Edgar Filing: MEDSTONE INTERNATIONAL INC/

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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

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FORM 10-K
(Mark One)

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934

For the fiscal year ended December 31, 2000

[_] 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: 0-16752

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MEDSTONE INTERNATIONAL, INC.
(Exact name of registrant as specified in its charter)

Delaware 66-0439440
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)

100 Columbia, Suite 100, Aliso Viejo, California 92656
(Address of principal executive offices) (Zip code)

Registrant's telephone number, including area code: (949) 448-7700

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

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.004 par value
(Title of Class)

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]

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

The number of shares of the Common Stock of the registrant outstanding as
of March 2, 2001 was 4,273,220. The number of shares of voting and non-voting
Common Stock held by non-affiliates on such date was 4,175,140 with an
approximate aggregate market value of $25,311,786.

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TABLE OF CONTENTS

Page
Number
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PART I

Item Number and Caption
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Item 1. Business.................................................... 1
Item 2. Properties.................................................. 10
Item 3. Legal Proceedings........................................... 10
Item 4. Submission of Matters to a Vote of Security Holders......... 10

PART II

Item 5. Market for Registrant's Common Equity and Related 11
Stockholder Matters.........................................
Item 6. Selected Financial Data..................................... 12
Item 7. Management's Discussion and Analysis of Financial Condition 13
and Results of Operations...................................
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.. 17
Item 8. Financial Statements and Supplementary Data................. 17
Item 9. Changes in and Disagreements with Accountants on Accounting 17
and Financial Disclosure....................................

PART III

Item 10. Directors and Executive Officers of the Registrant.......... 18
Item 11. Executive Compensation...................................... 20
Item 12. Security Ownership of Certain Beneficial Owners and 24
Management..................................................
Item 13. Certain Relationships and Investments....................... 25

PART IV

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 27
8-K.........................................................

(i)

PART I

Item 1. BUSINESS

Introduction

Medstone International, Inc., (the "Company" or "Medstone"), a Delaware
corporation formed in October 1984, manufactures, markets and maintains
lithotripters. The Company, as a manufacturer of capital medical devices, has
vertically integrated by offering its medical devices directly to providers on
a fee-per-procedure basis. Medstone currently offers lithotripsy services both
in the United States and internationally on a fee-per-procedure basis in both
the fixed and mobile environment. Medstone intends to expand efforts to grow
this medical service side of its business and has expanded its product
offerings to include several durable medical equipment products marketed to
the urology market. The Company's consolidated revenues during fiscal 2000
came primarily from Medstone's lithotripsy business.

One continuing element of the Company's strategic plan is the incubation,
financing and staffing of new medical businesses. If and when a new business
proves viable, the Company is then in a position to spin-out separate public
companies as dividends to the Company's stockholders.

The Company's first spin out was Cardiac Science, Inc. ("Cardiac Science")
(trade symbol: DFIB), which occurred in 1991. Cardiac Science designs,
manufactures and sells a line of external defibrillation devices for the
hospital cardiac care market. During 2000, the Company sold 304,667 shares of
its holdings of Cardiac Science for a gain of approximately $1,855,000. In
January 2001, the Company sold an additional 73,000 shares of Cardiac Science
for a gain of approximately $358,000. At March 2, 2001, when the market price
of the Cardiac Science stock was $4.00, the Company held 114,000 shares of
Cardiac Science with a balance sheet value of $0 and a market value of
approximately $456,000. (See Item 13. "Certain Relationships and Investments"
and "Note 9. Related Party Transactions" and "Note 13. Subsequent Events" in
the Notes to Consolidated Financial Statements.)

In early 1996, the Company spun off two additional subsidiaries, Endocare,
Inc. ("Endocare") (trade symbol: ENDO) and Urogen Corp. ("Urogen") (trade
symbol: UROG), to the Company's stockholders of record at December 29, 1995.
Endocare manufactures equipment and devices to treat urologic soft tissue
diseases. Urogen is a development stage biotechnology company currently
developing gene therapy products for the treatment of hemophilia A and
prostate cancer. During 2000, Urogen changed its name to Genstar Therapeutics
Corp. ("Genstar") (trade symbol: GNT). At March 2, 2001, when the market price
of the Genstar stock was $5.45 per share, the Company held 95,000 shares of
Genstar with a balance sheet value of $0 and a market value of approximately
$518,000. (See Note 9. "Related Party Transactions" in the Notes to
Consolidated Financial Statements.)

In June 1996 the Company purchased, for $1.35 million cash, a 60% interest
in Northern Nevada Lithotripsy Associates, LLC ("Northern Nevada"), an
operator of lithotripsy services. In March 1997, the Company purchased, for
$2.3 million cash, a 60% interest in Southern Idaho Lithotripsy Associates,
LLC ("Southern Idaho"), another operator of lithotripsy services. At March 2,
2001, the Company continued to own a majority interest in each of these
companies. These companies' revenues are derived from invoicing patients or
insurers. (See Note 3. "Acquisitions and Investments in Joint Ventures" in the
Notes to Consolidated Financial Statements.)

United Physicians Resources, Inc. ("UPR") was incorporated as a majority-
owned subsidiary of the Company in June 1996, to expand the Company's service
orientation to the urologist practitioners. UPR provides billing, practice
management and consulting services as an additional service line once the
initial physician relationship has been established. At March 2, 2001, the
Company continued to own a majority interest in UPR. UPR purchased the
operations of Integrated Healthcare Systems, Inc. in July 1996 for $30,000.

In September 1998, the Company was party to the formation of k.Biotech, an
Indian biotechnology company. k.Biotech is a development stage enterprise
which has purchased license agreements for four

compounds developed by the International Centre of Genetic Engineering and
Biotechnology of the United Nations ("ICGEB"). The four licensed ICGEB
compounds, Hepatitis B Vaccine, Interferon, Erythropoietin and GCSF, may be
marketed in ICGEG member countries, primarily in lower Asia and Africa. The
Hepatitis B Vaccine is currently in clinical trials in India, with a target of
2002 for the commercialization of this and the Interferon compounds. At March
2, 2001, the Company had invested a total of $325,000 in k.Biotech, giving the
Company then a 21% ownership share. (See Item 13. "Certain Relationships and
Investments" and Note 3. "Acquisitions and Investments in Joint Ventures" and
Note 9. " Related Party Transactions" in the Notes to Consolidated Financial
Statements.)

On April 16, 1999, a wholly-owned subsidiary of the Company, Medstone
International, Ltd., ("Ltd") purchased certain assets of Creos Ltd., a former
supplier of the Company, from its liquidator for $165,000 in cash. Upon
purchase, the subsidiary, located in Fife, Scotland, commenced manufacturing
operations. (See Note 3. "Acquisitions and Investments in Joint Ventures" in
the Notes to Consolidated Financial Statements.)

On October 11, 1999, Medstone International Ltd. purchased all outstanding
shares of Zenith Medical Systems, Ltd. ("Zenith"), a distributor of durable
medical equipment located in Manchester, England, for $870,000 in cash less
$284,000 of acquired cash for a net cost of $586,000. (See Note 3.
"Acquisitions and Investments in Joint Ventures" in the Notes to Consolidated
Financial Statements.)

On April 20, 2000, the Company purchased common stock representing a 46%
interest in Medicredit.com, Inc. ("MediCredit") for $1 million in cash.
MediCredit, a California based company, funds and services loans to physicians
to finance elective surgeries in the cosmetic and cash paying sector of
healthcare. Along with the cash investment in MediCredit, the Company also
agreed to a line of credit of up to $2 million at prime rate. At March 2,
2001, the full $2 million credit line was outstanding to MediCredit and the
Company retained its 46% ownership interest. (See Item 13. "Certain
Relationships and Investments" and Note 9. "Related Party Transactions" in the
Notes to Consolidated Financial Statements.)

Markets

The Company's current products and planned future products are targeted at
the urology, radiology and imaging table markets.

The Company's most important current market is the kidney stone treatment
market. In the United States, it is estimated that over 1,500,000 persons per
year suffer from kidney stones and an estimated 375,000 patients per year are
hospitalized with a primary kidney stone. Historically, approximately 180,000
of these patients have been treated with extra corporeal shockwave lithotripsy
each year. With an estimated installed base of 450 lithotripters in the United
States, there is a sufficient number of lithotripters to respond to this
market.

Outside the United States the incidence of kidney stones varies from
country to country. The installed base of extra corporeal shockwave
lithotripters is not as extensive as in the United States. Medstone has sold
systems into Japan, Egypt, Russia, Israel, Saudi Arabia, U.A.E., Hong Kong and
China.

The share of its markets that the Company will obtain will be dependent on
successful development of new products, obtaining appropriate regulatory
agency approvals, market acceptance of the products, the Company's ability to
market, the alternative sources of equivalent products and future
developments.

An estimated 25 million Americans have gallstones resulting in
approximately 500,000 surgeries each year. This compares to an estimated 1.5
million Americans with kidney stones resulting in approximately 200,000
extracorporeal shockwave lithotripsy procedures each year. As approved, the
combination of Medstone's lithotripter with a pharmaceutical dissolution is
indicated for use in fragmenting and eliminating symptomic, radiolucent, non-
calcified gallstones less than 20 mm in maximum diameter in certain patients
with a functioning gallbladder.

Products

Lithotripsy Equipment

The Medstone STS and STS-T lithotripter systems (the "Systems") are
presently being used to treat kidney stones, without invasive surgery, in the
U.S. and foreign locations. The Company received a pre-market approval ("PMA")
for the STS System from the U.S. Food and Drug Administration ("FDA") in 1988
authorizing commercial use of the device for treating patients with kidney
stones. A PMA supplement covering the STS-T System was approved by the FDA in
1998.

In the STS System ("STS"), a series of shockwaves are created outside the
patient's body and focused to travel through water-based fluids until they
enter the body and disintegrate the stone. Each successive shockwave serves to
further break apart the kidney stone into smaller particles until they are
small enough to be passed in the patient's urine. A treatment typically
requires 1200-1600 shockwaves in a procedure which lasts 45 to 60 minutes.

In addition to the shockwave generator, the STS's components include a
customized X-ray table on which the patient lies horizontally with his or her
kidney positioned above the shockwave generator, a computer, an X-ray system,
an ultrasound system, and an electrocardiogram ("ECG") monitor. The computer
generates information regarding the treatment and monitors the patient's
condition. The X-ray/ultrasound system produces images that are converted and
analyzed by the computer and then used by the physician for proper positioning
and to determine when the kidney stone has been sufficiently disintegrated to
terminate the treatment. The ECG monitor supplies the data that allows the
computer to synchronize the shockwaves with phases of the patient's heartbeat.

The Company has developed and copyrighted all the software that controls
the STS. This software, an integral part of the system and therefore subject
to review by regulatory agencies, is licensed for use on a per procedure
basis.

On September 6, 2000, the Company was notified by the FDA that its PMA
application for treatment of gallstones with the STS, in conjunction with the
drug Actigall, was approved for commercialization. This places the STS in the
position as the only dual-modality lithotripter available in the United
States, thereby enhancing the equipment's appeal to hospitals and surgery
centers.

The Medstone STS-T ("STS-T"), is a transportable lithotripter for treatment
of kidney stones. The STS-T contains components similar to the STS, except for
the ultrasound unit, with all components built to be modular, allowing the
STS-T to be moved in and out of a hospital surgical suite. This "in operating
room" technology, the current industry direction, allows hospitals and clinics
to set up the lithotripter for patient treatment in existing surgical
operating rooms and, once complete, the lithotripter can be moved to an
equipment holding area or loaded on to a truck for transportation to another
facility. This transportability allows hospitals and clinics the flexibility
of full-time access to a lithotripter without dedication of a surgical suite
to a fixed unit installation.

The STS-T has been commercially distributed for treatment of kidney stones
since the Company's PMA supplement was approved by the FDA in 1998. The STS-T
currently has ETL, ISO 9001 and EN46001 certifications and the Company is
currently undergoing testing for CE mark registration of the STS-T.

The Company also has developed and manufactures its own disposable
components for use with the STS and STS-T. Electrodes manufactured by the
Company are used to produce electrical sparks in the shockwave generator part
of the device. A disposable coupling bag containing fluid for transmission of
the shockwave is placed between the shockwave generator and the patient's back
or stomach during the treatment. One complete set of the supplies is normally
used in each patient procedure.

The Company, as a vertically integrated manufacturer, also offers fee-for-
service lithotripsy in the continental United States. It contracts with
hospitals, clinics, and ambulatory surgery centers to provide the

equipment necessary to treat kidney stones, usually on an outpatient basis. It
intends to expand the geographic coverage of this service, both domestically
and, in future years, to foreign markets.

The Company moves some of its fee-for-service Systems from place to place
either in mobile trailers for the STS where treatments are performed or in
small trucks for the STS-T. This allows small and mid-size facilities in wide
ranging geographic locations to access on a part-time basis equipment and
technology that otherwise would only be economically viable in larger
population centers. There are currently over 80 sites in the United States
that are active sites on the Company's mobile trailer and transmobile routes.

During 1999, the Company developed a business plan which calls for the
widespread "permanent" distribution of the STS-T in fee-for-service
arrangements. The program gives the hospital, clinic or surgery center full-
time access to the intuitive, easy to operate lithotripter and the convenience
of a fee-for-service payment plan where fees are incurred only if the
equipment is used.

The execution of this business strategy started in the fourth quarter of
1999 and the Company continues its implementation.

The fee-for-service procedures are currently provided by the Company using
15 STS Systems housed in mobile trailers, two STS Systems located at fixed
sites and 20 STS-T Systems which are located in "permanent" sites or moved to
different locations in small trucks.

Urotable

With its network of physicians and facilities that utilize lithotripsy
products, the Company has begun using that same contact base to market fixed
and mobile urological treatment tables, the Medstone "UTS-Series". These
urological tables, which are used for various urological procedures, are used
both as in-office devices for physicians and as in-facility devices in
hospital or clinic settings. The Company is an integrator of products
available on the market and will use the "UTS-Series" for bundling of
urological tables along with lithotripsy products, and will also sell the
"UTS-Series" as a stand-alone product.

The Company's entry in this market was achieved by $30,000 of development
funding to the Swedish manufacturer, Arcoma AB, to develop the mobile
urological treatment table. The product was successfully introduced in the
fourth quarter of 1999 and the Company continues to expand its distribution.

The Company is also completing development of a state of the art fixed
urology table to be introduced in early 2001. This table, also developed by
Arcoma for a contract of $250,000, has multi-plane movement for enhanced
patient positioning capability along with physician preference settings
programmable into a multifunction touch screen control panel which will
control all table, imaging and exposure functions. During 1999 and 2000, the
Company has paid a total of $230,000 to Arcoma for development costs with a
balance due of $20,000 upon deliver of final documentation.

X-Ray Generators

Since commencing operations in 1999, Medstone International, Ltd. has
manufactured and marketed a family of compact, high frequency X-ray generators
which are used in medical imaging. The compact design allows installation in a
very space efficient manner. Its modular design makes repairs in the field
time efficient as components can be replaced at the customer's site. Ltd.
supplies the equipment used in the STS-T imaging system and the Urotable. The
majority of its third party customers are in member countries of the European
Union.

Pain Management Tables

Drawing from the Company's relationships with the radiology market and
knowledge from the UTS-Series tables, the Company successfully introduced in
2000 the Pro-2000 series of pain management and vascular

tables. These portable, multi-position tables are used by pain management
clinics for imaging and vascular studies in a cost- efficient office or clinic
setting. The tables can also be used as portable imaging tables without
requiring complete rooms strictly for imaging. The Company currently offers
several models of the tables, including fixed height or multi-plane adjustable
types.

Kidney Stones and Treatment

A kidney stone develops when the salt and mineral substances in urine form
crystals that stick together and grow in size. In most cases, these crystals
are removed from the body by the flow of urine, but they sometimes stick to
the lining of the kidney or settle in places where the urine flow fails to
carry them away. These crystals may gather and grow into a stone ranging in
size from that of a grain of sand to a golf ball. Most stones start to form in
the kidney. Some may travel to other parts of the urinary system, such as the
ureter or bladder, and grow there.

