred tax assets. Goodwill In accordance with SFAS 142, the Company completed its adoption test for goodwill impairment in
June 2002 and concluded that consolidated goodwill in the amount of $3,474,000 was impaired
effective January 1, 2002. The Company recorded a non-cash charge of approximately $3,474,000 to
reduce the carrying value of its goodwill which was recorded as a cumulative effect of a change in
accounting principle. See Note 2 to the Notes to Consolidated Financial Statements, Goodwill and
Other Intangible Assets. There was no impairment in 2003 or 2004. 24




---



##### Table of Contents



Consolidated Results of Operations for the Year Ended December 31, 2003 Compared to the Year Ended
December 31, 2002 Revenue Net revenues during the year ended December 31, 2003 were $47,043,000 compared to $34,663,000 for
the prior year, an increase of 36%. Net product revenues increased 40% in 2003 to $34,021,000
compared to $24,370,000 in 2002. Rental income, comprised of the revenues of the Companys
InfuSystem subsidiary, increased by 27% to $13,022,000 for the year ended December 31, 2003 from
$10,293,000 for the prior year. The Companys product revenues during 2003 and 2002 were generated in two primary market segments:
Regional Anesthesia and IV Infusion Therapy. Regional Anesthesia product revenues for 2003, which
included revenue from the PainBuster and ON-Q Post-Operative Pain Relief Systems and the Soaker
Catheter, increased by 88% to $16,112,000 in 2003 compared to $8,582,000 for fiscal 2002. The
increase was primarily due to increased clinical usage of the ON-Q Post-Operative Pain Relief
System by surgeons in the United States. Average selling prices during 2003 remained fairly
constant throughout both years. Significant factors in the revenue increase and trend toward the
use of regional anesthesia for post-operative pain include the progressive increase during 2003 in
the size of the Companys direct sales force and the publication of favorable results from clinical
studies. IV Infusion Therapy product sales, which included the Companys intravenous elastomeric pumps,
mechanical infusion devices and electronic infusion pumps and disposables, increased 13% in 2003 to
$17,909,000 from $15,788,000 in 2002. The year-to-year increase primarily resulted from increased
sales of IV Infusion Therapy products to distributors in the United States. Pursuant to a
distribution agreement, B. Braun Medical, Inc. distributes I-Flows elastomeric pumps to B. Braun
Medical Inc.s IV Infusion Therapy customers in the United States. The Company has a separate
agreement with B. Braun Medical S.A. (France), a manufacturer and distributor of pharmaceuticals
and infusion products, to distribute I-Flows elastomeric infusion pumps in Western Europe, Eastern
Europe, the Middle East, Asia Pacific, South America and Africa. Rental revenues provided by the Companys InfuSystem subsidiary within the Oncology Infusion
Services market increased 27% to $13,022,000 in 2003 compared to $10,293,000 in 2002. The revenue
increase is substantially due to InfuSystems co-marketing activities with major pharmaceutical
companies, which contributed to an increased usage of new drugs and clinical protocols requiring
the use of ambulatory electronic pumps as opposed to oral application of chemotherapy drugs. This
increase in rental billings was slightly offset by changes to initial estimates of contractual
rental revenue of approximately $400,000 recorded during fiscal year 2003 as a result of lower
reimbursement levels than initially projected. InfuSystem revenues fluctuate based upon a number
of factors, including the number of client facilities utilizing the InfuSystem pump management
system, the number of contracts with managed care organizations, the number of potential patients
covered by those contracts, reimbursement levels, and periodic fluctuations in the prevalence of
continuous infusional administration of chemotherapy as opposed to oral administration of drug
therapies. Cost of Revenue Cost of revenues was $17,210,000 during the year ended December 31, 2003 compared to $11,986,000 in
the prior year, an increase of 44%. Cost of revenues in 2003 included a write-down of $582,000 for
tooling and inventory related to the Companys declining electronic IV pump business. The
write-down consisted of $394,000 for excess and obsolete inventory and $188,000 for tooling. The
Company phased out its electronic pump products in the IV Infusion Therapy Market during 2004. As
a percentage of net product sales, product cost of revenue increased by approximately two
percentage points in 2003 to 39% due to the write-down of assets related to the electronic IV pump
business. Rental cost of revenues increased by $1,011,000, or 34%, to $4,018,000 due to increases
in operating supplies and material costs, and increased depreciation expense due to the increasing
size of the Companys rental fleet of chemotherapy pumps. As a percentage of rental revenues,
rental cost of revenue increased by approximately two percentage points. 25




---



##### Table of Contents



Selling and Marketing Expenses Selling and marketing expenses for the year ended December 31, 2003 increased $8,652,000, or 74%,
from the prior year. This increase was primarily attributable to increases in direct sales force
salaries and commissions ($4,398,000), travel and entertainment ($865,000), non-cash compensation
expense related to the vesting of restricted stock granted to sales personnel ($327,000), increases
in marketing expenses ($866,000) and other costs related to the hiring and operation of an expanded
direct sales force in the United States during fiscal 2003 to support sales and marketing of the
ON-Q Post-Operative Pain Relief System. As a percentage of total revenues, selling and marketing
expenses increased by nine percentage points, to 43%. As of December 31, 2003, the Company
employed 99 sales professionals in support of its ON-Q sales effort, an increase of approximately
175% compared to December 31, 2002. General and Administrative Expenses General and administrative expenses for the year ended December 31, 2003 increased $2,242,000 or
28% from the prior year. The increase is attributable to increases in compensation ($881,000),
provision for bad debts ($573,000), investor relations ($84,000), telephone ($90,000), depreciation
expense ($91,000) and other costs associated with the growth of the business. The increase in
compensation resulted from increased staffing and year-end bonuses. The increase in the provision
for bad debts included a $279,000 accrual for the estimated amount of uncollectible 2003 billings
by the Companys rental business and other bad debt reserves determined based upon the growth in
the Companys operations and analyses of the accounts receivable agings. As a percentage of total
revenues, general and administrative expenses decreased for fiscal 2003 by one percentage point to
22%. Product Development Expenses Product development expenses included research and development for new products and the cost of
obtaining and maintaining regulatory approvals of products and processes. Product development
expenses for the year ended December 31, 2003 increased $257,000, or 12%, as compared to fiscal
2002. The increase included a $90,000 write-down of the carrying value of patents related to the
Companys declining electronic IV pump business, and increased compensation, consulting fees and
outside services. Product development expense as a percentage of net product sales decreased by
approximately one percentage point to 7% during 2003 compared to 2002. Income Taxes During the year ended December 31, 2003, the Company recorded an income tax benefit from continuing
operations of $1,173,000, compared to income tax expense of $305,000 recorded for the year ended
December 31, 2002. The Companys effective tax rate decreased to 35.9% in the year ended December
31, 2003 compared to 42.4% in 2002. The reduction in the effective tax rate is the result of the
method of taxation by the State of Michigan. This tax, which is based upon the activity of
InfuSystem only, was calculated in a way that generated a current year tax for 2003, even though
the overall activity of the Company resulted in a loss. As a result, the overall benefit received
from the current year loss is reduced. Goodwill In accordance with SFAS 142, the Company completed its adoption test for goodwill impairment in
June 2002 and concluded that consolidated goodwill in the amount of $3,474,000 was impaired
effective January 1, 2002. The Company recorded a non-cash charge of approximately $3,474,000 to
reduce the carrying value of its goodwill which was recorded as a cumulative effect of a change in
accounting principle. See Note 2 to the Notes to Consolidated Financial Statements, Goodwill and
Other Intangible Assets. There was no impairment of goodwill in 2003. 26




---



##### Table of Contents



Liquidity and Capital Resources During the year ended December 31, 2004, cash of $8,820,000 was used in operating activities
consisting primarily of a net loss of $17,110,000 less non-cash expenses of $11,680,000, plus net
changes in operating assets and liabilities of $3,390,000. The increases in accounts receivable
and inventory resulted from the overall increase in revenues. During the year ended
December 31, 2004, cash of $41,242,000 was used in investing activities of the
Company. This amount was primarily attributable to the purchases of
investments of $35,515,000 with a portion of the proceeds from the
Companys public offering in 2004, and secondarily due to the acquisition of electronic pumps for the
Companys rental business, leasehold improvements, furniture, fixtures, equipment, and other assets
of $6,603,000 for use in the Companys operations. The Company anticipates capital expenditures of
approximately $6,000,000 in 2005. It expects that the expenditures will be paid for using existing
cash and cash equivalents and working capital balances. It is the Companys
policy to invest its excess cash in highly liquid money market funds,
U.S. agency notes and investment grade corporate bonds and commercial
paper. During the year ended
December 31, 2004, cash of $44,943,000 was provided by financing activities
consisting primarily of $43,087,000 in net proceeds to the Company from the sale of 2,990,000
shares of the Companys common stock in a public offering at a sales price of $15.50 per share. In
addition, the Company received $1,856,000 in proceeds from the exercise of stock options and
warrants. As of December 31, 2004,
the Company had cash and cash equivalents of $10,021,000, short-term
investments of $34,087,000, net receivables
of $15,765,000 and net working capital of $57,948,000. Management believes the Companys funds,
together with possible borrowings on its existing lines of credit and other bank loans, are
sufficient to provide for its short and long-term needs for operations as currently projected. The
Company may decide to sell additional equity securities or to increase its borrowings in order to
fund an increase in its expenditures for selling and marketing expenses, to fund increased product
development, to make acquisitions, or for other purposes. The Company has a working capital line of credit with Silicon Valley Bank that expires on April 30,
2005. The Company currently intends to seek to renew the line of credit. Under the line of
credit, the Company may borrow up to the lesser of $4,000,000 or the sum of 80% of eligible
accounts receivable plus 25% of eligible inventory, as defined, at the banks prime rate (5.25% at
December 31, 2004). As of December 31, 2004, there were funds available for borrowing of
$3,072,000 and no outstanding borrowings. The Companys InfuSystem subsidiary has a revolving line of credit with a bank under which it may
borrow up to the lesser of $3,500,000 or 80% of eligible accounts receivable, as defined, at the
banks prime rate less 0.25% (5.0% at December 31, 2004). As of December 31, 2004, there were
funds available for borrowing of $3,500,000 and no outstanding borrowings. The credit line expires
June 30, 2006. In addition, InfuSystem has a loan facility under which it may borrow up to
$2,500,000 for the purchase of equipment. As of December 31, 2004, there were no outstanding
borrowings under the loan facility. The Companys lines of credit are collateralized by substantially all of the Companys assets and
require the Company to comply with certain covenants principally relating to working capital and
liquidity. As of December 31, 2004, the Company believes it was in compliance with or obtained
waivers for all such covenants. The Company did not meet the net
income covenant for the quarter ended December 31, 2004. Contractual Obligations and Commercial Commitments As of December 31, 2004, future payments related to contractual obligations and commercial
commitments are as follows: Payment Due by PeriodMore than 5Less than 1 year
    
    
    1 to 3 years
    
    
    3 to 5 years
    
    
    years
    
    
    TotalOperating Lease
Obligations for
Facilities
    
    $
    737,000
    
    
    $
    1,402,000
    
    
    $
    989,000
    
    
    $
    1,071,000
    
    
    $
    4,199,000Purchase
Commitments with
Suppliers
    
    
    3,736,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,736,000Total Contractual
Obligations and
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    1,071,000Commercial
Commitments
    
    $
    4,473,000
    
    
    $
    1,402,000
    
    
    $
    989,000
    
    
    
    
    
    
    $
    7,935,000
 27




---



##### Table of Contents



New Accounting
Pronouncements In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest
Entities(FIN 46). In general, a variable interest entity is a corporation, partnership, trust
or any other legal structure used for business purposes that either (a) does not have equity
investors with voting rights or (b) has equity investors that do not provide sufficient financial
resources for the entity to support its activities. FIN 46 requires a variable interest entity to
be consolidated by a company if that company is subject to a majority of the risk of loss from the
variable interest entitys activities or entitled to receive a majority of the entitys residual
returns or both. The consolidation requirements of FIN 46 apply immediately to variable interest
entities created after January 31, 2003. With respect to variable interest entities created before
January 31, 2003, in December 2003, the FASB issued FIN 46R which, among other things, revised the
implementation date to first fiscal years or interim periods ending after March 15, 2004, with the
exception of Special Purpose Entities (SPEs). The consolidated requirements apply to all SPEs in
the first fiscal year or interim period ending after December 15, 2003. Because the Company has
determined that it does not have any SPEs to which these interpretations apply, the Company adopted
FIN46R in the first quarter of 2004, and such adoption did not have a material impact on its
financial statements. In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity(SFAS 150). SFAS 150 establishes standards for
how an issuer classifies and 28




