**UNITED
STATES SECURITIES AND EXCHANGE COMMISSION**
 **Washington,
D.C. 20549**
 
 **FORM
10-K**
 
 (Mark
One)
 
 **x**
    **ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934**
 
 For the
fiscal year ended December 31, 2004
 
 OR
 
 ** ̈**
    **TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934**
 
 For the
transition period from  to
 
 Commission
file number: 0-11635
 **PHOTOMEDEX,
INC.**
 **(Exact
name of registrant as specified in its charter)**
 
 **Delaware**
    
    **59-2058100****(State
      or other jurisdiction**
      **of
      incorporation or organization)**
    
    **(I.R.S.
      Employer**
      **Identification
      No.)**
 
 **147
Keystone Drive, Montgomeryville, Pennsylvania 18936**
 **(Address
of principal executive offices, including zip code)**
 
 **(215)
619-3600**
 **(Issuer’s
telephone number, including area code)**
 
 **Securities
registered under Section 12(b) of the Exchange Act:**
 
 **Title
      of each class**
    
    **Name
      of each exchange**
      **on
      which registered**None
    
    None
 
 **Securities
registered under Section 12(g) of the Exchange Act:**
 
 **Common
Stock, $0.01 par value per share**
 **(Title
of Class)**
 Indicate
by check mark whether the registrant: (i) 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 (ii) has been subject to such
filing requirements for the past 90 days. Yes x No o
 
 Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein and will not be contained, to the best of
registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. x
 
 Indicate
by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Act). Yes xNo o
 
 The
number of shares outstanding of our common stock as of March 15, 2005, was 40,168,549 shares.
The aggregate market value of the common stock held by non-affiliates
( 39,509,458 shares),
based on the closing market price ($2.42) of the
common stock as of March 15, 2005 was $95,612,888 .
 
 
 
    **Table
of Contents**
  ****
    ****
    ****
    ****
    **Page****Part I**Item 1.
    
    Business
    
    1Item 2.
    
    Properties
    
    29Item 3.
    
    Legal
      Proceedings
    
    29Item 4.
    
    Submission
      of Matters to a Vote of Security Holders
    
    30**Part II**
    ****
    ****
    ****
    ****Item 5.
    
    Market
      for the Registrant's Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
    
    31Item 6.
    
    Selected
      Financial Data
    
    33Item 7.
    
    Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
    
    35Item 7A.
    
    Quantitative
      and Qualitative Disclosures About Market Risk
    
    53Item 8.
    
    Financial
      Statements and Supplementary Data
    
    53Item 9.
    
    Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
    
    53Item 9A.
    
    Controls
      and Procedures
    
    54Item
      9B.
    
    Other
      Information - Pending Acquisition
    
    56**Part III**
    ****
    ****
    ****
    ****Item 10.
    
    Directors
      and Executive Officers of the Registrant
    
    58Item 11.
    
    Executive
      Compensation
    
    62Item 12.
    
    Security
      Ownership of Certain Beneficial Owners and Management
    
    73Item 13.
    
    Certain
      Relationships and Related Transactions
    
    75Item 14.
    
    Principal
      Accountant Fees and Services
    
    76**Item IV**
    ****
    ****
    ****
    ****Item 15.
    
    Exhibits
      and Financial Statement Schedules
    
    77Signatures
    
    81
  
 i
  ***Certain
statements in this Annual Report on Form 10-K, or the Report, are
"forward-looking statements." These forward-looking statements include, but are
not limited to, statements about the plans, objectives, expectations and
intentions of PhotoMedex, Inc., a Delaware corporation, (referred to in this
Report as “we,” “us,” “our” or “registrant”) and other statements contained in
this Report that are not historical facts. Forward-looking statements in this
Report or hereafter included in other publicly available documents filed with
the Securities and Exchange Commission, or the Commission, reports to our
stockholders and other publicly available statements issued or released by us
involve known and unknown risks, uncertainties and other factors which could
cause our actual results, performance (financial or operating) or achievements
to differ from the future results, performance (financial or operating) or
achievements expressed or implied by such forward-looking statements. Such
future results are based upon management's best estimates based upon current
conditions and the most recent results of operations. When used in this Report,
the words "expect," "anticipate," "intend," "plan," "believe," "seek,"
"estimate" and similar expressions are generally intended to identify
forward-looking statements, because these forward-looking statements involve
risks and uncertainties. There are important factors that could cause actual
results to differ materially from those expressed or implied by these
forward-looking statements, including our plans, objectives, expectations and
intentions and other factors discussed under "Risk
Factors."***
  **PART
I**
 
 **Item
1.** **Business**
  We are a
medical device company focused on facilitating the cost-effective use of
technologies for doctors, hospitals and surgery centers. We engage in the
development and marketing, domestically and internationally, of proprietary
excimer laser and fiber optic systems, known as the XTRAC® laser system, or the
XTRAC, a 308 nanometer (nm) excimer laser for the treatment of psoriasis,
vitiligo, atopic dermatitis and leukoderma. We also engage in the development,
manufacture and sale of surgical products, including proprietary contact and
free-beam laser systems for surgery in such venues as hospitals, surgi-centers
and doctors offices. We offer a wide range of surgical laser services on a
turn-key procedural basis, including urology, gynecology, orthopedics and
general surgery.
  We have a
pending acquisition of ProCyte Corporation which we discuss in Item 9B, Other
Information.
  **Phototherapy
Lasers: an overview**
  We have
developed and continue to develop proprietary excimer laser and fiber optic
systems and techniques with dermatological applications, with Food and Drug
Administration, or FDA, concurrence to market the XTRAC laser system for the
treatment of psoriasis, vitiligo, atopic dermatitis and leukoderma. We are also
developing our technology for the treatment of other skin disorders. In August
2003, the FDA granted 510(k) clearance for the XTRAC XL Plus, an upgraded
version of the XTRAC excimer laser system. The upgrade improved the reliability
and functionality of the laser. In October 2004, the FDA granted 510(k)
clearance for the UltraTM excimer laser system, a downsized, high-performance
upgrade of the XTRAC XL Plus. Subsequent references to the XTRAC include the
XTRAC XL Plus and the Ultra.
  The
Current Procedural Terminology (CPT) Editorial Board of the American Medical
Association, or AMA, has issued reimbursement codes for laser therapies in the
treatment of psoriasis and other inflammatory diseases, which includes laser
therapy using our XTRAC system to treat such conditions. The designation for
laser treatment for inflammatory skin disease (psoriasis) was broken into three
distinct codes, based on the total skin surface area being treated. The Centers
for Medicare and Medicaid Services (CMS) has published the relative values and
national Medicare reimbursement rates for each of the three CPT codes.
  We
believe, based on our analysis set forth below, that the XTRAC system should
become a preferred treatment modality for the majority of those afflicted with
psoriasis. Although existing treatments provide some relief to psoriasis
sufferers, they are inconvenient and may involve negative side effects. We
believe that our patent-protected XTRAC system will enable more effective and
convenient treatment with minimal side effects.
  1
 Treatment
of psoriasis commonly follows a step approach with topical therapy as a
first-step, phototherapy as second-step, and systemic medications reserved for
when all other treatments fail. The clinical body of evidence developed by
PhotoMedex and others supports the use of the 308-nm excimer laser as safe and
effective for localized plaque-type psoriasis resistant to other first-step
therapies, such as topical creams and ointments. In addition, an economic
analysis completed in December 2003 has demonstrated that the addition of
excimer laser treatment results in no expected cost increase to the payer.
Further, this analysis demonstrates the cost-effectiveness of the excimer laser
is superior due to the increased number of expected disease-free days and
remission days.
  As a part
of our commercialization strategy in the United States, we are providing our
XTRAC system to targeted dermatologists at no initial capital cost to them. We
own the equipment and charge the dermatologists on a per-treatment basis for use
of the XTRAC system. We believe that this strategy, combined with more
widespread insurance reimbursement, will create attractive incentives for these
dermatologists to adopt our XTRAC system and will accelerate further market
penetration. We expect to receive a recurring stream of revenue from
per-treatment charges to dermatologists for use of our XTRAC system. Outside of
the United States, our strategy is primarily selling XTRAC systems directly to
dermatologists through our distributors, but we intend to supplement this
strategy by providing XTRAC systems to dermatologists in selected foreign
markets with a usage-based revenue stream shared between our distributors and
us.
  **Background
on Psoriasis**
 
 Psoriasis
is believed to be a non-contagious, autoimmune medical disorder and a chronic
inflammatory skin disease affecting more than 7 million Americans and between 1%
and 3% of the world's population. There is no known cure for psoriasis. Although
clinical symptoms and severity vary greatly between individuals over periods of
time, psoriasis appears most commonly as inflamed swollen lesions covered with
silvery white scales. Psoriasis patients often suffer from debilitating and
painful swelling, itching, bleeding, cracking and burning, resulting in
decreased mobility, depression and low self-esteem. The National Psoriasis
Foundation, or NPF, estimates that, in the United States, dermatologists treat
over 1.5 million psoriasis patients each year.
  While the
exact cause of the disease remains unknown, the emerging consensus among
scientists and physicians characterizes psoriasis as an autoimmune medical
disorder in which excessive "T" cell stimulation in skin cells activates an
inflammatory response and excessive skin cell production. The disease causes the
rate at which skin cells are produced and pushed to the outer skin layer to
increase seven-fold, from every 28 days to every two to four days. The body
cannot shed the skin cells fast enough and this process results in patches, or
"lesions," forming on the skin's surface . Psoriasis cases are classified as mild (less than 2% of the body's surface area
affected and usually localized on the knees, elbows, scalp, hands and feet),
moderate (between 2% and 10% of the body's surface area affected and usually
appearing on the arms, legs, torso and head) and severe (greater than 10% of the
body's surface area affected and potentially involving all areas of the skin).
Our initial target market is patients with mild to moderate psoriasis that
represent 80% of all psoriasis cases.
  **Conventional
Treatment Methods for Psoriasis**
 
 Psoriasis
is a chronic (life-long) illness that affects more than 7 million people in the
United States. Because psoriasis is chronic and unpredictable, it can be
challenging to treat. Most people need ongoing treatments and visits to the
doctor. In severe cases, people may need to be hospitalized. About 56 million
hours of work are lost each year by people who suffer from psoriasis, and
between $1.6 billion and $3.2 billion is spent per year to treat
psoriasis.
  Currently,
psoriasis is treated with topical treatments (such as skin creams and
ointments), phototherapy and systemic drugs. In addition, a new category of
drugs have recently been added which are commonly referred to as biologics.
Treatment of psoriasis commonly follows a step approach with topical therapy as
first step, phototherapy as second step, and systemic medications or biologics
reserved for when all other treatments fail.
  ***Topical
Treatments*** .
Although physicians generally use topical therapy as a starting point for the
treatment of psoriasis, regardless of its severity, it is typically recommended
for patients with mild and moderate psoriasis. The most commonly used topical
treatment is corticosteroids that are demonstrated to reduce inflammation and
itching and inhibit cell proliferation. Existing topical treatments have shown
efficacy for relatively short periods of
 
 2
 time in
only 45% of patients. Frequent recurrence of the disease associated with topical
therapies results in a high number of required treatments, making topical
therapies relatively inconvenient. In addition to inconvenience and inherent
messiness, topical therapies may cause numerous side effects including thinning
skin, irritation, burning, skin discoloration and light sensitivity. The
anticipated annual cost to treat a patient from a third-party payer perspective,
including those who fail the most common topical combination therapy and are
provided a currently available second-step therapy, is approximately
$2,340.
  ***Phototherapy
Treatments*** . The
most common phototherapy treatments are Ultraviolet B radiation, or UVB, and
psoralen with Ultraviolet A, or PUVA. According to the NPF, these therapies are
considered to be the most effective treatments for people with moderate to
severe psoriasis, temporarily clearing psoriasis in over 75% of patients when
prescribed.
  In most
UVB treatment protocols, the whole body of the patient is radiated with UVB
rays, as the patient stands in a special booth lined with UVB lamps. During this
procedure, healthy skin as well as psoriasis-affected skin is exposed to UVB
radiation, which may cause severe burns and increase the risk of skin cancer and
premature aging. In order to manage potentially harmful radiation and minimize
side effects to healthy skin, the treating physician must limit the intensity of
the dosage. This results in a typical treatment cycle of 20 to 40 sessions or
more, requiring a significant time commitment by psoriasis patients. This
time-consuming treatment cycle creates substantial inconvenience and disruption
to patients' life styles and leads to poor patient compliance. ****
  PUVA, a
treatment similar to UVB, is a combination of UVA with psoralen, a drug used to
increase a patient's sensitivity to the UVA rays. Although PUVA allows a
physician to achieve similar efficacy to UVB with fewer required sessions, PUVA
can cause additional side effects, including nausea, itching and increased risk
of cataracts. ****
  UVB and
PUVA treatments are expensive, with the average annual cost of UVB and PUVA
therapies ranging from $4,600 - $4,935 as a stand-alone therapy, with alternate
second-step therapy upon failure **.**
  ***Systemic
Drugs*** . These
drugs are called "systemic" because they work throughout the body to treat
psoriasis, rather than only on top of the skin. They include the prescription
drugs methotrexate , cyclosporine and oral
retinoids .
  Methotrexate
and cyclosporine, the most commonly used systemic drugs, can successfully treat
over 80% of psoriasis patients when prescribed. These drugs, however, have very
serious side effects including nausea, fatigue, liver damage and kidney
dysfunction. Because of the potential toxicity of these drugs, treatment
protocols for methotrexate therapy require ongoing liver biopsies, and
cyclosporine treatments are generally restricted in duration to one year. In
addition, these systemic drugs have annual treatment costs ranging from $1,700
to $8,300.
  ***Biologics*** *.*  According
to the NPF, several of the new treatments available to treat severe psoriasis (about
10 - 15% of psoriasis cases) and psoriatic
arthritis , called
"biologics," are made from living sources, such as viruses, animals and people.
Unlike other systemic
drugs ,
biologics must be injected or infused into the body, rather than taken orally.
These new drugs target very specific parts of the immune response.
  Alefacept (brand
name Amevive) is designed to block a misstep in the immune system--the
activation of T cells. Activated T cells fuel the development of psoriatic
lesions by causing skin cells to develop and mature at an accelerated rate.
Amevive became available to consumers in February 2003. Amevive reduces immune
cell counts, which could increase the chance for developing infection or
malignancy. The results of clinical studies demonstrate some improvement in
symptoms, with about 42% of patients achieving PASI 50 and about 21% achieving
PASI 75 two weeks after the 12 week treatment. “PASI” is an acronym for
Psoriasis Area and Severity Index, the standard benchmark for measuring
psoriasis.
  Efalizumab (brand
name Raptiva) is an antibody that is most similar to other human antibodies so
it can slip under the immune system's radar without being marked as "foreign."
Once inside, Raptiva blocks immune system reactions that lead to the formation
of psoriastic lesions. Raptiva became available to consumers in October 2003.
Raptiva can decrease the activity of the immune system. People using Raptiva may
have an increased chance
 