Stones vary in size, composition and the ease with which they can be
dissolved. In some cases, certain medications may be used to lower the amount
of acidity or alkalinity in the urine, thereby dissolving the stones. At
present, stones that contain calcium cannot be dissolved. Most stones can be
treated with conservative methods. This includes increased fluid intake,
changes in diet, and medications. About 90 percent of stones that leave the
kidney will pass through the ureter within three to six weeks. Stones that do
not pass through the ureter may be removed with the aid of a grasping device
(basket). The device is passed through a telescopic instrument (cystoscope)
that the doctor inserts into the bladder or ureter (urethroscope). In some
cases, the stones are removed whole, but sometimes they must be broken into
smaller pieces with ultrasound before they can be removed with the basket.

The Medstone STS and STS-T provide a non-invasive nonsurgical treatment for
stones in the kidney and ureter called extra corporeal shockwave lithotripsy.
In this method, X-rays are used to target the stone, and then high energy
shockwaves are used to break down the stones into gravel which passes out with
urine within a few weeks.

Although most stones can be treated with nonsurgical methods, certain
stones still require conventional surgery, particularly when there is internal
scarring and obstruction. With conventional surgery, an incision is made over
the stone site. The hospital stay and recovery period are several weeks longer
than when more conservative techniques are used. Therefore, stones are treated
with non-invasive methods when possible.

Gallstones and Treatment

Gallstones are hard deposits, of which approximately 85% are cholesterol
and approximately 15% are calcified, which form in the gallbladder and
occasionally may migrate into the common bile duct. Gallstones commonly grow
to an inch or more in diameter and two or more stones may be present in the
gallbladder and common bile duct at the same time. As the stones grow over
time, severe pain can result from inflammation of the gallbladder because of
blockage of the natural flow of bile from the liver in and out of the
gallbladder, from passage of stones through the common bile duct and from
inflammation of the pancreas if the pancreatic duct is blocked. The incidence
of gallstones is almost three times greater in women than in men, increases
with age and obesity, and is doubled in women who take estrogen and oral
contraceptives as these agents increase the body's secretion of cholesterol.

Surgery in which the gallbladder is removed either via laparoscopic or open
surgery historically has been the accepted method for treatment of patients
with gallstones. Although mortality rates for this type of surgery are low in
the U.S. because of the quality of medical care, health care costs associated
with hospital stays are substantial and a patient may be a poor surgical
candidate or may choose a course of treatment not involving surgery. Oral
administration of bile acids have been one method of non-surgical treatment,
but this may involve a lengthy period of treatment.

Under the recent approval from the FDA, gallstone disease patients fitting
certain criteria established in the Company's gallstone PMA may be treated
with non-surgical shockwave lithotripsy using the Company's STS and the drug
Actigall. The treatment is similar to the treatment described above for kidney
stones. In the treatment for gallstones, ultrasound images are used to target
the stone and the same type of high energy shock waves are used to fragment
the stone. The stone fragments are ejected from the gallbladder into the
digestive tract.

Production

The Company's Aliso Viejo, California facility, first occupied in 1994, is
certified by the FDA under its mandated Good Manufacturing Practices ("GMP").
It also has ISO 9001 and EN 46001 certifications to produce the STS-T. The
Company currently has several testing requirements to complete its CE mark
registration for the STS-T and has current CE mark registrations for the
portable urology and pain management table product lines. Ltd.'s plant in
Scotland also has GMP certification from the FDA, along with CE mark, EN46001
and ISO 9001 certifications, for the Company's x-ray generator products. The
Company has existing capacity in its plants to produce sufficient quantities
of its shockwave lithotripters, urotables, pain management tables and X-ray
generators to support its commercial needs for the foreseeable future.

Product Development

The Company research in 2000 concentrated on the development of the UroPro
2000 urology table and several variations of the UroPro 2000T pain table. The
Company also has continued expenditures for refinements to the STS-T and its
user interfaces. During the year, the Company tested several prototypes of the
UroPro 2000 and, late in 2000, took delivery of the first two production
units. Development expenses for 2001 will be for the costs associated with
refinements, options and new applications of the basic UroPro-2000 urology
system. The Company will continue its development program alliance with Arcoma
AB and has discussed a possible purchase of a minority interest in Arcoma AB.
During the years ended December 31, 1998, 1999, and 2000, the Company's
expenditures for research and development totaled $1,078,792, $1,455,429 and
$1,180,409, respectively.

Sales and Marketing

The Company's current products and planned future products are targeted at
the urology, radiology and imaging table markets. Medstone has a direct sales
force covering the continental United States. Outside the United States, the
Company uses a network of distributors and direct sales efforts in the United
Kingdom through the Ltd. and Zenith subsidiaries.

The Company generates revenue from the sale of equipment, and also from the
sale of software licenses, disposable supplies, procedure fees and service
contracts to hospitals, physicians, and other health care providers.

The Company offers to hospitals, surgery centers and physician groups
lithotripsy services on a fee basis. In the current cost conscious healthcare
environment, many facilities do not have the patient flow to justify owning,
or the available capital to purchase, a lithotripsy machine. These facilities
are candidates for fee-for-service. In a fee-for-service arrangement the
customer will sign a contract for a period of time, typically one to three
years, and will pay a fixed fee for each patient treated on the lithotripter
or a flat monthly equipment charge. Most often this service is provided by a
lithotripter that is in a mobile van so a single machine can provide service
over a wide geographic area. For facilities with adequate patient flow, fee-
for-service can be provided with a fixed unit installed in these facilities.

Marketing for the Company's products is accomplished through advertisement
in medical journals, direct mail, direct physician contact, company
participation in various associations, product exhibition and telephonic
marketing.

Product Liability and Insurance

The Company currently has in force commercial liability insurance, with
coverage limits of $1 million per incident, and $2 million on an annual
aggregate basis. It also has general umbrella liability insurance with a
coverage limit of $4 million per incident for a total aggregate coverage
amount of $5 million per incident. The Company has product liability and
directors and officers liability insurance with a $10 million coverage limit
per incident. The Company's insurance policies provide coverage on a claims-
made basis and are all subject to annual renewals.

Government Regulation

Governmental regulations in the United States and other countries are a
significant factor affecting the research and development, manufacture and
marketing of the Company's products. In the United States, the FDA has broad
authority under the Federal Food, Drug and Cosmetic Act and the Public Health
Service Act to regulate the distribution, manufacture and sale of drugs,
including biologics, and medical devices. Foreign sales of drugs and medical
devices are subject to foreign governmental regulation and restrictions which
vary from country to country.

Medical devices intended for human use in the United States are classified
into three categories, depending upon the degree of regulatory control to
which they will be subject. Such devices are classified by regulation into
either class I (general controls), class II (performance standards) or class
III (pre-market approval) depending upon the level of regulatory control
required to provide reasonable assurance of the safety and effectiveness of
the devices. A class III product, such as the Medstone STS and STS-T,
generally require initial Investigational Device Exemption ("IDE") approval by
the FDA. An IDE permits limited clinical evaluation of the product under
controlled conditions. Extensive reporting and monitoring of patient
treatments made pursuant to the IDE are required. After the PMA is obtained,
the product may be marketed to an unrestricted number of users in the United
States, but general medical device regulations regarding FDA inspection of
facilities, Good Manufacturing Practices, labeling, maintenance of records and
filings with the FDA continue to be applicable.

A subset of medical devices, including "old" devices commercially
distributed before March 28, 1976 or substantially equivalent to devices that
were in commercial distribution before that date, may be marketed under a
"510(k) exemption." Section 510(k) section of the Federal Food, Drug and
Cosmetic Act provides an exemption from the pre-market approval requirement
for such devices. The Medstone UTS-Series is sold under a 510(k) exemption
received by the original manufacturer of the components used in the equipment.

In September 2000, kidney stone lithotripters were classified from Class
III to Class II devices and became eligible for 510(k) exemptions, but the
Company's STS lithotripter still falls under Class III due to its gallstone
PMA certification.

Medstone has obtained from the California Department of Health Services a
license to manufacture medical devices and is subject to periodic inspections
and other regulation by that agency.

Certificate of Need ("CON") laws and regulations are in effect in many
states. Under such laws, a CON issued by a governmental agency is generally
required before the introduction of certain new health care services or before
a hospital or other provider can acquire certain new medical equipment or
facilities having values exceeding specified amounts. Failure to obtain a
required CON may prohibit the purchase of desired equipment or cause the
denial of Medicare or other governmental reimbursements or payments for
patient treatments. In recent years several states have repealed their CON
laws and many other states have made or are considering possible amendments to
the laws. Most of the revisions involve raising the thresholds for review,
eliminating certain types of facilities or services from review or
streamlining the review process.

On January 4, 2001, the Health Care Finance Administration ("HCFA")
published final "Stark II" regulations regarding various inpatient and
outpatient services, including lithotripsy facilities, and physician ownership
of such equipment. Under these regulations, the physician ownership of
lithotripsy equipment is not

expressly forbidden, but must, instead, meet strict guidelines in which any
compensation arrangement based on "per use" charges must be at "fair market
value". These regulations apply to the patients covered under Medicare,
Medicaid and Champus health care. Compliance with these regulations will
become effective January 4, 2002, allowing current ownership and contractual
arrangements time to be restructured as necessary. The Company believes that
its contractual arrangements with its customers are or will be in compliance
with the new regulations by the implementation date.

Patents, Copyrights, Trade Secrets and Licenses

The Company's policy is to secure and protect intellectual property rights
relating to its technology. While Medstone believes that the protection of
patents or licenses is important to its business, it also relies on trade
secrets, know-how and continuing technological innovation to maintain its
competitive position. The Company has received or filed for certain patents or
copyrights for its lithotripter operating systems and utilizes a licensing
agreement for certain technology incorporated in its X-ray generators.

The Company seeks to preserve the confidentiality of its technology by
entering into confidentiality agreements with its employees, consultants,
customers, and key vendors and by other means. No assurance can be given,
however, that these measures will prevent the unauthorized disclosure or use
of such technology.

Competition

The Company's products currently marketed and under development will be
competing with many existing products and therapies for market share. The
Company competes with fully integrated device companies, many of which have
substantially more experience, financial and other resources and superior
expertise in research and development, manufacturing, testing, obtaining
regulatory approvals, marketing and distribution.

Future products of the Company are expected to address the urological
market. The Company's competition will be determined in part by the particular
urological disease to which the Company's potential products relate. An
important factor in competition may be the timing of market introduction of
its or competitive products. Accordingly, the relative speed with which
Medstone can develop products, complete the clinical trials and approval
processes and supply commercial quantities of the products to the market are
expected to be important competitive factors. The Company expects that
competition among products approved for sale will be based on, among other
things, product efficacy, safety, reliability, availability, price, patent
position and sales, marketing and distribution capabilities.

The Company's competitive position also depends upon its ability to attract
and retain qualified personnel, obtain patent protection or otherwise develop
proprietary products or processes and secure sufficient capital resources for
the often substantial period between technological conception and commercial
sales.

Shockwave Lithotripters

The Company's two principal competitors in kidney stone shockwave
lithotripsy are Dornier, a subsidiary of a Singapore-based conglomerate, and
Siemens GmbH, a German electronic company. In addition, a number of other
companies, both in the U.S. and foreign countries, have PMAs or 510(k)
exemptions to sell their lithotripters for the treatment of kidney stones in
the U.S. or are applying for 510(k) device exemptions for the use of their
lithotripters for the treatment of kidney stones.

The Company believes that, in addition to the obtaining of FDA and other
governmental approvals, important competitive factors in the markets for
shockwave lithotripters include the reliability, effectiveness in treating
patients and pricing of particular systems. The Company believes the Medstone
Systems compare favorably with other lithotripters presently being offered by
competitors with respect to the precision of their imaging systems, their ease
of patient handling, their simplicity of operation design, their safety
features and their success rate in treating patients.

Fee-For-Services

In the fee-for-service business segment, the Company competes with a number
of service-oriented medical businesses, in a fragmented and highly competitive
industry, both nationally and locally. Moreover, certain of the Company's
current and potential competitors have substantially greater financial
resources than the Company and may compete with the Company for acquisitions
and development of operations in markets targeted by the Company. The Company
has experienced competition in the acquisition of existing lithotripsy
facilities and the development of relationships with treating physicians. The
Company has experienced competition from hospitals or treating physicians who
have opened their own lithotripsy facilities. Such competition could intensify
in the event of a decrease in the purchase price of lithotripters or if the
supply of new or used lithotripters increases over time.

The Company's main competitors in the fee-for-service business are Prime
Medical Services, Inc., a Texas-based mobile lithotripsy provider, the
lithotripsy business of Integrated Health Services, Inc., a Maryland based
healthcare concern, of which one operating entity owns lithotripsy provider
partnerships, and other smaller regional and local providers.

Tables and X-ray Generators

The Company's main competitors in the urological table business are Liebel
Flarsheim Co., an Ohio-based division of Mallinkrodt which manufactures
urology products, and OEC Medical Systems, Inc., a Utah-based division of GE
Medical Systems, which provides imaging and related products.

The Company's x-ray generators compete in a market which has been highly
competitive and price sensitive. This market includes hospital radiology,
oncology and orthopedic departments as well as clinics and surgery centers.
Most equipment is sold as replacements of existing equipment that has ceased
operating or fails performance criteria.

Competition in the x-ray and imaging equipment market is widespread, with
GE Medical Systems, a subsidiary of General Electric, a world wide
conglomerate, and Siemens Medical Systems, a subsidiary of Siemens GmbH, a
German conglomerate, and numerous smaller manufacturers, both domestic and
foreign.

Backlog--Shockwave Lithotripsy

The Company's lithotripsy equipment sale backlog for the STS-T was $0 for
the STS-T as of March 1, 2001 and $375,000 as of March 1, 2000. Due to the
high per unit price of the Medstone Systems, equipment backlog can vary
significantly from period to period based upon the number of systems on order.
Backlog consists only of orders evidenced by signed contracts for equipment
scheduled for delivery and installation within 12 months and does not include
revenues for maintenance and per procedure charges, or management services
contracts.

Backlog for radiology equipment (urology tables, pain tables and oncology
tables) totaled $1,156,000 as of March 1, 2001 with no comparable amount in
the prior year due to these products' introduction during 2000.

With the maturity of Medstone's lithotripsy business, recurring revenues
from fee for service and procedure fees and maintenance services have become a
major source of Medstone's revenue stream. Maintenance services are generally
provided under annual service contracts, and procedure and fee for service
fees are earned based upon usage of the System.

Human Resources

As of February 15, 2001, Medstone had 100 employees. Of the 100 employees,
5 are engaged directly in research and development activities, 27 are engaged
in manufacturing, 22 are engaged in mobile operations, 20 are engaged in field
service, 11 are engaged in sales and marketing and 15 are employed in general
and administrative positions.

Although Medstone conducts most of its research and development using its
own employees, the Company has funded, and plans to continue to fund, research
using consultants. Consultants provide services under written agreements and
are paid based on the amount of time spent on Company matters. Under their
consulting agreements, Medstone's consultants are required to disclose and
assign to the Company any ideas, discoveries and inventions developed by them
in the course of providing consulting services.

Item 2. PROPERTIES

In March 1994, the Company took occupancy of 20,600 square feet of office,
manufacturing, engineering, and warehouse space, and research and development
laboratories, located in Aliso Viejo, California. In April 2000, the Company
signed a new 64-month lease on the present facility with an average monthly
rent of $19,449 for the term. The initial term will expire November 30, 2005,
with an option to renew for five years at a rental rate to be negotiated in
the future based on the market rates.

Medstone International, Ltd. leases a 5,000 square foot facility in Fife,
Scotland, for manufacturing, warehouse and administrative operations for
approximately $2,900 per month with a term through October 2005.