---



##### Table of Contents



measures certain financial instruments with characteristics of both debt and equity and requires an
issuer to classify the following instruments as liabilities in its balance sheet:  
    a financial instrument issued in the form of shares that is mandatorily redeemable and
embodies an unconditional obligation that requires the issuer to redeem it by transferring
its assets at a specified or determinable date or upon an event that is certain to occur;
    a financial instrument, other than an outstanding share, that embodies an obligation to
repurchase the issuers equity shares, or is indexed to such an obligation, and required
the issuer to settle the obligation by transferring assets; and
    a financial instrument that embodies an unconditional obligation that the issuer must
settle by issuing a variable number of its equity shares if the monetary value of the
obligation is based solely or predominantly on (a) a fixed monetary amount, (b) variations
in something other than the fair value of the issuers equity shares, or (c) variations
inversely related to changes in the fair value of the issuers equity shares. In November 2003, the FASB issued FASB Staff Position No. 150-3, which deferred the effective dates
for applying certain provisions of SFAS 150 related to mandatorily redeemable financial instruments
of certain nonpublic entities and certain mandatorily redeemable noncontrolling interests for
public and nonpublic entities. For public entities, SFAS 150 it is effective for mandatorily
redeemable financial instruments entered into or modified after May 31, 2003 and is effective for
all other financial instruments as of the first interim period beginning after June 15, 2003. For
mandatorily redeemable noncontrolling interests that would not have to be classified as liabilities
by a subsidiary under the exception in paragraph 9 of SFAS 150, but would be classified as
liabilities by the parent, the classification and measurement provisions of SFAS 150 are deferred
indefinitely. For other mandatorily redeemable noncontrolling interests that were issued before
November 5, 2003, the measurement provisions of SFAS 150 are deferred indefinitely. For those
instruments, the measurement guidance for redeemable shares and noncontrolling interests in other
literature shall apply during the deferral period. The adoption of the provisions of SFAS 150 did
not have a material impact on the Companys consolidated financial statements. In November 2004, the FASB issued SFAS No. 151, Inventory Costs(SFAS 151), which amends ARB No.
43, Chapter 4, Inventory Pricing. SFAS 151 requires the allocation of fixed production overhead
costs be based on the normal capacity of the production facilities an unallocated overhead costs
recognized as an expense in the period incurred. In addition, other items such as abnormal
freight, handling costs and wasted materials require treatment as current period charges rather
than a portion of the inventory cost. SFAS 151 is effective for inventory costs incurred during
periods beginning after June 15, 2005. The Company is currently assessing the impact of the
adoption of SFAS 151 and its impact on its consolidated financial statements. In December 2004, the FASB enacted SFAS No.123-revised 2004, Share-Based Payment(SFAS 123R) which
replaces SFAS No. 123, Accounting for Stock-Based Compensationand supersedes APB Opinion No. 25,
Accounting for Stock Issued to Employees. SFAS 123R requires the measurement of all employee
share-based payments to employees, including grants of employee stock options, using a
fair-value-based method and the recording of such expense in the Companys consolidated statements
of income. The accounting provisions of SFAS 123R are effective for reporting periods beginning
after June 15, 2005. Accordingly, the Company will adopt the provisions of SFAS 123R effective
July 1, 2005, the third quarter of its 2005 fiscal year. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to
financial statement recognition. See Note 1 in the Notes to Consolidated Financial Statements for
the pro forma net loss and net loss per share amounts, for fiscal 2002 through fiscal 2004, as
if the Company had used a fair-value-based method similar to the methods required under SFAS 123R
to measure compensation expense for employee stock incentive awards. Although the Company has not
yet determined whether the adoption of SFAS 123R will result in amounts that are similar to the
current pro forma disclosures under SFAS 123, the Company is evaluating the requirements under SFAS
123R and expects the adoption to have a significant adverse impact on the Companys consolidated
statements of operations and net income per share. 29




---



##### Table of Contents



Item 7A. Quantitative and Qualitative Disclosures about Market Risk The Companys financial
instruments include cash and cash equivalents and short-term
investments. At
December 31, 2004, the carrying values of the Companys financial instruments approximated fair
values based upon current market prices and rates. We are susceptible to market
value fluctuations with regard to our short-term investments.
However, due to the relatively short maturity period of those
investments and based on their highly liquid nature, the risk of
material market value fluctuations is not expected to be significant. The Company has a subsidiary in Mexico. As a result, the Company is exposed to potential
transaction gains and losses resulting from fluctuations in foreign currency exchange rates. The
Company has not and currently does not hedge or enter into derivative contracts in an effort to
address the foreign exchange risk. 
 Item 8. Financial Statements and Supplementary Data Financial Statements The Report of Independent
Registered Public Accounting Firm and the Consolidated Financial Statements listed in the Index to
Consolidated Financial Statements in Item 15 are filed as part
of this report. Financial Statement Schedule SCHEDULE II  VALUATION AND QUALIFYING ACCOUNTS Balance at
    
    
    Charged to Costs
    
    
    
    
    
    
    Balance at End ofClassification
    
    Beginning of Period
    
    
    and Expenses
    
    
    Deductions (1)
    
    
    PeriodYEAR ENDED DECEMBER 31, 2002:Allowance for doubtful accounts
    
    $
    2,517,000
    
    
    $
    134,000
    
    
    $
    (676,000
    )
    
    $
    1,975,000Reserve for obsolete inventories
    
    
    1,716,000
    
    
    
    193,000
    
    
    
    (188,000
    )
    
    
    1,721,000YEAR ENDED DECEMBER 31, 2003:Allowance for doubtful accounts
    
    
    1,975,000
    
    
    
    701,000
    
    
    
    (978,000
    )
    
    
    1,698,000Reserve for obsolete inventories
    
    
    1,721,000
    
    
    
    799,000
    
    
    
    (364,000
    )
    
    
    2,156,000YEAR ENDED DECEMBER 31, 2004:Allowance for doubtful accounts
    
    
    1,698,000
    
    
    
    2,022,000
    
    
    
    (820,000
    )
    
    
    2,900,000Reserve for obsolete inventories
    
    
    2,156,000
    
    
    
    264,000
    
    
    
    (1,497,000
    )
    
    
    923,000
 The above schedule has been restated to exclude discontinued operations.   (1)
    
    Deductions in all years reported represent reductions to the reserve accounts and the related
asset accounts. Specifically, deductions from the reserve for allowance for doubtful accounts
represent the write-off of uncollectible accounts receivable balances. Deductions from the
reserve for obsolete inventories represent the write-off and disposal of specific inventory
items. Selected Quarterly Financial Data The Selected Quarterly Financial Data is set forth above under the heading Selected Quarterly
Financial Data on page 19 and is incorporated herein by reference. 30




---



##### Table of Contents



Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. 
 Item 9A. Controls and Procedures (a) Disclosure Controls and Procedures The Companys management, with the participation of its Chief Executive Officer and Chief Financial
Officer, has evaluated the effectiveness of the Companys disclosure controls and procedures as of
December 31, 2004. Based on that evaluation, because of the material weakness described below, the
Chief Executive Officer and Chief Financial Officer of the Company concluded that the Companys
disclosure controls and procedures were not effective as of December 31, 2004. (b) Management Report on Internal Control Over Financial Reporting The management of the Company is responsible for establishing and maintaining adequate internal
control over financial reporting. Internal control over financial reporting is defined in Rule
13a-15(f) or 15d-15(f) promulgated under the Securities Exchange Act of 1934, as amended, as a
process designed by, or under the supervision of, the Companys principal executive and principal
financial officers and effected by the Companys board of directors, management and other
personnel, to provide reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with generally accepted
accounting principles in the United States and includes those policies and procedures that:  
    Pertain to the maintenance of records that in reasonable detail accurately and
fairly reflect the transactions and dispositions of the assets of the Company;
    Provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the Company are being
made only in accordance with authorizations of management and directors of the
Company; and
    Provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use or disposition of the Companys assets that could
have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or
detect misstatements. Projections of any evaluation of effectiveness to future periods are subject
to the risk that controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate. An internal control material weakness is a significant deficiency, or aggregation of deficiencies,
that does not reduce to a relatively low level the risk that material misstatements in financial
statements will be prevented or detected on a timely basis by employees in the normal course of
their work. An internal control significant deficiency, or aggregation of deficiencies, is one
that could result in a misstatement of the financial statements that is more than inconsequential. The Companys management assessed the effectiveness of the Companys internal control over
financial reporting as of December 31, 2004. In making this assessment, the Companys management
used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO) in Internal Control-Integrated Framework. Based upon this assessment, management concluded that, as of December 31, 2004, the Company did not
maintain effective internal control over financial reporting due to a material weakness associated
with the characterization of certain investments as cash and cash equivalents rather than
short-term investments, as further described below. As part of the annual audit process, a material weakness was
 identified in our controls related to the application of generally accepted accounting principles, specifically related to
 the classification of
the Companys short-term investments, resulting in the Company reclassifying approximately $34
million of cash and cash equivalents to short-term investments. The Company first purchased a portion of these
 investments at the end of the third quarter of 2004. Debt securities that mature in 90
days or less from the date of the Companys purchase are classified as cash equivalents. Debt
securities that mature after 90 days from the date of the Companys purchase should not be
 classified as
cash equivalents under accounting principles generally accepted in the United States of America (GAAP). As a result of this
misapplication of GAAP, the Company made an adjustment to its Consolidated Balance Sheet as of
 December 31, 2004 to classify such investments as short term investments rather than cash equivalents, modified
the Consolidated Statement of Cash Flows for the year then ended to
classify purchases of such investments as investing activities rather
than cash equivalents and provided the additional
required disclosures. The
reclassification did not have any impact on the Companys
Consolidated Statements of Operations and
Comprehensive Operations for the year ended December 31, 2004, and did not change or affect the
Companys total current assets, total assets or net working capital. In addition, the Company has
the ability to sell its short-term investments at any time to provide additional liquidity. See
Investments under Note 1 and Note 3 in Notes to Consolidated Financial Statements for additional
details regarding the Companys short-term investments. Finally, the investment of the Companys
cash was, at all times, consistent with the Investment Policy of I-Flow Corporation adopted by the
Board of Directors of the Company. Nonetheless, the Company concluded that the need for the
reclassification resulted from this deficiency in the Companys internal control over
financial reporting. The Companys independent registered public accounting firm has
 issued their report on managements assessment of the
Companys internal control over financial reporting which
appears on the following page. March 16, 2005 31




---



##### Table of Contents



(c) Change in Internal Controls Other than the material weakness described above, there were no
other changes in the Companys internal controls over financial reporting during the quarter ended
December 31, 2004 that materially affected, or were reasonably likely to materially affect, the
Companys internal control over financial reporting. The Company has taken appropriate remedial steps to enhance
its internal control over financial reporting to ensure that investments are classified correctly based upon
their maturities as required by SFAS 115. (d) Report of Independent Registered
 Public Accounting Firm To the Board of Directors and Stockholders of
I-Flow Corporation:
Lake Forest, California We have audited managements assessment, included in the accompanying Management Report on Internal
Control Over Financial Reporting, appearing in item 9A,that I-Flow Corporation and subsidiaries
(the Company) did not maintain effective internal control over financial reporting as of December
31, 2004, because of the effect of the material weakness identified in managements assessment
based on criteria established in Internal ControlIntegrated Frameworkissued by the Committee of
Sponsoring Organizations of the Treadway Commission. The Companys management is responsible for
maintaining effective internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility is to express an
opinion on managements assessment and an opinion on the effectiveness of the Companys internal
control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether effective internal control over financial reporting was
maintained in all material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating managements assessment, testing and evaluating the
design and operating effectiveness of internal control, and performing such other procedures as we
considered necessary in the circumstances. We believe that our audit provides a reasonable basis
for our opinions. A companys internal control over financial reporting is a process designed by, or under the
supervision of, the companys principal executive and principal financial officers, or persons
performing similar functions, and effected by the companys board of directors, management, and
other personnel to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance with generally
accepted accounting principles. A companys internal control over financial reporting includes
those policies and procedures that (1) pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and dispositions of the assets of the
company; (2) provide reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted accounting principles,
and that receipts and expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and (3) provide reasonable assurance
regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the
companys assets that could have a material effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including the
possibility of collusion or improper management override of controls, material misstatements due to
error or fraud may not be prevented or detected on a timely basis. Also, projections of any
evaluation of the effectiveness of the internal control over financial reporting to future periods
are subject to the risk that the controls may become inadequate because of changes in conditions,
or that the degree of compliance with the policies or procedures may deteriorate. A material weakness is a significant deficiency, or combination of significant deficiencies, that
results in more than a remote likelihood that a material misstatement of the annual or interim
financial statements will not be prevented or detected. The following material weakness has been
identified and included in managements assessment: As of December 31, 2004, the Company did not
maintain effective operation of internal control over the application of accounting principles
generally accepted in the United States of America, which resulted in a material adjustment to the
Companys consolidated Balance Sheet and related disclosures as of December 31, 2004, as well as
the Statement of Cash Flows for the year then ended. The adjustment recorded was to properly
classify $34 million of investment securities which had been improperly classified as cash and cash
equivalents at December 31, 2004, as well as to provide the additional required disclosures. As a
result, cash used in investing activities was increased and cash and cash equivalents was decreased
on the Statement of Cash Flows. This material weakness was considered in determining the nature,
timing, and extent of audit tests applied in our audit of the December 31, 2004 consolidated
financial statements, and this report does not affect our opinion on those consolidated financial
statements. In our opinion, managements assessment that the Company did not maintain effective internal
control over financial reporting as of December 31, 2004, is fairly stated, in all material
respects, based on the criteria established in Internal ControlIntegrated Frameworkissued by the
Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, because of
the effect of the material weakness described above on the achievement of the objectives of the
control criteria, the Company has not maintained effective internal control over financial
reporting as of December 31, 2004, based on the criteria established in Internal ControlIntegrated
Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), the consolidated financial statements and financial statement schedule as of
and for the year ended December 31, 2004, of the Company and our report dated March 16, 2005
expressed an unqualified opinion on those financial statements and financial statement schedule. DELOITTE & TOUCHE LLP
Costa Mesa, California
March 16, 2005 
 Item 9B. Other Information On February 24, 2005, the Compensation Committee of the board of directors approved the 2005
Corporate Officer Incentive Plan (the COIP). The Chief Executive Officer, Chief Operating
Officer and Chief Financial Officer of the Company participate in the COIP. The COIP identifies
predetermined performance goals and target awards on an annual basis. Subject to achievement of
the goals and objectives, the participants in the COIP earn cash
bonuses and equity awards.
Equity awards, if any, are made pursuant to the I-Flow Corporation 2001 Equity Incentive Plan. The
officers and the Companys performance is reviewed in light of the predetermined goals set forth
in the COIP in order to determine the percentage used to calculate the bonus pool for cash bonuses
and equity grants at the end of the year. In determining the allocation of awards from the
bonus pool to individual executive officers, the Compensation Committee focuses on the
contributions made by each executive officer to the Companys performance. A summary of the terms
of the COIP for 2005 is filed with this report as exhibit 10.9. 32




---



##### Table of Contents



PART III 
 Item 10. Directors and Executive Officers of the Registrant Except for information concerning our executive officers, which is included in this report under
the heading Executive Officers of the Registrant, the information required by Item 10 is
incorporated by reference to the Companys proxy statement for its 2005 annual meeting of
stockholders, which will be filed with the Securities and Exchange Commission no later than 120
days after the close of the fiscal year ended December 31, 2004. 
 Item 11. Executive Compensation The information required by Item 11 is incorporated by reference to the Companys proxy statement
for its 2005 annual meeting of stockholders, which will be filed with the Securities and Exchange
Commission no later than 120 days after the close of the fiscal year ended December 31, 2004. 
 Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by Item 12 is incorporated by reference to the Companys proxy statement
for its 2005 annual meeting of stockholders, which will be filed with the Securities and Exchange
Commission no later than 120 days after the close of the fiscal year ended December 31, 2004. 
 Item 13. Certain Relationships and Related Transactions The information required by Item 13 is incorporated by reference to the Companys proxy statement
for its 2005 annual meeting of stockholders, which will be filed with the Securities and Exchange
Commission no later than 120 days after the close of the fiscal year ended December 31, 2004. 
 Item 14. Principal Accounting Fees and Services The information required by Item 14 is incorporated by reference to the Companys proxy statement
for its 2005 annual meeting of stockholders, which will be filed with the Securities and Exchange
Commission no later than 120 days after the close of the fiscal year ended December 31, 2004. 33




---



##### Table of Contents



PART IV 
 Item 15. Exhibits, Financial Statement Schedules. (a)
    
    Documents filed as part of this report:
    
    Page in This(1) Financial Statements
    
    ReportThe documents described in the Index to Consolidated Financial Statements
are included in this report.
    