 3
 of
getting serious infections and certain cancers. However, the role of Raptiva in
the development of cancer is not known. The results of clinical studies
demonstrate some improvement in symptoms, with 52-61% of patients achieving PASI
50 and 22-37% achieving PASI 75 after three months.
  These
drugs are large protein molecules that would be digested, if taken orally. In
that way, they are similar to etanercept (brand
name Enbrel) and infliximab (brand
name Remicade), which are used to treat psoriatic and rheumatoid arthritis and
which must be given by injection. Enbrel is approved for psoriatic arthritis,
but it also may be effective to treat psoriasis itself. It is given by
subcutaneous injection two times a week. Remicade is approved for rheumatoid
arthritis, but it also seems effective for psoriasis. It is given intravenously
over two to four hours.
  The NPF
reports that annual treatment costs using biologics generally exceed $10,000 to
$12,000.
  **Our
Solution for Psoriasis**
  The XTRAC
308 nanometer (nm) excimer laser has emerged as an important treatment option
for patients with stable localized mild-to-moderate plaque psoriasis (about 80%
of psoriasis cases), especially for patients whose plaques are recalcitrant to
topical therapy. We believe our XTRAC system should become a preferred treatment
modality for the majority of patients suffering from psoriasis. The XTRAC
excimer laser offers numerous benefits to the patient, the physician, and the
third-party insurance payer, including:
  ·
    At
      308 nanometers, the excimer laser utilizes an ultra-narrow wavelength in
      the narrowband UVB spectrum with a proven anti-psoriatic action. In
      addition, by focusing the energy exclusively to the psoriasis plaques, the
      laser avoids potentially detrimental exposure of normal skin to UVB
      energy, and with fewer side effects than other treatment
      methods.
  ·
    Unlike
      most other lasers, our XTRAC system emits a pulsating beam of light that
      is neither hot nor cold to the touch, resulting in no pain or discomfort
      to virtually all patients. Clinical studies have demonstrated the XTRAC
      system to have equal or greater efficacy than the most effective treatment
      alternatives presently available for psoriasis with fewer treatment visits
      than conventional phototherapy.
  ·
    Our
      XTRAC system enables the physician to deliver concentrated doses of
      ultraviolet light to the psoriasis-affected skin at a higher intensity
      than is possible with traditional ultraviolet light therapy. As a result,
      physicians can use the XTRAC system to treat all degrees of psoriasis from
      mild to moderate cases. The XTRAC system has also proven effective to
      treat hinged body areas (elbows and knees), which previously have been the
      most difficult areas of the body to effectively treat with topical
      treatments and other ultraviolet light
therapy.
  ·
    Most
      patients (84%) will obtain significant improvement (>75%) with 6 to 10
      treatments (2 treatments per week for 3 to 5 weeks). These results have
      been demonstrated to be long lasting as well, with mean remission rates
      reported from 3.5 to 6 months.
  ·
    The
      excimer laser also has an established cost-effectiveness profile. A
      clinical economic analysis, which was completed in 2003, has demonstrated
      that the addition of excimer laser treatment results in no expected cost
      increase to the payer. Additionally, the annual cost of excimer laser
      treatment is comparable to or less than other standard “Step 2” psoriasis
      treatment modalities, such as phototherapy treatment alternatives or
      alternative topical therapies. In addition, the cost-effectiveness of the
      excimer laser is superior due to the increased number of expected clear
      days.
  ·
    The
      acceptance of this procedure has been established by the American Medical
      Association through the establishment of three specific CPT codes
      describing this procedure (96920, 96921, 96922), as well as the
      establishment of Relative Value Units adopted by
CMS.
  ·
    Numerous
      private payers and CMS carriers have recognized the clinical and economic
      merits of this treatment and have adopted medical coverage policies
      endorsing its use. In addition, approximately 50,000 excimer laser
      psoriasis procedures have been performed in the United States in 2004 and
      approximately 30,000 in 2003 (since the issuance of relevant CPT codes),
      and approximately 108,000 such procedures have been performed since
      2001.
  4
 **Our
Solution for Vitiligo**
  In March
2001, the FDA granted 501(k) clearance to market our XTRAC system for the
treatment of vitiligo. Vitiligo is a disease in which the skin loses pigment due
to destruction of the pigment cells, causing areas of the skin to become lighter
in color than adjacent healthy skin. This condition can be distressing to
patients. Between 1% and 2% of the population suffers from the condition, and
there is no known cure. The principal conventional treatments for symptoms are
PUVA radiation and, to a lesser extent, topical steroids and combination
therapies. According to the National Vitiligo Foundation, or NVF, the cost of
PUVA treatments, over a 12 to 18 month period, can run $6,000 or more and
involve 120 clinic visits. Moreover, according to the NVF, current conventional
treatment methods are unsatisfactory and many patients tend to lose the pigment
they were successful in gaining through PUVA therapy. Our XTRAC system can
effectively re-pigment a patient's skin, allowing treated areas to become
homogeneous in pigment to healthy surrounding skin and restore the patient's
skin to its original condition.
  **Our
Solution for Atopic Dermatitis**
  In August
2001, the FDA granted 510(k) clearance to market our XTRAC system for the
treatment of atopic dermatitis. Atopic dermatitis is a common, potentially
debilitating condition that can compromise the quality of life for those it
affects. The condition appears as chronic inflammation of the skin that occurs
in persons of all ages, but is reported to be more common in children. Skin
lesions observed in atopic dermatitis vary greatly, depending on the severity of
inflammation, different stages of healing, chronic scratching and frequent
secondary infections. It is reported that atopic dermatitis affects some 10% of
children in the United States alone, and more than $364 million is spent
annually in the treatment of this disease. Treatment options include
corticosteroids, which can have negative side effects, and UVB phototherapy. The
use of UVB phototherapy in the treatment of atopic dermatitis has been shown
effective in published studies. Because of the controlled and targeted
application provided by our XTRAC laser, large areas of healthy skin are not
exposed to UVB light from the XTRAC laser and the corresponding potentially
carcinogenic effect of other phototherapy treatments. We believe that the XTRAC
system could be an alternative protocol for treating atopic dermatitis
effectively. However, we do not intend to undertake clinical research that would
clarify such an alternative protocol until we have secured our primary goal -
wider private-payer reimbursement for psoriasis.
  **Our
Solution for Leukoderma**
  In May
2002, the FDA granted 510(k) clearance to market our XTRAC system for the
treatment of leukoderma, commonly known as white spots, and skin discoloration
from surgical scars, stretch marks, burns or injury from trauma. The XTRAC
system utilizes UVB light to stimulate melanocytes, or pigment cells, deep in
the skin. As these cells move closer to the outer layer of skin, re-pigmentation
occurs.
  **Our
Business Strategy**
 
 Our
short-term goal is to establish the XTRAC system as a preferred treatment
modality for psoriasis and other inflammatory skin disorders through persuasive
clinical evidence and widespread private healthcare reimbursement. Our
longer-term goal is to be a world-class provider of highest quality,
cost-effective, medical technologies, including photo-medicine and surgical
procedures delivered in doctors’ offices, hospitals and surgical centers. The
following are the key elements of our strategy:
  ***Establish
Our XTRAC System as a Preferred Treatment Modality for Psoriasis and Other
Inflammatory Skin Disorders.*** Several
opinion leaders in the dermatological community have endorsed our XTRAC system
as a preferred treatment modality for the majority of psoriasis and vitiligo
patients. We are using these endorsements to accelerate the acceptance of our
XTRAC system among dermatologists. We have also developed a set of medical
practice tools, such as patient education videos, patient letters, sample press
releases, point-of-sale displays and other advertising literature, to assist the
dermatologist in marketing our XTRAC system.
  ***Build
Broad Consumer Awareness Program to Attract Those Not Currently Seeking
Treatment*** . Of the
7 million psoriasis patients in the United States, only about 1.5 million seek
care. Many do not seek care, largely due to the frustration caused by the
limited effectiveness, inconvenience and negative side effects of other
treatment alternatives. We have expended funds in print, radio and/or Internet
advertising to educate this frustrated segment of
 
 5
 the
population about how our XTRAC system enables more convenient and effective
psoriasis treatment. We intend to continue these marketing efforts once we have
received widespread private healthcare reimbursement for psoriasis and as our
needs and resources permit.
  ***Increase
Installed Base of Our XTRAC Systems by Minimizing Economic Risk to the
Dermatologist*** . In the
United States, we place our XTRAC system in dermatologists' offices free of
charge. This creates an opportunity for dermatologists to utilize our system
without any up-front capital costs, thereby eliminating an inherent economic
risk to them. We also intend to ultimately market our XTRAC system in this
manner outside of the United States in combination with continuing to sell XTRAC
systems directly to dermatologists in foreign markets through
distributors.
  ***Generate
Recurring Revenue by Charging the Dermatologist a Per-Treatment
Fee*** . Because
there is no known cure for psoriasis, which is a chronic condition, we generate,
and expect to continue to generate recurring revenue in the United States from
patients utilizing our XTRAC system. We charge the dermatologist a per-treatment
fee. Additionally, we intend to increase our recurring revenue by targeting
dermatologists whose practices are located in geographic regions with the
largest concentration of psoriasis and vitiligo patients and areas with
favorable private healthcare reimbursement.
  ***Sell
the XTRAC System in Foreign Countries to be Utilized to Treat Patients on a
Wider Basis.*** We have
entered into a number of distribution relationships or agreements with respect
to the proposed sale of the XTRAC system on an international basis. We have
chosen this marketing approach over a direct marketing approach because of the
varying economic, regulatory, insurance reimbursement and selling channel
environments outside of the United States. We intend to enter into additional
agreements in other countries. However, we cannot be certain that our
international distributors will be successful in marketing the XTRAC system
outside of the United States or that our distributors will purchase more than
the minimum contractual requirements or expected purchase levels under these
agreements or relationships. Our international strategy also includes placing
XTRAC systems with dermatologists to provide us a usage-based revenue stream. To
date, no units have been placed in international markets that provide a
usage-based revenue stream.
  ***Expand
Clinical Applications to the Treatment of Other Skin
Disorders*** . More
than 30 skin disorders other than psoriasis, vitiligo, atopic dermatitis and
leukoderma react positively to ultraviolet light therapy. We will continue to
invest in research and development of new products and in additional
applications of our existing patented laser technology to treat other skin
disorders which are susceptible to ultraviolet light therapy, once we have
received widespread private healthcare plan reimbursement for
psoriasis.
  ***Commercialize
Intellectual Property for Other Applications*** . Our
patented laser technology has potential applications for non-medical uses and
for medical uses beyond skin disorders. We also intend to continue to expand our
intellectual property base through research and development efforts. We will
consider appropriate commercial opportunities arising from third party
applications of our proprietary technology in areas other than skin disorders.
For example, in August 2000, we entered into a non-exclusive license
agreement with Komatsu, Ltd. under which Komatsu has agreed to pay us a royalty
for the use of a United States laser patent we own in connection with its
manufacture of semi-conductor lithography equipment. However, we have received
no royalties to date.
  ***Achieve
Widespread Private Healthcare Reimbursement.*** The
Centers for Medicare and Medicaid Services (CMS) published national Medicare
rates, effective January 1, 2003, for the newly established laser reimbursement
codes for inflammatory skin disorders such as psoriasis. A data compendium of
clinical and economic evidence establishing the XTRAC as safe, efficacious, and
cost-effective, was mailed to virtually all insurance plans in the United States
between December 2003 and February 2004. A critical component of the mailing was
a psoriasis health economic study, which concluded that the overall clinical
impact of the XTRAC excimer laser has proven to be outstanding for expected
treatment-free days and remission days. Further, it stated the expected costs
are lower than those for other phototherapies and comparable to the most
commonly used second-step topical alternatives. Because total expected annual
per-patient costs, with or without XTRAC, are equivalent for patients who start
on combination first-step therapy, payers bear no incremental procedure cost if
the excimer laser is included in the overall mix of second-step care. The data
contained therein supports the establishment of medical policies by private
healthcare reimbursement plans for the treatment of mild to moderate psoriasis.
We are
 
 6
 developing
wider private healthcare reimbursement arrangements through this marketing
effort, but can give you no assurances to increasing this effect.
  **Our
XTRAC System**
 
 Our XTRAC
system combines the technology of an excimer laser, or "cold" laser system
(already in use for a variety of medical and cosmetic treatments), with the use
of ultraviolet light therapy. The XTRAC system applies a concentrated dose of
UVB radiation directly to diseased skin at a higher intensity than traditional
ultraviolet light therapy. Our XTRAC system utilizes a 308 nm light wavelength,
which studies have shown to be the optimal wavelength to treat psoriasis
effectively. Our XTRAC system consists of the laser, which is mobile, and a hand
piece attached to the laser by a liquid light guide or by a fiber optic cable,
which are designed to permit direct application of the ultraviolet light to
psoriasis-affected skin.
  Between
March 1998 and November 1999, we initiated five clinical trials of our
XTRAC system at Massachusetts General Hospital. Our objective in these clinical
trials was to compare our XTRAC laser technology with standard ultraviolet light
therapy in the treatment of psoriasis. In January 2000, we received a 510(k)
clearance to market the XTRAC system from the FDA based on the clinical results
from these trials. The Massachusetts General Hospital clinical trial, which
involved 13 patients, concluded that our XTRAC laser made it possible to treat
psoriasis effectively in one session with moderately long remission. The study
also concluded that the number of treatments to remission depended largely on
the intensity of the ultraviolet light used, finding that medium intensities
seemed to provide the best results with a superior balance between quick
clearing and patient comfort. We supported the clinical trials with research
grants of approximately $954,000.
  To
support our commercialization strategy, we completed an additional clinical
trial in 2000. The trial was designed to validate the results obtained in
the Massachusetts General Hospital clinical study in mainstream dermatologists'
offices. We established five Beta sites throughout the United States using our
XTRAC system in a clinical trial of 124 persons. This study examined various
aspects of excimer laser therapy, including the number of treatments necessary
for clearing, the ultraviolet light intensity necessary for clearing and overall
patient satisfaction. Our Beta-Site Clinical Study indicated that:
  ·
    approximately
      72% of the subjects treated were 75% improved in slightly more than six
      sessions, with minimal and well-tolerated side
effects;
  ·
    some
      subjects were cleared in as little as one session;
and
  ·
    subjects
      were successfully treated who had psoriasis in the hinged body areas
      (knees and elbows), which have proven the most difficult for other
      alternative therapies to demonstrate any significant remedial
      impact.
  In 2001,
we received clearance to market our XTRAC system for the treatment of vitiligo
and atopic dermatitis, and in 2002 for the treatment of leukoderma. Overall,
approximately 37 clinical studies have validated the clinical efficacy of our
phototherapy treatments and have advanced the insurance reimbursement process.
  **Domestic
Commercialization of Our XTRAC System**
 
 In the
United States, we are commercializing our XTRAC system in a manner designed to
provide a recurring revenue stream not only to us, but also to the attending
dermatologist, who would otherwise refer the patient for alternative treatment
and thereby forego associated revenues. We place units in the offices of
dermatologists with high-volume psoriasis practices at no up-front capital cost
to the dermatologists. We own the equipment and charge the dermatologist on a
per-treatment basis for the use of the XTRAC system.
  A
dermatologist generally takes delivery of our XTRAC system under the terms of
our standard usage agreement. Our agreements do not provide the dermatologist
with any purchase options. Title to the lasers remains either in our name or in
the name of a third-party who may hold title as a security device within the
context of an equipment financing transaction. There is no fixed amount that is
to be paid over pre-set intervals of time by the
 