Zenith owns a 6,107 square foot building in Manchester, England which it
uses to house administration, warehouse and equipment staging.

United Physicians Resources leases a 1,417 square foot office in Phoenix,
Arizona with a monthly rental expense of $2,150 under an operating lease which
expires in October 2002.

Item 3. LEGAL PROCEEDINGS

The Company carries director and officer liability insurance, and has
indemnification agreements with its officers and directors.

From time to time, the Company is subject to legal actions and claims for
personal injuries or property damage related to patients who use its products.
The Company has obtained a liability insurance policy providing coverage for
product liability and other claims. Management does not believe that the
resolution of any current proceedings will have a material financial impact on
the Company or the consolidated financial statements.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Company's annual meeting of shareholders was held on June 21, 2000. At
the meeting Frank R. Pope, David V. Radlinski, Donald Regan and Michael C.
Tibbitts were elected directors of the Company.

EXECUTIVE OFFICERS OF THE REGISTRANT

Information regarding the Company's executive officers is included in Item
10 of Part III.

PART II

Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The Company's common stock is traded on the NASDAQ Stock Market under the
symbol MEDS. The following table sets forth the high and low sales prices of
the Company's common stock for the two years ended December 31, 2000 and
December 31, 1999 as reported in the NASDAQ National Market System for the
quarter indicated.

High Low
---- ---

Year ended December 31, 2000
----------------------------
First quarter.......................................... $8 $4 3/4
Second quarter......................................... 6 3/4 5 1/32
Third quarter.......................................... 9 5 19/64
Fourth quarter......................................... 7 17/16 5 5/16

Year ended December 31, 1999
----------------------------
First quarter.......................................... $8 1/2 $6 1/8
Second quarter......................................... 8 9/16 6 1/2
Third quarter.......................................... 7 5/32 6
Fourth quarter......................................... 6 17/32 4 3/8

The stock markets have experienced extreme price and volume fluctuations
during certain periods. These broad market fluctuations and other factors may
adversely affect the market price of the Company's Common Stock. Any shortfall
in revenue or earnings from levels expected by securities analysts could have
an immediate and significant adverse effect on the trading price of the
Company's common stock in any given period. Additionally, the Company may not
learn of such shortfalls until late in the fiscal quarter, which could result
in an even more immediate and adverse effect on the trading price of the
Company's stock. Finally, the Company participates in a highly dynamic
industry, which often results in significant volatility of the Company's common
stock price.

At March 2, 2001, there were 233 stockholders of record and approximately
2,200 beneficial owners of the Company's Common Stock.

The Company has not paid any cash dividends during its two most recent
fiscal years. The Company's board of directors does not presently anticipate
that any cash dividends will be paid in the foreseeable future.

Item 6. SELECTED FINANCIAL DATA

Year ended December 31,
-------------------------------------------
2000 1999 1998 1997 1996
------- ------- ------- ------- -------
(in thousands, except per share
amounts)

Consolidated Statements of
Operations Data:
Revenues:
Net equipment sales............ $ 3,284 $ 3,338 $ 2,144 $ 2,722 $ 2,420
Procedure, maintenance, and
management fees............... 18,930 19,532 21,129 18,476 14,884
Interest and dividends......... 608 598 552 536 676
------- ------- ------- ------- -------
Total revenues............... 22,822 23,468 23,825 21,734 17,980
Costs and expenses:
Cost of sales.................. 13,942 12,106 11,000 9,503 8,009
Research and development....... 1,180 1,456 1,079 1,021 522
Selling........................ 2,175 2,048 1,988 2,257 2,146
General and administrative..... 2,651 2,592 2,131 2,231 1,666
------- ------- ------- ------- -------
Total operating costs........ 19,948 18,202 16,198 15,012 12,343
------- ------- ------- ------- -------
Operating income................. 2,874 5,266 7,627 6,722 5,637
Lawsuit settlement costs......... -- -- -- -- 5,500
Other (income) expense........... (1,773) (97) (61) (39) 402
Minority interest in subsidiaries
income.......................... 895 603 628 468 143
------- ------- ------- ------- -------
Income (loss) before provision
(benefit)for income taxes....... 3,752 4,760 7,060 6,293 (408)
Provision (benefit) for income
taxes........................... 1,663 1,919 2,718 2,329 (170)
------- ------- ------- ------- -------
Net income (loss)................ $ 2,089 $ 2,841 $ 4,342 $ 3,964 $ (238)
======= ======= ======= ======= =======
Net income (loss) per share:(1)
Basic.......................... $ .46 $ .57 $ .84 $ .74 $ (.04)
======= ======= ======= ======= =======
Diluted........................ $ .46 $ .56 $ .82 $ .72 $ (.04)
======= ======= ======= ======= =======

December 31,
-------------------------------------------
2000 1999 1998 1997 1996
------- ------- ------- ------- -------
(in thousands)

Consolidated Balance Sheet Data:
Working capital.................. $15,597 $17,539 $18,432 $16,256 $14,983
Total assets..................... 29,877 30,175 29,149 27,688 25,395
Total liabilities................ 3,569 3,758 3,216 3,567 4,230
Stockholders' equity............. 26,308 26,417 25,933 24,121 21,165

--------
(1) Restated in accordance of SFAS Statement No. 128 "Earnings Per Share".

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

General

Medstone manufactures, markets and maintains lithotripters, and continues
to expand its Fee-for-Service Program to supply lithotripsy equipment to
providers on a per procedure basis. The lithotripters manufactured by Medstone
is approved to treat both kidney stones and gallstones. The Company is also
marketing a urology imaging and treatment table, used for various urological
functions, mobile urology and pain management table to serve the mobile
treatment market and various radiology room equipment, capitalizing on the
relationships that the Company has with radiology equipment manufacturers. To
date, the Company's consolidated revenues have come primarily from Medstone's
lithotripsy business.

As a manufacturer of medical devices, the Company has been vertically
integrating by offering its medical devices directly to providers. It
currently offers lithotripsy procedures using 15 mobile systems, two fixed
sites and 20 transmobile lithotripters located throughout the United States on
a per procedure basis. With the ability to offer quality equipment at
reasonable prices, Medstone intends to continue the growth of this
manufacturer direct business.

In June 1996, the Company completed the acquisition of a 60% interest in
Northern Nevada, a lithotripsy partnership which deals directly with patient
and insurers, and also founded UPR as a majority-owned subsidiary of the
Company, to expand the Company's service orientation to the urologist
practitioner. Both entities signify the Company's emphasis on growth through
expansion of relationships and acquisition. In March 1997, the Company
completed the acquisition of a 60% interest in Southern Idaho Lithotripsy
Associates LLC, another operator of "retail" lithotripsy operations in
Southern Idaho, and operating results have been consolidated effective March
1, 1997. In April 1999, the Company purchased certain assets of Creos, Ltd., a
manufacturer of high performance x-ray generators and a supplier to the
Company. The Company then commenced manufacturing operations in a facility,
located in Fife, Scotland, formerly occupied by Creos, Ltd. In October 1999,
the Company purchased the outstanding shares of Zenith Medical Systems, Ltd.,
a distributor of major imaging equipment to the British National Health
Service, located in Manchester, England. Both 1999 acquisitions' operating
results have been consolidated effective with their respective acquisition
dates.

Goodwill represents approximately 11% and 12% of the Company's total assets
and stockholders' equity, respectively, at December 31, 2000. Goodwill
resulted from the excess of the purchase price of Northern Nevada, Southern
Idaho and Zenith Medical Systems, Ltd. over the fair value of the net assets
acquired. Goodwill is being amortized over periods ranging from 15 to 40
years, the expected period of benefit, using the straight-line method. The
Company reviews goodwill and other long-lived assets for impairment whenever
changes in circumstances indicate that the carrying value of the asset may not
be recoverable. Based upon the Company's analysis, which includes a comparison
of the carrying amount of such assets to the Company's historical actual cash
flows and estimated future undiscounted cash flows, the Company is not aware
of any material portion of goodwill or other long-lived assets which will
dissipate over a shorter period than the amortization period used.

From time to time, the Company makes investments in businesses which are
accounted for under the equity method. During 2000, the Company made an
investment, including loans, in Medicredit.com aggregating $3 million. During
1998 and 1999, the Company made an aggregate investment in k.Biotech of
$325,000. The Company's share of losses in unconsolidated subsidiaries in
2000, related to Medicredit.com, approximated $61,000. No earnings or losses
in unconsolidated subsidiaries were recognized in 1999 or 1998. The Company
does not have additional financial commitments to these unconsolidated
subsidiaries. The future performance of the unconsolidated subsidiaries is
uncertain and therefore, the Company may recognize earnings or losses in
unconsolidated subsidiaries in the future.

The Company began the year with approximately $9.7 million in cash and
short-term investments, no debt, inventories of $5.8 million, and total assets
of $30.2 million. After the purchase of $2.7 million of treasury stock, an
investment in and lendings to MediCredit totaling $3.0 million and fixed asset
additions of $1.5 million,

partially offset by proceeds from the sale of long-term investments of $1.9
million, the Company ended the year with approximately $6.2 million in cash
and short-term investments, no debt, inventories of $6.1 million and total
assets of $29.9 million.

Through its research and development, acquisitions and clinical
submissions, management believes that it is hiring and retaining the
appropriate personnel necessary to continue growth and development of the
Company's product lines and brand recognition.

Results of Operations

Year Ended December 31, 2000 Compared to Year ended December 31, 1999

The Company recorded total revenue of $22.8 million in 2000, a 3% decrease
compared to the $23.5 million in total revenue recognized for the year ending
December 31,1999. Revenues from procedures, maintenance fees and fee-for-
service decreased to $18.9 million in 2000 when compared to the $19.5 million
in revenue in 1999. Pricing pressures continue to force per patient charges
lower as competing equipment has saturated the market with low cost,
transportable lithotripsy equipment. Patient volume and per patient fees both
decreased during 2000 as sites continued to transition to lower cost equipment
and more sites are selecting a flat daily or monthly fee in anticipation of
the release of final Stark II regulations which occurred on January 4, 2001.
Procedure fees from third party equipment decreased by 11%, the second year in
a row with decreased fees. Although patient volume increased by 4% in 2000
when compared to 1999 fees per procedure decreased. The Company experienced an
increase in volume as STS-T units, which commenced shipment in 1999, reached
full utilization and also renewed interest in the Company's lithotripsy
products was achieved due to the approval of the gallstone procedure. Revenue
from radiographic supplies increased in the current year due to a full year of
activity from both the Medstone Ltd., and Zenith operations and additional
activity from the expanding product offerings from the Company during 2000.

Equipment revenues decreased by 2% in 2000 when compared to the same period
in 1999 as the number of lithotripters sold decreased to 7 in 2000, compared
to 10 in 1999 and average sales prices decreased slightly. Offsetting this
decrease in lithotripters was the introduction of the imaging tables in 2000,
with a total of 29 various units sold in 2000. This equipment included pain
management tables, radiology tables and portable urology tables along with the
imaging systems associated with several unit sales.

Interest income increased by 1% in the current year when compared to the
same period of the prior year due to higher investment yields even though the
average invested balance has decreased substantially.

Costs on recurring revenue increased to $11.7 million, or 62% of recurring
revenue in 2000, compared to $10.2 million, or 52% of recurring revenue in
1999 due to the continuation of the Company's program of placement of a large
number of fixed-site fee-for-service lithotripsy units at hospitals and
surgery centers. It is expected that these units will drive long-term patient
volume growth with the continuous availability of equipment, along with the
expectation of additional volume due to the gallstone approval. Costs of
providing maintenance increased also due to the higher number of Company-owned
units in service.

Cost of equipment sales increased to $2.3 million in 2000, or 69% of sales
in the current year compared to $1.9 million, or 58%, for the year ended
December 31, 1999. This increase is due to the lower margin associated with
the sale of radiology equipment when compared to the historical higher margin
on lithotripsy equipment. Lithotripsy equipment margins deteriorated slightly
due to unabsorbed overhead expenses due to lower actual production levels when
compared to plan.

Research and development costs decreased by 19%, or $275,000 in the twelve
months ending December 31, 2000 when compared to the same period of 1999. This
decrease is due to the majority of the development work on the UroPro-2000
urology imaging table occurring earlier in 2000 and reduced staffing after
completion in 1999 of the final development of the STS-T.

Selling costs increased by $126,000, or 6%, for the year ending December
31, 2000 compared to the same period in 1999 due to higher advertising,
tradeshow and consulting expenses with the introduction of the new imaging
table products. The Company has also increased its efforts to sell into the
government contract market and is incurring expenses to establish
reimbursement guidelines for gallstone lithotripsy.

General and administrative expenses increased by $59,000 or 2% in the
twelve months ended December 31, 2000 compared to the same period in the prior
year due to higher consulting expenses for the gallstone post-approval work,
higher audit expenses due to the expanded scope of the Company's operations,
and a full year's expenses in Medstone Ltd..

Gain on sale of investments was approximately $1,882,000 in the twelve
months ending December 31, 2000 compared to $244,000 in the same period of
1999. In 2000, the Company sold 304,667 shares of Cardiac Science, Inc. common
stock and 5,000 shares of Genstar common stock, while in 1999 the Company sold
warrants to purchase 87,500 shares of Cardiac Science common stock. The net
book value of these sales was $0.

Minority interest in subsidiaries income increased by $292,000 or 48% in
the twelve months ended December 31, 2000 when compared to the same period of
the prior year due to substantially higher activity in the Northern Nevada and
Southern Idaho operations. Also the Company, through its equity investment in
Medicredit, recognized a $61,000 expense for its portion of the operating
losses of Medicredit from April 1, 2000 through December 31, 2000.

Provision for income taxes for the year 2000 decreased by $256,000 as a
result of lower taxable income in the current year when compared to the same
period of 1999.

Year Ended December 31, 1999 Compared to Year ended December 31, 1998

Total revenue of $23.5 million in 1999 represented a 1% decrease in revenue
when compared to $23.8 million in 1998, breaking a string of several years of
continuous revenue growth. Results were lower in the procedure, maintenance
and management fee revenue partially offset by an increase in the equipment
revenue generated by 1999's sales activity.

Revenue from procedure, maintenance fees and fee-for-service decreased to
$19.5 million in 1999, an 8% decrease, when compared to the $21.1 million in
revenue in 1998. This decline was due to the market pressures of the
widespread availability of transportable lithotripters that caused patient
volume to shift as customers purchased lower cost lithotripsy systems and
average revenue per patient decreased. With the lower price for transportable
technology, some larger patient volume customers chose to purchase equipment
from the Company or its competitors and price concessions were instituted for
continuing customers. In 1999, procedure revenue from third party owned
equipment decreased by 11% compared to the prior year, due to declines in both
volume and lower per procedure fees. Maintenance fees decreased by 20% in the
current period when compared to 1998 due to lower average contract prices and
a lower number of sites under maintenance contracts. The Company also realized
revenue of $604,000 in 1999 from sales of the imaging product lines acquired
with the Zenith and Ltd operations.

Net equipment sales in 1999 increased to $3.3 million, or 56%, from $2.1
million for the comparable period of the prior year. This was due to the
increased shipments of equipment related to the introduction of the STS-T
transportable lithotripter in 1999, even though transportable lithotripters
carry a lower average unit sales price when compared to the fixed unit models.
The activity level of equipment upgrades remained level in the current year
compared to the prior year.

Interest income increased by 9%, or $47,000, in the year ended December 31,
1999 when compared to the same period of the prior year as average invested
cash balances increased even as yields remained level from year to year.

Costs on recurring revenue increased to $10.2 million in 1999, or a 12%
increase when compared to the $9.0 million in 1998 due to the Company's
strategy of placing STS-T equipment in customer sites on a permanent basis,
making the technology always available to the customer, rather than a
scheduled service program. This approach has a large up-front investment with
the results reflected in the patient volume as utilization increases.