    
    F-1(2) Financial Statement Schedule included herein:Schedule II  Valuation and Qualifying Accounts
    
    
    30All other schedules are omitted, as the required information is inapplicable.(3) ExhibitsThe list of exhibits contained in the accompanying Index to Exhibits is
herein incorporated by reference.(b)
    
    See (a)(3) above.(c)
    
    There are no financial statements required by Regulation S-X (17 CFR 210) which are or
will be excluded from the annual report to shareholders by Rule 14a-3(b).
 34




---



##### Table of Contents



INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Consolidated Financial Statements PageReport of Independent Registered Public Accounting Firm:Audit of Consolidated Financial Statements
    
    
    F-1Consolidated Balance Sheets as of December 31, 2004 and 2003
    
    
    F-2Consolidated
Statements of Operations and Comprehensive Operations For the Years Ended December 31, 2004, 2003 and 2002
    
    
    F-3Consolidated
Statements of Stockholders Equity for the Years Ended December 31, 2004, 2003 and 2002
    
    
    F-4Consolidated
Statements of Cash Flows for the Years Ended December 31, 2004, 2003 and 2002
    
    
    F-5Notes to Consolidated Financial Statements
    
    
    F-6Financial Statement ScheduleSchedule II  Valuation and Qualifying Accounts
    
    
    30
 35




---



##### Table of Contents



Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders of
I-Flow Corporation
Lake Forest, California: We have audited the accompanying consolidated balance sheets of I-Flow Corporation and subsidiaries
(the Company) as of December 31, 2004 and 2003, and the related consolidated statements of
operations and comprehensive operations, stockholders equity and cash flows for each of the three
years in the period ended December 31, 2004. Our audits also included the financial statement
schedule for each of the three years in the period ended December 31, 2004, listed in the Index at
Item 15(a)(2). These consolidated financial statements and the financial statement schedule are
the responsibility of the Companys management. Our responsibility is to express an opinion on
these consolidated financial statements and the financial statement schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight
Board (United States). 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 consolidated financial statements present fairly, in all material respects,
the financial position of I-Flow Corporation and subsidiaries as of December 31, 2004 and 2003, and
the results of their operations and their cash flows for each of the three years in the period
ended December 31, 2004, in conformity with accounting principles generally accepted in the United
States of America. Also in our opinion, such financial statement schedule, when considered in
relation to the basic consolidated financial statements taken as a whole, presents fairly, in all
material respects, the information set forth therein. As discussed in Note 2 to the
consolidated financial statements, the Company changed its method of
accounting for goodwill and other intangible assets during 2002 as a
result of adopting Statement of Financial Accounting Standards
No. 142, Goodwill and Other Intangible Assets. As discussed in Note 4 to the consolidated financial statements, on November 1, 2003, the Company
completed the sale of its wholly-owned subsidiary, Spinal Specialties, Inc. The consolidated
statements of operations and comprehensive operations and of cash flows referred to above have been
restated to reflect Spinal Specialties, Inc. as a discontinued operation for all periods presented. We have also audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), the effectiveness of the Companys internal control over financial reporting
as of December 31, 2004, based on the criteria established in
Internal ControlIntegrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway
Commission and our report, dated
March 16, 2005, expressed an unqualified opinion on managements assessment of the effectiveness of
the Companys internal control over financial reporting and an
adverse opinion on the
effectiveness of the Companys internal control over financial
reporting because of a material weakness. /s/ Deloitte & Touche LLP DELOITTE & TOUCHE LLP
Costa Mesa, California
March 16, 2005 F-1




---



##### Table of Contents



CONSOLIDATED BALANCE SHEETS December 31,
    
    
    December 31,(Amounts in thousands, except share and per share amounts)
    
    2004
    
    
    2003AssetsCurrent assets:Cash and cash equivalents
    
    $
    10,021
    
    
    $
    15,185Short-term
investments
    
    
    34,087
    
    
    
    Accounts receivable, less allowance for doubtful accounts of $2,900
and $1,698 at December 31, 2004 and 2003, respectively
    
    
    15,765
    
    
    
    12,392Inventories, net
    
    
    8,365
    
    
    
    6,815Prepaid expenses and other current assets
    
    
    921
    
    
    
    652Deferred taxes
    
    
    
    
    
    
    3,546Total current assets
    
    
    69,159
    
    
    
    38,590Property, net
    
    
    11,097
    
    
    
    6,744Goodwill
    
    
    2,639
    
    
    
    2,639Other intangible assets, net
    
    
    1,407
    
    
    
    1,214Other long-term assets
    
    
    128
    
    
    
    147Deferred taxes
    
    
    
    
    
    
    2,562Total assets
    
    $
    84,430
    
    
    $
    51,896Liabilities and Stockholders EquityCurrent liabilities:Accounts payable
    
    $
    4,392
    
    
    $
    3,570Accrued payroll and related expenses
    
    
    5,995
    
    
    
    2,961Income taxes payable
    
    
    115
    
    
    
    236Other current liabilities
    
    
    709
    
    
    
    356Total current liabilities
    
    
    11,211
    
    
    
    7,123Commitments and contingencies (Note 7)Stockholders equityPreferred stock, $0.001 par value; 5,000,000 shares authorized; no
shares issued and outstanding
    
    
    
    
    
    
    Common stock, $0.001 par value; 40,000,000 shares authorized, 22,219,849
and
18,305,787 shares issued and outstanding at December 31, 2004 and 2003,
respectively
    
    
    105,703
    
    
    
    60,049Accumulated other comprehensive loss
    
    
    (290
    )
    
    
    (192
    )Accumulated deficit
    
    
    (32,194
    )
    
    
    (15,084
    )Net stockholders equity
    
    
    73,219
    
    
    
    44,773Total liabilities and shareholders equity
    
    $
    84,430
    
    
    $
    51,896
 See accompanying Notes to Consolidated Financial Statements. F-2




---



##### Table of Contents



CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE OPERATIONS Years ended December 31,(Amounts in thousands, except per share amounts)
    
    2004
    
    
    2003
    
    
    2002Revenues:Net product sales
    
    $
    51,796
    
    
    $
    34,021
    
    
    $
    24,370Rental income and other
    
    
    19,349
    
    
    
    13,022
    
    
    
    10,293Total revenues
    
    
    71,145
    
    
    
    47,043
    
    
    
    34,663Cost of revenues:Product cost of revenues
    
    
    15,703
    
    
    
    13,192
    
    
    
    8,979Rental cost of revenues
    
    
    5,626
    
    
    
    4,018
    
    
    
    3,007Total cost of revenues
    
    
    21,329
    
    
    
    17,210
    
    
    
    11,986Gross profit
    
    
    49,816
    
    
    
    29,833
    
    
    
    22,677Operating expensesSelling and marketing
    
    
    44,394
    
    
    
    20,412
    
    
    
    11,760General and administrative
    
    
    16,391
    
    
    
    10,341
    
    
    
    8,099Product development
    
    
    2,779
    
    
    
    2,361
    
    
    
    2,104Total operating expenses
    
    
    63,564
    
    
    

    33,114
    
    
    
    21,963Operating income (loss)
    
    
    (13,748
    )
    
    
    (3,281
    )
    
    
    714Interest expense (income), net
    
    
    (525
    )
    
    
    46
    
    
    
    (6
    )Income (loss) from continuing operations before income taxes and
cumulative effect of a change in accounting principle
    
    
    (13,223
    )
    
    
    (3,327
    )
    
    
    720Income tax provision (benefit)
    
    
    3,887
    
    
    
    (1,173
    )
    
    
    305Income (loss) from continuing operations before cumulative effect
of a change in accounting principle
    
    
    (17,110
    )
    
    
    (2,154
    )
    
    
    415Discontinued operations:Income from discontinued operations, net of tax
    
    
    
    
    
    
    328
    
    
    
    24Gain on sale of discontinued operations, net of tax
    
    
    
    
    
    
    2,283
    
    
    
    Income (loss) before cumulative effect of a change in accounting
principle
    
    
    (17,110
    )
    
    
    457
    
    
    
    439Cumulative effect of a change in accounting principle for goodwill
    
    
    
    
    
    
    
    
    
    
    (3,474
    )Net income (loss)
    
    $
    (17,110
    )
    
    $
    457
    
    
    $
    (3,035
    )Per share of common stock, basic:Income (loss) from continuing operations before cumulative effect
of a change in accounting principle
    
    $
    (0.83
    )
    
    $
    (0.13
    )
    
    $
    0.03Income from discontinued operations, net of tax
    
    

    
    
    
    
    0.02
    
    
    
    Gain on sale of discontinued operations, net of tax
    
    
    
    
    
    
    0.14
    
    
    
    Income (loss) before cumulative effect of a change in accounting
principle
    
    
    (0.83
    )
    
    
    0.03
    
    
    
    0.03Cumulative effect of a change in accounting principle
    
    
    
    
    
    
    
    
    
    
    (0.23
    )Net income (loss)
    
    $
    (0.83
    )
    
    $
    0.03
    
    
    $
    (0.20
    )Per share of common stock, diluted:Income (loss) from continuing operations before cumulative effect
of a change in accounting principle
    
    $
    (0.83
    )
    
    $
    (0.13
    )
    
    $
    0.03Income from discontinued operations, net of tax
    
    
    
    
    
    
    0.02
    
    
    
    Gain on sale of discontinued operations, net of tax
    
    
    
    
    
    
    0.14
    
    
    
    Income (loss) before cumulative effect of a change in accounting
principle
    
    
    (0.83
    )
    
    
    0.03
    
    
    
    0.03Cumulative effect of a change in accounting principle
    
    
    
    
    
    
    
    
    
    
    (0.22
    )Net income (loss)
    
    $
    (0.83
    )
    
    $
    0.03
    
    
    $
    (0.19
    )Comprehensive Operations:Net income (loss)
    
    $
    (17,110
    )
    
    $
    457
    
    
    $
    (3,035
    )Foreign currency translation adjustments
    
    
    (29
    )
    
    
    (97
    )
    
    
    (96
    )Unrealized loss on securities
    
    
    (69
    )
    
    
    
    
    
    
    Comprehensive income (loss)
    
    $
    (17,208
    )
    
    $
    360
    
    
    $
    (3,131
    )
 See accompanying Notes to Consolidated Financial Statements.
 F-3




---



##### Table of Contents



CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY AccumulatedOtherComprehensiveCommon Stock
    
    
    Income
    
    
    Accumulated(Amounts in thousands)
    
    Shares
    
    
    Amount
    
    
    (Loss)
    
    
    Deficit
    
    
    NetBalance, December 31, 2001
    
    
    15,345
    
    
    $
    42,274
    
    
    $
    1
    
    
    $
    (12,506
    )
    
    $
    29,769Exercise of common stock options
    
    
    55
    
    
    
    63
    
    
    
    
    
    
    
    
    
    
    
    63Reversal of tax benefit from exercise of stock options
    
    
    
    
    
    
    17
    
    
    
    
    
    
    
    
    
    
    
    17Stock based compensation
    
    
    73
    
    
    
    752
    
    
    
    
    
    
    
    
    
    
    
    752Foreign currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    (96
    )
    
    
    
    
    
    
    (96
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,035
    )
    
    
    (3,035
    )Balance, December 31, 2002
    
    
    15,473
    
    
    $
    43,106
    
    
    $
    (95
    )
    
    $
    (15,541
    )
    
    $
    27,470Exercise of common stock options and warrants
    
    
    1,092
    
    
    
    2,070
    
    
    
    
    
    
    
    
    
    
    
    2,070Tax benefit from exercise of stock options
    
    
    
    
    
    
    2,000
    
    
    
    
    
    
    
    
    
    
    
    2,000Stock based compensation
    
    
    74
    
    
    
    1,268
    
    
    
    
    
    
    
    
    
    
    
    1,268Sale of common stock, net
    
    
    1,667
    
    
    
    11,563
    
    
    
    
    
    
    
    
    
    
    
    11,563Grants of common stock warrants
    
    
    
    
    
    
    42
    
    
    
    
    
    
    
    
    
    
    
    42Foreign currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    (97
    )
    
    
    
    
    
    
    (97
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    457
    
    
    
    457Balance, December 31, 2003
    
    
    18,306
    
    
    $
    60,049
    
    
    $
    (192
    )
    