 7
 dermatologist.
We reserve the right to remove the laser unit from a dermatologist’s office if
the parties’ economic expectations from the onset of the placement are not borne
out.
  Payment
for access codes is usually set for 60 days. The agreement does not provide for
delay in payment based on third-party reimbursement.
  The
agreements do not provide for minimum purchase amounts. If a dermatologist
treats fewer patients than the dermatologist or we had expected at the onset of
the agreement, we would be entitled to cancel the agreement and take back the
laser. Our agreements do not require the purchases of disposable products or
similar items from us. We make available various accessory products (e.g.
canisters of xenon chloride gas, subject to a special, proprietary formula tied
to the specifications of the XTRAC laser), but do not require the purchase of
set amounts of such items. However, we insist that only our qualified
technicians maintain the lasers and that the physicians observe the instructions
for use for the laser.
  The
dermatologist has the right to purchase pre-paid treatments, which are generally
ordered telephonically and added to the laser’s computer by way of a random
access code obtained from us and input by the dermatologist. These purchased
treatments may be used for multiple treatments for the same or different
patients, for psoriasis, vitiligo, atopic dermatitis or leukoderma. A single
treatment is then deducted from the laser’s computer upon patient treatment. The
dermatologist retains any revenue received from patients or their medical
insurance providers.
  Generally,
dermatologists who treat psoriasis patients refer those patients to independent
treatment centers for ultraviolet light or write prescriptions for topical
creams or systemic drugs. In such cases, the physician does not ordinarily share
in any of the revenue generated from providing treatments to the patient.
However, physicians using our XTRAC system will treat the patient in their own
office and, therefore, will retain revenue that would otherwise be lost to
outside providers. In addition, in most states, a trained technician, rather
than the physician, may apply the treatment, thus allowing the dermatologist to
continue treating other patients, while at the same time increasing revenue from
treatments using our XTRAC system. We believe that this will create an
attractive incentive for the dermatologists to use our XTRAC
system.
  We have
promoted our XTRAC system through trade shows, advertising in scientific
journals, industry magazines, radio and newsprint, as well as direct mail
programs. Our marketing campaign has been designed to accelerate market
acceptance of our XTRAC system by increasing physician and patient awareness for
our new, unique technology. We intend to increase such initiatives once we have
received widespread private health plan reimbursement for psoriasis.
  **International
Commercialization of Our XTRAC System**
  Our
international marketing plan is based on the sale of our XTRAC system through
independent, exclusive distributors. We have relationships with distributors and
end users in more than 30 countries in Europe, the Middle East, the Far East and
Southeast Asia, and in Australia, South Africa and parts of Central and South
America. We intend to expand our products in more countries in these markets. In
some countries, we anticipate developing relationships similar to those in the
United States, whereby we, acting through our distributors, place a laser system
in the doctor's office for free or at minimal cost, charge the doctor a
per-procedure fee and share the revenue stream with the distributor. We have
only recently begun to enter into such relationships.
  **Surgical
Products and Services: an overview**
 
 We market
lasers used in surgery in such venues as hospitals, surgi-centers and doctors
offices. We did this through our wholly-owned subsidiary, SLT. We continue these
businesses under the trademark of SLT and trade name of Surgical Innovations
& Services. We market many of our surgical laser products using a similar
business model to the marketing of our excimer laser products by charging a
per-procedure fee, thereby limiting the initial outlay to the customer for
capital expenditure, while ensuring continued revenue flow to us. We offer a
wide range of laser services in various specialties, including urology,
gynecology, orthopedics and general surgery. We are currently marketing such
services under the trade name PhotoMedex Surgical Services. We also provide
products that we manufacture for use in our surgical services business.
  8
 We also
engage in the development, manufacture and sale of surgical products, including
proprietary Contact and free-beam Laser Systems for surgery and in the provision
of surgical services on a turn-key procedural basis. We introduced Contact
LaserTM surgery by combining proprietary Contact Laser Delivery Systems with an
Nd:YAG laser unit to create a multi-specialty surgical instrument that can cut,
coagulate or vaporize tissue. Our Contact Laser Delivery Systems can be used
effectively with any wavelength of laser between 532nm and 1064nm, including the
KTP laser (532nm), diode laser (various wavelengths) and Nd:YAG laser (1064nm).
We are currently marketing such products under the trade name PhotoMedex
Surgical Products.
  Our
proprietary Contact Laser probe and scalpel surface treatments provide the
ability to alter selectively the temperature profile of tissue, replicating the
clinical effect of many different types of lasers. Through our patented Contact
Laser Delivery Systems, we are able to produce a wide range of temperature
gradients, which address a broad range of surgical procedures within multiple
specialties. Our multiple-specialty capability reduces a hospital’s need to
purchase several lasers to meet its specialists’ varied requirements. These
factors, coupled with the precision, hemostasis, tactile feedback and control
that our Contact Laser Delivery Systems provide, are our primary competitive
strengths in surgical products.
  During
2001, we introduced the LaserPro CTH holmium laser, a versatile and compact
holmium laser for lithotripsy, or fragmentation of calculi of the genito-urinary
tract, as well as a broad range of other surgical applications. We also
introduced a line of fiber-optic laser delivery systems to be used with the
holmium laser. This laser has been used in the provision of surgical services
and has also been offered for sale. In 2004, we introduced our new CO2 laser
system as well as our own diode laser system, which we anticipate over time will
replace the Nd:YAG laser.
  Our
surgical revenues will thus continue to be generated primarily
from:
  ·
    the
      provision of surgical services;
  ·
    the
      sale of Contact Laser Delivery Systems and related accessories;
  ·
    the
      sale of Nd:YAG and CTH holmium laser units; and
  ·
    the
      sale of CO2 and diode units, and related service.
  Our
Contact Laser Delivery Systems consist of proprietary fiberoptic delivery
systems which deliver the laser beam from our Nd:YAG or diode laser unit via an
optical fiber to the tissue, either directly or through a proprietary Laser
Probe or Laser Scalpel. These delivery systems can also be used with the laser
systems of certain other manufacturers. Our holmium laser delivery systems
consist of fiber-optic delivery systems, which deliver the laser beam from our
CTH holmium laser unit to the surgical site. The CO2 laser system does not use a
fiberoptic and therefore will have less of a recurrent revenue steam. However,
we anticipate that in conjunction with sales of the CO2 laser, we will sell more
of our CO2-related accessories.
  **Surgical
Services**
  We
provide our customers with the ability to utilize our laser systems, as well as
those of other companies, on a per-procedure basis. We provide these services
through field technicians, called clinical support specialists, for a variety of
surgical procedures utilizing various laser technologies. The per-procedure
prices we charge for surgical services vary based on the surgical procedure
performed.
  Our
primary competitive strengths in surgical services are in the training we
provide to our clinical service specialists, our adherence to quality standards
and our ability to integrate products which we manufacture into the range of
services we provide. These strengths allow us to provide multiple specialty
capability on a cost-effective basis, which in turn reduces or eliminates a
hospital’s need to purchase laser systems, associated delivery systems and
clinical support to meet its professionals’ requirements.
  Most of
our operations in surgical services are in the southeastern states of the United
States. We also have operations in Milwaukee, Baltimore-Washington DC and
Philadelphia areas. We intend to continue to expand the
 
 9
 territory
where we provide such services and shall explore how we may expand the range of
surgical procedures, which we can support. We see surgical services as a
business with favorable prospects for revenue growth.
  **Surgical
Products**
  The
following is a summary of our major surgical products:
  ***Fiberoptic
Delivery Systems*** *.* We ** have
designed disposable optical quartz fibers **** to
channel the laser beam from our laser unit to the fiber end, the Laser Probe or
the Laser Scalpel or to one of 24 interchangeable, application-specific
handpieces that hold the Laser Scalpel or Laser Probe. Many of these proprietary
optical fibers and handpieces are intended for single use, while others are
designed to be reusable.
  ***Laser
Probes and Laser Scalpels*** *.* Our
proprietary Laser Probes and Laser Scalpels are made of either synthetic
sapphire or fused silica and have high mechanical strength, high melting
temperature and appropriate thermal conductivity. Most of these Laser Probes and
Laser Scalpels use our patented Wavelength Conversion Effect treatments. We
offer more than 60 interchangeable Laser Probes and Laser Scalpels that provide
different power densities through various geometric configurations appropriate
for cutting, coagulation or vaporization. Our Laser Probes and Laser Scalpels
are made with varying distal tip diameters and surface treatments, each with a
different balance between cutting and coagulation, so that the instrument can be
suited to the particular tissue effect desired. Additionally, but at much lesser
volumes, we market side-firing and direct-firing free-beam laser probes. Instead
of changing laser units, surgeons may choose a different Laser Probe or Laser
Scalpel to perform a different procedure. The Laser Probes and Laser Scalpels
can be re-sterilized and reused.
  ***Disposable
Gas or Fluid Cartridge Systems*** *.* Our
proprietary cartridge system provides gas or fluid to cool the junction between
the optical fiber and the Laser Scalpel or the Laser Probe. These cartridges are
sterile and used in one set of procedures.
  ***Reusable
Laser Aspiration Handpieces.*** ** Our
reusable stainless steel handpieces are all used with interchangeable laser
aspiration wands and flexible endoscopic fibers. **** These
proprietary handpieces are intended for intra-nasal/endoscopic sinus and
oropharyngeal procedures requiring smoke and/or fluid evacuation.
  ***Laser
Units*** *.* We market
the CLMD line of Nd:YAG laser units for use with our Contact Laser Delivery
Systems. The line consists of 4 units:
  ·
    the
      CLMD 25-watts to tissue, on 110 volts;
  ·
    the
      CLMD 40-watts to tissue, on 110 volts;
  ·
    the
      CLMD Dual which operates up to 40-watts to tissue on 110 volts and up to
      60-watts to tissue on 220 volts; and
  ·
    the
      CLMD 100-watts to tissue, on 220 volts.
  The laser
units feature a modular design that allows the customer to upgrade from the
25-watt laser to the 40-watt or Dual laser and from the 40-watt laser to the
Dual laser. This modularity provides the customer the flexibility and
versatility to change its laser system easily to meet its changing surgery
needs. We have discontinued production of the 100-watt unit but will continue in
the near term to refurbish such units. In 2004, we began phasing out the other
CLMD units and replacing the line with our diode laser unit.
  We market
the CTH holmium laser unit for use with fiber-optic laser delivery systems. The
laser unit is 20-watts to tissue, and includes a variable speed foot pedal for
improved control of energy. It has a superior duty cycle. The delivery systems
are re-useable.
  The diode
laser unit can provide up to 20 watts of power to tissue. The laser has three
versions, depending on which wavelength the user desires to be installed in the
laser. The wavelengths are 810-nm, 940-nm and 980-nm. The laser unit is small
and portable, but also is designed to be rugged and dependable. Acting as an
original
 
 10
 equipment
manufacturer (OEM), we have provided the diode laser to third parties to market
in specialties lying outside our area of focus. We expect to cultivate more such
relationships in the future.
  The CO2
laser unit can provide up to 30 watts of power to tissue at a wavelength of
10,600-nm. Like the diode, the CO2 laser is readily transportable and has been
designed for dependable use. This laser was also designed to work seamlessly
with a line of premiere CO2 accessories, including the Unimax® micromanipulator,
which we acquired from Reliant Technologies. As in the case of the diode laser,
we have in the case of the CO2 laser undertaken discussions to supply the laser
on an OEM basis to third parties.
  The
holmium, diode and CO2 lasers are marketed under the trademark
”LaserPro.”
  We
manufacture virtually all of our laser systems and laser delivery systems (other
than those manufactured by other companies that are utilized in the provision of
surgical services) at our Montgomeryville, Pennsylvania facility. The raw
materials we use are generally available in adequate supply from multiple
suppliers. We obtain all of our partially finished Laser Probes and Laser
Scalpels from three suppliers in the United States. We perform materials
processing and final assembly on the Laser Probes and Laser Scalpels using
proprietary and patented treatment processes. We also manufacture the fiberoptic
delivery systems, with and without handpieces. A domestic supplier manufactures
our sterile gas and fluid cartridge systems on an exclusive basis in accordance
with our specifications.
  ***Handheld
Sinus Instrumentation*** **.** We market
a line of 27 precision thru-cutting instruments used for minimally invasive
sinus surgery. The line includes instruments with cutting tips at several
different angles to allow for convenient access to difficult-to-reach anatomy.
  ***Irrigation
and Suction System.*** We
manufacture ClearESS, which provides convenient and effective irrigation and
suction to remove blood and debris for enhanced visualization during endoscopic
sinus surgery. We supply this product to Linvatec Corporation, which has
exclusive worldwide marketing rights.
  **Marketing**
 
 As of
March 15, 2005, our sales and marketing organization included 17 full-time
employees in North America, seven of whom are direct account representatives
serving the United States market. We pay our direct sales force employees a
salary plus commission. We have one international marketing representative who
markets our XTRAC system to distributors worldwide and one international
marketing coordinator, both of whom are based in North America.
  In the
past, our revenues from phototherapy, derived predominantly from sales of lasers
to our international distributors. With increasing U.S. reimbursement, domestic
dermatology revenue has increased significantly and our plan is to continue to
increase significantly our revenues in the United States from a rollout of laser
placements in doctors’ offices and earn revenues from per-procedure fees. The
timing and scale of the rollout are dependent on gaining widespread private
healthcare plan reimbursement for psoriasis.
  We sell
our surgical products and services to hospitals and surgery centers as well as
to individual practitioners. We design our products to be cost-effective and,
where applicable, to be accessible and easy to use with various other
technologies or products. Our marketing efforts include activities designed to
educate physicians and nurses in the use of our products and
services.
  Our sales
organization provides consultation and assistance to customers on the effective
use of our products, whether in phototherapy or in surgery. The consultative
sales effort varies depending on many factors, which include the nature of the
specialty involved and complexity of the procedures. Maintaining this
consultative effort allows us to develop a long-term relationship with our
customers.
  The time
between identifying a U.S. customer for the XTRAC system and placing a unit with
the customer can be from one to several months. The length of the sales cycle
for a laser unit, whether an excimer unit sold internationally or one of our
surgical lasers, varies from one month to one year, with the average sale or
placement
 
 11
 requiring
approximately six months. The length of the sales cycle for the provision of
surgical services can range from immediate to several months depending on the
services desired.
  Our sale
and post-sale support personnel includes regional managers and clinical support
specialists and marketing and technical personnel. We train the regional
managers and clinical support specialists in the utilization of our products and
services, which allows them to provide clinical consultation regarding safety,
efficacy and clinical protocols. Our marketing and technology personnel provide
our link to the customer to create innovative solutions and identify new
applications and product opportunities. In some areas of the United States, we
use independent distributors to provide this support for surgical products.
  **Manufacturing**
 
 We
manufacture our phototherapy products at our 11,500 sq. ft. facility in
Carlsbad, California and our
surgical products at our 42,000 sq. ft. facility in Montgomeryville,
Pennsylvania . Our
California and Pennsylvania facilities are ISO 13485 certified. Our Carlsbad,
California lease expires June 30, 2005. We anticipate relocating the facilities
to a new location prior to that lease expiration. We believe that our present
manufacturing capacity at these facilities is sufficient to meet foreseeable
demand for our products.
  We
manufacture most of our own components and utilize certain suppliers for the
manufacture of selected standard components and subassemblies, which are
manufactured, to our specifications. Most major components and raw materials,
including optics and electro-optic devices, are available from a variety of
sources. We conduct all final testing and inspection of our products. We have
established a quality control program, including a set of standard manufacturing
and documentation procedures intended to ensure that, where required, our
instruments are manufactured in accordance with FDA Quality System Requirements
and the comparable requirements of the European Community.
  **Research
and Development**
 
 As of
March 15, 2005, our research and development team included three full-time
research employees and 12 engineers. We conduct our research and development
activities at both of our facilities in Carlsbad, California and
Montgomeryville, Pennsylvania. Our research and development expenditures were
approximately $1.8 million in 2004, $1.8 million in 2003 and $1.8 million in
2002.
  Our
research and development activities are focused on:
  ·
    the
      application of our XTRAC system to the treatment of other inflammatory
      skin disorders;
  ·
    the
      development of additional devices to further improve the phototherapy
      treatments performed with our XTRAC system;
  ·
    the
      development of new lines of phototherapy products for medical
      treatments;
  ·
    the
      improvement of surgical products through tissue effect technologies that
      include laser and non-laser based technologies focused on improving our
      product and service offerings;
  ·
    the
      development of new lines of surgical lasers and related delivery systems
      for medical treatments;
  ·
    the
      development of additional products and applications, whether in
      phototherapy or surgery, by working closely with medical centers,
      universities and other companies worldwide;
and
  ·
    the
      development of new applications in minimally invasive and open surgery
      procedures where precision and hemostasis are critical to the procedure
      being performed and where our products and services can demonstrate
      distinct clinical advantages and cost-effectiveness relative to
      traditional surgical methods.
  12
 **Patents
and Proprietary Technologies**
 