Cost of equipment sales decreased to 58% of revenue for the year ended
December 31, 1999 compared to 89% of revenue for the year ended December 31,
1998. In absolute dollars the costs remained level from year to year as the
Company realized substantial cost savings from the introduction of its
transportable lithotripter even as total unit shipments doubled.

Research and development costs increased by $377,000, or 35% when compared
to 1998 levels due to increased spending on the transportable lithotripter and
continued development of the "UTS Series" of products.

Selling expenses increased by $60,000, or 3%, in 1999 when compared to 1998
due to the introductory advertising expenses for the Medstone STS-T
transportable lithotripter and the Company's trade show expenses for the
medical imaging business.

General and administrative expenses increased by 22% or $461,000 from 1998
to 1999, due to the increased staffing costs for foreign operations, costs
associated with the strategic planning process during 1999 and legal costs
associated with actions against the Company.

Other income/expense increased by $36,000 in 1999 when compared to 1998 due
to recognition of gains on sale of Cardiac Science securities partially offset
by an investment reserve in 1999 compared to the gain on sales of a joint
venture in 1998.

Minority interest expense decreased to $603,000 in 1999 compared to
$628,000 in 1998 due to a slight decrease in the per patient revenue and the
corresponding effect on profitability.

Provision for income taxes decreased due to a lower level of profitability
in the current year when compared to the prior year.

Liquidity and Capital Resources

At December 31, 2000, the Company had cash and short-term investments of
approximately $6.2 million. These funds were generated from operating
activities.

During 2000, the Company purchased 459,800 shares of treasury stock for
approximately $2,736,000. The Company estimates that the purchase resulted in
a 10% increase in basic net income per share.

The Company's long-term capital expenditure requirements will depend upon
numerous factors, including the progress of the Company's research and
development programs, the time required to obtain regulatory approvals, the
resources that the Company devotes to the development of self-funded products,
proprietary manufacturing methods and advanced technologies, the cost of
acquisition and/or new revenue opportunities, the ability of the Company to
obtain additional licensing arrangements and to manufacture products under
those arrangements, the demand for its products if and when approved and
possible acquisitions of products, technologies and companies.

The Company believes that its existing working capital and funds
anticipated to be generated from operations will be sufficient to meet the
cash needs for continuation of its present operations during 2000. See "Safe
Harbor Statement under the Private Securities Litigation Reform Act of 1995."

Safe Harbor Statement Under the Private Securities Litigation Reform Act of
1995

Forward-looking statements in this report, including without limitation,
statements relating to the Company's plans, strategies, objectives,
expectations, intentions and adequacy of resources, are made pursuant to the
safe harbor provisions of the Private Securities Litigation Reform Act of
1995. Investors are cautioned that such forward-looking statements involve
risks and uncertainties including without limitation the following: (i) the
Company's plans, strategies, objectives, expectations and intentions are
subject to change at any time at the discretion of the Company, (ii) the
Company's plans and results of operations will be affected by the Company's
ability to manage its growth; (iii) the Company's businesses are highly
competitive and the entrance of new competitors into or the expansion of the
operations by existing competitors in the Company's markets and other changes
could adversely affect the Company's plans and results of operations; and (iv)
other risks and uncertainties indicated from time to time in the Company's
filings with the Securities and Exchange Commission.

Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company has no financial instruments which are subject to market risk.
Although the Company's earnings and cash flows are subject to fluctuations due
to changes in the interest rates on its investments, a hypothetical 10%
adverse decrease in the interest rates would not have a material adverse
effect on the results of operations because the majority of the Company's
investments are short-term treasury bills. A 10% reduction in interest rates
would reduce interest income by approximately $50,000 annually. Due to the
short period to maturity, the Company believes that the impact of a 10%
reduction in interest rates would not have a material effect on the carrying
value of its securities.

The Company's earnings and cash flows at Medstone International, Ltd., a
Scottish subsidiary are subject to fluctuations due to changes in foreign
currency rates. The Company believes that changes in the foreign currency
exchange rate would not have a material adverse effect on its results of
operations as the majority of its foreign transactions are delineated in
Medstone International, Ltd.'s functional currency, the British Pound.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

See Item 14. "Exhibits, Financial Statement Schedules, and Reports on Form
8-K."

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

PART III

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Directors

The following are the directors of the Company:

Name Age Principal Occupation
---- --- --------------------

David V. Radlinski............... 56 Chairman of the Board and Chief
Executive Officer of the Company

Frank R. Pope.................... 51 Executive Managing Director The
Global Financial Group

Donald J. Regan.................. 66 Chairman of the Board Advanced
Biocatalytics Corporation

Michael C. Tibbitts.............. 53 Executive Vice President Quality
System Solutions

David A. Reed.................... 68 Consultant DAR Consulting Group

Mr. Radlinski has been the Chairman of the Board and Chief Executive
Officer of the Company since September 1995. He had been the President of the
Company's subsidiary, Medstone International, Inc., and Chief Financial
Officer and Secretary of the Company from January 1991 to September 1995. From
July 1987 to January 1991, he was the Company's Executive Vice President of
Finance, Chief Financial Officer and Secretary. From 1984 to 1987, he was Vice
President of Finance and Chief Financial Officer of Printronix, Inc., a
publicly-owned company which manufactured computer printers.

Mr. Pope has been the Executive Managing Director of The Global Financial
Group, a private fund management firm since April 2000. He is also Managing
Director of Verdigris Capital, a private investment firm. From April 1981 to
October 1996, Mr. Pope was a General Partner with Technology Funding, a
venture capital investment firm. He is also the Executive Vice President,
Chief Financial Officer and a director of Technology Funding Inc. Mr. Pope is
also a director of Thermatrix, Inc., Breadcrumbs.com, and a director and
officer of Advanced BioCatalytics Corp. Mr. Pope is a C.P.A. and a member of
the California Bar. He has been a director of the Company since January 1991.

Mr. Regan, an attorney, is currently the Chairman of the Board of Advanced
Biocatalytics Corporation, a private biotech company and a founder and
director of Breadcrumbs, Inc., developer of a new search engine, and is a
consultant to Kinsell, Newcomb & De Dios, Inc., a municipal securities
investment banking firm. Mr. Regan has practiced securities, municipal
finance, nonprofit corporation, real estate, and business transactions law for
over thirty years. He has published several articles on securities law and
served as a lecturer for the Practicing Law Institute. He has been a director
of the Company since September 1995.

Mr. Tibbitts is currently Executive Vice President of Quality System
Solutions, a medical software company. From May 1991 to May 1999, he was Vice
President of Gulf South Medical Supply, Inc., a medical supply distributor.
Prior to joining that corporation, he was employed for 19 years by Johnson &
Johnson in two divisions: Sterile Design (which manufactured and marketed kit
packages) and Surgikos (which manufactured and marketed surgical supplies). He
has been a director of the Company since May 1996.

Mr. Reed is now retired, was formerly president and chief executive officer
of St. Joseph Health System in Orange, California. He is the former Board
Chairman of Mission Hospital Regional Medical Center in Mission Viejo,
California. He also serves as a Board Chairman of PacifiCare Health Systems, a
publicly traded company. He has been a director of the Company since August
1999.

Executive Officers

The names, ages and positions of all the executive officers of the Company
as of March 2000 are listed below, followed by a brief account of their
business experience during the past five years. Officers are normally
appointed annually by the Board of Directors at a meeting of the directors
immediately following the Annual Meeting of Shareholders. There are no family
relationships among these officers nor any arrangements or understandings
between any officer and any other person pursuant to which an officer was
selected. None of these officers has been involved in any court or
administrative proceeding within the past five years adversely reflecting on
his or her ability or integrity.

Name Age Position
---- --- --------

David V. Radlinski............... 56 Chief Executive Officer and Chairman of the Board

Mark Selawski.................... 45 Vice President of Finance, Chief Financial Officer
and Secretary

Eva Novotny...................... 43 Executive Vice President of Sales and Marketing

Mr. Radlinski has been the Chairman and Chief Executive Officer of the
Company since September 1995. He had been the President of the Company's
subsidiary, Medstone International, Inc., and Chief Financial Officer and
Secretary of the Company from January 1991 to September 1995. From July 1987
to January 1991, he was the Company's Executive Vice President of Finance,
Chief Financial Officer and Secretary. From 1984 to 1987, he was Vice
President of Finance and Chief Financial Officer of Printronix, Inc., a
publicly-owned company which manufactured computer printers.

Mr. Selawski has been the Chief Financial Officer, Vice President of
Finance and Secretary of the Company since September 1995. He had previously
served as the Company's Manager of Planning and Analysis since joining the
Company in 1988. Prior to joining the Company he held various finance
management positions with several high-tech manufacturing companies.

Ms. Novotny has been Executive Vice President of Sales and Marketing of the
Company since October 1997. Prior to joining the Company, she was Director of
Marketing for Imagyn Medical, formerly UroHealth, from June 1995 to October
1997. From 1985 to 1995, she was employed by Mentor Corporation, manufacturer
of aesthetic and general surgery products, as a Marketing Manager and later as
Director of Marketing for Mentor Urology.

Section 16(a) Beneficial Ownership Reporting Compliance

The Company is not aware of any director, officer or 10% shareholder who
during 2000 failed to file on a timely basis any report regarding the
Company's securities required by Section 16(a) of the Securities Exchange Act
of 1934.

Item 11. EXECUTIVE COMPENSATION

Executive Compensation

The following table sets forth certain information regarding compensation
paid by the Company during each of the Company's last three fiscal years to
the Company's Chief Executive Officer and to each of the Company's other
executive officers during fiscal 2000.

SUMMARY OF COMPENSATION TABLE

Long Term Compensation
-----------------------------
Annual Compensation Awards Payouts
-------------------------- --------------------- -------
Other Restricted Securities
Annual Stock Underlying LTIP All Other
Name and Principal Fiscal Salary Bonus Compensation Award(s) Options Payouts Compensation
Position Year ($)(1) ($) ($) ($) (#)(2) ($) ($)
------------------ ------ ------- ----- ------------ ---------- ---------- ------- ------------

David V. Radlinski...... 2000 250,000 -- 2,224 -- -- -- --
Chairman of the Board 1999 250,000 -- 2,426 -- -- -- --
and Chief Executive 1998 219,135 -- 2,426 -- 350,000 -- --
Officer
Mark Selawski........... 2000 101,667 5,500 -- -- -- -- --
Chief Financial 1999 105,625 500 -- -- -- -- --
Officer, Vice 1998 99,038 300 -- -- 80,000 -- --
President of
Finance and Secretary

Eva Novotny............. 2000 120,000 5,500 -- -- -- -- --
Executive Vice 1999 120,000 500 -- -- -- -- --
President of Sales 1998 120,000 300 -- -- 70,000 -- --
and Marketing

--------
(1) In addition to the cash compensation shown in the table, executive
officers of the Company may receive indirect compensation in the form of
perquisites and other personal benefits. For each of the named executive
officers, the amount of this indirect compensation in 2000, 1999 and 1998
did not exceed the lesser of $50,000 or 10% of the executive officer's
total salary and bonus for that year.

(2) Options to acquire shares of Common Stock granted or repriced.

Employment Agreements

Mr. Radlinski - On August 13, 1998, the Company entered into an employment
agreement with Mr. Radlinski to assure his continued service to the Company.
The agreement runs for a term of five years, expiring on August 13, 2003. The
agreement provides for a base salary of not less than $250,000 per year,
subject to adjustments as authorized by the Board of Directors.

Mr. Radlinski is also eligible for bonuses based on performance of the
Company's Common Stock. The Common Stock's closing price must attain and
remain at or above various levels, ranging from $11 to $21, for a period of 90
consecutive days. If these breakpoint prices are achieved within a set number
of months, the longest which is 48 months, from the commencement of the
contract, a cash bonus will be paid following the achievement period. Each
breakpoint bonus can be earned separately if achieved within the stated
achievement period, but each bonus can only be awarded once.

Concurrent with the commencement of this agreement, the exercise prices of
Mr. Radlinski's existing stock options to purchase up to 350,000 shares of the
Company's Common Stock from $7.13 to $10.63 were reduced to equal $6.375 per
share, the closing price per share of the Company's Common Stock on the
commencement date as reported on the NASDAQ National Market System. Such
option agreements were amended to provide that they shall become fully
exercisable, regardless of any otherwise applicable vesting requirements,
i) concurrently with any termination of Mr. Radlinski's employment by the
Company without "Good Cause" (as defined), or ii) if there is an acquisition
of substantially all of the Company's assets or business while he is still
employed by the Company and he does not immediately enter into an employment
agreement with a buying or surviving party in the transaction (a "change in
control").

If he is terminated without "Good Cause" or a change of control occurs
within the first three years of the agreement, a severance payment of five
times his then current base salary will be due and payable. If he is
terminated without "Good Cause" or such a change of control occurs within the
fourth year of the agreement, a severance payment of four times his then
current base salary will be due and payable. If he is terminated without "Good
Cause" or a change of control occurs within the fifth year of the agreement, a
severance payment of three times his then current base salary will be due and
payable.

In addition to the preceding paragraph, if Mr. Radlinski is terminated
without Good Cause in the first three years of this agreement, he will become
a consultant to the Company for a period of five years following termination
at a monthly compensation of $16,500 per month. If he is terminated without
Good Cause in the fourth year of this agreement, he will become a consultant
to the Company for a period of four years following termination at the same
monthly compensation. If he is terminated without Good Cause in the fifth year
of this agreement, he will become a consultant to the Company for a period of
three years following termination at the same monthly compensation. The
Company, during the consulting contract, shall provide term life insurance
equivalent to the unpaid amount of the consulting fees as established above,
payable to the beneficiary of his designation.

Mr. Selawski and Ms. Novotny - On August 13, 1998, the Company entered
into employment agreements with both Mr. Selawski and Ms. Novotny to assure
their continued service to the Company. The agreements run for a term of three
years, expiring on August 13, 2001. The agreements provide for a base salary
of not less than $100,000 per year for Mr. Selawski and $120,000 per year for
Ms. Novotny, subject to adjustments as authorized by the Board of Directors.

Concurrent with the commencement of these agreements, the exercise prices
of Mr. Selawski's existing stock options to purchase up to 80,000 shares of
the Company's Common Stock at from $7.13 to $9.68 were reduced to equal $6.375
per share, the closing price per share of the Company's Common Stock on the
commencement date as reported on the NASDAQ National Market System. Ms.
Novotny's existing stock options to purchase up to 70,000 shares of the
Company's Common Stock at from $9.68 to $10.68 were reduced to equal $6.375
per share, the closing price per share of the Company's Common Stock on the
commencement date as reported on the NASDAQ National Market System. Each such
option agreement was amended to provide that it shall become fully
exercisable, regardless of any otherwise applicable vesting requirements, i)
concurrently with any termination of the officer's employment by the Company
without Good Cause, or ii) if there is an acquisition of substantially all of
the Company's assets or business while such officer is still employed by the
Company and he or she does not immediately enter into an employment agreement
with a buying or surviving party in the transaction. If the officer is
terminated without "Good Cause" or such a change of control occurs within the
term of the agreement, a severance payment of two times his or her then
current base salary will be due and payable.

Stock Option Grants During 2000

No options were granted during 2000.

Stock Options Held at End of Fiscal Year

The following table provides information related to options exercised
during 2000 and options held by the named executive officers at December 31,
2000.

Number of Securities Value of Unexercised
Underlying Unexercised In-the-Money
Options at FY-End (#) Options at FY-End ($)(2)
Shares Acquired Value ------------------------- -------------------------
Name on Exercise (#) Realized ($)(1) Exercisable/Unexercisable Exercisable/Unexercisable
---- --------------- --------------- ------------------------- -------------------------

David V. Radlinski...... -- -- 295,000/55,000 ----/----
Mark Selawski........... -- -- 62,333/17,667 ----/----
Eva Novotny............. -- -- 42,334/27,666 ----/----

--------
(1) The value is calculated based on the difference between the option
exercise price and the market price for the Company's Common Stock on the
exercise date, multiplied by the number of shares purchased. For this
purpose, the surrender or withholding of shares to pay the exercise price
is not taken into account.