    $
    (15,084
    )
    
    $
    44,773Exercise of common stock options and warrants
    
    
    924
    
    
    
    1,856
    
    
    
    
    
    
    
    
    
    
    
    1,856Reversal of tax benefit from exercise of stock options
    
    
    
    
    
    
    (2,000
    )
    
    
    
    
    
    
    
    
    
    
    (2,000
    )Stock based compensation
    
    
    
    
    
    
    2,711
    
    
    
    
    
    
    
    
    
    
    
    2,711Sale of common stock, net
    
    
    2,990
    
    
    
    43,087
    
    
    
    
    
    
    
    
    
    
    
    43,087Unrealized loss on securities
    
    
    
    
    
    
    
    
    
    
    (69
    )
    
    
    
    
    
    
    (69
    )Foreign currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    (29
    )
    
    
    
    
    
    
    (29
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (17,110
    )
    
    
    (17,110
    )Balance, December 31, 2004
    
    
    22,220
    
    
    $
    105,703
    
    
    $
    (290
    )
    
    $
    (32,194
    )
    
    $
    73,219
 See accompanying Notes to Consolidated Financial Statements. F-4




---



##### Table of Contents



CONSOLIDATED STATEMENTS OF CASH FLOWS Year ended December 31,(Amounts in thousands)
    
    2004
    
    
    2003
    
    
    2002Cash flows from operating activities:Net income (loss)
    
    $
    (17,110
    )
    
    $
    457
    
    
    $
    (3,035
    )Income from discontinued operations
    
    
    
    
    
    
    (328
    )
    
    
    (24
    )Gain on sale of subsidiary
    
    
    
    
    
    
    (2,283
    )
    
    $
    Adjustments to reconcile net income (loss) to net cash provided by (used in)
operating activities:Deferred taxes
    
    
    4,108
    
    
    
    (1,257
    )
    
    
    235Depreciation and amortization
    
    
    2,575
    
    
    
    2,513
    
    
    
    2,020Expense related to common stock warrants
    
    
    
    
    
    
    42
    
    
    
    Cumulative effect of a change in accounting principle
    
    
    
    
    
    
    
    
    
    
    3,474Loss on disposal of property
    
    
    
    
    
    
    213
    
    
    
    8Stock based compensation
    
    
    2,711
    
    
    
    941
    
    
    
    752Provision for inventory obsolescence
    
    
    264
    
    
    
    799
    
    
    
    193Provision for doubtful accounts receivable
    
    
    2,022
    
    
    
    701
    
    
    
    134Changes in operating assets and liabilities, net of effect of
discontinued operations:Accounts receivable
    
    
    (5,395
    )
    
    
    (3,171
    )
    
    
    (690
    )Inventories
    
    
    (1,814
    )
    
    
    (1,360
    )
    
    
    (87
    )Prepaid expenses and other
    
    
    (269
    )
    
    
    (243
    )
    
    
    (12
    )Accounts payable and accrued payroll and related expenses
    
    
    3,856
    
    
    
    1,636
    
    
    
    12Income taxes payable
    
    
    (121
    )
    
    
    30
    
    
    
    (51
    )Other liabilities
    
    
    353
    
    
    
    296
    
    
    
    31Net cash provided by (used in) operating activities from continuing operations
    
    
    (8,820
    )
    
    
    (1,014
    )
    
    
    2,960Net cash provided by (used in) operating activities of discontinued operations
    
    
    
    
    
    
    (56
    )
    
    
    137Net cash provided by (used in) operating activities
    
    
    (8,820
    )
    
    
    (1,070
    )
    
    
    3,097Cash flows from investing activities:Capital expenditures
    
    
    (6,603
    )
    
    
    (3,671
    )
    
    
    (2,634
    )Net Proceeds from sale of subsidiary
    
    
    
    
    
    
    5,044
    
    
    
    Change in other assets
    
    
    (499
    )
    
    
    12
    
    
    
    (478
    )Purchases of
Investments
    
    
    (35,515
    )
    
    
    
    
    
    
    Maturities
of Investments
    
    
    1,375
    
    
    
    
    
    
    
    Net cash provided by (used in) investing activities from continuing operations
    
    
    (41,242
    )
    
    
    1,385
    
    
    
    (3,112
    )Net cash used in investing activities from discontinued operations
    
    
    
    
    
    
    (382
    )
    
    
    (43
    )Net cash provided by (used in) investing activities
    
    
    (41,242
    )
    
    
    1,003
    
    
    
    (3,155
    )Cash flows from financing activities:Net proceeds from sale of common stock
    
    
    43,087
    
    
    
    11,563
    
    
    
    Principal payments on debt
    
    
    
    
    
    
    (77
    )
    
    
    (226
    )Proceeds from exercise of stock options and warrants
    
    
    1,856
    
    
    
    2,070
    
    
    
    63Net cash provided by (used in) financing activities
    
    
    44,943
    
    
    
    13,556
    
    
    
    (163
    )Effect of exchange rates on cash
    
    
    (45
    )
    
    
    (4
    )
    
    
    (112
    )Net increase (decrease) in cash and cash equivalents
    
    
    (5,164
    )
    
    
    13,485
    
    
    
    (333
    )Cash and cash equivalents at beginning of year
    
    
    15,185
    
    
    
    1,700
    
    
    
    2,033Cash and cash equivalents at end of year
    
    $
    10,021
    
    
    $
    15,185
    
    
    $
    1,700SUPPLEMENTAL CASH FLOW INFORMATION:Interest paid
    
    $
    1
    
    
    $
    65
    
    
    $
    11Income tax payments
    
    $
    126
    
    
    $
    29
    
    
    $
    139Tax benefit from exercise of stock options
    
    $
    (2,000
    )
    
    $
    2,000
    
    
    $
    17
 See accompanying Notes to Consolidated Financial Statements. F-5




---



##### Table of Contents



Notes to Consolidated Financial Statements 1. Nature of Operations and Summary of Significant Accounting Policies Nature of Operations  I-Flow Corporation (I-Flow or the Company) was incorporated in
California on July 17, 1985. On July 30, 2001, the Company reincorporated in the State of Delaware
by merging into a wholly owned subsidiary incorporated in Delaware. The Company designs, develops,
manufactures and markets technically advanced, low-cost ambulatory infusion systems that seek to
redefine the standard of care by providing life enhancing, cost effective solutions for pain
management and infusion therapy. The Companys products are used in hospitals and alternate site
settings. I-Flow manufactures a growing line of compact, portable infusion pumps, catheters and
pain kits that administer medication directly to the wound site as well as administer local
anesthetic, chemotherapy, antibiotics, nutritional supplements and other medications. InfuSystem,
Inc., a wholly owned subsidiary, is primarily engaged in the rental of infusion pumps on a
month-to-month basis for the treatment of cancer. Principles of Consolidation  The consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of America and
include the accounts of the Company and its wholly owned subsidiaries. All intercompany accounts
and transactions have been eliminated. Cash and Cash Equivalents  Cash and cash equivalents consist of cash in the bank,
investment-grade bonds with a maturity date of 90 days or less
at the date of purchase and money-market funds with immediate availability. The Company maintains
its cash and cash equivalents primarily with a single financial institution. Investments The Company considers
all highly liquid interest-earning investments with a maturity of
90 days or less at the date of purchase to be cash equivalents.
Investments with a maturity beyond one year may be classified as
short-term based on their highly liquid nature and because such
marketable securities represent the investment of cash that is
available for current operations. All short-term investments
are classified as available for sale in accordance with SFAS No. 115, Accounting for Certain
 Investments in Debt and Equity Securities, and are recorded at fair market
value using the specific identification method; unrealized gains and
losses (excluding other-than-temporary impairments) are reflected in
other comprehensive loss. Inventories  Inventories are stated at the lower of cost (determined on a first in, first
out basis) or market. Inventories consisted of the following as of December 31: 2004
    
    
    2003Raw Materials
    
    $
    5,145,000
    
    
    $
    5,368,000Work in Process
    
    
    1,369,000
    
    
    
    765,000Finished Goods
    
    
    2,774,000
    
    
    
    2,838,000Reserve for Obsolescence
    
    
    (923,000
    )
    
    
    (2,156,000
    )Total
    
    $
    8,365,000
    
    
    $
    6,815,000
 Long Lived Assets  The Company accounts for the impairment and disposition of long-lived
assets in accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting
for Impairment or Disposal of Long-Lived Assets(SFAS 144).SFAS 144 addresses financial
accounting and reporting for the impairment of long-lived assets and for the disposal of long-lived
assets. The Company adopted SFAS 144 on January 1, 2002. In accordance with SFAS 144,
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 an impairment to such value has occurred. During
the fourth quarter of 2003, the Company determined that the carrying value of certain tooling and
patents related to the Companys electronic IV infusion pump products within the manufacturing and
marketing operating segment was impaired due to a cessation of sales of the products to which the
assets related. The write-down of the tooling assets and patents resulted in charges of $188,000
to cost of sales and $90,000 to product development expenses in 2003.
See Note 4 below. Property  Property is stated at cost and depreciated using the straight-line method over
the estimated useful lives of the related assets, ranging from two to seven years. Leasehold
improvements are amortized using the straight-line method over the life of the asset or the
remaining term of the lease, whichever is shorter. Maintenance and minor repairs are charges to
operations as incurred. When assets are sold, or otherwise disposed of, the cost and related
accumulated depreciation are removed from the accounts and any gain or loss is recorded in the
current period. Property consisted of the following as of December 31: F-6




---



##### Table of Contents



2004
    
    
    2003Furniture, fixtures and equipment
    
    $
    9,314,000
    
    
    $
    8,243,000Rental and demonstration equipment
    
    
    13,055,000
    
    
    
    8,454,000Accumulated depreciation and amortization

    
    
    (11,272,000
    )
    
    
    (9,953,000
    )Total
    
    $
    11,097,000
    
    
    $
    6,744,000
 Goodwill  Prior to the adoption of SFAS No. 142, Goodwill and Other Intangible Assets
(SFAS 142), on January 1, 2002, the excess of cost over fair value of net assets acquired was
amortized on a straight-line basis over five to fifteen years. Prior to the adoption of SFAS 142,
the Company periodically evaluated the recoverability of goodwill based upon the future
undiscounted cash flows and had determined that there was no impairment of goodwill. Effective
January 1, 2002, goodwill is no longer amortized, but is tested for impairment at least annually.
A transitional impairment charge of $3,474,000 was recognized upon adoption of SFAS 142. See Note
2 to Notes to Consolidated Financial Statements. The Company reviews the recoverability of the
carrying value of goodwill on an annual basis or more frequently if an event occurs or
circumstances change to indicate that an impairment of goodwill has possibly occurred. The Company
compares fair value of its reporting units to their carrying value, as well as other factors, to
determine whether or not any potential impairment of goodwill exists. If a potential impairment
exists, an impairment loss is recognized to the extent the carrying value of goodwill exceeds the
difference between the fair value of the reporting unit and the fair value of its other assets and
liabilities. Revenue Recognition  Revenue from product sales is recognized at the time of shipment and
passage of title. Provision is made currently for estimated returns of defective products and
warranty obligations. Amounts incurred have been within managements expectations and historically
insignificant. Rental revenue from medical pumps is recorded as earned over the term of the related rental
agreements, normally on a month-to-month basis. Pump rentals are billed at the Companys
established rates, which often differ from contractually allowable rates provided by third party
payors such as Medicare, Medicaid and commercial insurance carriers. Provision is made currently
to reduce revenue to the estimated allowable amount per such contractual rates. Due to the nature of the industry and the reimbursement environment in which the Company operates,
certain estimates are required to record net revenues and accounts receivable at their net
realizable values. Inherent in these estimates is the risk that they will have to be revised or
updated as additional information becomes available. Specifically, the complexity of many
third-party billing arrangements and the uncertainty of reimbursement amounts for certain services
from certain payors may result in adjustments to amounts originally recorded. Because of
continuing changes in the healthcare industry and third-party reimbursement, it is possible that
managements estimates could change in the near term, which could have an impact on operations and
cash flows. Accounts
Receivable  The Company performs various analyses to
evaluate its accounts receivable balances. It records an allowance
for bad debts based upon the estimated collectibility of the accounts
such that the recorded amounts reflect estimated net realizable
value. The Company applies specified percentages to the accounts
receivable agings to estimate the amount that will ultimately be
uncollectible and therefore should be reserved. The percentages are
increased as the accounts age. Product Warranties  The Company maintains a reserve for estimated defective product
returns based upon historical activity. The Company does not provide an explicit product warranty
for its products and warranty claims have been insignificant in the past. Income Taxes  The Company accounts for income taxes in accordance with SFAS No. 109,
Accounting for Income Taxes, which requires that the Company recognize deferred tax liabilities and
assets based upon the differences between the financial statement carrying amounts and the tax
bases of assets and liabilities, using enacted tax rates in effect in the years the differences are
expected to reverse. Deferred income tax benefit (expense) results from the change in net deferred
tax assets or deferred tax liabilities. A valuation allowance is recorded when it is more likely
than not that some or all of any deferred tax assets will not be realized. Accounting for Stock Based Compensation  The Company accounts for employee stock options
using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No.
25, Accounting for Stock F-7




---



##### Table of Contents



Issued to Employeesand Financial Accounting Standards Board (FASB) Interpretation No. 28,
Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans, and has
adopted the disclosure-only alternative of SFAS No. 123, Accounting for Stock-Based Compensation
(SFAS 123). Stock options issued to consultants and vendors are accounted for at fair value. Because the Company has adopted the disclosure-only provisions of SFAS 123, no compensation cost
has been recognized for stock option grants to employees and non-employee directors with exercise
prices equal to the fair market value of the underlying shares at the grant date. Had compensation
cost for the Companys option plans been determined based upon the fair value of the options at the
grant date consistent with the provisions of SFAS 123, the Companys net income (loss) and net
income (loss) per share would have been the pro forma amounts indicated below: Years Ended December 31,(Amounts in thousands, except per share amounts)
    