 We intend
to protect our proprietary rights from unauthorized use by third parties to the
extent that our proprietary rights are covered by valid and enforceable patents
or are effectively maintained as trade secrets.
  Patents
and other proprietary rights are an element of our business. Our policy is to
file patent applications and to protect technology, inventions and improvements
to inventions that are commercially important to the development of our
business. As of March 15, 2005, we have more than 40 domestic and foreign issued
patents, which serve to help protect the technology of our businesses in
phototherapy and surgical products and services. To the same purpose, we have a
number of patent applications pending in the United States and abroad.
  We have
licensed certain of our proprietary technology in phototherapy to Komatsu, Ltd.
in connection with its manufacture of semi-conductor lithography equipment, for
which we are entitled to receive royalty fees. Conversely, from time to time, we
seek licenses from third parties for technology that can broaden our product and
service offerings.
  We also
rely on trade secrets, employee and third-party nondisclosure agreements and
other protective measures to protect our intellectual property rights pertaining
to our products and technology.
  Many of
our products and services are offered under trademarks and service marks, both
registered and unregistered. We believe our trademarks encourage customer
loyalty and aid in the differentiation of our products from competitors’
products. Accordingly, we have registered two of our phototherapy trademarks and
seven of our trademarks in surgical products with the U.S. Patent and Trademark
Office.
  **Government
Regulation**
 
 Our
products and research and development activities are regulated by numerous
governmental authorities, principally the FDA and corresponding state and
foreign regulatory agencies. Any device manufactured or distributed by us will
be subject to pervasive and continuing regulation by the FDA. The Federal Food,
Drug and Cosmetics Act and other federal and state laws and regulations govern
the pre-clinical and clinical testing, design, manufacture, use and promotion of
medical devices and drugs, including our XTRAC system, surgical lasers and other
products currently under development by us. Product development and approval
within this regulatory framework takes a number of years and involves the
expenditure of substantial resources.
  In the
United States, medical devices are classified into three different classes,
Class I, II and III, on the basis of controls deemed reasonably necessary
to ensure the safety and effectiveness of the device. Class I devices are
subject to general controls, such as labeling, pre-market notification and
adherence to the FDA's good manufacturing practices, and quality system
regulations. Class II devices are subject to general as well as special
controls, such as performance standards, post market surveillance, patient
registries and FDA guidelines. Class III devices are those which must
receive pre-market approval by the FDA to ensure their safety and effectiveness,
such as life-sustaining, life-supporting and implantable devices, or new
devices, which have been found not to be substantially equivalent to legally
marketed devices.
  Before a
new medical device can be marketed, marketing clearance must be obtained through
a pre-market notification under Section 510(k) of the Food and Drug
Modernization Act of 1997, or the FDA Act, or a pre-market approval application
under Section 515 of such FDA Act. The FDA will typically grant a 510(k)
clearance if it can be established that the device is substantially equivalent
to a predicate device that is a legally marketed Class I or II device or
certain Class III devices. We have received FDA 510(k) clearance to market
our XTRAC system for the treatment of psoriasis, vitiligo, atopic dermatitis and
leukoderma. Additionally, the FDA has issued clearances to commercially market
our Contact Laser System, including the laser unit, Laser Probes and Laser
Scalpels and Fiberoptic Delivery System, in a variety of surgical specialties
and procedures in gynecology, gastroenterology, urology, pulmonology, general
and plastic surgery, cardio-thoracic surgery, ENT surgery, ophthalmology,
neurosurgery and head and neck surgery. The FDA granted these clearances under
Section 510(k) on the basis of substantial equivalence to other laser or
electrosurgical cutting devices that had received prior clearances or were
otherwise permitted to be used in such areas. We have also received FDA
clearance under Section 510(k) to market
 
 13
 our
holmium laser system, including the laser unit and fiberoptic delivery systems,
in a variety of surgical specialties and procedures in urology,
otorhinolaryngology, discectomy and percutaneous laser disc decompression.
  For any
devices that are cleared through the 510(k) process, modifications or
enhancements that could significantly affect the safety or effectiveness, or
that constitute a major change in the intended use of the device, will require
new 510(k) submissions. In August 2003, the FDA granted 510(k) clearance for
modifications that had been made to the XTRAC laser, which we have marketed as
the XTRAC XL Plus excimer laser system. In October 2004, the FDA granted
clearance for the UltraTM (AL 8000) excimer laser system. We also received in
2004, 510(k) marketing clearance for our diode and CO2 surgical laser
systems.
  A
pre-market approval application may be required if a proposed device is not
substantially equivalent to a legally marketed Class I or II device, or for
certain Class III devices. A pre-market approval application must be
supported by valid scientific evidence to demonstrate the safety and
effectiveness of the device, typically including the results of clinical trials,
bench tests and laboratory and animal studies. In addition, the submission must
include the proposed labeling, advertising literature and any training
materials. The pre-market approval process can be expensive, uncertain and
lengthy, and a number of devices for which FDA approval has been sought by other
companies have never been approved for marketing.
  We are
subject to routine inspection by the FDA and have to comply with a number of
regulatory requirements that usually apply to medical devices marketed in the
United States, including labeling regulation, good manufacturing process
requirements, medical device reporting regulation (which requires a manufacturer
to report to the FDA certain types of adverse events involving its products),
and the FDA's prohibitions against promoting products for unapproved or
off-label uses.
  We are
also subject to the Radiation Control for Health and Safety Act with laser
radiation safety regulations administered by the Center for Devices and
Radiological Health, or CDRH, of the FDA. These regulations require laser
manufacturers to file new product reports and annual reports, to maintain
quality control, product testing and sales records, to incorporate certain
design and operating features in lasers sold to end users and to certify and
label each laser sold, except those sold to private-label customers, as
belonging to one of four classes, based on the level of radiation from the laser
that is accessible to users. Various warning labels must be affixed and certain
protective devices installed, depending on the class of product. The CDRH is
empowered to seek fines and other remedies for violations of the regulatory
requirements. To date, we have filed the documentation with the CDRH for our
laser products requiring such filing, and have not experienced any difficulties
or incurred significant costs in complying with such regulations.
  We have
received ISO 13485/EN46001 certification for our XTRAC system and our Nd:YAG,
holmium, diode and CO2 laser systems. This certification authorizes us to affix
a CE Mark to our products as evidence that they meet all European Community, or
EC, quality assurance standards and compliance with applicable European medical
device directives for the production of medical devices. This will enable us to
market our approved products in all of the member countries of the European
Union, or EU. We also will be required to comply with additional individual
national requirements that are outside the scope of those required by the EU.
Our products have also met the discrete requirements for marketing in various
other countries. Failure to comply with applicable regulatory requirements can
result in fines, injunctions, civil penalties, recalls or seizures of products,
total or partial suspensions of production, refusals by foreign governments to
permit product sales and criminal prosecution.
  **Third-Party
Reimbursement**
 
 Our
ability to market our phototherapy products successfully will depend in large
part on the extent to which various third parties are willing to reimburse
patients or providers for the cost of medical procedures utilizing our treatment
products. These third parties include government authorities, private health
insurers and other organizations, such as health maintenance organizations.
Third-party payers are systematically challenging the prices charged for medical
products and services. They may deny reimbursement if they determine that a
prescribed device is not used in accordance with cost-effective treatment
methods as determined by the payer, or is experimental, unnecessary or
inappropriate. Accordingly, if less costly drugs or other treatments are
available, third-party payers may not authorize or may limit reimbursement for
the use of our products, even if our products are
 
 14
 safer or
more effective than the alternatives. Additionally, they may require changes to
our pricing structure and revenue model before authorizing
reimbursement.
  Third-party
reimbursement has not changed significantly in 2004 from 2003 for our
international XTRAC business segment or in our segments of surgical services and
surgical products. Reimbursement systems in international markets vary
significantly by country and by region within some countries, and reimbursement
approvals must be obtained on a country-by-country basis. Many international
markets have government-managed healthcare systems that control reimbursement
for new devices and procedures. In most markets, there are private insurance
systems, as well as government-managed systems. Our XTRAC products remain
substantially without approval for reimbursement in any international markets
under either government or private reimbursement systems. Reimbursement for the
products and services provided by our Surgical Services and Surgical Products
segments has been generally well established and is not viewed as an obstacle to
growth in those segments.
  Our
primary focus in 2004 was to amplify our efforts which we began in 2002 on
third-party reimbursement in our domestic XTRAC business segment. In February
2002, the Current Procedural Terminology Editorial Board of the American Medical
Association, or AMA, approved the request by the American Academy of Dermatology
to issue reimbursement codes for laser therapies in the treatment of psoriasis
and other inflammatory skin diseases, which would include laser therapy using
our XTRAC system to treat such conditions. In December 2002, the Centers for
Medicare and Medicaid Services, or CMS, published the relative values and
national Medicare reimbursement rates for each of the CPT codes. These
reimbursement rates were effective January 1, 2003. However, they could not be
paid sooner than March 1, 2003. The designation for laser treatment for
inflammatory skin disease (psoriasis) was broken into three distinct codes,
based on the total skin surface area being treated:
  ·
    96920
      - designated for: the total area less than 250 square centimeters. CMS
      assigned a 2003 national payment of approximately $151.53 per treatment;
      the 2005 rate is approximately $140.60 per
treatment.
  ·
    96921
      - designated for: the total area 250 to 500 square centimeters. CMS
      assigned a 2003 national payment of approximately $155.20 per treatment;
      the 2005 rate is approximately $144.01 per treatment
and
  ·
    96922
      - designated for: the total area over 500 square centimeters. CMS assigned
      a 2003 national payment of approximately $214.05 per treatment; the 2005
      rate is approximately $212.36 per treatment
  The state
rates will vary by overhead factors applicable to each state. The 2004 CMS
Medicare payment levels were announced in December 2003 with significant
increases.
  In
addition to Medicare and Medicaid, consistent domestic private healthcare
reimbursement is critical for significant growth in XTRAC laser system
procedures. Although there were more than 30,000 XTRAC procedures in 2003 and
more than 50,000 XTRAC procedures in 2004 with the majority being covered by
third-party reimbursement, our reimbursement experts developed an understanding
that a rapid increase in widespread adoption of private healthcare reimbursement
was being thwarted by a perception that the XTRAC therapy, although widely
publicized as clinically safe and efficacious, was not economically
cost-effective compared to other existing therapies.
  ***The
Data Compendium***
  In
October 2003, we engaged an independent health economic research firm to study
the economic profile of the XTRAC. The results of this study were included in a
Data Compendium mailing in December 2003 and February 2004 to almost all private
medical insurance carriers throughout the country.
  The Data
Compendium instigated a re-evaluation by many private payers of their policies
on reimbursement for treatment of psoriasis using the XTRAC. In 2004, approved
medical policies for the medically necessary treatment of psoriasis were adopted
by several of the large independent health insurance providers. The key
components of the Data Compendium included information on:
  ·
    Epidemiology
      and Pathophysiology of Psoriasis
  15
 ·
    Goal
      of Therapy
  ·
    Product
      Description
  ·
    Technology
      Evaluation
  ·
    Place
      in Therapy
  ·
    Expected
      Clinical and Economic Outcomes
  ·
    Appendices.
  The
following is a synopsis of the key components of the Data Compendium, which
advocates that the XTRAC is proven to be safe, effective and economical. We
cannot assure you that we will continue to obtain any additional reimbursement
approvals as a result of the Data Compendium.
  ***Epidemiology
and Pathophysiology.*** Psoriasis is a common immune-mediated chronic skin disease that comes in
different forms and varying degrees of severity. About 80% of people with
psoriasis develop plaque psoriasis, the most common form of this disease. Plaque
psoriasis is a genetic disease, with a family association in 1 out of every 3
cases. It can develop at any time and, for most people, it appears between the
ages of 15 and 35 years.
  Plaque
psoriasis, characterized by well-defined patches of red, raised skin, is most
commonly located on the knees, elbows, scalp, trunk, and nails. The severity of
psoriasis is measured in terms of its physical and emotional impact. If less
than 2% of the body is involved, the case is considered mild. Between 3% and 10%
is considered moderate, and more than 10% is severe. Psoriasis is also measured
by its impact on quality of life. When psoriasis impairs function (either by
involving hands and feet or damaging emotional well being), the case may be
considered severe.
  ***Goal
of Therapy.*** The
National Psoriasis Foundation (NPF) states the goal of therapy is to find a
treatment that achieves the best results with the fewest side effects. Treatment
of psoriasis commonly follows a step approach with topical therapy as first
step, phototherapy as second step, and systemic or biologic medications reserved
for when all other treatments fail.
  ***Product
Description.*** 308-nm UV
laser energy is a refined source of narrow-band ultraviolet light that is
limited to one preferred wavelength within the narrow-band UVB range. Targeted
delivery of the light solely to the psoriatic plaque is enabled with a focused
handpiece. Since the energy is targeted only to plaque areas, normal skin areas
are unexposed and unaffected; thus, higher light energy fluences can be
delivered to the target plaque, which enhances the antipsoriatic action of the
light energy delivered.
  This
refined delivery of traditional narrowband UVB light energy as targeted
308nm-only light is a safe and effective treatment for psoriasis.
  The ideal
treatment candidate for 308-nm UV laser light therapy would be a patient with
mild or moderate plaque psoriasis covering less than 10% of body surface area
for whom first-line therapy, such as topicals, has been unsuccessful. (The
treatment time required to treat over 10% body surface area in a targeted
fashion under current regimes would not be clinically practical.)
  ***Technology
Evaluation*** . To
evaluate whether the use of the 308-nm UV (xenon chloride excimer) monochromatic
(laser) light therapy improves health outcomes for patients with
mild-to-moderate stable, localized plaque-type psoriasis, who have failed
standard topical therapy, objective evaluation criteria consistent with
evidence-based medicine are used. Many standard criteria have been developed for
this purpose. In the Data Compendium, the use of 308-nm laser therapy for
psoriasis is evaluated utilizing a set of technology evaluation criteria similar
to those employed by many insurers, including:
  16
 **1.**
    **The
      technology must have final approval from the appropriate governmental
      regulatory bodies.**
  Our
308-nm excimer laser obtained marketing clearance by the US Food and Drug
Administration in March 2001 via 510(k) number K003705. The intended use is UVB
phototherapy for psoriasis and vitiligo.
  **2.**
    **Scientific
      evidence must permit conclusions concerning the effect of the technology
      on health outcomes.**
  There is
a basic scientific foundation in the literature that UVB light is effective in
treating psoriasis, that narrow-band UVB light is more effective, and that
super-narrow-band UVB light at 308-nm enables a more potent delivery of the
antipsoriatic action of the light energy at that wavelength spectrum. There have
been numerous clinical studies to validates this scientific
foundation.
  **3.**
    **The
      technology must improve the net health
outcome.**
  Studies
have shown that carcinogenicity of different UV therapies increases in parallel
with the cumulative UV dose during life. Targeted phototherapy, such as with the
xenon chloride (XeCl) laser, results in sparing the surrounding normal skin from
unnecessary (potentially carcinogenic) UV radiation exposure, as opposed to
traditional, non-targeted phototherapy, which exposes normal skin to potentially
harmful UV energy. The body of clinical evidence and scientific literature
supports the conclusion that the beneficial effects on health outcomes outweigh
any harmful effects on health outcomes.
  **4.**
    **The
      technology must be as beneficial as any established
      alternatives.**
  Established
alternative therapies for mild-to-moderate psoriasis include topical therapy and
UV phototherapy. A direct comparative trial of 308-nm therapy versus narrow-band
UVB showed that the 308-nm therapy achieved clearance similar to narrow-band UVB
but with fewer treatments, specifically in only 8 treatments on average with the
308-nm laser versus 30 treatments with narrow-band UVB. The number of treatments
was 3.6 times less with the laser than with narrow-band UVB, providing the
patients with a significantly more efficient alternative.
  Efficacy
of the variety of topical therapies is well established and has been reported
extensively in the literature, as has the effect of placebo treatments.
Published studies reported results with topical therapy, phototherapy and
combination therapy, and compared that to the reported results with 308-nm UVB
laser treatment. This study reported that:
  *“A
greater percentage of patients achieved 75% improvement with the UVB laser
treatments than was reported for other forms of phototherapy or systemic therapy
with acetretin or low dose cyclosporine, and did so more rapidly. The UVB laser
study patients achieved the 75% improvement endpoint in an average of 46% fewer
treatments than was observed in other phototherapy studies. Laser treatment and
topical calcipotriene had similar efficacies, and both were more effective than
topical tazarotene or topical fluocinonide. As compared to topical therapies,
the time to achieve 75% improvement favored the UVB laser. 308-nm laser
treatments for psoriasis are clearly more effective than placebo and are
comparable to or more effective than many other standard treatments for
psoriasis.”*
  **5.**
    **Improvement
      must be attainable outside the investigational
      settings**
  Clinical
investigations of the 308-nm UVB excimer laser therapy were conducted under the
usual conditions of medical practice; thus, patients are expected to achieve
similar results when receiving this treatment in the clinical
setting.
  Typically,
in the clinical setting, psoriasis patients will be treated initially with
topical therapy as a first-step treatment. The 308-nm therapy will be generally
considered as a treatment option for patients for whom topical therapy has
failed.
  Additionally,
in the clinical setting, it is not practical to treat more than 10% body surface
area of psoriasis, because of the extended treatment time required due to the
relatively small treatment-spot size.
 