(2) The closing price for the Company's Common Stock as reported by the
National Association of Securities Dealers (NASD) on December 31, 2000 was
$5.875. Value is calculated on the basis of the difference between the
option exercise price and $5.875, multiplied by the number of shares of
Common Stock underlying the option.

Compensation Committee Interlocks and Insider Participation

During 2000 Donald J. Regan and Frank R. Pope served as the members of the
Company's Compensation Committee. Neither such individual is a current or
former officer or employee of the Company or any of its subsidiaries. During
2000 there were no compensation committee interlocks between the Company and
other entities involving Medstone executive officers serving as directors or
members of compensation or similar committees of such other entities.

Compensation of Directors

The Company currently compensates its outside directors, Messrs. Regan,
Tibbitts, Pope and Reed, a $10,000 annual retainer, paid quarterly, and $1,000
per Board meeting for their services, and reimburses all directors for
expenses incurred by them in connection with the Company's business.

Under the Nonemployee Director Stock Option Plan which expired in June
1999, each new nonemployee director was automatically granted an option to
purchase up to 5,000 shares as of the effective date of his or her first
appointment to the Board or first election to the Board by the shareholders,
whichever is earlier. Subject to acceleration of the option exercises in the
event of certain events specified in the plan, including certain changes in
control based on altered makeup of the Company's Board or stockholders, each
such option becomes exercisable with respect to 1/60 of the shares issuable
for each elapsed full month during the five-year period after its grant date
during which the optionee remains on the Company's board. The exercise price
of each option equals the fair market value of the underlying Common Stock on
the date the option was granted. Each option will expire six years after its
grant, except that the expiration will be extended until one year after the
optionee's death if it occurs less than one year before the option's
expiration date. An option granted under the plan is not transferrable during
the grantee's lifetime and must be exercised within one year following his or
her death, or within 90 days after the grantee ceases to be a member of the
Board for any other reason, and will only be exercisable to the extent it is
exercisable on the date the grantee leaves the Board. Under this plan, Mr.
Regan was granted 5,000 shares in September 1995 and Mr. Tibbitts was granted
5,000 shares in May 1996. Both grants have exercise prices of $6.375 after
repricing of the options on August 13, 1998.

Options to purchase 15,000 shares of Common Stock were issued to Mssrs.
Pope, Regan and Tibbitts in November 1996 and have exercise prices of $6.375
after repricing of the options on August 13, 1998. The options are
exercisable, after six months following their grant dates, in incremental
amounts equal to 1/48 of the

underlying shares for each elapsed calendar month during which the director
remains on the Company's Board. The terms of the options are five years,
subject to earlier termination related to the director no longer serving on
the Board. Additionally, each such director was granted options under the
Company's 1997 Stock Incentive Plan, on August 13, 1998 and June 24, 1999, for
4,000 shares at an exercise price of $6.375 and $7.375, respectively. These
options are exercisable, after six months following their grant dates, in
incremental amounts equal to 1/36 of the underlying shares for each elapsed
calendar month during which the director remains on the Company's Board. The
term of the options are four years, subject to early termination related to
the director no longer serving on the Board.

Upon his becoming a director in July 1999, Mr. Reed was granted an option
under the 1997 Stock Incentive Plan to purchase up to 5,000 shares of Common
Stock at an exercise price of $6.56 per share. Subject to acceleration of the
option exercise in the event of certain events specified in the option
agreement, including certain changes in control based on altered makeup of the
Company's Board or shareholders, the option becomes exercisable, after six
months following its grant date, with respect to 1/60 of the shares issuable
for each elapsed full month during the five-year period after its grant date
during which Mr. Reed remains on the Company's Board. The option term is six
years, subject to early termination related to Mr. Reed no longer serving on
the Board, but the option will be extended one year after his death if it
occurs less than one year before the expiration date.

Subject to certain exceptions set forth in the applicable plan or agreement
provisions, the exercisability of the outstanding options held by the
nonemployee directors will be accelerated, and the options will thereafter
terminate, if there is a reorganization, merger or consolidation as a result
of which the Company is not the surviving corporation or the Company's
outstanding shares are changed into or exchanged for cash, property or
securities not of the Company's issue, or if there is a sale of all or
substantially all of the Company's assets. Such accelerations will not apply
if appropriate provision is made in the transaction for the assumption of such
options by, or the substitution of new options for such options covering the
stock of, the surviving, successor or purchasing corporation or its affiliate.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth the number of shares of the Company's Common
Stock known to the Company to be beneficially owned as of March 2, 2001 by
each person who owns beneficially more than 5 percent of the outstanding
shares of Common Stock, by each of the present directors, by each of the
executive officers named in the Executive Compensation in Item 11 and by all
executive officers and directors of the Company as a group, and the percentage
of the total outstanding shares of Common Stock such shares represented as of
March 2, 2001.

Number of Shares
Beneficially Percentage of
Name and Address of Beneficial Owner Owned(1) Ownership
------------------------------------ ---------------- -------------

FMR Corp. .................................. 561,200 13.1%
82 Devonshire Street
Boston, MA 02109

Hathaway & Associates, Ltd. ................ 500,000 11.7%
119 Rowayton Avenue
Rowayton, CT 06853

David V. Radlinski(2)(3) ................... 390,833(4) 8.5%
100 Columbia, Suite 100
Aliso Viejo, CA 92656

Dimensional Fund Advisors, Inc.............. 363,700 8.5%
1299 Ocean Ave., 11th Floor
Santa Monica, CA 90401

Mark Selawski(3)............................ 70,513(5) 1.6%
100 Columbia, Suite 100
Aliso Viejo, CA 92656

Eva Novotny(3).............................. 47,800(6) (11)
100 Columbia, Suite 100
Aliso Viejo, CA 92656

Donald J. Regan(2).......................... 32,600(7) (11)
462 Stevens Avenue, Suite 308
Solana Beach, CA 92075

Michael C. Tibbitts(2) ..................... 27,917(8) (11)
27001 La Paz Road, Suite 448B
Mission Viejo, CA 92691

Frank R. Pope(2)............................ 23,000(9) (11)
3460 Baker St.
San Francisco, CA 94123

David A. Reed(2)............................ 1,750(10) (11)
24681 La Plaza, Suite 240
Dana Point, CA 92629

All executive officers and directors
as a group (7 persons)(12)................. 592,663 12.4%

--------
(1) All such shares were held of record with sole voting and investment
power, subject to applicable community property laws, by the named
individual and/or by his wife, except as indicated in the following
footnotes.

(2) Director of the Company.

(3) Executive officer of the Company.

(4) Includes 308,333 shares issuable upon exercise of presently outstanding
stock options.

(5) Includes 66,333 shares issuable upon exercise of presently outstanding
stock options.

(6) Includes 47,000 shares issuable upon exercise of presently outstanding
stock options.

(7) Includes 26,000 shares issuable upon exercise of presently outstanding
stock options.

(8) Includes 25,917 shares issuable upon exercise of presently outstanding
stock options.

(9) Includes 21,000 shares issuable upon exercise of presently outstanding
stock options.

(10) Includes 1,750 shares issuable upon exercise of presently outstanding
stock options.

(11) Percentage information is omitted because the beneficially owned shares
represent less than 1% of the outstanding shares of the Company's Common
Stock

(12) Includes 496,333 shares issuable upon exercise of presently outstanding
stock options.

Item 13. CERTAIN RELATIONSHIPS AND INVESTMENTS

Cardiac Science, Inc.

During 1991, the Company was a party to the formation of Cardiac Science,
Inc., for which the Company purchased 5,353,031 (pre-split) shares of common
stock, for a cash payment of $.0016 per share. This purchase represented 77.3%
of the outstanding stock. As of July 8, 1991, the Company distributed, as a
dividend to its stockholders of record on that date, one share of Cardiac
Science, Inc. stock for each share of Medstone stock held. The Company
retained 629,768 (pre-split) shares of common stock of Cardiac Science, Inc.

From 1991 through 1996, the Company performed various financings for
Cardiac Science and received warrants to purchase Cardiac Science common
stock. Due to exercise of warrants, common stock issued in lieu of interest
and unsecured advances, the Company received 5,619,054 (pre-split) shares of
Cardiac Science.

In April 1997, Cardiac Science effectuated a 1 for 11.42857142 reverse
stock split, reducing the Company's holdings to 546,772 shares.

Since mid-1999, the Company has been actively selling its position in
Cardiac Science, selling 55,105 shares for a gain of approximately $244,000 in
1999 and selling 304,667 shares for a gain of approximately $1,855,000 in 2000
and selling 73,000 shares for a gain of approximately $358,000 in
January 2001. As of March 2, 2001, the Company held 114,000 shares of Cardiac
Science common stock.

Also during 1999, the Company, which held unexpired warrants to purchase
87,500 shares at $.011 each, sold these warrants for a cash price of $3.00 per
share, resulting in a gain of approximately $262,000.

Digital Imaging Systems, Inc.

In 1998, the Company entered into a supply agreement with Digital Imaging
Systems, Inc. ("DIS") for components integral in the Company's STS-T. The
Company has purchased $300,000, or 300,000 shares, of DIS preferred stock,
which represented a 14% ownership interest. DIS commenced shipments of the
components to the Company as of January 1999. In 1999, the Company recorded an
investment writedown of $300,000 for impairment as a result of its review of
the realizable value of its investment in DIS shares.

k. Biotech

In 1998, the Company was made aware of an opportunity to invest in a
developmental biotech drug company catering to the members of the
International Centre for Genetic Engineering and Biotechnology ("ICGEB"), a
United Nations sponsored institute. k. Biotech purchased license agreements
for formulas, developed by the ICGEB, for commercialization purposes in the
Indian sub-continent as its primary market. The Company has purchased $325,000
of preferred stock to assist k. Biotech in establishing itself as a viable
business entity. Two of the Company's directors, Mssrs. Pope and Regan, are
investors in k.Biotech and Mr. Regan serves as k. Biotech's President.
Additional funding from international sources is currently being evaluated.

Chinese Joint Venture

The Company, along with Acuity International ("Acuity") and Phenix Optical
Ltd ("Phenix"), a Chinese company, created a joint venture, in March 1998, to
provide lithotripsy services to inland Chinese areas. Each entity was a 1/3
owner of the joint venture. The Company recognized a gain of $105,000 on its
contribution of equipment to the joint venture in the first quarter of 1998,
and recorded its investment of $92,000 as other assets. In December 1998,
documents were drawn to turn ownership over to Phenix in return for delivery
of optical products to both Acuity and the Company. In 1999, the Company
received optical products in release of its share in the joint venture and
final release documents were processed. The Company is carrying the value of
the optical products at the remaining estimated fair value, based on the value
established in the joint venture, for the quantity remaining from the
remarketing efforts of the Company.

Medicredit .com, Inc.

In April 2000, the Company purchased common stock representing a 46%
interest in Medicredit.com, Inc. ("Medicredit") for $1 million in cash.
Medicredit, a California-based company, funds and service loans to physicians
to finance elective surgeries in the cosmetic and cash paying sector of
healthcare. Mssrs. Radlinski and Selawski serve on the Medicredit Board of
Directors. Along with the cash investment in Medicredit, the Company also
agreed to a line of credit of up to $2 million at the prime interest rate. As
of March 2, 2001, the full $2 million credit line was outstanding to
Medicredit and is reflected as long-term receivable from unconsolidated
subsidiary in the Consolidated Balance Sheets of the Company.

PART IV

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a) Index to Consolidated Financial Statements

Page
----

1. Consolidated Financial Statements
Report of Independent Auditors.................................... 29
Consolidated Balance Sheets at December 31, 2000 and 1999......... 30
Consolidated Statements of Income for the years ended December 31,
2000, 1999 and 1998.............................................. 31
Consolidated Statements of Stockholders' Equity for the years
ended December 31, 2000, 1999 and 1998........................... 32
Consolidated Statements of Cash Flows for the years ended December
31, 2000, 1999 and 1998.......................................... 33
Notes to Consolidated Financial Statements........................ 34

2. Schedule to Consolidated Financial Statements
Schedule II--Valuation and Qualifying Accounts.................... 47

All other schedules are omitted because they are not applicable or the
required information is included in the consolidated financial statements or
notes thereto.

(b) Reports on Form 8-K

There were no reports on Form 8-K filed with the Commission during the
quarter ended December 31, 2000.

Exhibit
No. Description
------- -----------

3.1 Certificate of Incorporation of the Company, as amended (1)

3.2 Restated and Amended Bylaws of the Company (2)

4.2 Specimen Certificate of the Company's Common Stock (3)

10.26 1989 Stock Incentive Plan (4)(5)

10.27 Non-employee Director Stock Option Plan (4)(5)

10.29 1997 Stock Incentive Plan (5)(6)

10.30 Employment Agreement with David Radlinski (5)(7)

10.31 Employment Agreement with Mark Selawski (5)(7)

10.32 Employment Agreement with Eva Novotny (5)(7)

10.33 Amended Lease for Aliso Viejo Property (8)

21 Subsidiaries

23.1 Consent of Independent Auditors

28.2 Form of Cytocare, Inc. Information Statement--Distribution to
Shareholders of Stock of Cardiac Science, Inc. (9)

28.3 Form of Medstone International, Inc. Information Statement--
Distribution to Shareholders of Stock of Endocare, Inc. and Urogen
Corp. (10)

--------
(1) Previously filed with the same exhibit number with the Company's
Registration Statement on Form S-1 under the Securities Act of 1933, Reg.
No. 33-16340 and with the Company's Quarterly Report on Form 10-Q for the
quarter ended June 30, 1998 and incorporated herein by reference.

(2) Previously filed with the same exhibit number with the Company's
Quarterly Report on Form 10-Q for the quarter ended June 30, 1999, and
incorporated herein by reference.

(3) Previously filed with the same exhibit number with the Company's
Registration Statement on Form S-1 under the Securities Act of 1933, Reg.
No. 33-16340 and incorporated herein by reference.

(4) Previously filed with the same exhibit number with the Company's
Quarterly Report on Form 10-Q for the quarter ended June 30, 1989, and
incorporated herein by reference.

(5) Compensatory plan or arrangement.

(6) Previously filed with the same exhibit number with the Company's
Quarterly Report on Form 10-Q for the quarter ended June 30, 1997.

(7) Previously filed with the same exhibit number with the Company's
Quarterly Report on Form 10-Q for the quarter ended September 30, 1998.

(8) Previously filed with the same exhibit number with the Company's
Quarterly Report on Form 10-Q for the quarter ended March 31, 2000.

(9) Previously filed with the same exhibit number with the Company's current
report on Form 8-K dated June 26, 1991, and incorporated herein by
reference.

(10) Previously filed with the Company's current report on Form 8-K dated
February 9, 1996, and incorporated herein by reference.

The Company will furnish to a requesting beneficial owner of its securities
a copy of any such exhibits upon payment of a fee equal to $.20 per exhibit
page.

REPORT OF INDEPENDENT AUDITORS

Stockholders and Board of Directors
Medstone International, Inc.

We have audited the accompanying consolidated balance sheets of Medstone
International, Inc. and subsidiaries (the "Company") as of December 31, 2000
and 1999, and the related consolidated statements of income, stockholders'
equity, and cash flows for each of the three years in the period ended
December 31, 2000. Our audits also included the financial statement schedule
listed in the Index at Item 14(a). These financial statements and schedule are
the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements and schedule based on our
audits.

We conducted our audits in accordance with auditing standards generally
accepted in the 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, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of Medstone International, Inc. and subsidiaries at December 31, 2000 and
1999, and the consolidated results of their operations and their cash flows
for each of the three years in the period ended December 31, 2000, in
conformity with accounting principles generally accepted in the United States.
Also, in our opinion, the related financial statement schedule, when
considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information set forth therein.