    2004
    
    
    2003
    
    
    2002Net income (loss)  as reported
    
    $
    (17,110
    )
    
    $
    457
    
    
    $
    (3,035
    )Stock-based employee compensation included in
net income (loss), net of tax
    
    $
    1,073
    
    
    $
    471
    
    
    $
    397Total stock-based employee compensation
expense determined under fair value based
method for all awards, net of tax
    
    $
    (4,806
    )
    
    $
    (1,024
    )
    
    $
    (1,017
    )Net (loss)  pro forma
    
    $
    (20,843
    )
    
    $
    (96
    )
    
    $
    (3,655
    )Basic earnings (loss) per share  as reported
    
    $
    (0.83
    )
    
    $
    0.03
    
    
    $
    (0.20
    )Basic earnings (loss) per share  pro forma
    
    $
    (1.01
    )
    
    $
    (0.01
    )
    
    $
    (0.24
    )Diluted earnings (loss) per share  as reported
    
    $
    (0.83
    )
    
    $
    0.03
    
    
    $
    (0.19
    )Diluted earnings (loss) per share  pro forma
    
    $
    (1.01
    )
    
    $
    (0.01
    )
    
    $
    (0.23
    )
 The amounts in the above table related to stock-based employee compensation included in net income
(loss), net of tax relate to employee stock options only and exclude compensation expense related
to consultant stock options and restricted stock. The fair value of each option grant is estimated on the date of grant using the Black-Scholes
option-pricing model with the following weighted-average assumptions used for grants in 2004, 2003
and 2002: no dividend yield; expected volatility 89% in 2004, 93% in 2003 and 94% in 2002;
risk-free interest rate of 3.70% in 2004, 3.08% in 2003 and 3.04% in 2002; and expected lives of 5
years. Earnings Per Share  Pursuant to SFAS No. 128, Earnings Per Share, the Company provides
dual presentation of Basic and Diluted earnings per share. Basic net income (loss) per share is computed using the weighted average number of common shares
outstanding during the periods presented, excluding unvested restricted stock which the Company has
a right to repurchase in the event of early termination of employment. Diluted net income (loss) per share is computed using the weighted average number of common and
common equivalent shares outstanding during the periods utilizing the treasury stock method for
stock options and unvested restricted stock. Potentially dilutive securities are not considered in
the calculation of net loss per share as their impact would be anti-dilutive. F-8




---



##### Table of Contents



The following is a reconciliation between weighted average shares used in the basic and
diluted earnings per share calculations: Years ended December 31,2004
    
    
    2003
    
    
    2002Basic net income per shareWeighted-average number of common
shares outstanding
    
    
    20,628,000
    
    
    
    16,384,000
    
    
    
    15,368,000Effect of dilutive securities:Stock options and unvested restricted stock
    
    
    
    
    
    
    
    
    
    
    511,000Diluted net income per shareWeighted-average number of common
shares outstanding
    
    
    20,628,000
    
    
    
    16,384,000
    
    
    
    15,879,000
  Options to purchase 70,000, 179,000, and 2,426,164 shares of common stock have been excluded from
the treasury stock method calculation for diluted weighted average common shares for the years
ended December 31, 2004, 2003 and 2002, respectively, because their exercise prices exceeded the
average market price of the Companys common stock during these periods.Comprehensive Income Pursuant to SFAS No. 130, Reporting Comprehensive Income, the
Company has included a calculation of comprehensive income (loss) in its accompanying consolidated
statements of operations and comprehensive operations for the years ended December 31, 2004, 2003
and 2002.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 materially from these estimates.Foreign Currency The financial position and results of operations of the Companys
foreign subsidiary are generally measured using the local currency as the functional currency.
Assets and liabilities of the subsidiary are translated at the exchange rate in effect at each
year-end. Income statement accounts are translated at the average rate of exchange prevailing
during the year. Translation adjustments arising from differences in exchange rates from period to
period are included as a separate component within shareholders equity. Realized gains or losses
from foreign currency transactions are included in operations as incurred and historically have not
been significant. F-9




---



##### Table of Contents



New Accounting Pronouncements In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest Entities(FIN 46).
In general, a variable interest entity is a corporation, partnership, trust or any other legal
structure used for business purposes that either (a) does not have equity investors with voting
rights or (b) has equity investors that do not provide sufficient financial resources for the
entity to support its activities. FIN 46 requires a variable interest entity to be consolidated by
a company if that company is subject to a majority of the risk of loss from the variable interest
entitys activities or entitled to receive a majority of the entitys residual returns or both.
The consolidation requirements of FIN 46 apply immediately to variable interest entities created
after January 31, 2003. With respect to variable interest entities created before January 31,
2003, in December 2003 the FASB issued FIN 46R which, among other things, revised the
implementation date to first fiscal years or interim periods ending after March 15, 2004, with the
exception of Special Purpose Entities (SPEs). The consolidated requirements apply to all SPEs in
the first fiscal year or interim period ending after December 15, 2003. As the Company has
determined that it does not have any SPEs to which these interpretations apply, the Company adopted
FIN46R in the first quarter of 2004 and such adoption did not have a material impact on its
financial statements.In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity(SFAS 150). SFAS 150 establishes standards for
how an issuer classifies and measures certain financial instruments with characteristics of both
debt and equity and requires an issuer to classify the following instruments as liabilities in its
balance sheet:  
    a financial instrument issued in the form of shares that is mandatorily redeemable and
embodies an unconditional obligation that requires the issuer to redeem it by transferring
its assets at a specified or determinable date or upon an event that is certain to occur;
    a financial instrument, other than an outstanding share, that embodies an obligation to
repurchase the issuers equity shares, or is indexed to such an obligation, and required
the issuer to settle the obligation by transferring assets; and
    a financial instrument that embodies an unconditional obligation that the issuer must
settle by issuing a variable number of its equity shares if the monetary value of the
obligation is based solely or predominantly on (1) a fixed monetary amount, (2) variations
in something other than the fair value of the issuers equity shares, or (3) variations
inversely related to changes in the fair value of the issuers equity shares.  In November 2003, the FASB issued FASB Staff Position (FSP) No. 150-3 which deferred the effective
dates for applying certain provisions of FSAS No. 150 related to mandatorily redeemable financial
instruments of certain nonpublic entities and certain mandatorily redeemable noncontrolling
interests for public and nonpublic entities.For public entities, SFAS No. 150 is effective for mandatorily redeemable financial instruments
entered into or modified after May 31, 2003 and is effective for all other financial instruments as
of the first interim period beginning after June 15, 2003.For mandatorily redeemable noncontrolling interests that would not have to be classified as
liabilities by a subsidiary under the exception in paragraph 9 of SFAS No. 150, but would be
classified as liabilities by the parent, F-10




---



##### Table of Contents



the classification and measurement provisions of SFAS No.
150 are deferred indefinitely. For other mandatorily redeemable noncontrolling interests that were
issued before November 5, 2003, the measurement provisions of SFAS No. 150 are deferred
indefinitely. For those instruments, the measurement guidance for redeemable shares and
noncontrolling interests in other literature shall apply during the deferral period. The adoption
of the provisions of SFAS No. 150 did not have a material impact on the Companys consolidated
financial statements.In November 2004, the FASB issued SFAS No. 151,
Inventory Costs(SFAS 151), which amends ARB No.
43, Chapter 4, Inventory Pricing.SFAS 151 requires the allocation of fixed production overhead
costs be based on the normal capacity of the production facilities an unallocated overhead costs
recognized as an expense in the period incurred. In addition, other items such as abnormal
freight, handling costs and wasted materials require treatment as current period charges rather
than a portion of the inventory cost. SFAS 151 is effective for inventory costs incurred during
periods beginning after June 15, 2005. The Company is currently assessing the impact of the
adoption of SFAS 151 and its impact on its consolidated financial statements.In December 2004, the FASB enacted SFAS No. 123-revised 2004, Share-Based Payment(SFAS 123R)
which replaces SFAS No. 123, Accounting for Stock-Based Compensationand supersedes APB Opinion No.
25, Accounting for Stock Issued to Employees. SFAS 123R requires the measurement of all employee
share-based payments to employees, including grants of employee stock options, using a
fair-value-based method and the recording of such expense in the Companys consolidated statements
of operations. The accounting provisions of SFAS 123R are effective for reporting periods beginning
after June 15, 2005. Accordingly, the Company will adopt the provisions of SFAS 123R effective
July 1, 2005, the third quarter of its 2005 fiscal year.The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to
financial statement recognition. See Note 1 in the Notes to Consolidated Financial Statements for
the pro forma net loss and net loss per share amounts, for fiscal 2002 through fiscal 2004, as
if the Company had used a fair-value-based method similar to the methods required under SFAS 123R
to measure compensation expense for employee stock incentive awards. Although the Company has not
yet determined whether the adoption of SFAS 123R will result in amounts that are similar to the
current pro forma disclosures under SFAS 123, the Company is evaluating the requirements under SFAS
123R and expect the adoption to have a significant adverse impact on the Companys consolidated
statements of operations and net income per share.  Reclassifications Certain prior year amounts have been reclassified to conform to the
current year presentation. 2. Goodwill and Other Intangible Assets  SFAS 142 addresses the financial accounting and reporting requirements for acquired goodwill and
other intangible assets. The Company adopted the provisions of SFAS 142 in January 2002. Under
SFAS 142, the Company is no longer required to amortize goodwill and other intangible assets with
indefinite lives. Instead, SFAS 142 requires that goodwill and intangible assets deemed to have an
indefinite useful life be reviewed for impairment upon adoption of SFAS 142 and at least annually
thereafter. Under SFAS 142, goodwill impairment is deemed to exist if the net book value of a
reporting unit exceeds its estimated fair value. The Companys reporting units are consistent with
the operating segments underlying the reporting segments identified
in Note 10  Operating Segments
and Revenue Data.In accordance with SFAS 142, the Company completed a test for impairment in June 2002 and concluded
that consolidated goodwill in the amount of $3,474,000 was impaired. The Company recorded a
non-cash charge of $3,474,000 to reduce the carrying value of its goodwill. Such charge is not
included in operating income and is reflected as a cumulative effect of a change in accounting
principle, effective January 1, 2002, in the accompanying Consolidated Statements of Operations and
Comprehensive Operations.The total impairment amount of $3,474,000 is attributable to the Companys manufacturing and
marketing operating segment, and represents the previously unamortized goodwill resulting from the
Companys purchase of substantially all of the assets of Block Medical, Inc. on July 22, 1996, and
the Companys acquisition of all of the outstanding stock of Spinal Specialties, Inc. on January
14, 2000. In calculating the impairment charge, the fair value of the impaired reporting unit was
estimated using a market multiple methodology. The impairment of the F-11




---



##### Table of Contents



goodwill associated with the
manufacturing and marketing operating segment resulted from the low profitability of the operating
segment.The changes in carrying amount of goodwill by operating segment for the years ended December 31,
2004 and 2003 are as follows: Manufacturing andMarketing
    
    
    Rentals
    
    
    TotalBalance as of January 1, 2002
    
    $
    3,474,000
    
    
    $
    2,639,000
    
    
    $
    6,113,000Impairment loss
    
    
    (3,474,000
    )
    
    
    
    
    
    
    (3,474,000
    )Balance as of December 31,
2002, 2003 and 2004
    
    
    
    
    
    $
    2,639,000
    
    
    $
    2,639,000
  As of December 31, 2004, the remaining goodwill of $2,639,000 is attributable to the Companys
rentals operating segment and the Company has determined that there was no impairment of this
goodwill as of December 31, 2004.Amortizable intangible assets in the accompanying consolidated balance sheets are as follows: As of December 31, 2004Carrying
    
    
    AccumulatedAmount
    
    
    Amortization
    
    
    NetPatents
    
    $
    2,310,000
    
    
    $
    903,000
    
    
    $
    1,407,000
 As of December 31,2003Carrying
    
    
    AccumulatedAmount
    
    
    Amortization
    
    
    NetPatents
    
    $
    1,960,000
    
    
    $
    746,000
    
    
    $
    1,214,000
  The Company amortizes patents and licensing rights over a period of seven and five years,
respectively. Amortization expense was $325,000 and $299,000 for the years ended December 31, 2004
and 2003, respectively. Annual amortization expense of intangible assets recorded as of December
31, 2004 is expected to be approximately $280,000 in each of the next five fiscal years. During
the fourth quarter of 2003, the Company determined that the carrying value of certain patents
related to the Companys electronic IV infusion pump products, within the manufacturing and
marketing operating segment, were impaired. The write-down of the patents resulted in a charge of
$90,000 to product development expense in 2003. 3. Investments The following tables
summarize the Companys investments. December 31, 2004
    
    AmortizedCost
    
    
    GrossUnrealizedLosses
    
    
    Fair ValueMoney market
funds
    
    $
    1,903,000
    
    
    $
    
    
    
    $
    1,903,000U.S. agency
discount notes
    
    
    13,073,000
    
    
    
    (8,000
    )
    
    
    13,065,000U.S. agency
- non callable
    
    
    4,560,000
    
    
    
    (13,000
    )
    
    
    4,547,000Corporate
debentures and bonds
    
    
    8,356,000
    
    
    
    (43,000
    )
    
    
    8,313,000Commercial
paper
    
    
    14,506,000
    
    
    
    (5,000
    )
    
    
    14,501,000Total
    
    $
    42,398,000
    
    
    $
    (69,000
    )
    
    $
    42,329,000Reported as:Cash
equivalents
    
    
    
    
    
    
    
    
    
    $
    8,242,000Short-term
investments
    
    
    
    
    
    
    
    
    
    
    34,087,000Total
    
    
    
    
    
    
    
    
    
    $
    42,329,000December 31, 2003
    
    AmortizedCost
    
    
    GrossUnrealizedLosses
    
    
    Fair ValueMoney market
funds
    
    $
    15,075,000
    
    
    $
    
    
    