 17
 Investigations
generally reflected this clinical setting reality, limiting eligible study
patients to those with less than 10% body surface area of
psoriasis.
  Approximately
30,000 excimer laser procedures had been performed in the United States in 2003
(since the issuance of relevant CPT codes), and approximately 56,000 such
procedures had been performed since 2001 to the end of 2003. This was further
evidence that the procedure is effectively performed outside of investigational
settings.
  ***Place
in Therapy.*** The body
of evidence contained in the Data Compendium supports our first thesis that the
use of the 308-nm excimer laser is safe and effective for localized plaque-type
psoriasis resistant to other first-step therapies, such as topical creams and
ointments.
  The ideal
treatment candidate for 308-nm UV laser light therapy would be a patient with
mild or moderate plaque psoriasis covering less than 10% of body surface area
for whom first-step therapy, such as topicals, has been unsuccessful. (The
treatment time required to treat over 10% body surface area in a targeted
fashion would not be clinically practical under current regimes.)
  ***Expected
Clinical and Economic Outcomes.*** Our
second thesis is that the XTRAC is cost-effective. Our clinical economic
analysis has demonstrated that the addition of excimer laser treatment results
in no expected cost increase to the payer. Additionally, the annual cost of
excimer laser treatment is comparable to or less than other standard “Step 2”
psoriasis treatment modalities, such as phototherapy treatment alternatives or
alternative topical therapies. In addition, the cost-effectiveness of the
excimer laser is superior due to the increased number of expected clear
days.
  **Competition**
 
 The
market for our XTRAC phototherapy system is highly competitive. We compete with
other products and methodologies used to treat the symptoms of psoriasis,
vitiligo, atopic dermatitis and leukoderma, including topical treatments,
systemic medications and other phototherapies. We believe that our XTRAC system
will compete with alternative treatments for these disorders primarily on the
basis of its effectiveness, as well as on the basis of the lower out-of-pocket
costs, as compared to costs associated with alternative treatments. Market
acceptance of our XTRAC system treatment for these diseases is dependent on our
ability to establish, with the medical and patient communities, the efficacy of
our XTRAC system as a preferred treatment modality. In addition, all or a
portion of patient costs for many of the alternative treatments are paid or are
reimbursable by health insurance coverage or other third-party payers, such as
Medicaid and Medicare. Patient costs for treatments utilizing our XTRAC system
may not be initially eligible for health care coverage or reimbursement by
third-party payers until such payers approve reimbursement. This may cause some
patients or physicians to choose alternative treatments offered by our
competitors.
  We also
face direct competition from other companies, including large pharmaceutical
companies, engaged in the research, development and commercialization of
treatments for psoriasis, atopic dermatitis, vitiligo and leukoderma. In some
cases, those companies have already received FDA approval or commenced clinical
trials for such treatments. Many of these companies have significantly greater
financial resources and expertise in research and development, manufacturing,
conducting pre-clinical studies and clinical trials, and marketing than we do.
  Various
other companies are now marketing laser-based phototherapy treatment products.
One competitor has received FDA clearance to market an excimer laser for the
treatment of psoriasis in the United States, and another competitor has asserted
that it has such clearance - an assertion we are disputing. At least three
foreign-based companies are currently marketing an excimer laser for the
treatment of skin disorders outside of the United States. Two others have
developed pulse-dye lasers, which are being explored as treatments for
psoriasis. Another company has announced FDA clearance for a standard UVB light
based system using a fiber-optic delivery system for the treatment of skin
disorders. All of these technologies will continue to evolve with time. We
cannot say how much these technologies will impact on us.
  With
regard to surgical lasers, we face substantial competition from other
manufacturers of surgical laser systems, whose identity varies depending on the
medical application for which the surgical system is being used,
 
 18
 and from
traditional surgical methods. Other companies are developing competitive
surgical systems and related technologies. Many of these companies are
substantially larger and have substantially greater resources than we do. These
efforts could result in additional competitive pressures on our
operations.
  In
addition, we face competition from other surgical services companies and from
product manufacturers who may offer their products through a similar
per-procedure method. Additionally, we face substantial competition from
well-established manufacturers of non-laser products. These well-established
companies have substantially greater resources than we do and could exert
considerable competitive pressure on us. We continue to monitor the concepts or
products and services some companies have introduced into the market that draw
on Contact Laser technology. We do not believe, however, that such concepts or
products will have a significant impact on our sales.
  In
addition, our competitors compete with us in recruiting and retaining qualified
scientific, management and marketing personnel.
  **Employees**
 
 As of
March 15, 2005, we had 138 full-time employees, which consisted of five
executive personnel (four executive personnel at our Montgomeryville,
Pennsylvania facility and one at our Carlsbad, California facility), 17 sales
and marketing staff, 81 people engaged in manufacturing of lasers and
laser-related products, seven customer-field service personnel, three people
engaged in research and development, 12 engineers and 13 finance and
administration staff. We intend to hire additional personnel as the development
of our business makes such action appropriate. The loss of the services of key
employees could have a material adverse effect on our business. Since there is
intense competition for qualified personnel knowledgeable in our industry, no
assurances can be given that we will be successful in retaining and recruiting
needed personnel.
  Our
employees are not represented by a labor union or covered by a collective
bargaining agreement. We believe that we have good relations with our employees.
We provide our employees with certain benefits, including health
insurance.
  **Risk
Factors**
  **Certain
statements in this Report are "forward-looking statements." These
forward-looking statements include, but are not limited to, statements about our
plans, objectives, expectations and intentions and other statements contained in
this Report that are not historical facts. Forward-looking statements in this
Report or hereafter included in other publicly available documents filed with
the Securities and Exchange Commission, or the Commission, reports to our
stockholders and other publicly available statements issued or released by us
involve known and unknown risks, uncertainties and other factors which could
cause our actual results, performance (financial or operating) or achievements
to differ from the future results, performance (financial or operating) or
achievements expressed or implied by such forward-looking statements. Such
future results are based upon management's best estimates based upon current
conditions and the most recent results of operations. When used in this Report,
the words "expect," "anticipate," "intend," "plan," "believe," "seek,"
"estimate" and similar expressions are generally intended to identify
forward-looking statements, because these forward-looking statements involve
risks and uncertainties. There are important factors that could cause actual
results to differ materially from those expressed or implied by these
forward-looking statements, including our plans, objectives, expectations and
intentions and other factors discussed in the risk factors, described
below.**
  **Risks
Related to Our Business**
  **We
have a history of losses, expect future losses and cannot assure you that we
will become or remain profitable.**
  Historically,
we have incurred significant losses and have had negative cash flows from our
phototherapy operations. Our surgical products and services business also has
generated losses in recent years. To date, we have
 
 19
 dedicated
most of our financial resources to research and development and selling, general
and administrative expenses. As of December 31, 2004, our accumulated deficit
was approximately $76.2 million.
  Our
future revenues and success depend significantly upon acceptance of our excimer
laser systems for the treatment principally of psoriasis, but also of vitiligo,
atopic dermatitis and leukoderma. Our XTRAC system for the treatment of these
conditions generates revenues, but those revenues are presently insufficient to
generate positive cash flows from our operations in the two XTRAC-related
business segments. Our future revenues and success also depend on the continued
revenue growth of our surgical services business and revenue stability within
our surgical products business. Our ability to market our products and services
successfully and the expected benefits to be obtained from our products and
services may be adversely affected by a number of factors, such as unforeseen
costs and expenses, technological changes, economic downturns, competitive
factors or other events beyond our control.
  We expect
to incur operating losses as we move into fiscal 2005 because we plan to spend
substantial amounts on securing broader reimbursement for psoriasis by private
healthcare plans and in expanding, in controlled fashion, our operations, both
in phototherapy and in surgical services. We cannot assure you that we will
market any products successfully, operate profitably in the future, or that we
will not require significant additional financing in order to accomplish our
business plan.
  **We
may need additional financing to maintain and expand our business, and such
financing may not be available on favorable terms, if at
all.**
  We have
historically financed our operations through working capital provided from the
private placement of equity securities and from lines of credit. We believe that
our cash balance, together with access to lease financing for capital
expenditures and other existing financial resources, and revenues from sales,
distribution, licensing and manufacturing relationships, should be sufficient to
meet its operating and capital requirements into the first quarter of 2006.
However, we may have to raise substantial additional capital if:
  ·
    changes
      in our research and development plans necessitate unexpected large future
      expenditures;
  ·
    operating
      losses continue, if anticipated approvals for reimbursement by private
      healthcare plans or demand for the XTRAC system for the treatment of
      psoriasis, vitiligo, atopic dermatitis and leukoderma, or surgical laser
      systems do not meet our current
expectations;
  ·
    the
      geographic expansion of our surgical services is stymied by competition
      and revenue increases do not materialize;
or
  ·
    we
      need to maintain or accelerate favorable, but costlier, growth of our
      revenues.
  **If
we need additional financing, we cannot assure you that such financing will be
available on favorable terms, if at all. In addition, any future issuance may
result in substantial dilution to existing stockholders. If we need funds and
cannot raise them on acceptable terms, we may not be able
to:**
  ·
    execute
      our growth plan for the XTRAC system and surgical
  services;
  ·
    take
      advantage of future opportunities, including synergistic
      acquisitions;
  ·
    expand
      our manufacturing facilities, if necessary, based on increased demand for
      the XTRAC system or other surgical
products;
  ·
    respond
      to customers, competitors or violators of our proprietary and contractual
      rights; or
  ·
    remain
      in operation.
  20
 **Our
laser treatments of psoriasis, vitiligo, atopic dermatitis and leukoderma, our
surgical laser products, and any of our future products or services may fail to
gain market acceptance, which would adversely affect our competitive
position.**
  No
independent studies with regard to the feasibility of our proposed business plan
have been conducted by third parties with respect to our present and future
business prospects and capital requirements. We have generated limited
commercial distribution for our XTRAC system and our other products. Our
surgical services may fail to gain market acceptance in new territories into
which we expand. In addition, our infrastructure to enable such expansion,
though stronger than in the past, is still limited. Even if adequate financing
is available and our products are ready for market, we cannot assure you that
our products and services will find sufficient acceptance in the marketplace to
fulfill our long and short-term goals. We cannot assure you that the marketplace
will be receptive to our surgical services or our excimer laser technology over
competing services and therapies or that a cure will not be found for the
underlying diseases we assist in treating. Failure of our products and surgical
services to achieve market acceptance would have a material adverse effect on
our business, financial condition and results of operations.
  While we
have engaged in clinical studies for our psoriasis treatment, and based on these
studies, we have gained FDA clearance, appropriate CPT reimbursement codes for
treatment and suitable reimbursement rates from CMS for those codes, we may face
yet other hurdles to market acceptance if, for example, practitioners in
significant numbers wait to see longer-term studies or if it becomes necessary
to conduct studies corroborating the role of the XTRAC laser as a second-line
therapy for psoriasis. We have not had sufficient time to observe the long-term
effectiveness or potential side effects of our treatment system for psoriasis,
or for vitiligo, atopic dermatitis or leukoderma.
  In 2003,
we improved the reliability and functionality of the XTRAC laser and upgraded
such lasers both in the United States and overseas. In 2004, we obtained FDA
510(k) marketing clearance for a smaller and faster XTRAC laser system known as
the Ultra. These efforts should help us gain market acceptance for the XTRAC
both in the United States and abroad, but do not guarantee such acceptance or
that we may not encounter further problems in reliability.
  **Our
success depends on third-party reimbursement of patients' costs for our XTRAC
system, which could result in price pressure or reduced
demand.**
  Our
ability to market the XTRAC system and other treatment products successfully
will depend in large part on the extent to which various third parties are
willing to reimburse patients or providers for the costs of medical procedures
utilizing such products. These third parties include government authorities,
private health insurers and other organizations, such as health maintenance
organizations. Third-party payers are systematically challenging the prices
charged for medical products and services. They may deny reimbursement if they
determine that a prescribed device is not used in accordance with cost-effective
treatment methods as determined by the payer, or is experimental, unnecessary or
inappropriate. Further although third-parties may approve reimbursement, such
approvals may be under terms and conditions that discourage use of the XTRAC
laser system. Accordingly, if less costly drugs or other treatments are
available, third-party payers may not authorize or may limit reimbursement for
the use of its products, even if our products are safer or more effective than
the alternatives.
  Although
we have received reimbursement approvals from an increased number of private
healthcare plans, we cannot give assurance that private plans will continue to
adopt favorable reimbursement policies or to accept the XTRAC in its clinical
role as a second-line therapy in the treatment of psoriasis. Additionally, third
party payers may require further clinical studies or changes to our pricing
structure and revenue model before authorizing reimbursement.
  As of
March 15, 2005, we have received reports that more than 90 private insurance
companies, along with 24 Medicare plans throughout the country, have paid for
claims submitted by patients or their doctors for treatment of psoriasis
utilizing the XTRAC system. We estimate that there are in the United States
approximately 140 million people, or roughly 67% of the insured population, who
are covered by the insurance coverage or payment policies that reimburse
physicians for using the XTRAC for treatment of psoriasis. Based on these
reports and estimates, we are continuing the implementation of a rollout
strategy for the XTRAC system in the United States. The success of
 