Ernst & Young LLP

Orange County, California
February 14, 2001

MEDSTONE INTERNATIONAL, INC.

CONSOLIDATED BALANCE SHEETS

December 31,
-------------------------
2000 1999
------------ -----------
ASSETS
------

Current assets:
Cash and cash equivalents.......................... $ 945,610 $ 1,061,422
Short-term investments held to maturity............ 5,223,659 8,629,990
Accounts receivable, less allowance for doubtful
accounts of $477,180 and $571,252 in 2000 and
1999, respectively................................ 4,165,563 3,291,372
Inventories, less allowance for inventory
obsolescence of $457,088 and $307,203 in 2000 and
1999, respectively................................ 6,103,051 5,760,887
Deferred tax assets................................ 1,005,814 1,273,386
Prepaid expenses and other current assets.......... 526,825 366,774
------------ -----------
Total current assets............................. 17,970,522 20,383,831
Buildings, property and equipment, at cost:
Building........................................... 359,324 359,324
Lithotripters...................................... 12,316,739 11,163,744
Equipment.......................................... 1,835,855 1,698,185
Furniture and fixtures............................. 948,362 879,458
Leasehold improvements............................. 157,083 147,200
------------ -----------
15,617,363 14,247,911
Less accumulated depreciation and amortization..... (10,440,172) (8,308,841)
------------ -----------
Net property and equipment......................... 5,177,191 5,939,070
------------ -----------
Goodwill, net....................................... 3,306,622 3,409,916
Investment in unconsolidated subsidiaries........... 1,263,598 325,000
Long-term receivable from unconsolidated
subsidiary......................................... 2,000,000 --
Other assets, net................................... 158,914 117,195
------------ -----------
$ 29,876,847 $30,175,012
============ ===========

LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------

Current liabilities:
Accounts payable................................... $ 657,878 $ 611,492
Accrued expenses................................... 580,232 716,619
Accrued income taxes............................... 73,314 263,058
Accrued payroll expenses........................... 347,034 346,262
Customer deposits.................................. 58,441 --
Deferred revenue................................... 656,332 907,326
------------ -----------
Total current liabilities........................ 2,373,231 2,844,757
Deferred tax liabilities............................ 562,313 628,856
Minority interest................................... 554,292 284,350
Deferred rent....................................... 78,697 --

Commitments and contingencies (Notes 7 and 8)

Stockholders' equity:
Common stock--$.004 par value, 20,000,000 shares
authorized, 5,742,670 and 5,667,142 shares issued
and outstanding at December 31, 2000 and 1999,
respectively...................................... 22,971 22,669
Additional paid-in capital......................... 19,646,388 19,177,274
Accumulated earnings............................... 16,708,143 14,619,507
Accumulated other comprehensive income (loss)...... 55,395 (13,942)
Treasury stock, at cost, 1,434,450 and 974,650
shares at December 31, 2000 and 1999,
respectively...................................... (10,124,583) (7,388,459)
------------ -----------
Total stockholders' equity....................... 26,308,314 26,417,049
------------ -----------
$ 29,876,847 $30,175,012
============ ===========

See accompanying notes

MEDSTONE INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF INCOME

For the year ended December 31,
-------------------------------------
2000 1999 1998
----------- ----------- -----------

Revenue:
Procedures, maintenance fees and fee-
for-service.......................... $18,930,319 $19,532,046 $21,128,586
Net equipment sales................... 3,284,119 3,337,650 2,144,500
Interest income....................... 607,616 598,661 551,723
----------- ----------- -----------
Total revenues........................ 22,822,054 23,468,357 23,824,809

Costs and expenses:
Cost of procedures and maintenance
fees................................. 11,678,337 10,186,243 9,098,822
Cost of equipment sales............... 2,264,073 1,920,117 1,900,803
Research and development.............. 1,180,409 1,455,429 1,078,792
Selling............................... 2,174,592 2,048,390 1,988,331
General and administrative............ 2,651,172 2,592,308 2,131,373
----------- ----------- -----------
Total costs and expenses.............. 19,948,583 18,202,487 16,198,121
----------- ----------- -----------

Operating income........................ 2,873,471 5,265,870 7,626,688

Other expense (income):
Gain on sale of investments........... (1,882,545) (244,305) --
Other expense......................... 109,046 147,031 (61,045)
----------- ----------- -----------
Total other expense (income).......... (1,773,499) (97,274) (61,045)

Minority interests:
Minority interest in subsidiaries
income............................... 833,942 602,594 627,639
Equity loss from unconsolidated
subsidiary........................... 61,402 -- --
----------- ----------- -----------
Total minority interest............... 895,344 602,594 627,639

Income before provision for income
taxes.................................. 3,751,626 4,760,550 7,060,094
Provision for income taxes.............. 1,662,990 1,919,400 2,718,000
----------- ----------- -----------
Net income.............................. $ 2,088,636 $ 2,841,150 $ 4,342,094
=========== =========== ===========

Net income per share:
Basic................................. $ .46 $ .57 $ .84
=========== =========== ===========
Diluted............................... $ .46 $ .56 $ .82
=========== =========== ===========
Number of shares used in the computation
of net income per share:
Basic................................. 4,504,468 4,956,508 5,162,112
=========== =========== ===========
Diluted............................... 4,511,119 5,034,850 5,286,967
=========== =========== ===========

See accompanying notes

MEDSTONE INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

Common Stock Accumulated
------------------ Additional Other
Number of paid-in Accumulated Stock Purchase Comprehensive Treasury
shares Amount capital earnings Note Receivable income (loss) Stock Total
--------- ------- ----------- ----------- --------------- ------------- ------------ -----------

Balance at December
31, 1997............. 5,365,988 $22,539 $18,998,260 $ 7,436,263 $(134,800) $ (579) $ (2,200,736) $24,120,947
Net income............ -- -- -- 4,342,094 -- -- -- 4,342,094
Other comprehensive
income:
Unrealized loss on
short-term
investments......... -- -- -- -- -- (598) -- (598)
-----------
Total comprehensive
income............... -- -- -- -- -- -- -- 4,341,496
-----------
Common stock options
exercised............ 15,717 63 77,844 -- -- -- -- 77,907
Repayment of stock
purchase note........ -- -- -- -- 134,800 -- -- 134,800
Treasury stock
repurchased.......... (318,300) -- -- -- -- -- (2,742,473) (2,742,473)
--------- ------- ----------- ----------- --------- -------- ------------ -----------
Balance at December
31, 1998............. 5,063,405 22,602 19,076,104 11,778,357 -- (1,177) (4,943,209) 25,932,677
Net income............ -- -- -- 2,841,150 -- -- -- 2,841,150
Other comprehensive
income:
Unrealized gain on
short-term
investments......... -- -- -- -- -- 1,177 -- 1,177
Unrealized loss on
foreign currency
translation......... -- -- -- -- -- (13,942) -- (13,942)
-----------
Total comprehensive
income............... -- -- -- -- -- -- -- 2,828,385
-----------
Common stock options
exercised............ 16,637 67 101,170 -- -- -- -- 101,237
Treasury stock
repurchased.......... (387,550) -- -- -- -- -- (2,445,250) (2,445,250)
--------- ------- ----------- ----------- --------- -------- ------------ -----------
Balance at December
31, 1999............. 4,692,492 $22,669 $19,177,274 $14,619,507 $ -- $(13,942) $ (7,388,459) $26,417,049
--------- ------- ----------- ----------- --------- -------- ------------ -----------
Net income............ -- -- -- 2,088,636 -- -- -- 2,088,636
Other comprehensive
income:
Unrealized gain on
foreign currency
translation, net.... -- -- -- -- -- 69,337 -- 69,337
-----------
Total comprehensive
income............... -- -- -- -- -- -- -- 2,157,973
-----------
Common stock options
exercised............ 75,528 302 469,114 -- -- -- -- 469,416
Treasury stock
repurchased.......... (459,800) -- -- -- -- -- (2,736,124) (2,736,124)
--------- ------- ----------- ----------- --------- -------- ------------ -----------
Balance at December
31, 2000............. 4,308,220 $22,971 $19,646,388 $16,708,143 $ -- $ 55,395 $(10,124,583) $26,308,314
========= ======= =========== =========== ========= ======== ============ ===========

See accompanying notes

MEDSTONE INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

Year ended December 31,
-------------------------------------
2000 1999 1998
----------- ----------- -----------

Cash flows from operating activities:
Net income............................. $ 2,088,636 $ 2,841,150 $ 4,342,094
Adjustments to reconcile net income to
net cash provided by operating
activities:
Depreciation and amortization........ 2,377,014 2,075,884 1,946,746
Provision for doubtful accounts...... -- 35,000 130,000
Writedown of investment.............. -- 300,000 --
Minority interest in partnership..... 833,942 602,595 627,639
Minority equity in unconsolidated
subsidiary.......................... 61,402 -- --
Provision for inventory
obsolescence........................ 277,138 -- --
Gain on sale of long-term
investments......................... (1,882,545) (506,805) --
Changes in operating assets and
liabilities:
Accounts receivable................ (874,191) 309,763 (544,794)
Inventories........................ (619,302) (1,992,704) (915,686)
Deferred tax assets................ 201,029 (219,364) (183,183)
Prepaid expenses and other current
assets............................ (160,051) 374,474 (263,624)
Accounts payable................... 46,386 215,090 (498,151)
Accrued expenses................... (99,225) 104,189 274,687
Accrued income taxes............... (226,674) 69,388 816,444
Accrued payroll expenses........... 772 42,575 64,183
Deferred revenue................... (250,994) (39,756) (347,010)
Customer deposits.................. 58,441 (86,125) (46,574)
Other, net......................... 70,884 (4,444) 124,616
----------- ----------- -----------
Net cash provided by operating
activities........................ 1,902,662 4,120,910 5,527,387
----------- ----------- -----------

Cash flows from investing activities:
Purchases of short-term investments.... (12,575,069) (23,351,435) (25,798,243)
Proceeds from sales of short-term
investments........................... 15,981,400 25,216,697 25,205,077
Proceeds from sale of long-term
investments........................... 1,882,545 506,805 --
Investment in unconsolidated
subsidiary............................ (1,000,000) (100,000) (617,369)
Purchase of net assets................. -- (751,712) --
Long-term loan to unconsolidated
subsidiary............................ (2,000,000) -- --
Distribution of minority interest...... (564,000) (638,300) (676,800)
Purchases of property and equipment,
net................................... (1,518,177) (2,718,288) (1,106,832)
----------- ----------- -----------
Net cash provided by (used in)
investing activities.............. 206,699 (1,836,233) (2,994,167)
----------- ----------- -----------
Cash flows from financing activities:
Proceeds from issuance of common
stock................................. 469,416 101,237 77,907
Proceeds from stock purchase note...... -- -- 134,800
Purchase of treasury stock............. (2,736,124) (2,445,250) (2,742,473)
Deferral of rent payments.............. 78,697 -- --
Loan payments.......................... (37,162) (7,705) --
----------- ----------- -----------
Net cash used in financing
activities........................ (2,225,173) (2,351,718) (2,529,766)

Net increase (decrease) in cash and cash
equivalents............................ (115,812) (67,041) 3,454
Cash and equivalents at beginning of
year................................... 1,061,422 1,128,463 1,125,009
----------- ----------- -----------
Cash and equivalents at end of year..... $ 945,610 $ 1,061,422 $ 1,128,463
=========== =========== ===========
Supplemental cash flow disclosures:
Cash paid during the year for:
Income taxes.......................... $ 1,694,826 $ 1,925,645 $ 2,588,819
=========== =========== ===========
Supplemental disclosures of non-cash
investing activities:
Liabilities assumed in connection with
the purchase transaction (Note 3)..... $ -- $ 365,110 $ --
=========== =========== ===========

See accompanying notes

MEDSTONE INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2000

1. Organization and Operations of the Company

Medstone International, Inc. ("Medstone" or the "Company") designs,
manufactures and markets the Medstone STS(TM) and STS-T Shockwave Therapy
Systems (the "System") for the noninvasive disintegration of kidney stones in
human patients. The Company also generates revenues from use of the Systems
under procedure fees and fee for service arrangements and from repairs and
maintenance. The Company's customers are primarily located in the United
States.

2. Summary of Significant Accounting Policies

Principles of consolidation

The consolidated financial statements include the accounts of the Company;
Medstone International, Ltd., a Scotish subsidiary group; United Physicians
Resources, an 80% owned physicians practice management operation incorporated
in June 1996; Northern Nevada Lithotripsy Associates, LLC, a 60% owned Nevada
Limited Liability Company; Southern Idaho Lithotripsy Associates, LLC, a
California Limited Liability Company, also 60% owned (See Note 3); and Medstone
Sales Corporation, a 100% owned foreign sales corporation. All majority-owned
subsidiaries are consolidated and all material intercompany accounts and
transactions are eliminated. Investments in less than 20% owned affiliates are
accounted for on the cost method, unless the Company is able to exercise
significant influence over the affiliates operating and financial policies, in
which case the investments are accounted for on the equity method.

Reclassifications

Certain prior year balances have been reclassified to conform with the
December 31, 2000 presentation.

Use of estimates

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that 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 reporting period. Actual results could differ from those
estimates.

Statement of cash flows

The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents.

Fair Value of Financial Instruments

The fair market value of cash and cash equivalents, short-term investments
and accounts receivable approximate cost due to the short period of time to
maturity. The carrying value of the long term receivable from unconsolidated
subsidiary approximates fair value because the interest rate fluctuates with
market conditions.

Short-term Investments

The Company applies the provisions of Statement of Financial Accounting
Standards No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," to its short-term investments. Under this statement, management
determines the appropriate classification of such securities at the time of
purchase and reevaluates such classification as of each balance sheet date.
Based on its intent, the Company's investments are classified as held-to-
maturity and are carried at amortized cost.

MEDSTONE INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

December 31, 2000

The amortized cost and market value of investments at December 31, 2000, by
contractual maturity, is shown below.

Amortized Market
Cost Value
---------- ----------

Due in one year or less............................... $5,223,659 $5,400,953

Comprehensive Income

As of January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 130, Reporting Comprehensive Income (SFAS 130). SFAS
No. 130 established new rules for the reporting and display of comprehensive
income and its components; however, the adoption of this Statement had no
impact on the Company's net income. SFAS No. 130 requires unrealized gains or
losses on available-for-sale securities and unrealized gains or losses on
foreign currency translation, to be included in other comprehensive income.
Prior financial statements have been reclassified to conform to the
requirements of SFAS No. 130.

The components of accumulated other comprehensive income/(loss) are as
follows:

Unrealized
Foreign Gains on
Currency Available-
Translation for-Sale
Adjustment Securities Total
----------- ---------- --------

Balance at December 31, 1998.............. $ -- $(1,177) $ (1,177)
Foreign currency translation adjustment... (13,942) -- (13,942)
Unrealized gain on available-for-sale
securities............................... -- 1,177 1,177
-------- ------- --------
Balance at December 31, 1999.............. (13,942) -- (13,942)
Foreign currency translation adjustment
net of income taxes...................... 69,337 -- 69,337
-------- ------- --------
Balance at December 31, 2000.............. $ 55,395 $ -- $ 55,395
======== ======= ========

Concentrations of Credit Risk

Financial instruments which potentially subject the Company to
concentrations of credit risk consist principally of cash and cash
equivalents, and short-term investments, which are not federally insured, and
accounts receivable. The Company's short-term investments consist principally
of U.S. Treasury Bills, U.S. Government Agency Notes and Commercial Paper.

The Company sells its products primarily to hospitals worldwide. Credit is
extended based on an evaluation of the customer's financial condition and
collateral generally is not required. The Company's ten largest customers
accounted for approximately 10% of accounts receivable at December 31, 2000.