    $
    15,075,000Total
    
    $
    15,075,000
    
    
    $
    
    
    
    $
    15,075,000Reported as:Cash
equivalents
    
    
    
    
    
    
    
    
    
    $
    15,075,000Short-term
investments
    
    
    
    
    
    
    
    
    
    
    Total
    
    
    
    
    
    
    
    
    
    $
    15,075,000
 The following table
summarizes the maturities of the Companys investments as of
December 31, 2004: Notes and
bonds:Maturities
of one year or less
    
    
    
    
    
    
    
    
    
    $
    33,919,000Maturities
between one and two years
    
    
    
    
    
    
    
    
    
    
    6,507,000Money market
funds:Original
maturities of three months or less
    
    
    
    
    
    
    
    
    
    
    1,903,000Total
    
    
    
    
    
    
    
    
    
    $
    42,329,000
 There were no net realized
gains and losses from sales of available-for-sale securities during
2004. 4. Divestiture of Spinal Specialties  The Company sold Spinal Specialties, Inc., a wholly owned subsidiary, on November 1, 2003 to
Integra LifeSciences Holdings Corporation for approximately $6,000,000 in cash and net proceeds of
approximately $5,044,000. Assets and liabilities included in the sale consisted primarily of
approximately $722,000 of accounts receivable, $1,155,000 of inventory, $400,000 of fixed assets,
and $313,000 of accounts payable and accrued liabilities. The Company recorded a pretax gain on
the sale of $2,999,000 and a tax provision on the gain of $716,000,
resulting in an after-tax gain of
$2,283,000. The reported gain includes the effect of a charge of $327,000 related to the
acceleration of vesting of certain stock options upon the closing of the sale. This amount has
been accounted for as an increase in common stock.The net income of Spinal Specialties prior to divestiture is presented in the Companys
Consolidated Statements of Operations and Comprehensive Operations as income from discontinued
operations, net of tax. Reported in income (loss) from discontinued operations, net of tax, are
net product sales from Spinal Specialties of $3,795,000, $3,454,000 and $2,774,000 in 2003, 2002
and 2001, respectively, and income (loss) before taxes from Spinal Specialties of $532,000, $42,000
and $(524,000) in 2003, 2002 and 2001, respectively. Also reported in income F-12




---



##### Table of Contents



(loss) from discontinued operations, net of tax, is income tax expense (benefit) of $204,000, $18,000 and
$(211,000) for 2003, 2002, and 2001, respectively. 5. Lines of Credit  The Company has a working capital line of credit with Silicon Valley Bank that expires on April 30,
2005. Under the line of credit, the Company may borrow up to the lesser of $4,000,000 or the sum
of 80% of eligible accounts receivable plus 25% of eligible inventory, as defined, at the banks
prime rate (5.25% at December 31, 2004). As of December 31, 2004, there were funds available for
borrowing of $3,072,000 and no outstanding borrowings.The Companys InfuSystem subsidiary has a revolving line of credit with a bank under which it may
borrow up to the lesser of $3,500,000 or 80% of eligible accounts receivable, as defined, at the
banks prime rate less 0.25% (5.0% at December 31, 2004). As of December 31, 2004, there were
funds available for borrowing of $3,500,000 and no outstanding borrowings. The credit line expires
June 30, 2006. In addition, InfuSystem has a loan facility under which it may borrow up to
$2,500,000 for the purchase of equipment. As of December 31, 2004, there were no outstanding
borrowings under the loan facility.The Companys lines of credit are collateralized by substantially all of the Companys assets and
require the Company to comply with certain covenants principally relating to working capital and
liquidity. As of December 31, 2004, the Company believes it was in compliance with or obtained
waivers for all such covenants. The Company did not meet the net
income covenant for the quarter ended December 31, 2004. 6. Stockholders Equity  Preferred Stock - As of December 31, 2004, the Company was authorized to issue 5,000,000
shares of preferred stock with a par value of $0.001 per share, in one or more series. There were
no shares of preferred stock issued and outstanding as of December 31, 2004, 2003, or 2002.On March 8, 2002, in connection with the adoption of a Stockholder Rights Plan (discussed below),
the Company filed a Certificate of Designation with the State of Delaware designating 300,000
shares of preferred stock as Series A Junior Participating Cumulative Preferred Stock (the Series
A Preferred Stock). The Series A Preferred Stock is nonredeemable and, unless otherwise provided,
is subordinate to any other series of the Companys preferred stock. A holder of a share of Series
A Preferred Stock is entitled to receive when, as and if declared, the greater of (i) cash and
non-cash dividends in an amount equal to 100 times the dividends declared on each share of common
stock or (ii) a preferential annual dividend of $1.00 per preferred share ($0.01 per one
one-hundredth (1/100) of a preferred share). Each share of Series A Preferred Stock has one
hundred (100) votes per share (one vote per one one-hundredth (1/100) of a preferred share), voting
together with the shares of common stock. In the event of any merger, consolidation or other
transaction in which shares of common stock are exchanged, the holder of a share of Series A
Preferred Stock is entitled to receive 100 times the amount received per common share. The rights
of the Series A Preferred Stock as to dividends, voting and liquidation preferences are protected
by antidilution provisions.Stockholder Rights Plan-On February 26, 2002, the Board of Directors of the Company
adopted a Stockholder Rights Plan (the Rights Plan). The Rights Plan provides for a dividend of
one right (a Right) to purchase fractions of shares of the Companys Series A Preferred Stock for
each share of the Companys common stock. Under certain conditions involving an acquisition by any
person or group of 15% or more of the common stock, the Rights permit the holders (other than the
15% holder) to purchase the Companys common stock at a 50% discount upon payment of an exercise
price of $30 per Right. In addition, in the event of certain business combinations, the Rights
permit the purchase of the common stock of an acquirer at a 50% discount. Under certain
conditions, the Rights may be redeemed by the board of directors in whole, but not in part, at a
price of $0.001 per Right. The Rights have no voting privileges and are attached to and
automatically trade with the Companys common stock. The Rights expire on February 26, 2012,
unless earlier redeemed or exchanged, unless the distribution date has previously occurred and the
Rights have separated from the shares of common stock, in which case the Rights will remain
outstanding for 10 years from the date they separate. F-13




---



##### Table of Contents



Common Stock  - In December 2001, the board of directors of the Company approved a
restricted stock plan (the 2001 Restricted Stock Plan) pursuant to which employees of the Company
may be offered the opportunity to acquire common stock of the Company. Shares granted under the
plan generally vest, and the restrictions on the shares lapse, over a period of three years,
subject to possible acceleration of vesting based upon the achievement of individual performance
goals. A total of 125,000 shares were authorized for issuance under the 2001 Restricted Stock
Plan. As of December 31, 2001, no shares were issued under the 2001 Restricted Stock Plan. As of
December 31, 2002, 73,500 shares were issued and outstanding under the 2001 Restricted Stock Plan,
of which 3,000 were vested. Compensation expense of $32,000 related to such shares was recognized
in 2002. As of December 31, 2003, 64,000 shares were issued and outstanding under the plan of
which 52,000 were vested (3,000 vested in 2002 and 49,000 vested in 2003). Compensation expense of
$83,000 related to such shares was recognized in 2003. In 2003, the board of directors decided to
terminate all future grants under the 2001 Restricted Stock Plan. As of December 31, 2004,
64,000 shares were issued and outstanding under the plan of which 58,000 were vested (3,000 vested
in 2002, 49,000 vested in 2003, and 6,000 vested in 2004). Compensation expense of $10,000 related
to such shares was recognized in 2004. As of December 31, 2004,
unrecognized deferred compensation expense
related to the unvested shares was approximately $2,000.On May 29, 2003, the board of directors of the Company approved a new restricted stock plan (the
2003 Restricted Stock Plan) pursuant to which employees of the Company may be offered the
opportunity to acquire common stock of the Company. Shares granted under the 2003 Restricted Stock
Plan generally vest, and the restrictions on the shares lapse, over a period of three years,
subject to possible acceleration of vesting based upon the achievement of individual performance
goals. The board of directors authorized a total of 250,000 shares for issuance under the 2003
Restricted Stock Plan. In July 2003, the Company issued 91,000 shares of restricted stock under
the 2003 Restricted Stock Plan. As of December 31, 2003, 83,000 shares were issued and outstanding
under the plan (30,000 vested during 2003 and 167,000 shares remained available for future
issuances). Compensation expense of $276,000 related to such shares was recognized in 2003. As of
December 31, 2003, unrecognized deferred compensation expense related to the unvested shares as of December 31,
2003 was approximately $311,000. As of December 31, 2004, 63,000 shares were issued and
outstanding under the plan of which 55,000 were vested (30,000 vested during 2003 and 25,000 vested
during 2004), and 187,000 shares remained available for future issuances. Compensation expense of
$142,000 related to such shares was recognized in 2004. As of December 31, 2004, unrecognized deferred
compensation expense related to the unvested shares as of December 31, 2004 was approximately
$28,000.In a private placement transaction completed on September 4, 2003, the Company sold 1,666,740
shares of its common stock at $7.50 per share for net proceeds to the Company of $11,563,000.
Gross proceeds from the transaction were $12,500,550. The Company also granted warrants entitling
the stockholders that participated in the transaction to purchase up to 250,011 additional shares
of common stock at an exercise price of $10.00 per share. The warrants are exercisable for a
period of five years from the date of issue. See discussion below under Stock Options and
Warrants.On April 19, 2004, the Company completed a public offering of 2,990,000 shares of common stock at
$15.50 per share, of which 390,000 shares were issued pursuant to the exercise of the underwriters
over-allotment option. The shares were sold at a price to the public of $15.50 per share resulting
in net proceeds to the Company of approximately $43,087,000.Stock Options and Warrants - In connection with the sale of common stock in the private
placement transaction completed on September 4, 2003, the Company granted the investors warrants to
purchase up to 250,011 shares of common stock at an exercise price of $10.00 per share. The
estimated fair value of these warrants on the grant date was $1,272,000 as calculated using the
Black-Scholes pricing model. These warrants were immediately exercisable and expire five years
from the date of grant. Of the 250,011 warrants granted, 24,900 were exercised during 2004 and
225,111 remain outstanding as of December 31, 2004. The following weighted average assumptions
were used to calculate the fair value of these warrants using the Black-Scholes pricing model:
contractual life of five years; stock volatility of 87%; risk-free interest rate of 2.73%; and no
dividends during the term. The fair value of the warrants is included in common stock in the
accompanying balance sheet.In May 2003, and in connection with an amendment to its existing line of credit agreement, the
Company granted warrants to a financial institution to purchase 15,625 shares of the Companys
common stock at an exercise price of F-14




---



##### Table of Contents



$3.84 per share. The estimated fair value of these warrants
on the grant date was $42,000 as calculated using the Black-Scholes pricing model. These warrants
were immediately exercisable and expire seven years from the date of grant. The following weighted
average assumptions were used to calculate the fair value of these warrants using the Black-Scholes
pricing model: contractual life of seven years; stock volatility of 75%; risk-free interest rate of
2.73%; and no dividends during the term. The estimated fair value of these warrants of $42,000 was
recorded as interest expense over the term of the amended line of credit agreement and is included
in common stock in the accompanying balance sheet. As of December 31, 2003, all of these warrants
had been exercised.The Company had a stock option plan approved by the shareholders in 1992 which provided for the
granting of options to non-employee directors (the 1992 Director Plan) to purchase up to 400,000
shares of the Companys common stock at exercise prices not less than the fair market value of the
Companys common stock at the date of grant. Under the terms of the plan, options to purchase
10,000 shares of the Companys common stock were to be granted to each non-employee director
serving in such capacity as of the first business day of January of each year as long as the plan
remained in existence. Options granted became exercisable in four equal installments, with one
installment becoming exercisable at the end of each calendar quarter subsequent to the date of
grant. The options expire at the earlier of five years from the date of grant or two years after
termination of the option holders status as a director. The 1992 Director Plan was terminated on
May 23, 2002. Options granted under the 1992 Director Plan which were currently outstanding as of
the date of plan termination were unaffected by the plan termination and continued to vest under
their original terms.In May 1996, the shareholders of the Company approved an equity incentive plan (the 1996 Plan)
which provided for the grant of stock options (including incentive stock options or nonqualified
stock options) and other stock-based benefits to directors, officers, employees, consultants and
advisors of the Company and its affiliated entities. The maximum number of shares of common stock
which may be the subject of awards granted under the 1996 Plan could not exceed 2,500,000 shares in
the aggregate, subject to adjustments for stock splits or other adjustments. Options granted
become exercisable at such times as determined by the compensation committee of the board of
directors and expired on various dates up to 10 years from the date of grant. The 1996 Plan was
terminated on May 17, 2001 concurrent with the shareholder approval of the I-Flow Corporation 2001
Equity Incentive Plan (the 2001 Plan). Options granted under the 1996 Plan that were outstanding
as of the date of plan termination were unaffected by the plan termination and continued to vest
under their original terms.On May 17, 2001, the shareholders of the Company approved the I-Flow Corporation 2001 Equity
Incentive Plan (the 2001 Plan) which provides for the grant of stock options (including incentive
stock options or nonqualified stock options), restricted stock, and other stock-based benefits to
officers, employees, consultants and advisors of the Company and its affiliated entities. The 2001
Plan was amended on May 23, 2002 to make non-employee directors eligible for grants under the plan.
The maximum number of shares of common stock that may be issued pursuant to awards granted under
the 2001 Plan, as amended, may not exceed 4,750,000 shares in the aggregate, subject to adjustments
for stock splits or other adjustments as defined. Options granted become exercisable at such times
as determined by the compensation committee of the board of directors and expire on various dates
up to 10 years from the date of grant.Prior to the approval of the 2001 Plan, the Company issued options under the 1996 Plan to purchase
an aggregate of 651,336 shares of its common stock to certain key employees at exercise prices
below fair market value at the date of grant as deferred compensation for services rendered. In
addition, as of December 31, 2004, the Company has issued options under the 2001 Plan to purchase
an aggregate of 155,504 shares of its common stock to certain key employees at exercise prices
below fair market value at the date of grant as deferred compensation. Also, the Company granted
options for 320,000 shares to sales representatives and sales management during 2004 at exercise
prices below fair market value.Compensation expense related to stock options and restricted stock, including stock options granted
to non-employees as discussed below, aggregating $2,711,000, $1,268,000 and $752,000 has been
recorded for each of the years ended December 31, 2004, 2003 and 2002, respectively. As of
December 31, 2004, the remaining deferred compensation expense related to unvested stock options
was approximately $4,650,000 and will be amortized as the related awards are earned and vested
through 2007. F-15