 21
 the
rollout depends on more plans beginning to pay claims and adopting favorable
reimbursement policies. We can give no assurance that any other health insurers
will begin to pay claims or that currently reimbursing insurers will not
adversely modify their reimbursement policies for the use of the XTRAC system in
the future.
  We intend
to seek coverage and reimbursement for the use of the XTRAC system to treat
other inflammatory skin disorders, after additional clinical studies are
completed. There can be no assurances that we will be in position to expand
coverage for vitiligo or to seek reimbursement for the use of the XTRAC system
to treat atopic dermatitis or leukoderma, or, if we do, that any health insurers
will agree to any reimbursement policy.
  **Cost
containment measures and any general healthcare reform could adversely affect
our ability to market our products.**
  Cost
containment measures instituted by healthcare providers and insurers and any
general healthcare reform could affect our ability to receive revenue from the
use of our XTRAC system or to market our surgical laser products, and may have a
material adverse effect on us. We cannot predict the effect of future
legislation or regulation concerning the healthcare industry and third-party
coverage and reimbursement on our business. In addition, fundamental reforms in
the healthcare industry in the United States and the EU continue to be
considered, although we cannot predict whether or when any healthcare reform
proposals will be adopted and what impact such proposals might have on demand
for our products.
  **The
XTRAC system will continue to be the most promising product that is currently
marketed. If physicians do not adopt the XTRAC system, we will not achieve
anticipated revenue growth.**
  We
commercially introduced the XTRAC system in August 2000, but decelerated that
introduction while we sought appropriate CPT codes and suitable rates of
reimbursement from CMS. After we obtained CPT codes and reimbursement rates from
CMS for the CPT codes, we began a rollout strategy for the XTRAC system in the
United States. To achieve increasing revenue, this product must also gain
recognition and adoption by physicians who treat psoriasis and other skin
disorders. The XTRAC system represents a significant departure from conventional
psoriasis treatment methods. We believe that the recognition and adoption of the
XTRAC system would be expedited if there were long-term clinical data
demonstrating that the XTRAC system provides an effective and attractive
alternative to conventional means of treatment for psoriasis. Currently,
however, there are still only limited peer-reviewed clinical reports and
short-term clinical follow-up data on the XTRAC system. Physicians are
traditionally cautious in adopting new products and treatment practices,
partially due to the anticipation of liability risks and partially due to
uncertainty of third-party reimbursement. If physicians do not adopt the XTRAC
system, we may never achieve significant revenues or profitability.
  **If
the effectiveness and safety of our products are not supported by long-term
data, our revenues could decline.**
  Our
products may not be accepted if we do not produce clinical data supported by the
independent efforts of clinicians. We received clearance from the FDA for the
use of the XTRAC system to treat psoriasis based upon our study of a limited
number of patients. Also, we have received clearance from the FDA for the use of
the XTRAC system to treat vitiligo, atopic dermatitis and leukoderma based
primarily on equivalence. Safety and efficacy data presented to the FDA for the
XTRAC system was based on studies on these patients. We may find that data from
longer-term psoriasis patient follow-up studies may be inconsistent with those
indicated by our relatively short-term data. If longer-term patient studies or
clinical experience indicate that treatment with the XTRAC system does not
provide patients with sustained benefits or that treatment with our product is
less effective or less safe than our current data suggests, our revenues could
decline. Further, we may find that our data is not substantiated in studies
involving more patients, in which case we may never achieve significant revenues
or profitability.
  **Any
failure in our physician education efforts could significantly reduce product
marketing.**
  It is
important to the success of our marketing efforts to educate physicians and
technicians in the techniques of using the XTRAC system. We rely on physicians
to spend their time and money to attend our pre-sale educational sessions.
Positive results using the XTRAC system are highly dependent upon proper
physician and
 
 22
 technician
technique. If physicians and technicians use the XTRAC system improperly, they
may have unsatisfactory patient outcomes or cause patient injury, which may give
rise to negative publicity or lawsuits against us, any of which could have a
material adverse effect on our revenue and profitability.
  Similarly,
it is important to our success that we educate and persuade hospitals, surgery
centers and practitioners of the clinical and economic benefits of our surgical
products and services. If we fail to educate and persuade our customers, we
could suffer adversely in our revenues and our profitability.
  **Our
success is dependent on intellectual property rights held by us, and our
business will be adversely affected by direct competition if we are unable to
protect these rights.**
  Our
success will depend, in part, on our ability to maintain and defend our patents.
However, we cannot give you assurance that the technologies and processes
covered by all of our patents may not be found to be obvious or substantially
similar to prior work, which could render these patents unenforceable. As some
of the patents covering our excimer technology and Wavelength Conversion Effect
technology expire over the next three years, we may not be able to protect the
technology underlying such patents from our competitors. We may not be
successful in securing additional patents on critical, commercially desirable
improvements to the inventions of the expiring patents. Without the protection
of these patents, competitors may utilize our technology to commercialize their
own laser systems for the treatment of skin conditions and for use in Contact
Laser surgery.
  Trade
secrets and other proprietary information which are not protected by patents are
also critical to our business. We attempt to protect our trade secrets by
entering into confidentiality agreements with third parties, employees and
consultants. However, these agreements can be breached and, if they are and even
if we are able to prove the breach or that our technology has been
misappropriated under applicable state law, there may not be an adequate remedy
available to us. Costly and time-consuming litigation could be necessary to
enforce and determine the scope of our proprietary rights, and even if we
prevail in litigation, the party we prevail over may have scant resources
available to satisfy a judgment. Also, third parties may independently discover
trade secrets and proprietary information that allow them to develop
technologies and products that are substantially equivalent or superior to our
own. Without the protection afforded by our patent, trade secret and proprietary
information rights, we may face direct competition from others commercializing
their products using our technology and that could have a material adverse
effect on our business.
  **Defending
against intellectual property infringement claims could be time-consuming and
expensive, and if we are not successful, could cause substantial expenses and
disrupt our business.**
  We cannot
be sure that the products, services, technologies and advertising we employ in
our business do not or will not infringe valid patents, trademarks, copyrights
or other intellectual property rights held by third parties. We may be subject
in the ordinary course of our business to legal proceedings and claims from time
to time relating to the intellectual property of others. Any legal action
against us claiming damages or seeking to enjoin commercial activities relating
to the affected products or our methods or processes could have a material
adverse effect on our business by:
  ·
    requiring
      us, or our collaborators, to obtain a license to continue to use,
      manufacture or market the affected products, methods or processes, and
      such a license may not be available on commercially reasonable terms, if
      at all;
  ·
    preventing
      us from making, using or selling the subject matter claimed in patents
      held by others and subject us to potential liability for
      damages;
  ·
    consuming
      a substantial portion of our managerial and financial resources;
      or
  ·
    resulting
      in litigation or administrative proceedings that may be costly, whether we
      win or lose.
  **We
may not be able to protect our intellectual property rights outside the United
States.**
  Intellectual
property law outside the United States is uncertain and in many countries is
currently undergoing review and revision. The laws of some countries do not
protect our intellectual property rights to the
 
 23
 same
extent as laws in the United States. The intellectual property rights we enjoy
in one country or jurisdiction may be rejected in other countries or
jurisdictions, or, if recognized there, the rights may be significantly diluted.
It may be necessary or useful for us to participate in proceedings to determine
the validity of our foreign intellectual property rights, or those of our
competitors, which could result in substantial cost and divert our efforts and
attention from other aspects of our business. If we are unable to defend our
intellectual property rights internationally, we may face increased competition
outside the United States, which could materially adversely affect our future
business, operating results and financial condition.
  **Our
failure to obtain or maintain necessary FDA clearances or approvals could hurt
our ability to distribute and market our products in the United
States.**
  Our laser
products are considered medical devices and are subject to extensive regulation
in the United States and in foreign countries where we intend to do business.
Unless an exemption applies, each medical device that we wish to market in the
United States must first receive either 510(k) clearance or pre-market approval
from the FDA. Either process can be lengthy and expensive. The FDA’s 510(k)
clearance process may take from four to twelve months, or longer. The pre-market
application approval process is much more costly, lengthy and uncertain. It may
take one to three years or even longer. Delays in obtaining regulatory clearance
or approval could adversely affect our revenues and profitability.
  Although
we have obtained 510(k) clearances for our XTRAC system for use in treating
psoriasis, vitiligo, atopic dermatitis and leukoderma, and 510(k) clearances for
our surgical products, our clearances can be revoked if post-marketing data
demonstrates safety issues or lack of effectiveness. Further, more stringent
regulatory requirements and/or safety and quality standards may be issued in the
future with an adverse effect on our business. Although we believe that we are
in compliance with all material applicable regulations of the FDA, current
regulations depend heavily on administrative interpretation. Future
interpretations made by the FDA or other regulatory bodies, with possible
retroactive effect, may vary from current interpretations and may adversely
affect our business.
  **Even
if we obtain the necessary regulatory approvals for our phototherapy products
from foreign governments, market acceptance in international markets may depend
on third party reimbursement of participants’ costs.**
  We have
introduced our XTRAC system through our distributors and to end users into
markets in more than 35 countries in Europe, the Middle East, the Far East and
Southeast Asia, and in Australia, South Africa and parts of Central and South
America. We intend to expand the number of countries in these markets where we
distribute our products. We cannot be certain that our distributors will be
successful in marketing XTRAC systems in these or other countries or that our
distributors will purchase more than their contractual obligations or in
accordance with our expectations.
  Underlying
our approvals in a number of countries are our quality systems. We are regularly
audited on the compliance of our quality systems with applicable requirements,
which can be extensive and complex and subject to change due to evolving
interpretations and changing requirements. Adverse audit findings could
negatively affect our ability to market our products.
  Even if
we obtain and maintain the necessary foreign regulatory registrations or
approvals, market acceptance of our products in international markets may be
dependent, in part, upon the availability of reimbursement within applicable
healthcare payment systems. Reimbursement and healthcare payment systems in
international markets vary significantly by country, and include both
government-sponsored healthcare and private insurance. Although we intend to
seek international reimbursement approvals for our products, we cannot assure
you that any such approvals will be obtained in a timely manner, if at all.
Failure to receive international reimbursement approvals in any given market
could have a material adverse effect on the acceptance of our products in that
market or others.
  24
  **We
have limited marketing experience, and our failure to build and manage our
marketing force or to market and distribute our products effectively will hurt
our revenues and profits.**
  We have
limited marketing experience. We currently rely on seven full-time direct
account representatives to market our XTRAC system in the United
States. **** We had
reduced our domestic sales and marketing team, while we awaited the
establishment of CPT codes applicable to treatments using the XTRAC system and
reimbursement rates applicable to those codes. Although we now have the CPT
codes and reimbursement rates set by CMS, and a number of private health care
plans have, as a consequence, adopted the CPT codes and established
reimbursement rates for them, it is critical that these codes be recognized and
approved for suitable reimbursement by more private health care plans. As we
seek to achieve these additional approvals, we shall need to expand our
marketing team over the next 24 months in order to achieve our market share and
revenue growth goals. We re-launched the XTRAC system in 2003 and only recently
have engaged in closer dialogue with private healthcare plans concerning
reimbursement for psoriasis. Our personnel have limited experience in marketing
the XTRAC system and in persuading private carriers to adopt favorable
reimbursement policies for the treatment of psoriasis, and we cannot assure you
how successful they will be in expanding these efforts.
  In
similar fashion, we cannot predict how successful we may be in expanding our
surgical services in other parts of the United States, nor can we predict the
success of new surgical products that we may introduce. There are, for example,
diode and CO2 lasers already in the market against which our diode and CO2
lasers must compete.
  There are
significant risks involved in building and managing our marketing force and
marketing our products, including our ability:
  ·
    to
      hire, as needed, a sufficient number of qualified marketing people with
      the skills and understanding to market the XTRAC system and our surgical
      products and services effectively;
  ·
    to
      adequately train our marketing force in the use and benefits of our
      products and services, making them more effective promoters;
      and
  ·
    to
      set the prices and other terms and conditions for our surgical services
      and treatments using an XTRAC system in a complex legal environment so
      that they will be accepted as attractive and appropriate alternatives to
      conventional service modalities and
treatments.
  **We
have limited experience manufacturing our products in commercial quantities,
which could adversely impact the rate at which we grow.**
  We may
encounter difficulties manufacturing our products for the following reasons:
  ·
    we
      have limited experience manufacturing our products in commercial
      quantities; and
  ·
    we
      will, in order to increase our manufacturing output significantly, have to
      attract and retain qualified employees, who are in short supply, for
      assembly and testing operations.
  Although
we believe that our current manufacturing facilities are adequate to support our
commercial manufacturing activities for the foreseeable future, we may be
required to expand our manufacturing facilities to increase capacity
substantially. If we are unable to provide customers with high-quality products
in a timely manner, we may not be able to achieve market acceptance for our
XTRAC system or to maintain the benefits of vertical integration in the delivery
of our surgical services. Our inability to manufacture or commercialize our
devices successfully could have a material adverse effect on our
revenue.
  **We
may have difficulty managing our growth.**
  Assuming
additional private carriers approve favorable reimbursement policies for
psoriasis, we expect to experience growth in the number of our employees and
customers and the scope of our operations. This growth may place a strain on our
management and operations. Our ability to manage this growth will depend upon
our ability to
 
 25
 broaden
our management team and our ability to attract, hire and retain skilled
employees. We also expect that compliance with the requirements of governmental
and quasi-governmental bodies will grow more complex and burdensome. Our success
will also depend on the ability of our officers and key employees to continue to
implement and improve our operational, financial and other systems, to manage
multiple, concurrent customer relationships, to respond to increasing compliance
requirements and to hire, train and manage our employees. Our future success is
heavily dependent upon growth and acceptance of our products. If we cannot scale
our business appropriately or otherwise adapt to anticipated growth and
complexity and new product introductions, a key part of our strategy may not be
successful.
  **The
XTRAC system and laser systems we manufacture for surgery require specific
component parts that may not be readily available or cost effective, which may
adversely affect our competitive position or
profitability.**
  Production
of our XTRAC system requires specific component parts obtained from our
suppliers. Production of our surgical laser systems requires some component
parts that will become harder to procure, as the design of the system ages. In
the event that our suppliers cannot meet our needs, we believe that we could
find alternative suppliers. However, a change in suppliers or any significant
delay in our ability to have access to such resources would have a material
adverse effect on our delivery schedules, business, operating results and
financial condition.
  **Our
failure to respond to rapid changes in technology and its applications and
intense competition in the medical devices industry or the development of a cure
for skin conditions treated by our products could make our treatment system
obsolete.**
  The
medical devices industry is subject to rapid and substantial technological
development and product innovations. To be successful, we must respond to new
developments in technology, new applications of existing technology and new
treatment methods. Our response may be stymied if we require, but cannot secure,
rights to essential third-party intellectual property. We compete against
numerous companies offering alternative treatment systems to ours, some of which
have greater financial, marketing and technical resources to utilize in pursuing
technological development and new treatment methods. Our financial condition and
operating results could be adversely affected if our medical device products
fail to compete favorably with these technological developments, or if we fail
to be responsive on a timely and effective basis to competitors’ new devices,
applications, treatments or price strategies. The development of a cure for
psoriasis, vitiligo, atopic dermatitis or leukoderma would eliminate the need
for our XTRAC system for these diseases and would require us to focus on other
uses of our technology, which would have a material adverse effect on our
business.
  **Our
products may be found defective or physicians and technicians may misuse our
products and damages may exceed our insurance coverage.**
  One or
more of our products may be found to be defective after they have been shipped
in volume, and require product replacement. Product returns and the potential
need to remedy defects or provide replacement products or parts could result in
substantial costs and have a material adverse effect on our business and results
of operations. The clinical testing, manufacturing, marketing and use of our
products and procedures may also expose us to product liability claims. In
addition, the fact that we train technicians whom we do not supervise in the use
of our XTRAC system and the fact that we train and provide our technicians as
part of our surgical services business may expose us to third party claims if
such training is found to have been inadequate or if a technician errs in the
application of the training. We presently maintain liability insurance with
coverage limits of at least $5,000,000 per occurrence. We cannot assure you that
the coverage limits of our insurance policies are adequate or that one or more
successful claims brought against us would not have a material adverse effect
upon our business, financial condition and results of operations.
   26
 **If
we use hazardous materials in a manner that causes injury or violates laws, our
business and operations may suffer.**
 