Inventories

Inventories are stated at the lower of cost (first-in, first-out) or market
and consist of the following:

December 31,
---------------------
2000 1999
---------- ----------

Raw materials.......................................... $3,888,640 $3,699,983
Work in process........................................ 231,175 427,600
Finished goods......................................... 1,983,236 1,633,304
---------- ----------
$6,103,051 $5,760,887
========== ==========

MEDSTONE INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

December 31, 2000

Building, Property and Equipment

Building, property and equipment are carried at cost. Depreciation and
amortization are computed on the straight-line method over the following
estimated useful lives:

Building...................................................... 50 years
Lithotripters................................................. 5 years
Equipment..................................................... 5 years
Furniture and fixtures........................................ 5 years
Leasehold improvements........................................ Life of lease

Depreciation expense for the years ended December 31, 2000, 1999 and 1998
was $2,274,183, $1,987,000, and $1,863,000, respectively.

Goodwill

The Company recorded goodwill resulting from the excess of the purchase
prices of Northern Nevada, Southern Idaho and Zenith Medical Systems, Ltd.
over the fair market value of the net assets acquired. Goodwill is being
amortized over periods ranging from fifteen to forty years using the straight-
line method. Accumulated amortization at December 31, 2000 and 1999 is
$371,194 and $269,635, respectively.

Long-Lived Assets

Long-lived assets and certain identifiable intangibles held and used by the
Company are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. Based upon the Company's analysis, the Company believes no
material impairment of the carrying value of its long-lived assets, inclusive
of intangible assets, existed at December 31, 2000 and 1999. The Company's
analysis was based on a comparison of the carrying amount of such assets to
the Company's historical actual cash flows and to an estimate of future
undiscounted cash flows.

Earnings Per Share

The Company has adopted SFAS No. 128, "Earnings Per Share," and applied
this pronouncement to all periods presented. This statement requires the
presentation of both basic and diluted net income per share for financial
statement purposes. Basic net income per share is computed by dividing income
available to common stockholders by the weighted average number of common
shares outstanding. Diluted net income per share includes the effect of the
potential shares outstanding, including dilutive stock options and warrants
using the treasury stock method. All earnings per share amounts for all
periods have been restated to conform with the SFAS No. 128 requirements.

MEDSTONE INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

December 31, 2000

The following table sets forth the computation of earnings per share:

Year Ended December 31,
--------------------------------
2000 1999 1998
---------- ---------- ----------

Numerator: Net income..................... $2,088,636 $2,841,150 $4,342,094
========== ========== ==========
Denominator for weighted average shares
outstanding.............................. 4,504,468 4,956,508 5,162,112
========== ========== ==========
Basic earnings per share.................. $ .46 $ .57 $ .84
========== ========== ==========
Effect of dilutive securities:
Weighted average shares outstanding..... 4,504,468 4,956,508 5,162,112
Stock options........................... 6,651 78,342 124,855
---------- ---------- ----------
Denominator for diluted earnings per
share.................................... 4,511,119 5,034,850 5,286,967
========== ========== ==========
Diluted earnings per share................ $ .46 $ .56 $ .82
========== ========== ==========

Stock Compensation

The Company has elected to follow Accounting Principles Board Opinion No.
25, Accounting for Stock Issued to Employees, (APB 25) and related
Interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under FASB
Statement No. 123, Accounting for Stock-Based Compensation, requires the use
of option valuation models that were not developed for use in valuing employee
stock options. Under APB 25, because the exercise price of the Company's
employee stock options equals the market price of the underlying stock on the
date of grant, no compensation expense is recognized.

To calculate the pro forma information required by Statement 123, the
Company uses the Black-Scholes option pricing model. The Black-Scholes model
was developed for use in estimating the fair value of traded options which
have no vesting restrictions and are fully transferable. In addition, option
valuation models require the input of highly subjective assumptions including
the expected stock price volatility. Because the Company's employee stock
options have characteristics significantly different from those of traded
options, and because changes in the subjective input assumptions can
materially affect the fair value estimate, in management's opinion, the
existing models do not necessarily provide a reliable single measure of the
fair value of its employee stock options.

Revenue recognition

Revenues recognized in the fee-for-service segment of the Company's
operations are invoiced as the customer uses the equipment in the month that
service has been provided. Revenues from equipment sales are recognized in
accordance with the underlying contractual terms of each sale. Typically,
revenue recognition requires the transfer of title upon shipment, customer
acceptance, receipt of specified down payments and performance of all
significant contractual obligations.

Service and maintenance contract revenues are deferred and amortized over
the terms of the related contracts.

Advertising

The Company expenses advertising costs including promotional literature,
brochures and trade shows as incurred. Advertising expense was $32,000,
$58,000 and $135,000 for the years ended December 31, 2000, 1999 and 1998,
respectively.

MEDSTONE INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

December 31, 2000

Business Segments and Geographic Information

The Company applies the provisions of Statement of Financial Accounting
Standards No. 131, Disclosures about Segments of an Enterprise and Related
Information (SFAS 131). SFAS No. 131 establishes standards for related
disclosures about products and services, geographic areas and major customers.

The Company operates in two business segments, equipment sales and fees for
procedures, maintenance and management. The equipment sales segment is not
significant. The fees for procedures, maintenance and management segment
represents recurring revenue from procedure fees and fee for service
arrangements for use and the maintenance of lithotripter equipment. The
accounting policies of these segments are the same as those described in the
summary of significant accounting policies except that certain expenses, such
as amortization of certain intangibles and certain corporate expenses, are not
allocated to the segments. Asset categories used for allocation to segment
reporting include net accounts receivable, net inventory, net property and
equipment and net goodwill.

Selected financial information for the Company's reportable segments as of
and for the years ended December 31, 2000, 1999 and 1998 follows (in
thousands):

2000 1999 1998
------- ------- -------

Revenue:
Equipment sales................................ $ 3,284 $ 3,338 $ 2,145
Fees for procedures, maintenance and
management.................................... 18,930 19,532 21,128
Nonreportable segment.......................... 608 598 552
------- ------- -------
$22,822 $23,468 $23,825
======= ======= =======
Operating income (loss):
Equipment sales................................ $ (8) $ 678 $ (537)
Fees for procedures, maintenance and
management.................................... 2,394 4,085 7,751
Nonreportable segment.......................... 487 600 474
------- ------- -------
$ 2,873 $ 5,363 $ 7,688
======= ======= =======
Assets:
Equipment sales................................ $ 3,642 $ 3,228 $ 1,764
Fees for procedures, maintenance and
management.................................... 15,110 15,173 13,252
------- ------- -------
$18,752 $18,401 $15,016
======= ======= =======
Depreciation and amortization:
Equipment sales................................ $ 252 $ 206 $ 149
Fees for procedures, maintenance and
management.................................... 2,125 1,870 1,798
------- ------- -------
$ 2,377 $ 2,076 $ 1,947
======= ======= =======
Expenditures for long-lived assets and equity
method investments:
Equipment sales................................ $ 1,198 $ 1,171 $ 473
Fees for procedures, maintenance and
management.................................... 1,319 2,399 634
------- ------- -------
$ 2,517 $ 3,570 $ 1,107
======= ======= =======

MEDSTONE INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

December 31, 2000

Selected financial information for the Company's operations by geographic
segment is as follows (in thousands):

2000 1999 1998
------- ------- -------

Revenue:
United States..................................... $21,121 $22,733 $22,977
Europe and Middle East............................ 1,464 459 17
Asia Pacific Rim.................................. 237 276 831
------- ------- -------
$22,822 $23,468 $23,825
======= ======= =======
Long-Lived Assets:
United States..................................... $21,699 $17,263 $14,898
Europe............................................ 865 820 --
------- ------- -------
$22,564 $18,083 $14,898
======= ======= =======

Recently Issued Accounting Pronouncements

In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, Accounting for Certain Derivatives and
Hedging Activities (SFAS 133), as amended, which is required to be adopted
effective January 1, 2001. SFAS 133 established new standards for recording
derivatives in interim and annual financial reports requiring that all
derivative instruments, except those qualifying as a hedge under the criteria
set forth in SFAS 133, be recorded on the balance sheet at fair value with
adjustments to the fair value through earnings. The Company will adopt the new
requirements effective with the filing of its Quarterly Report on Form 10-Q
for the quarter ended March 31, 2001. The Company anticipates that the
adoption of SFAS No. 133 will not have an impact on its financial position,
results of operations, or cash flows.

3. Acquisitions and Investments in Joint Ventures

Equity Investment in Medicredit.com, Inc.

In April 2000, the Company purchased common stock representing a 46%
interest in Medicredit.com. Inc. ("Medicredit") for $1 million in cash.
Medicredit, a California-based company, funds and services patient accounts to
finance elective surgeries in the cosmetic and cash paying sector of
healthcare. The investment in Medicredit is accounted for under the equity
method. The investment, net of the Company's share of net losses for the
period from April 1, 2000 through December 31, 2000 of $61,000, is included in
Investment in unconsolidated subsidiary.

Along with the cash investments in Medicredit, the Company also provides
Medicredit a line of credit of up to $2 million at the prime interest
rate(9.5% at December 31, 2000). Interest payments are due monthly with
principal due at maturity on April 20, 2002. As of December 31, 2000, the
Company had advanced $2 million to Medicredit under the line of credit, and
has accrued interest of $21,550 due from Medicredit, which are recorded as a
long term receivable from unconsolidated subsidiary and other assets,
respectively.

Purchase of Assets of Creos, Ltd.

In April 1999, Medstone International, Ltd., a wholly-owned subsidiary of
the Company located in Scotland, purchased certain assets of Creos Ltd. from
its liquidator for $165,600 cash. The acquisition has been accounted for as a
purchase and did not generate any goodwill. Medstone International, Ltd. then
commenced manufacturing x-ray generator products previously produced by Creos
Ltd. The operating results of Medstone International, Ltd. have been included
in the consolidated financial statements of the Company since April 1999.

MEDSTONE INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

December 31, 2000

Purchase of Zenith Medical Systems, Ltd.

In October 1999, Medstone International, Ltd. purchased all outstanding
shares of Zenith Medical Systems, Ltd., for $870,000 cash less $284,000 of
acquired cash for a net cost of $586,000. The acquisition has been accounted
for as a purchase and, accordingly, the excess of cost over the fair value of
net assets acquired has been recorded as goodwill of approximately $317,000
and is being amortized over its expected benefit period of 15 years. Zenith
Medical Systems Ltd., is a distributor of major medical imaging systems to the
British National Health Service located in Manchester, England. The operating
results of Zenith Medical Systems, Ltd. are included in the consolidated
financial statements of the Company since October 1999.

Investment in Digital Imaging Systems, Inc.

In 1998, the Company entered into a supply agreement with Digital Imaging
Systems, Inc. ("DIS") for components integral in the Company's new
transportable lithotripsy product. DIS commenced shipments of that product to
the Company in January 1999. The Company has purchased 300,000 shares of DIS
preferred stock for $300,000, which represents a 14% ownership interest. In
1999, the Company recorded an investment writedown of $300,000 as a result of
its review of the realizable value of its investment.

Investment in k. Biotech

In 1998, the Company was made aware of an opportunity to invest in a
developmental biotech drug company catering to the members of the
International Centre for Genetic Engineering and Biotechnology ("ICGEB"), a
United Nations sponsored institute. k. Biotech purchased license agreements
for formulas, developed by the ICGEB, for commercialization purposes in the
Indian sub-continent as its primary market. The Company's investment in
k.Biotech preferred stock was $325,000, representing a 21% ownership interest,
and $225,000, representing a 15.3% ownership interest, at December 31, 1999
and 1998, respectively. The investment in k. Biotech is accounted for under
the equity method because the Company has the ability to exercise significant
influence over k.Biotech and is included in other assets. k. Biotech is
continually seeking additional funding from international sources to finance
its required investment in plant and equipment.

Investment in Chinese Joint Venture

The Company, along with Acuity International ("Acuity") and Phenix Optical
Ltd ("Phenix"), a Chinese company, created a joint venture in March 1998 to
provide lithotripsy services to inland Chinese areas. Each entity was a 1/3
owner of the joint venture. The Company recorded its investment of $92,000 as
other assets. In December 1998, documents were drawn and executed to turn
ownership over to Phenix in return for delivery of optical products to both
Acuity and the Company. In 1999, the Company received the optical products in
release of its share in the joint venture. The Company estimates the resale
value of the optical products to approximate the value of the investment
established in the joint venture. The Company intends to sell these optical
products or distribute them as promotional items.

Unaudited pro forma consolidated results after giving effect to the
businesses acquired during fiscal 1999 would not have been materially
different from the reported amounts for 1999 and 1998 due to the immateriality
of these acquisitions.

MEDSTONE INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

December 31, 2000

4. Income Taxes

The Company provides for income taxes under the liability method.
Accordingly, deferred income tax assets and liabilities are computed for
differences between the financial statement and tax bases of assets and
liabilities that will result in taxable or deductible amounts in the future
based on enacted tax laws and rates applicable to the periods in which the
differences are expected to affect taxable income. Valuation allowances are
established when necessary to reduce deferred tax assets to amounts which are
more likely than not to be realized.

The provision for income taxes consists of the following:

Year ended Year ended Year ended
December 31, December 31, December 31,
2000 1999 1998
------------ ------------ ------------

Current:
Federal............................ $1,125,000 $1,653,400 $2,270,000
State.............................. 336,000 486,000 631,000
---------- ---------- ----------
Total current.................... 1,461,000 2,139,400 2,901,000
---------- ---------- ----------
Deferred:
Federal............................ 171,000 (168,000) (153,000)
State.............................. 31,000 (52,000) (30,000)
---------- ---------- ----------
Total deferred................... 202,000 (220,000) (183,000)
---------- ---------- ----------
Provision for income taxes........... $1,663,000 $1,919,400 $2,718,000
========== ========== ==========

The following is a reconciliation of the provision for income taxes at the
federal statutory rate compared to the Company's effective tax rate:

Year ended Year ended Year ended
December 31, December 31, December 31,
2000 1999 1998
------------ ------------ ------------

Income tax at the statutory rate.... $1,580,000 $1,885,000 $2,400,000
State income taxes (net of federal
benefit)........................... 244,000 286,000 398,000
Minority interest................... (284,000) (195,000) --
Other............................... 123,000 (56,600) (80,000)
---------- ---------- ----------
Provision for income taxes.......... $1,663,000 $1,919,400 $2,718,000
========== ========== ==========

MEDSTONE INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

December 31, 2000

The tax effect of temporary differences that give rise to significant
portions of the deferred tax assets and deferred tax liabilities are as
follows:

December 31, December 31,
2000 1999
------------ ------------

Deferred tax assets (liabilities):
State taxes........................................ $ 113,000 $ 165,000
Cardiac investment reserve......................... 239,000 417,000
Inventory reserve.................................. 196,000 131,000
Bad debt reserve................................... 154,000 246,000
Accruals not currently deductible for tax.......... 78,000 87,000
Inventory adjustment............................... 97,000 66,000
Product reserves................................... 129,000 161,000
---------- ----------
Deferred tax assets................................ 1,006,000 1,273,000
---------- ----------
Depreciation and amortization...................... (562,000) (629,000)
---------- ----------
Deferred tax liabilities........................... (562,000) (629,000)
---------- ----------
Net deferred tax assets............................ $ 444,000 $ 644,000
========== ==========

5. Stock Options

In June 1989, the Company's stockholders approved the 1989 Stock Incentive
Plan ("1989 Plan") which provided for the granting of a variety of stock-
related securities, including shares of common stock, stock options and stock
appreciation rights to employees and other selected individuals. In May 1991,
the Company's stockholders amended the 1989 Plan to increase the number of
shares issuable to 1,593,783 and eliminated the provision for an automatic
increase in the number of shares issuable on January 1 of each year by one
percent of the then outstanding shares. In May 1997, the Company terminated
the 1989 Plan as to the granting of additional options. As of December 31,
2000 473,201 options for shares of common stock had been granted and remain
outstanding under this plan.