---



##### Table of Contents



During fiscal year 2001, the Company granted options to non-employees to purchase 15,000 shares of
the Companys common stock in connection with consulting services. These options have exercise
prices equal to the fair market value of the underlying shares at the date of grant and vest over
one year. The fair value of these options was determined using the Black-Scholes Pricing Model
with the following weighted-average assumptions: expected life, contractual life of 5 years; 90%
stock volatility; average risk-free interest rate of 4.75%; and no dividends during the expected
term.During fiscal years 2004, 2003 and 2002, the Company granted options to non-employees to purchase
7,000, 22,000 and 48,600 shares of the Companys common stock, respectively, in connection with
consulting services. These options have exercise prices equal to the fair market value of the
underlying shares at the date of grant and vest over one to five years. Of these options, 74,000
have been accounted for as a variable award because the consultants performance was not complete
and a performance commitment date had not been satisfied in accordance with the provisions of EITF
No. 96-18. During fiscal year 2004, 2003 and 2002, the Company recorded stock-based compensation
of $92,000, $182,000 and $31,000, respectively, related to these options calculated using the
Black-Scholes pricing model with the following weighted-average assumptions: expected life,
contractual life of 5 years; stock volatility of 66% in 2004, 79% in 2003 and 94% in 2002; average
risk-free interest rate of 3.62% in 2004, 2.73% in 2003 and 3.04% in 2002; and no dividends during
the expected term.Stock-based compensation expense recognized in each of the years ended December 31, 2004, 2003 and
2002 related to stock options granted to employees, stock options granted to consultants, and
restricted stock granted to employees is summarized as follows: 2004
    
    
    2003
    
    
    2002Options to Employees
    
    $
    2,467,000
    
    
    $
    400,000
    
    
    $
    689,000Options to Consultants
    
    
    92,000
    
    
    
    182,000
    
    
    
    31,000Restricted Stock
    
    
    152,000
    
    
    
    359,000
    
    
    
    32,000Employee Options Related to
Discontinued Operations (Note 4)
    
    
    
    
    
    
    327,000
    
    
    
    Total
    
    $
    2,711,000
    
    
    $
    1,268,000
    
    
    $
    752,000
 Stock option activity for all plans is summarized as follows: Weighted-AverageNumber of
    
    
    ExerciseShares
    
    
    PriceBalance, January 1, 2002 (2,397,074 exercisable at a weighted-average price of $2.34)
    
    
    4,256,317
    
    
    $
    2.18Granted (weighted-average fair value of $2.01 per share)
    
    
    976,302
    
    
    $
    2.32Canceled/Expired
    
    
    (673,610
    )
    
    $
    2.45Exercised
    
    
    (55,088
    )
    
    $
    1.79Balance, December 31, 2002 (2,611,385 exercisable at a weighted-average price of $2.31)
    
    
    4,503,921
    
    
    $
    2.19Granted (weighted-average fair value of $4.50 per share)
    
    
    527,000
    
    
    $
    6.02Canceled/Expired
    
    
    (711,069
    )
    
    $
    2.63Exercised
    
    
    (1,082,440
    )
    
    $
    2.02Balance, December 31, 2003 (1,680,888 exercisable at a weighted-average price of $2.25)
    
    
    3,237,412
    
    
    $
    2.77Granted (weighted-average fair value of $9.52 per share)
    
    
    1,453,884
    
    
    $
    13.72Canceled/Expired
    
    
    (146,310
    )
    
    $
    5.49Exercised
    
    
    (918,162
    )
    
    $
    2.04Balance, December 31, 2004 (1,595,649 exercisable at a weighted-average price of $2.70)
    
    
    3,626,824
    
    
    $
    5.57
  Options to purchase 2,111,251 shares of the Companys Common Stock were available for grant under
the 2001 Plan as of December 31, 2004. F-16




---



##### Table of Contents



The following table summarizes information concerning outstanding and exercisable options for all
plans and grants as of December 31, 2004: Options Outstanding
    
    
    
    
    
    
    Options ExercisableWeighted-Average
    
    
    
    
    
    
    
    
    
    
    Weighted-Number
    
    
    Remaining
    
    
    Weighted-
    
    
    Number
    
    
    AverageOf Shares
    
    
    Contractual
    
    
    Average
    
    
    Of Shares
    
    
    ExerciseRange of Exercise Prices
    
    Outstanding
    
    
    Life in Years
    
    
    Exercise Price
    
    
    Exercisable
    
    
    Price$  0.00 -
$  1.04
    
    
    403,000
    
    
    
    4.33
    
    
    $
    0.31
    
    
    
    131,000
    
    
    $
    0.95$  1.12 -
$  1.28
    
    
    505,447
    
    
    
    3.52
    
    
    $
    1.27
    
    
    
    412,359
    
    
    $
    1.27$  1.33 -
$  1.66
    
    
    228,587
    
    
    
    2.85
    
    
    $
    1.41
    
    
    
    86,050
    
    
    $
    1.47$  1.77 -
$  2.47
    
    
    541,726
    
    
    
    2.02
    
    
    $
    2.43
    
    
    
    294,926
    
    
    $
    2.43$  2.50 -
$  3.37
    
    
    639,693
    
    
    
    3.78
    
    
    $
    2.98
    
    
    
    579,333
    
    
    $
    2.99$  3.52 -
$11.41
    
    
    78,569
    
    
    
    3.73
    
    
    $
    6.71
    
    
    
    22,443
    
    
    $
    4.60$11.52 - $11.52
    
    
    822,802
    
    
    
    4.01
    
    
    $
    11.52
    
    
    
    
    
    
    
    $12.05 - $15.90
    
    
    363,000
    
    
    
    4.17
    
    
    $
    13.90
    
    
    
    69,538
    
    
    $
    13.97$15.95 - $19.04
    
    
    13,000
    
    
    
    4.74
    
    
    $
    16.27
    
    
    
    
    
    
    
    $19.81 - $19.81
    
    
    31,000
    
    
    
    4.91
    
    
    $
    19.81
    
    
    
    
    
    
    
    Total
    
    
    3,626,824
    
    
    
    3.59
    
    
    $
    5.57
    
    
    
    1,595,649
    
    
    $
    2.70
 7. Income Taxes  The Company accounts for income taxes under the provisions of SFAS No. 109, Accounting for Income
Taxes. Under this method, deferred tax assets and liabilities are established for temporary
differences between the financial reporting basis and the tax basis of the Companys assets and
liabilities at tax rates expected to be in effect when such assets or liabilities are realized or
settled.  The income tax provision (benefit) for the years ended December 31, 2004, 2003 and 2002 is
summarized as follows: Years Ended December 31,2004
    
    
    2003
    
    
    2002Current:Federal
    
    $
    
    
    
    $
    
    
    
    $
    State
    
    
    203,000
    
    
    
    84,000
    
    
    
    70,000203,000
    
    
    
    84,000
    
    
    
    70,000Deferred:Federal
    
    
    3,189,000
    
    
    
    (1,161,000
    )
    
    
    462,000State
    
    
    495,000
    
    
    
    (96,000
    )
    
    
    (227,000
    )Subtotal
    
    
    3,684,000
    
    
    
    (1,257,000
    )
    
    
    235,000Total income tax (benefit) provision
    
    $
    3,887,000
    
    
    $
    (1,173,000
    )
    
    $
    305,000
  The difference between the deferred income tax provision of $3,684,000 and the change in the net
deferred tax assets in 2004, excluding the current tax benefit from the exercise of stock options
of $4,972,000, is due primarily to an increase in the valuation allowance relating to deferred
tax assets in 2004. F-17




---



##### Table of Contents



A deferred tax asset in the amount of $465,000 was acquired in conjunction with the acquisition of
InfuSystem II, Inc. and Venture Medical, Inc. in 1998. A valuation allowance of $465,000 was
established for the deferred tax asset. If this deferred tax asset is realized, the benefit will
first go to reduce any unamortized goodwill remaining from the acquisition.  The reconciliations of the effective income tax rate to the federal statutory rate are as follows: Years Ended December 31,2004
    
    
    2003
    
    
    2002Tax at federal statutory rate
    
    
    (35.0
    %)
    
    
    (35.0
    %)
    
    
    35.0
    %State income taxes, net of federal benefit
    
    
    (3.6
    %)
    
    
    (2.5
    %)
    
    
    11.3
    %Foreign operations
    
    
    (0.5
    %)
    
    
    (1.2
    %)
    
    
    (5.0
    %)Research credit
    
    
    (1.0
    %)
    
    
    (1.4
    %)
    
    
    (4.1
    %)Valuation Allowance
    
    
    67.9
    %
    
    
    0.0
    %
    
    
    0.0
    %Nondeductible charges
    
    
    2.1
    %
    
    
    3.7
    %
    
    
    5.4
    %Other
    
    
    (0.5
    %)
    
    
    1.1
    %
    
    
    (0.2
    %)Total
    
    
    29.4
    %
    
    
    (35.3
    %)
    
    
    42.4
    %
  The Companys effective tax rate for the year ended December 31, 2004 was a tax expense rate of
29.4% compared to tax benefit rate of 35.3% in 2003. The change in the effective tax rate is
primarily the result of the increase in the provision for income taxes in 2004 resulting from the
increase in the valuation allowance for deferred tax assets.As of December 31, 2004 and 2003, the Company had net deferred tax assets comprised of the
following: December 31,Deferred Tax Assets:
    
    2004
    
    
    2003Net operating losses
    
    $
    13,634,000
    
    
    $
    3,517,000Amortization of goodwill and other intangibles
    
    
    2,389,000
    
    
    
    2,645,000Reserves not currently deductible
    
    
    4,475,000
    
    
    
    3,138,000State taxes
    
    
    (995,000
    )
    
    
    (388,000
    )Credits
    
    
    1,469,000
    
    
    
    1,052,000Depreciation
    
    
    (1,574,000
    )
    
    
    (407,000
    )Total deferred income taxes
    
    
    19,398,000
    
    
    
    9,557,000Valuation allowance
    
    
    (19,398,000
    )
    
    
    (3,449,000
    )Net deferred income taxes
    
    $
    
    
    
    $
    6,108,000
  At December 31, 2004, the Company had federal and state net operating loss carryforwards of
approximately $35,003,000 and $27,375,000, respectively, which begin to expire in the year 2006.
Due to certain tax regulations, future use of a portion of the federal net operating loss
carryforwards is limited to approximately $600,000 per year. Tax credits for federal and state
taxes of approximately $1,027,000 and $442,000, respectively, begin to expire in 2007.A valuation allowance increase equal to the net deferred tax asset has
been provided as management believes that based upon the available evidence and the criteria
provided by SFAS 109, it is more likely than not that the Company will not realize the benefits of
the remaining net deferred tax asset at December 31, 2004. The effective increase in the valuation
allowance for the year 2004 was $15,949,000. F-18




---



##### Table of Contents



8. Commitments and Contingencies  In July 1997, the Company entered into a noncancelable-operating lease for a 51,000 square foot
building for its primary facility. The lease agreement contains certain scheduled rent increases
(which are accounted for on a straight-line basis) and expires in June 2007. There is an option to
extend the lease for an additional five years, which the Company currently intends to exercise. In
January 2000, the Company entered into a noncancelable-operating lease for a 26,000 square foot
facility in Tijuana, Mexico. The term of the lease has been extended through 2008, and the Company
has two renewal options of four years each. Additionally, the Companys Infusystem subsidiary
entered into leases in July 2002 for 8,120 square feet of general office space and 3,000 square
feet of warehouse space in Madison Heights, Michigan. Each lease has a term of five years.  Future minimum lease payments under these leases are as follows: Years Ended December 31,2005
    
    $
    737,0002006
    
    
    747,0002007
    
    
    655,0002008
    
    
    561,0002009
    
    
    428,000Thereafter
    
    
    1,071,000Total
    
    $
    4,199,000
  Rent expense for the years ended December 31, 2004, 2003 and 2002 was $915,000, $833,000 and
$844,000, respectively.The Company is involved in litigation arising from the normal course of operations. In the opinion
of management, the ultimate impact of such litigation will not have a material adverse effect on
the Companys financial position and results of operations.The Company enters into certain types of contracts from time to time that contingently require the
Company to indemnify parties against third party claims. These contracts primarily relate to: (i)
divestiture and acquisition agreements, under which the Company may provide customary
indemnifications to either (a) purchasers of the Companys businesses or assets; or (b) entities
from whom the Company is acquiring assets or businesses; (ii) certain real estate leases, under
which the Company may be required to indemnify property owners for environmental and other
liabilities, and other claims arising from the Companys use of the applicable premises; (iii)
certain agreements with the Companys officers, directors and employees, under which the Company
may be required to indemnify such persons for liabilities arising out of their relationship with
the Company; and (iv) Company license, consulting, distribution and purchase agreements with its
customers and other parties, under which the Company may be required to indemnify such parties for
intellectual property infringement claims, product liability claims, and other claims arising from
the Companys provision of products or services to such parties.The terms of such obligations vary. A maximum obligation arising out of these types of agreements
is not explicitly stated and, therefore, the overall maximum amount of these obligations cannot be
reasonably estimated. Historically, the Company has not been obligated to make significant
payments for these obligations and, thus, no liabilities have been recorded for these obligations
on its balance sheets as of December 31, 2004. 9. Employee Benefit Plan  The Company has a 401(k) retirement plan in which any full time employee may participate. The
Company contributes $0.33 for each dollar of employee contribution up to a maximum employer
contribution of 1.32% of each participants annual salary. The maximum employer contribution at
1.32% corresponds to an employee F-19