 Our XTRAC
system utilizes a xenon chloride gas mixture under high pressure, which is
extremely corrosive. While methods for proper disposal and handling of this gas
are well-known, we cannot completely eliminate the risk of accidental
contamination, which could cause:
  ·
    an
      interruption of our research and development
efforts;
  ·
    injury
      to our employees, physicians, technicians or patients which could result
      in the payment of damages; or
  ·
    liabilities
      under federal, state and local laws and regulations governing the use,
      storage, handling and disposal of these materials and specified waste
      products.
  From time
to time, customers return to us surgical products that appear not to have
performed to specification. Such products must be decontaminated before being
returned to us. If they are not, our employees may be exposed to dangerous
diseases.
  **We
depend on our executive officers and key personnel to implement our business
strategy and could be harmed by the loss of their
services.**
  We
believe that our growth and future success will depend in large part upon the
skills of our management and technical team. The competition for qualified
personnel in the laser industry is intense, and the loss of our key personnel or
an inability to continue to attract, retain and motivate key personnel could
adversely affect our business. We cannot assure you that we will be able to
retain our existing key personnel or to attract additional qualified personnel.
We do not have key-person life insurance on any of our employees.
  Our
success depends in part upon the continued service and performance
of:
  ·
    Jeffrey
      F. O’Donnell, President and Chief Executive Officer;
  ·
    Dennis
      M. McGrath, Chief Financial Officer; and
  ·
    Michael
      R. Stewart, Executive Vice President of Corporate
    Operations
  Although
we have employment agreements with Mr. O’Donnell, Mr. McGrath and Mr.
Stewart, the loss of the services of one or more of our executive officers could
impair our ability to develop and introduce our new products.
  **Delaware
law and our charter documents have anti-takeover provisions that could delay or
prevent actual and potential changes in control, even if they would benefit
stockholders.**
  We are
subject to Section 203 of the Delaware General Corporation Law, which
prohibits a business combination between a corporation and an interested
stockholder within three years of the stockholder becoming an interested
stockholder, except in limited circumstances. In addition, our bylaws contain
certain provisions which require stockholders' actions to be taken at meetings
and not by written consent, and also require supermajority votes of stockholders
to amend our bylaws and to notice special meetings of stockholders. These
anti-takeover provisions could delay or prevent actual and potential changes in
control, even if they would benefit our stockholders **.**
  **Potential
fluctuations in our operating results could lead to fluctuations in the market
price for our common stock.**
  Our
results of operations are expected to fluctuate significantly from
quarter-to-quarter, depending upon numerous factors, including:
  ·
    healthcare
      reform and reimbursement policies;
  ·
    demand
      for our products;
  27
 ·
    changes
      in our pricing policies or those of our
competitors;
  ·
    increases
      in our manufacturing costs;
  ·
    the
      number, timing and significance of product enhancements and new product
      announcements by ourselves and our
competitors;
  ·
    our
      ability to develop, introduce and market new and enhanced versions of our
      products on a timely basis considering, among other things, delays
      associated with the FDA and other regulatory approval processes and the
      timing and results of future clinical trials;
and
  ·
    product
      quality problems, personnel changes, and changes in our business
      strategy.
  Our
quarter-to-quarter operating results could also be affected by the timing and
usage of individual laser units in the treatment of patients, since our revenue
model for the excimer laser system for the treatment of psoriasis patients and
for our surgical services is based on a payment per usage plan.
  **Our
stock price has been and continues to be volatile.**
  The
market price for our common stock could fluctuate due to various factors. These
factors include:
  ·
    announcements
      related to our efforts to secure favorable reimbursement policies from
      private carriers concerning the treatment of psoriasis with the
      XTRAC;
  ·
    acquisition-related
      announcements;
  ·
    announcements
      by us or our competitors of new contracts, technological innovations or
      new products;
  ·
    changes
      in government regulations;
  ·
    fluctuations
      in our quarterly and annual operating results;
and
  ·
    general
      market conditions.
  In
addition, the stock markets have, in recent years, experienced significant price
fluctuations. These fluctuations often have been unrelated to the operating
performance of the specific companies whose stock is traded. Market
fluctuations, as well as economic conditions, have adversely affected, and may
continue to adversely affect, the market price of our common stock.
  **We
may suffer loss of time, money and energy if we fail to consummate the
acquisition of ProCyte** ***.***
  We have
invested considerable financial and personnel resources in connection with the
proposed merger with ProCyte Corporation. If the shareholders of ProCyte do not
approve the transaction with at least a two-thirds majority, then the
transaction, as structured to date, will fail. In such a case, we may be unable
to recover the amounts that we have expended in the transaction and we would be
obligated to pay our expenses incurred with the transaction, including
obligations to our professionals and investment bankers in the transaction. As
of March 15, 2005, we have outstanding liabilities amounting to $752,382 which
we have incurred and accrued for in connection with the merger. ****
  **Our
ability to pay dividends on our common stock may be
limited.**
  We do not
expect to pay any cash dividends in the foreseeable future. We intend to retain
earnings, if any, to provide funds for the expansion of our
business.
  **Limitations
on director liability may discourage stockholders from bringing suit against a
director.**
  Our
certificate of incorporation provides, as permitted by governing Delaware law,
that a director shall not be personally liable to us or our stockholders for
monetary damages for breach of fiduciary duty as a director, with
 
 28
 certain
exceptions. These provisions may discourage stockholders from bringing suit
against a director for breach of fiduciary duty and may reduce the likelihood of
derivative litigation brought by stockholders on our behalf against a director.
In addition, our certificate of incorporation and bylaws provide for mandatory
indemnification of directors and officers to the fullest extent permitted by
Delaware law.
  **Item
2.** **Properties**
  We lease
an 11,500 sq. ft. facility consisting of office, manufacturing and warehousing
space located at 2431 Impala Drive, Carlsbad, California 92008. The lease
expires on June 30, 2005. The base sub rent is $9,250 per month. We are
currently seeking and believe we will be successful in finding a new facility by
July 1, 2005. Our Carlsbad facility houses the manufacturing and development
operations for our excimer laser business.
 
 We lease
a 42,000 sq. ft. facility in Montgomeryville, Pennsylvania that houses our
executive offices and surgical laser manufacturing operations. The term of the
lease runs until July 2006, and has an option to renew for an additional five
years. In addition to this facility, we also lease several offices throughout
the southeastern United States and other locations elsewhere. Our sales
representatives use these offices to perform their sales and training
responsibilities. These offices consist of small one-room facilities and are
leased for various terms and amounts.
  Up until
December 31, 2002, we occupied approximately 1,850 square feet of office space
in Radnor, Pennsylvania, which formerly served as our executive offices. The
lease expires in March 2005, and currently provides for a monthly rent of $5,586
per month.
  **Item
3.** **Legal
Proceedings**
  We are
the defendant in an action filed by City National Bank of Florida, which had
been our landlord in Orlando, Florida. The action was brought in December 2000
in the Circuit Court of the Ninth Judicial Circuit, in and for Orange County,
Florida. The complaint seeks to recover unpaid rent for the facility we had
occupied prior to the sale to Lastec of assets related to the operations of our
former facility in Orlando, Florida. City National has alleged that the Company
and Lastec owe it $143,734, primarily for rent that was unpaid for the period
after the sale of the assets to Lastec up to an abandonment of the facility by
Lastec. We have denied liability and have asserted that City National neglected
to mitigate its damages by repossessing the facility after it was abandoned by
Lastec and further that our obligations to City National ceased on the effective
date of the asset sale to Lastec. In connection with the settlement and
dismissal of a separate action filed by us against Lastec and its principals
related to the asset sale, Lastec and its principals agreed in writing to be
responsible to pay any settlement or monetary judgment to City National and, if
necessary, to post a surety bond of $100,000 to secure such a payment. Lastec
and its principals defaulted in their undertakings, so we are maintaining our
own defense. Attempts to mediate a settlement with the Bank have been so far
unsuccessful. Based on information currently available, we cannot evaluate the
likelihood of an unfavorable outcome.
  On or
about April 29, 2003, we brought an action against RA Medical Systems, Inc. and
Dean Stewart Irwin in the Superior Court for San Diego County, California. Mr.
Irwin had been our Vice President of Research and Development until July 2002,
when we terminated his employment. Shortly after his termination, Mr. Irwin
founded RA Medical Systems, Inc. We alleged claims for misappropriation of our
trade secrets, unfair competition, intentional interference with contractual
relationships, breach of contract and conversion. Defendants brought a motion
for summary judgment on all counts in the complaint. On November 13, 2003, the
Court denied summary judgment on the counts of misappropriation and unfair
competition, but granted summary judgment on the other counts. We dismissed the
counts for misappropriation and unfair competition without prejudice on December
31, 2003. The defendants filed a motion for costs and attorneys’ fees. The
Superior Court granted costs; the Court denied attorneys’ fees on defendants’
allegations of bad faith but granted attorneys’ fees based on a provision in the
confidentiality agreement which we asserted Mr. Irwin had breached. We appealed
this ruling to the Court of Appeals, which on February 23, 2005, upheld the
lower court’s ruling. We have filed a petition for re-hearing on this
ruling.
  We
brought an action against the same defendants in the United States District
Court for the Southern District of California on Federal and California claims
for false advertising and unfair competition. There are no claims of patent
infringement in this case. The complaint in the Federal action was filed on
January 6, 2004. The
 
 29
 defendants
have answered the complaint with general denials. Attempts at settlement have
failed. The case is now in the discovery phase.
  On
January 25, 2005, RA Medical Systems, Inc. and Dean Stewart Irwin brought an
action against PhotoMedex, Inc., Jeffrey Levatter Ph.D. (our Chief Technology
Officer), Jenkens & Gilchrist, LLP (our outside counsel) and Michael R.
Matthias, Esq. (litigation partner at our outside counsel). The action was
brought in the Superior Court for San Diego County, California and based on
allegations that we and the other defendants had engaged in malicious
prosecution in bringing and maintaining the action brought by PhotoMedex in
April 2003. We and the other defendants have filed a motion to strike the
actions, based on California Code of Civil Procedure section 425.16, the
so-called SLAPP statute. Our motion to strike was denied.
  We
brought an action against Edwards Lifesciences Corporation and Baxter Healthcare
Corporation on January 29, 2004 in the Superior Court for Orange County,
California. The complaint states claims for breach of contract and under a claim
known as “money had and received.” We have moved to amend the complaint to
include a claim of unjust enrichment. The motion to amend is set for hearing on
April 1, 2005. We seek recovery of the sum of $4,000,000 paid to the defendants
in connection with a series of agreements between the parties, costs incurred in
raising the $4,000,000, interest thereon and attorneys’ fees and costs incurred
in the action (see *Note
14* ).
Defendants answered the complaint with general denials, multiple defenses and no
counterclaims. Defendants filed a demurrer, which was denied. Defendants have
filed a motion for summary judgment, to which we are preparing our opposition.
Hearing on the summary judgment is set for April 18, 2005. Discovery in this
action is continuing. A trial date is set for May 23, 2005.
  We are
involved in certain other legal actions and claims arising in the ordinary
course of business. We believe, based on discussions with legal counsel, that
such litigation and claims will be resolved without a material effect on our
consolidated financial position, results of operations or
liquidity.
  **Item
4.** **Submission
of Matters to a Vote of Security Holders**
  We held
our Annual Meeting of Stockholders on December 28, 2004. Richard J. DePiano,
Jeffrey F. O’Donnell, John J. McAtee, Jr., Alan R. Novak, Warwick Alex Charlton,
Anthony J. Dimun and David Anderson, the director nominees set forth in the
Notice of Annual Meeting, were elected to serve as directors. The vote tally is
set forth below:
  **Votes
      For**
    
    **Votes
      Against**
    
    **Votes
      Abstaining**Richard
      J. DePiano
    34,260,936
    
    0
    
    97,549Jeffrey
      F. O’Donnell
    34,262,959
    
    0
    
    94,526Warwick
      Alex Charlton
    33,528,816
    
    0
    
    829,669John
      J. McAtee, Jr.
    34,163,445
    
    0
    
    195,040Alan
      R. Novak
    34,260,603
    
    0
    
    97,882Anthony
      J. Dimun
    34,262,230
    
    0
    
    96,255David
      Anderson
    34,260,730
    
    0
    
    97,755
 
  Amper,
Politziner & Mattia, P.C. was ratified to be our independent auditors for
the year ending December 31, 2004, with 34,230,413 votes for, 81,424 votes
against and 46,607 votes abstaining.
  We held a
Special Meeting of Stockholders on March 3, 2005. The stockholders voted to
approve the issuance of shares in the proposed acquisition of ProCyte
Corporation and to increase the number of shares authorized for issuance out of
our 2000 Stock Option Plan from 3,350,000 shares to 4,350,000, as
follows:
  **Votes
      For**
    
    **Votes
      Against**
    
    **Votes
      Abstaining**To
      acquire ProCyte Corporation
    24,334,253
    
    142,533
    
    66,769To
      increase shares in 2000 Option Plan
    22,998,256
    
    1,460,220
    
    85,075
 
 30
  **PART
II**
 
 **Item
5.** **Market
for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases
of Equity Securities**
  As of
March 15, 2005, we had 40,168,549 shares of common stock issued and outstanding.
Further, we had issued and outstanding options to purchase 4,954,165 shares of
common stock, of which 3,185,949 were vested as of the date of this Report, and
warrants to purchase up to 2,082,943 shares of common stock.
  Our
common stock is listed on the NASDAQ National Market under the symbol "PHMD."
The following table sets forth, for the periods indicated, the high and low
closing sale prices of our common stock:
  **High**
    
    **Low**Year
      Ended December 31, 2004:Fourth
      Quarter
    
    $
    2.73
    
    $
    1.86Third
      Quarter
    
    
    3.26
    
    
    1.89Second
      Quarter
    
    
    3.99
    
    
    2.54First
      Quarter
    
    
    2.69
    
    
    1.63Year
      Ended December 31, 2003:Fourth
      Quarter
    
    $
    2.54
    
    $
    1.66Third
      Quarter
    
    
    2.95
    
    
    2.15Second
      Quarter
    
    
    2.30
    
    
    1.39First
      Quarter
    
    
    1.85
    
    
    1.22Year
      Ended December 31, 2002:Fourth
      Quarter
    
    $
    1.92
    
    $
    1.24Third
      Quarter
    
    
    1.57
    
    
    0.84Second
      Quarter
    
    
    1.97
    
    
    1.49First
      Quarter
    
    
    2.37
    
    
    1.50
  On March
15, 2005, the closing market price for our common stock in The NASDAQ National
Market System was $2.42 per share. As of March 15, 2005, we had
approximately 850 stockholders of record, without giving effect to determining
the number of stockholders who hold shares in “street name” or other nominee
accounts.
  The
following is a summary of all of our equity compensation plans, including plans
that were assumed through acquisitions and individual arrangements that provide
for the issuance of equity securities as compensation, as of December 31, 2004.
See Notes 1 and 12 to the consolidated financial statements for additional
discussion.
  **(A)**
    
    **(B)**
    
    **(C)****Number
      of Securities to be Issued Upon Exercise of Outstanding Options, Warrants
      and Rights**
    
    ****
      
      **Weighted-Average
      Exercise Price of Outstanding Options, Warrants and
      Rights**
    
    ****
      **Number
      of Securities Remaining Available for Future Issuance Under Equity
      Compensation Plans (excluding securities reflected in column
      (A))****Equity
      compensation plans****approved
      by security holders**
    