In June 1989, the Company's stockholders also approved the Nonemployee
Director Stock Option Plan. This plan provides for the issuance of up to
50,000 shares of the Company's common stock upon exercise of options granted
under the plan. On June 1, 1999, this plan expired and no additional shares
may be granted under this plan. Outstanding options shall continue to vest and
remain exercisable in accordance with the grants outstanding. As of December
31, 2000, 10,000 options for shares of common stock had been granted and
remain outstanding under this Plan.

Options to purchase 15,000 shares of common stock were issued to each
member of the Board of Directors in November 1996 and have exercise prices of
$6.375 after repricing of the options on August 31, 1998. The options are
exercisable, after six months following their grant dates, in incremental
amounts equal to 1/48 of the underlying shares of each elapsed calendar month
during which the director remains on the Company's Board. The terms of the
options are five years, subject to earlier termination related to the director
no longer serving on the Board. As of December 31, 2000, 45,000 options for
shares of common stock had been granted and are outstanding.

In May 1997, the Company's stockholders approved the 1997 Stock Incentive
Plan which provides for the granting of a variety of stock-related securities,
including shares of common stock, stock options and stock appreciation rights
to employees and other selected individuals. The Plan allows for the issuance
of up to

MEDSTONE INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

December 31, 2000

800,000 shares, with increases each January 1 that the Plan is in effect by a
number of shares equal to one percent of the total number of outstanding
shares of common stock on that date. As of January 1, 2001 the number of
shares authorized by the plan increased to 951,234. As of December 31, 2000,
521,950 options for shares of common stock had been granted and are
outstanding under this plan.

Effective August 13, 1998, the Company repriced all outstanding options
granted under all plans with exercise prices exceeding the closing market
value of the stock on that date. Accordingly, the exercise price of these
options was reduced to $6.375 per share.

A summary of the Company's stock option plans as of the end of 2000, 1999
and 1998 and changes during the years is presented below:

December 31, 2000 December 31, 1999 December 31, 1998
------------------------ ------------------------ ------------------------
Weighted-Avg. Weighted-Avg. Weighted-Avg.
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
--------- ------------- --------- ------------- --------- -------------

Outstanding, beginning
of year................ 1,122,428 $6.45 1,082,902 6.39 970,803 $8.34
Granted................. 136,667 5.74 92,500 6.70 230,000 6.52
Exercised............... (75,528) 6.22 (16,637) 6.09 (15,717) 4.95
Canceled................ (133,416) 6.36 (36,337) 6.48 (102,184) 7.90
--------- ----- --------- ---- --------- -----
Outstanding, end of
year................... 1,050,151 $6.38 1,122,428 6.45 1,082,902 $6.39
========= ===== ========= ==== ========= =====
Available for future
grants................. 406,517 394,585 470,810
--------- --------- ---------
Exercisable at end of
year................... 761,534 663,457 474,446
--------- --------- ---------
Weighted-average fair
value of options
granted during the
year................... $3.24 3.64 $3.56
===== ==== =====

The following table summarizes information about stock options outstanding
at December 31, 2000:

Options Outstanding
Range of --------------------------------------------------------------
Exercise Number Outstanding Weighted-average Weighted-average
Prices at 12/31/00 Exercise Price Remaining Term
-------- ------------------ ---------------- ----------------

$5.30 to $6.00 121,667 $5.686 5.4 years
$6.01 to $6.38 823,851 $6.375 1.7 years
$6.56 to $7.50 104,633 $7.224 4.0 years
-------------- --------- ------
$5.30 to $7.50 1,050,151 $6.380 2.4 years
============== ========= ======

In calculating pro forma information regarding net income and net income
per share, as required by Financial Accounting Standards Board Statement No.
123, Accounting for Stock-Based Compensation, the fair value was estimated at
the date of grant using a Black-Scholes option pricing model with the
following weighted-average assumptions for the options on the Company's common
stock for the years ended December 31, 2000, 1999, and 1998, respectively:
risk free interest rates of 6% for all periods; dividend yields of 0% for all
periods; volatility of the expected market prices of the Company's common
stock of .555, .469 and .542; and expected life of the options of 5.5 years
for all periods.

MEDSTONE INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

December 31, 2000

For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. The
Company's proforma information for the years ended December 31, 2000, 1999 and
1998 follows (in thousands, except per share information):

Year ended December 31,
-----------------------
2000 1999 1998
------- ------- -------

Pro forma net income................................ $ 1,837 $ 2,464 $ 4,077
Pro forma diluted net income per share.............. $ .41 $ .50 $ .77

These pro forma amounts do not give effect to options granted prior to
January 1, 1995.

6. Stock Repurchase Plan

The Company's Stock Repurchase Programs have authorized repurchase of up to
1,550,000 shares of its common stock. For the year ending December 31, 2000,
the Company repurchased a total of 459,800 shares at a cost of $2,736,124. For
the year ending December 31, 1999, the Company repurchased a total of 387,550
shares at a cost of $2,445,250. For the year ended December 31, 1998 the
Company repurchased a total of 318,300 shares at a cost of $2,742,473. The
Company has repurchased a total of 1,434,450 shares since the inception of its
Stock Repurchase Programs at a total cost of $10,124,583 with all amounts
recorded as treasury stock. The Company's current repurchase program was
active as of December 31, 2000.

7. Commitments

In March 1994, the Company took occupancy of office, manufacturing,
engineering and warehouse space, and research and development laboratories
under an operating lease with an initial term of two years. The first extended
lease on this facility, with a monthly lease rate of $14,410 expired June 30,
2000. In April 2000, the Company signed a new sixty-four month lease of this
facility, with the term running through November 2005. The average monthly
rental expense is $19,449 over the term of the lease. The new lease has the
option for one five-year extension at a rate to be negotiated based on then
current market rates.

In April 1999, the Company's subsidiary took possession of manufacturing,
office and warehouse space under a monthly operating lease until October 2000,
at which time it entered into a new sixty-month lease at a monthly rent of
$2,980, commencing October 1, 2000.

The future minimum lease payments under all operating leases are as
follows:

Minimum
Rental
--------

2001............................................................ $256,000
2002............................................................ $260,000
2003............................................................ $252,000
2004............................................................ $263,000
2005............................................................ $248,000

Total net rent expense under all operating leases for the years ended
December 31, 2000, 1999 and 1998 was $204,000, $227,000 and $194,000,
respectively.

MEDSTONE INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

December 31, 2000

8. Contingencies

The Company is involved in legal proceedings incidental to the normal
conduct of its business. The Company has obtained various liability insurance
policies providing coverage for general liability, product liability and other
claims. Management does not believe that the resolution of any current
proceedings will have a material financial impact on the Company or its
consolidated financial position, results of operations and cash flows.

9. Related Party Transactions

Cardiac Science, Inc.

Cardiac Science, Inc. was formed as a subsidiary of the Company during 1991
and shortly thereafter was spun off as a separate entity with a majority of
the common stock of Cardiac Science, Inc. distributed to the Company's
stockholders. During 1991 through 1996, the Company performed various
financing activities for Cardiac Science in exchange for common stock and
warrants.

As of December 31, 2000 and 1999, the Company held approximately 187,000
and 492,000 shares of common stock and 0 and 87,500 warrants to purchase
common stock, respectively in Cardiac Science, Inc. The common stock and
warrants had a carrying value of zero. At December 31, 2000, the fair market
value of the investment in Cardiac Science, Inc. common stock approximates
$795,000.

During 2000 and 1999, the Company sold approximately 305,000 and 55,000
shares for $1,855,000 and $244,000 in cash, respectively. During 1999, the
Company sold the 87,500 warrants for $262,000 in cash. All proceeds from these
sales of the common stock and warrants were included in other income.

k. Biotech

During 1999, the Company increased its ownership interest in k.Biotech,
Inc. by $100,000 for a total investment of $325,000 which represents a 21%
interest. Two members of the Board of Directors of the Company are also
shareholders of k.Biotech, Inc. and one member of the Board of Directors is
the President of k.Biotech.

Digital Imaging Systems

During 1998, the Company obtained a 14% ownership interest in Digital
Imaging Systems, Inc. ("DIS") for $300,000 and entered into a supply agreement
whereby the Company would purchase equipment up to $1.1 million from DIS. In
1999, the Company recorded an investment writedown of $300,000 as a result of
its review of the realizable value of this investment. DIS commenced shipments
of its products to the Company in January 1999 pursuant to the supply
agreement.

Genstar Therapeutics Corporation

Genstar Therapeutics Corp. (formerly Urogen Corp.) was a subsidiary of the
Company until early 1996 at which time the Company spun off this subsidiary as
a separate company. The Company distributed all the stock of Genstar to its
stockholders, except for 100,000 shares which the Company retained. During
2000, the Company sold 5,000 shares of Genstar for a gain of approximately
$28,000 and still holds 95,000 shares of Genstar common stock with a book
value of $0 as of December 31, 2000. The market value of the retained Genstar
common stock is approximately $926,000 at December 31, 2000.

MEDSTONE INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

December 31, 2000

Investment in Medicredit.com, Inc.

In April 2000, the Company purchased common stock representing a 46%
interest in Medicredit.com. Inc. ("Medicredit") for $1 million in cash.
Medicredit, a California-based company, funds and services loans to physicians
to finance elective surgeries in the cosmetic and cash paying sector of
healthcare. Along with the cash investment in Medicredit, the Company agreed
to a line of credit of up to $2 million at the prime interest rate. As of
December 31, 2000, the full $2 million credit line was outstanding to
Medicredit and is reflected in long-term assets in the Consolidated Balance
Sheets of the Company. The Company reflects its equity position of the
operating results of Medicredit since its purchase in the Minority Interest
section of the Consolidated Statements of Income.

10. Employee Benefit Plan

In January 1990, the Company established a defined contribution profit
sharing 401(k) plan for all eligible employees. The plan provides for the
deferral of up to 15% of an employee's qualifying compensation under Section
401(k) of the Internal Revenue Code. Contributions by the Company may be made
to the plan at the discretion of the Board of Directors. During 1997, the
Company's Board of Directors elected to match the employee contributions $.25
on a dollar, up to a maximum company contribution of $2,000 per year. In 2000,
1999 and 1998, the Company's contribution totaled $58,382, $50,557 and
$44,430, respectively.

11. Major Customers and Foreign Sales

During the three years ended December 31, 2000, 1999 and 1998, no single
customer has accounted for 10% or more of total revenues in any one year. The
Company derived 7%, 3% and 4% of total revenues from sales to foreign
customers in the years ending December 31, 2000, 1999 and 1998, respectively.

12. Selected Quarterly Financial Data (Unaudited)

The tables below set forth selected quarterly financial information for
2000 and 1999 (in thousands, except per share amounts):

2000 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
---- ----------- ----------- ----------- -----------

Net sales................... $6,109 $5,983 $5,443 $5,287
Gross profit................ 2,487 2,455 2,011 1,927
Net income.................. 922 555 573 39
Basic earnings per share.... $ .20 $ .12 $ .13 $ .01

1999 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
---- ----------- ----------- ----------- -----------

Net sales................... $4,904 $6,493 $6,440 $5,632
Gross profit................ 2,437 3,434 3,172 2,317
Net income.................. 532 633 1,182 494
Basic earnings per share.... $ .11 $ .12 $ .23 $ .10

13. Subsequent Events

In January 2001, the Company sold 73,000 shares of Cardiac Science Common
Stock for a gain of approximately $358,000.

In January 2001, the Company purchased 10,000 shares of its Common Stock
for a cost of $62,475 under its current Stock Repurchase Program.

MEDSTONE INTERNATIONAL, INC.

SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS

Additions
Balance ---------------------
at Charged to Charged to Balance
beginning costs and other at end
Description of year expenses accounts Deductions of year
------------------------- --------- ---------- ---------- ---------- --------

For the year ended
December 31, 2000:
Allowance for doubtful
accounts.............. $571,252 $ -- $ -- $ 94,072(b) $477,180
======== ======== ======= ======== ========
Allowance for inventory
obsolescence.......... $307,203 $277,138 $ -- $127,253(a) $457,088
======== ======== ======= ======== ========

For the year ended
December 31, 1999:
Allowance for doubtful
accounts.............. $602,564 $ 35,000 $ -- $ 66,312(b) $571,252
======== ======== ======= ======== ========
Allowance for inventory
obsolescence.......... $337,437 $ -- $ -- $ 30,234(a) $307,203
======== ======== ======= ======== ========
For the year ended
December 31, 1998:
Allowance for doubtful
accounts.............. $534,918 $130,000 $ -- $ 62,354(b) $602,564
======== ======== ======= ======== ========
Allowance for inventory
obsolescence.......... $337,437 $ -- $ -- $ -- $337,437
======== ======== ======= ======== ========

--------
(a) Write-off of inventories
(b) Write-off of bad debts

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of Securities Exchange
Act of 1934, the Registrant has duly caused this Report to be signed on its
behalf by the undersigned, thereunto duly authorized.

MEDSTONE INTERNATIONAL, INC.

/s/ David V. Radlinski
By: _________________________________
David V. Radlinski
Chief Executive Officer

Dated: March 30, 2001

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities indicated on March 23, 2001.

Signature Title Date
--------- ----- ----

/s/ David V. Radlinski Chairman of the Board and March 23, 2001
____________________________________ Chief Executive Officer and
David V. Radlinski Director (Principal
Executive Officer)

/s/ Mark Selawski Chief Financial Officer March 23, 2001
____________________________________ (Principal Financial and
Marck Selawski Accounting Officer)

/s/ Donald J. Regan Director March 23, 2001
____________________________________
Donald J. Regan

/s/ Frank R. Pope Director March 23, 2001
____________________________________
Frank R. Pope

/s/ David A. Reed Director March 23, 2001
____________________________________
David A. Reed

/s/ Michael C. Tibbitts Director March 23, 2001
____________________________________
Michael C. Tibbitts

Exhibit Index

Exhibit No. Description
----------- -----------

3.1 Certificate of Incorporation of the Company, as amended (1)

3.2 Restated and Amended Bylaws of the Company (2)

4.2 Specimen Certificate of the Company's Common Stock (3)

10.26 1989 Stock Incentive Plan (4)(5)

10.27 Non-employee Director Stock Option Plan (4)(5)

10.28 Facility Lease on 100 Columbia (6)

10.29 1997 Stock Incentive Plan (5)(7)

10.30 Employment Agreement with David Radlinski (5)

10.31 Employment Agreement with Mark Selawski (5)

10.32 Employment Agreement with Eva Novotny (5)

21 Subsidiaries

23.1 Consent of Independent Auditors

28.2 Form of Cytocare, Inc. Information Statement--Distribution to
Shareholders of Stock of Cardiac Science, Inc. (8)

28.3 Form of Medstone International, Inc. Information Statement--
Distribution to Shareholders of Stock of Endocare, Inc. and Urogen
Corp. (9)

(2) Previously filed with the same exhibit number with the Company's
Quarterly Report on Form 10-Q for the quarter ended June 30, 1999, and
incorporated herein by reference.

(3) Previously filed with the same exhibit number with the Company's
Registration Statement on Form S-1 under the Securities Act of 1933, Reg.
No. 33-16340 and incorporated herein by reference.

(4) Previously filed with the same exhibit number with the Company's
Quarterly Report on Form 10-Q for the quarter ended June 30, 1989, and
incorporated herein by reference.

(5) Compensatory plan or arrangement.

(6) Previously filed with the same exhibit number with the Company's
Quarterly Report on Form 10-Q for the quarter ended June 30, 1997.

(7) Previously filed with the same exhibit number with the Company's
Quarterly Report on Form 10-Q for the quarter ended September 30, 1998.

(8) Previously filed with the same exhibit number with the Company's
Quarterly Report on Form 10-Q for the quarter ended March 31, 2000.

(9) Previously filed with the same exhibit number with the Company's current
report on Form 8-K dated June 26, 1991, and incorporated herein by
reference.

(10) Previously filed with the Company's current report on Form 8-K dated
February 9, 1996, and incorporated herein by reference.