---



##### Table of Contents



contribution of 4% of annual salary. Such contributions totaled
$224,000, $86,000, and $102,000 for the years ended December 31, 2004, 2003, and 2002,
respectively. The Company does not provide post-retirement benefits to its employees. 10. Operating Segments and Revenue Data  The Company operates in two reportable operating segments: the manufacturing and marketing of
medical infusion pumps (the Manufacturing and Marketing operating segment), and the rental and
third party insurance billing of electronic medical infusion pumps that are manufactured by
companies other than I-Flow Corporation (the Rentals operating segment). The Rentals operating
segment principally consists of the activities of InfuSystem, Inc. within the Oncology Infusion
Services market segment.Management has chosen to organize the enterprise around differences in products and services, which
is the level at which the Companys chief operating decision maker regularly reviews operating
results to make decisions about resource allocation and segment performance. The products within
the Manufacturing and Marketing operating segment are predominately assembled from common
subassembly components in an integrated manufacturing facility. The Company believes it is most
meaningful for the purposes of revenue analyses, however, to group the product lines within the
Manufacturing and Marketing operating segment into two categories representing specific clinical
applications  IV Infusion Therapy and Regional Anesthesia. Revenues from sales of IV Infusion
Therapy products in 2004, 2003 and 2002 were $19,404,000, $17,909,000 and $15,788,000,
respectively. Revenues from sales of Regional Anesthesia products in 2004, 2003 and 2002 were
$32,392,000, $16,112,000 and $8,582,000, respectively.The accounting policies of the two operating segments are the same as those described in the
summary of significant accounting policies (Note 1). Operating segment information is as follows
for the years ended December 31, 2004, 2003 and 2002: Manufacturing andMarketing
    
    
    Rentals
    
    
    Consolidated2004:Revenues
    
    $
    51,796,000
    
    
    $
    19,349,000
    
    
    $
    71,145,000Operating income (loss)
    
    
    (18,678,000
    )
    
    
    4,930,000
    
    
    
    (13,748,000
    )Assets
    
    
    66,903,000
    
    
    
    17,527,000
    
    
    
    84,430,000Depreciation and amortization
    
    
    671,000
    
    
    
    1,904,000
    
    
    
    2,575,000Property additions
    
    
    491,000
    
    
    
    6,112,000
    
    
    
    6,603,0002003:Revenues
    
    $
    34,021,000
    
    
    $
    13,022,000
    
    
    $
    47,043,000Operating income (loss)
    
    
    (5,404,000
    )
    
    
    2,123,000
    
    
    
    (3,281,000
    )Assets
    
    
    41,026,000
    
    
    
    10,870,000
    
    
    
    51,896,000Depreciation and amortization
    
    
    1,305,000
    
    
    
    1,208,000
    
    
    
    2,513,000Property additions
    
    
    1,135,000
    
    
    
    2,536,000
    
    
    
    3,671,0002002:Revenues
    
    $
    24,370,000
    
    
    $
    10,293,000
    
    
    $
    34,663,000Operating income (loss)
    
    
    (1,600,000
    )
    
    
    2,314,000
    
    
    
    714,000Assets
    
    
    21,778,000
    
    
    
    11,283,000
    
    
    
    33,061,000Depreciation and amortization
    
    
    1,069,000
    
    
    
    951,000
    
    
    
    2,020,000Property additions
    
    
    1,648,000
    
    
    
    986,000
    
    
    
    2,634,000
  The Company had a major customer which accounted for 9%, 10%, and 12% of total revenues for the
years ended December 31, 2004, 2003, and 2002, respectively. F-20




---



##### Table of Contents



All of the Companys rental revenue is domestic. Export sales of medical products represented 16%,
20% and 26% of total revenue during 2004, 2003 and 2002, respectively. Total revenue by
geographical region is summarized as follows: Sales to unaffiliated customers:
    
    2004
    
    
    2003
    
    
    2002United States
    
    $
    59,838,000
    
    
    $
    37,503,000
    
    
    $
    25,697,000Europe
    
    
    9,214,000
    
    
    
    7,588,000
    
    
    
    7,202,000Asia / Pacific Rim
    
    
    1,365,000
    
    
    
    969,000
    
    
    
    1,095,000Other
    
    
    728,000
    
    
    
    983,000
    
    
    
    669,000Total
    
    $
    71,145,000
    
    
    $
    47,043,000
    
    
    $
    34,663,000
 11. Related Party Transactions  During June 2001, the Company loaned its chief executive officer $150,000 for personal use. The
loan has not been modified or amended since that time. The unsecured note receivable due from the
chief executive officer bears interest at 5.58% per annum and is to be repaid over a 10 year period
through bi-weekly payroll deductions. As of December 31, 2004, the amount due to the Company under
the note receivable is approximately $107,000, the majority of which is included in other long-term
assets in the accompanying consolidated balance sheets.Daniel Earhart, the Companys facilities administrator, is the son of the Companys chief executive officer. His
total salaries and wages during fiscal 2004 was $70,864. F-21




---



##### Table of Contents



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. I-FLOW CORPORATIONDated:
March 16, 2005
    
    By:
    
    /s/ Donald M. EarhartDonald M. EarhartChairman, President and Chief Executive Officer
 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed
below by the following persons on March 16, 2004 on behalf of the registrant and in the capacities
indicated. Signature
    
Title/s/ Donald M. Earhart
    
    Chairman, President and Chief Executive Officer
(Principal Executive Officer)Donald M. Earhart/s/ James J. Dal Porto
    
    Executive Vice President, Chief Operating
Officer, Director and SecretaryJames J. Dal Porto/s/ James R. Talevich
    
    Chief Financial Officer and Treasurer
(Principal Financial and Accounting Officer)James R. Talevich/s/ John H. Abeles
    
    DirectorJohn H. Abeles, M.D./s/ Jack H. Halperin
    
    DirectorJack H. Halperin/s/ Joel S. Kanter
    
    DirectorJoel S. Kanter/s/ Erik H. Loudon
    
    DirectorErik H. Loudon/s/ Henry Tsutomu Tai
    
    DirectorHenry Tsutomu Tai, Ph.D., M.D.




---



##### Table of Contents



INDEX TO EXHIBITS Exhibit No.
    
    
    Exhibit2.1
    
    
    Stock Purchase Agreement, dated October 28, 2003, by and between Integra LifeSciences
Corporation and I-Flow Corporation (1)2.2
    
    
    Merger Agreement, dated July 27, 2001, by and between I-Flow Corporation, a Delaware
corporation, and I-Flow Corporation, a California corporation (2)2.3
    
    
    Agreement and Plan of Merger, dated January 13, 2000, by and among I-Flow Corporation, Spinal
Acquisition Corp., Spinal Specialties, Inc. and the Shareholders of Spinal Specialties, Inc. (3)2.4
    
    
    Agreement and Plan of Merger, dated February 9, 1998, by and among I-Flow Corporation, I-Flow
Subsidiary, Inc., Venture Medical, Inc., InfuSystems II, Inc. and the Shareholders of Venture
Medical, Inc. and InfuSystems II, Inc. (4)2.5
    
    
    Agreement for Purchase and Sale of Assets, dated July 3, 1996, by and among I-Flow Corporation,
Block Medical, Inc. and Hillenbrand Industries, Inc. (5)3.1
    
    
    Amended and Restated Certificate of Incorporation of I-Flow Corporation, a Delaware Corporation
(6)3.2
    
    
    Bylaws of I-Flow Corporation, a Delaware Corporation (2)3.3
    
    
    Certificate of Designation Regarding Series A Junior Participating Cumulative Preferred Stock (7)4.1
    
    
    Specimen Common Stock Certificate (20)4.2
    
    
    Warrant Agreement, dated February 13, 1990, between the Company and American Stock Transfer &
Trust Company, as warrant agent (9)4.3
    
    
    Rights Agreement, dated as of March 8, 2002, by and between I-Flow Corporation and American
Stock Transfer & Trust Company, as rights agent, which includes, as Exhibit A, the Form of
Rights Certificate, the Form of Assignment and the Form of Election to Purchase (7)4.4
    
    
    Warrant to Purchase Stock, dated May 8, 2003, between I-Flow Corporation and Silicon Valley Bank
(10)4.5
    
    
    Registration Rights Agreement, dated May 8, 2003, between I-Flow Corporation and Silicon Valley
Bank (10)4.6
    
    
    Form of Warrant, dated September 4, 2003 (1)4.7
    
    
    Form of Registration Rights Agreement, dated September 4, 2003 (1)10.1
    
    
    Form of Securities Purchase Agreement, dated September 2, 2003 (1)10.2
    
    
    I-Flow Corporation Amended and Restated 2001 Equity Incentive Plan (11)*10.3
    
    
    2003 Restricted Stock Plan of I-Flow Corporation (10)*10.4
    
    
    2001 Restricted Stock Plan of I-Flow Corporation (12)*10.5
    
    
    1996 Stock Incentive Plan (13)*10.6
    
    
    1992 Non-Employee Director Stock Option Plan (14)*10.7
    
    
    1987-1988 Incentive Stock Option Plan and Non-Statutory Stock Option Plan, restated as of March
23, 1992 (15)*10.8
    
    
    License and Transfer Agreement with SoloPak Pharmaceuticals Inc., dated March 6, 1996 (16)10.9
    
    

Summary of the terms of the COIP for 2005*10.10
    
    
    Addendum to manufacturing plant lease agreement




---



##### Table of Contents



10.11
    
    
    Lease Agreement between Industrial Developments International, Inc. as Landlord and I-Flow
Corporation as Tenant dated April 14, 1997 (17)10.12
    
    
    Block Medical de Mexico lease agreement dated December 7, 199910.13
    
    
    Amendment to Loan Agreement between Silicon Valley Bank and I-Flow Corporation dated
January 30, 2004.10.14
    
    
    Amended and Restated Loan and Security Agreement between Silicon Valley Bank and I-Flow
Corporation dated May 8, 2003 (10)10.15
    
    
    Loan Agreement, dated March 31, 2000, by and among InfuSystem, Inc., I-Flow Corporation
and Old Kent Bank (10)10.16
    
    
    First Amendment to Loan Agreement, dated April 1, 2002, by and among InfuSystem, Inc.,
I-Flow Corporation and Fifth Third Bank (formerly Old Kent Bank) (10)10.17
    
    
    Second Amendment to Loan Agreement, dated April 1, 2003, by and among InfuSystem, Inc.,
I-Flow Corporation and Fifth Third Bank (formerly Old Kent Bank) (10)10.18
    
    
    Second Amended and Restated Promissory Note, dated April 1, 2003, between InfuSystem, Inc.
and Fifth Third Bank (formerly Old Kent Bank) (10)10.19
    
    
    Promissory Note with Donald M. Earhart dated June 15, 2001 (8)*10.20
    
    
    Reserved.10.21
    
    
    Employment Agreement with Donald M. Earhart, dated May 16, 1990 (18)*10.22
    
    
    Amendment No. 1 to Employment Agreement with Donald M. Earhart, dated June 21, 2001 (8)*10.23
    
    
    Amended and Restated Employment Agreement with James J. Dal Porto, dated June 21, 2001 (8)*10.24
    
    
    Employment Agreement with James R. Talevich, dated June 30, 2000 (19) *10.25
    
    
    Agreement Re: Change in Control with Donald M. Earhart dated June 21, 2001 (8)*10.26
    
    
    Agreement Re: Change in Control with James J. Dal Porto dated June 21, 2001 (8)*10.27
    
    
    Agreement Re: Change in Control with James R. Talevich, dated June 21, 2001 (8)*21.1
    
    
    List of Subsidiaries23.1
    
    
    Consent of Independent Registered Public Accounting Firm31.1
    
    
    Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act
on 200231.2
    
    
    Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act
on 200232.1
    
    
    Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002
  *
    
    
    Management contract or compensatory plan or arrangement required to be
filed as an exhibit pursuant to applicable rules of the Securities and
Exchange Commission.(1)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Quarterly Report on Form 10-Q for the quarter ended
September 30, 2003.(2)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Current Report on Form 8-K filed on August 3, 2001.




---



##### Table of Contents



(3)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Quarterly Report on Form 10-Q for the quarter ended March
31, 2000.(4)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Current Report on Form 8-K/A filed on March 6, 1998.(5)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Current Report on Form 8-K dated July 22, 1996.(6)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Current Report on Form 8-K dated May 29, 2002.(7)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Current Report on Form 8-K filed on March 13, 2002.(8)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Quarterly Report on Form 10-Q for the quarter ended June
30, 2001.(9)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Annual Report on Form 10-K for the fiscal year ended
September 30, 1990.(10)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Quarterly Report on Form 10-Q for the quarter ended June
30, 2003.(11)
    
    
    Reserved.(12)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Annual Report on Form 10-K for the fiscal year ended
December 31, 2002.(13)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Definitive Proxy Statement filed on March 27, 1996.(14)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Annual Report on Form 10-K for the fiscal year ended
December 31, 1991.(15)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Post-Effective Amendment to its Registration Statement (No.
33-41207) filed on October 27, 1992.(16)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Annual Report on Form 10-K for the fiscal year ended
December 31, 1995.(17)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Current Report on Form 8-K dated April 14, 1997.(18)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Annual Report on Form 10-K for the fiscal year ended
September 30, 1990.(19)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Annual Report on Form 10-K for the fiscal year ended
December 31, 2000.(20)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Quarterly Report on Form 10-Q for the quarter ended March
31, 2002.(21)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Current Report on Form 8-K filed on April 14, 2004.(22)
    
    
    Incorporated by reference to exhibit with this title filed with the
Companys Annual Report on Form 10-K for the fiscal year ended
December 31, 2003.