    
    3,026,540
    
    $
    2.87
    
    
    1,291,137**Equity
      compensations plan not****approved
      by security holders**
    
    
    1,184,000
    
    $
    5.03
    
    
    -**Total**
    
    
    4,210,540
    
    $
    3.48
    
    
    1,291,137
  31
 Most
warrants issued by us have been to investors and not pursuant to equity
compensation plans. Additionally, virtually all options have been issued as
compensation for benefits inuring to us other than for benefits from
capital-raising activities. With limited exceptions under NASDAQ membership
requirements, we intend in the future to issue options pursuant to equity
compensation plans which have already been approved by our stockholders without
necessity of further, special approval by our stockholders.
  **Dividend
Policy**
 
 We have
not declared or paid any dividend since inception on our common stock. We do not
anticipate that any dividends will be declared or paid in the future on our
common stock.
  **Certain
Business Combinations and Other Provisions of the Certificate of
Incorporation**
 
 As a
Delaware corporation, we are currently subject to the anti-takeover provisions
of Section 203 of the Delaware General Corporation Law. Section 203 provides,
with certain exceptions, that a Delaware corporation may not engage in any of a
broad range of business combinations with a person or an affiliate, or associate
of such person, who is an interested stockholder for a period of three years
from the date that such person became an interested stockholder
unless:
  ·
    the
      transaction resulting in a person becoming an interested stockholder, or
      the business combination, is approved by the Board of Directors of the
      corporation before the person becomes an interested
      stockholder;
  ·
    the
      interested stockholder acquired 85% or more of the outstanding voting
      stock of the corporation in the same transaction that makes such person an
      interested stockholder (excluding shares owned by persons who are both
      officers and directors of the corporation, and shares held by certain
      employee stock ownership plans); or
  ·
    on
      or after the date the person becomes an interested stockholder, the
      business combination is approved by the corporation's board of directors
      and by the holders of at least 66-2/3% of the corporation's outstanding
      voting stock at an annual or special meeting, excluding shares owned by
      the interested stockholder.
  Under
Section 203, an interested stockholder is defined as any person: (i) who is the
owner of 15% or more of the outstanding voting stock of the corporation; or (ii)
who is an affiliate or associate of the corporation and who was the owner of 15%
or more of the outstanding voting stock of the corporation at any time within
the three-year period immediately prior to the date on which it is sought to be
determined whether such person is an interested stockholder.
  A
corporation may, at its option, exclude itself from the coverage of Section 203
by amending its certificate of incorporation or bylaws by action of its
stockholders to exempt itself from coverage, provided that such amendment to its
certificate of incorporation or bylaws shall not become effective until 12
months after the date it is adopted. We have not adopted such an amendment to
our certificate of incorporation or bylaws.
  In
addition, our bylaws contain certain provisions which require stockholders'
actions to be taken at meetings and not by written consent, and also require
supermajority votes of stockholders to amend our bylaws and to notice special
meetings of stockholders. These anti-takeover provisions could delay or prevent
actual and potential changes in control, even if they would benefit our
stockholders.
  **Recent
Issuances of Unregistered Securities**
  We issued
92,464 and 21,413 unregistered shares on September 7 and 17, 2004, respectively,
to Stern Laser srl. The shares were issued in connection with a Master Asset
Purchase Agreement under which we acquired rights to certain technology. We
issued to GE Capital Corporation 23,903, 6,656 and 3,102 warrants to purchase
our
 
 32
 common
stock. The warrants were issued on June 30, 2004, September 24, 2004 and
December 30, 2004, in connection with draws we made against a Master Lease
Agreement. The shares issued to Stern Laser and the shares underlying the
warrants issued to GE Capital Corporation are the subject of a registration
statement on Form S-3 (No. 333-120921) filed with the Securities and Exchange
Commission (SEC).
  We
believe that all of the foregoing issuances of securities were made solely to
accredited investors in transactions exempt from registration under Section 4(2)
of the Securities Act.
  **Shares
Eligible for Future Sale**
 
 As of
March 15, 2005, we had 40,168,549 issued and outstanding shares of common stock.
All of these shares are either covered by currently effective registration
statements or are eligible for resale in accordance with the provisions of Rule
144. Further, we had issued and outstanding options to purchase 4,954,165 shares
of common stock, of which 3,185,949 are vested as of the date of this Report,
and currently exercisable warrants to purchase up to 2,082,943 shares of common
stock.
  Holders
of restricted securities must comply with the requirements of Rule 144 in order
to sell their shares in the open market. In general, under Rule 144, as
currently in effect, any of our affiliates and any person (or persons whose
sales are aggregated) who has beneficially owned his or her restricted shares
for at least one year, may be entitled to sell in the open market, within any
three-month period, in brokerage transactions or to market makers a number of
shares that does not exceed the greater of: (i) 1% of the then outstanding
shares of our common stock (now approximately 401,685 shares), or (ii) the
average weekly trading volume reported in the principal market for our common
stock during the four calendar weeks preceding such sale. Sales under Rule 144
are also subject to certain limitations on manner of sale, a notice requirement
and the availability of current public information about us. Non-affiliates who
have held their restricted shares for two years are entitled to sell their
shares under Rule 144(k), without regard to any of the above limitations,
provided they have not been one of our affiliates for the three months preceding
such sale.
  We can
make no prediction as to the effect, if any, that sales of shares of common
stock or the availability of shares for sale will have on the market price of
our common stock. Nevertheless, sales of significant amounts of our common stock
could adversely affect the prevailing market price of the common stock, as well
as impair our ability to raise capital through the issuance of additional equity
securities.
  As of
March 15, 2005, the average weighted exercise price of our outstanding and fully
vested options and warrants are $3.77 and $2.30, respectively. The shares
underlying virtually all of the warrants and the options granted to employees,
directors and other non-employees have been registered with the SEC. In April
2004, we filed a registration statement with the SEC for the balance, but for
25,000 options, of the currently unregistered shares underlying such other
options. The exercise of the options and warrants and the sale of the underlying
shares in the public market may cause additional dilution to our existing
stockholders and may cause the price of our common stock to fluctuate.
  **Item
6.** **Selected
Financial Data**
  You
should read the following selected historical consolidated financial data in
conjunction with our consolidated financial statements included elsewhere in
this Report and “Management’s Discussion and Analysis of Financial Condition and
Results of Operations,” beginning in Item 7 below. The selected historical
consolidated statement of operations data for the five-year period ended
December 31, 2004 and the selected historical consolidated balance sheet data as
of December 31, 2000, 2001, 2002, 2003 and 2004 have been derived from our
consolidated financial statements:
  33
  **Year
Ended December 31,**
 **(In
thousands, except per share data)**
  **2004**
    
    **2003**
    
    **2002**
    
    **2001**
    
    **2000****Statement
      of Operations Data:**Revenues
    
    $
    17,745
    
    $
    14,319
    
    $
    3,274
    
    $
    4,730
    
    $
    969Costs
      of revenues
    
    
    10,363
    
    
    10,488
    
    
    4,425
    
    
    4,952
    
    
    543Gross
      profit (loss)
    
    
    7,382
    
    
    3,831
    
    
    (1,151
    )
    
    (222
    )
    
    426Selling,
      general and administrative
    
    
    10,426
    
    
    9,451
    
    
    6,191
    
    
    10,519
    
    
    10,365Research
      and development
    
    
    1,802
    
    
    1,777
    
    
    1,757
    
    
    3,329
    
    
    3,015Depreciation
      and amortization
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    721Asset
      impairment charge
    
    
    -
    
    
    -
    
    
    -
    
    
    1,958
    
    
    -Loss
      from continuing operations before interest and other income, net and
      income taxes
    
    
    (4,846
    )
    
    (7,397
    )
    
    (9,099
    )
    
    (16,028
    )
    
    (13,675
    )Interest
      income
    
    
    43
    
    
    50
    
    
    42
    
    
    238
    
    
    580Interest
      expense
    
    
    (181
    )
    
    (96
    )
    
    (16
    )
    
    (25
    )
    
    (13
    )Other
      income, net
    
    
    -
    
    
    -
    
    
    1
    
    
    77
    
    
    362Loss
      from continuing operations
    
    
    (4,984
    )
    
    (7,443
    )
    
    (9,072
    )
    
    (15,738
    )
    
    (12,746
    )Discontinued
      operationsLoss
      from discontinued operations, (including loss on disposal of $277 realized
      in 2001)
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (646
    )Net
      loss
    
    
    ($4,984
    )
    
    ($7,443
    )
    
    ($9,072
    )
    
    ($15,738
    )
    
    ($13,392
    )Basic
      and diluted net loss per share:Continuing
      operations
    
    
    ($0.13
    )
    
    ($0.21
    )
    
    ($0.34
    )
    
    ($0.80
    )
    
    ($0.81
    )Discontinued
      operations
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (0.04
    )Basic
      and diluted net loss per share
    
    
    ($0.13
    )
    
    ($0.21
    )
    
    ($0.34
    )
    
    ($0.80
    )
    
    ($0.85
    )Shares
      used in computing basic and diluted net loss per share (1)
    
    
    38,835
    
    
    35,134
    
    
    26,566
    
    
    19,771
    
    
    15,755**Balance
      Sheet Data (At Period End):**Cash
      and cash equivalents
    
    $
    3,997
    
    $
    6,633
    
    $
    4,008
    
    $
    4,067
    
    $
    9,561Working
      capital
    
    
    6,119
    
    
    8,678
    
    
    6,578
    
    
    5,546
    
    
    9,273Total
      assets
    
    
    22,962
    
    
    22,753
    
    
    21,513
    
    
    15,585
    
    
    19,871Long-term
      debt (net of current portion)
    
    
    1,399
    
    
    457
    
    
    900
    
    
    -
    
    
    20Stockholders’
      equity
    
    $
    14,580
    
    $
    15,978
    
    $
    13,309
    
    $
    12,710
    
    $
    17,768
  (1)
    Common
      stock equivalents and convertible issues are antidilutive and, therefore,
      are not included in the weighted shares outstanding during the years in
      which we incurred net losses.
  34
 **Item
7.** **Management's
Discussion and Analysis of Financial Condition and Results of Operations**
  ***The
following discussion and analysis should be read in conjunction with the
Consolidated Financial Statements and related notes included elsewhere in this
Report.***
  **Introduction
and Outlook**
 
 Our
primary focus in 2004 was to secure from private health plans favorable
reimbursement policies for treatment of psoriasis using the XTRAC® excimer
laser. Starting in March 2003, we had re-introduced the XTRAC and, based on the
establishment of CPT codes by the AMA and reimbursement rates from the Centers
for Medicare and Medicaid Services, we began efforts to secure such favorable
policies. To persuade such plans to adopt favorable policies, we also
commissioned a clinical and economic study of the use of the XTRAC laser as a
second-step therapy for psoriasis. In December 2003, we deployed the findings of
the study through a Data Compendium and mailed a copy of the Data Compendium to
numerous medical insurance plans in our ongoing marketing efforts to secure
favorable reimbursement policies.
  Moving
into 2004, we expanded our deployment of the study. From feedback we have
received from the medical insurers to the Data Compendium, we anticipate that
the study, coupled with our other marketing efforts, will succeed in continuing
to gain a place on the agenda of private plans as they consider their coverage
and reimbursement policies. We secured such approval in 2004 from four
significant plans, Regence, Wellpoint, Aetna, and Anthem, and we are under
consideration by other plans. We cannot at this time provide assurance that
other plans will adopt the favorable policies that we desire, and if they do
not, what further requirements may be asked of us. In addition to reimbursement,
our focus in 2004 was to continue to improve care for those suffering from
psoriasis, and to obtain a larger body of satisfied practitioners using the
XTRAC and to increase our domestic XTRAC revenues. Domestic XTRAC revenues are
derived from a fee-per-use charged to the practicing physician rather than
selling the laser outright. In this revenue model we maintain ownership of the
laser and earn revenue each time the physician treats a patient with the
equipment. The ability to increase the number of patients treated by physicians
is dependent upon the adoption by private health plans to provide reimbursement
coverage for the XTRAC to its subscribers.
  In
October 2004, we received from the FDA concurrence under a 510 (k) to market the
new XTRAC Ultra, a smaller-size dermatology laser with increased functionality
for inflammatory skin disorders. We introduced this product at the American
Academy of Dermatology trade show on February 19-21, 2005 in New
Orleans.
  Our
revenues from International XTRAC sales provided needed working capital in 2003
and continued to do so in 2004. Unlike the domestic market, we derive revenues
from the XTRAC in the international market by selling the dermatology laser
system to distributors, or in certain countries, directly to physicians. We have
enjoyed some distinction in the market from our clinical studies and the
physician researchers involved in such studies. Due to the revenue model used
overseas, the international XTRAC operations are more widely influenced by
competition from similar laser technology from other manufacturers and non-laser
lamp alternatives for treating inflammatory skin disorders. In 2004, we sold 26
laser systems, while in 2003 and 2002; we sold 18 and 32 systems, respectively.
Over time, competition has also served to reduce the international prices we
charge distributors for our excimer products. While the average price per laser
systems and parts was less in the year ended December 31, 2004 ($62,563) than in
the same period for 2003 ($64,807), the number of lasers sold was greater in the
2004 period (26) than in the 2003 period (18). The XTRAC laser sales vary from
quarter to quarter. We have also benefited in 2003 and 2004 from the improved
reliability and functionality of the XTRAC.  Due to
the financial resources required,  we have
been reluctant to implement an international XTRAC fee-per-use revenue model,
similar to the domestic revenue model, but as reimbursement in the domestic
market becomes more widespread, we have recently begun to implement a pilot
version of this model overseas. We also expect to expand our product offerings
to our international customers as a result of the recent acquisition of
worldwide rights to certain proprietary technology from Stern Laser srl of
Italy. The technology is expected to expand our product offerings in the
dermatology field, and is the subject of a patent application filed in the
European Union with an application in the United States expected in the near
term. We expect that the specific introduction of the technologies based on
these newly acquired rights could be made by the second half of
2005.
  35
 We
integrated the business of SLT in 2003. We acquired two revenue streams from
SLT: one from surgical services, the other from surgical products; these
supplemented our own discrete product lines, XTRAC Domestic and XTRAC
International. We presently view our business as comprised of four business
segments: Domestic XTRAC, International XTRAC, Surgical Services and Surgical
Products.
  Segments
are distinguished primarily by the organization of our management structure.
Distinctions are also influenced by the industry considerations and the business
model used to generate revenues. The Domestic XTRAC segment is a procedure-based
business model used only in the Untied States with revenues derived from
procedures performed by dermatologists. The International XTRAC segment
presently generates revenues from the sale of equipment to dermatologists
through a network of distributors outside the United States. The Surgical
Services segment generates revenues by providing fee-based procedures generally
using our mobile surgical laser equipment delivered and operated by a technician
at hospitals and surgery centers in the United States. The Surgical Products
segment generates revenues by selling (not fee-per-procedure) laser products and
disposables to hospitals and surgery centers on both a domestic and
international basis.
  We
experienced revenue growth in Surgical Services in 2004 and 2003 from 2002. Our
plan in 2003 was to grow in a controlled fashion such that capital expenditures
necessary for that growth would come from operations. Although we have increased
our investment in this business segment for 2004, we continue to be very
deliberate and controlled with capital expenditures to grow this business. In
this manner, we intend to conserve our cash resources for the XTRAC business
segments.
  The
surgical product revenues decreased by $837,936 in the year ended December 31,
2004 when compared to the same period in 2003. We expect that the surgical laser
systems and the related disposable base may erode over time, as hospitals
continue to seek outsourcing solutions instead of purchasing lasers and related
disposables for their operating rooms. We have continued to seek an offset to
this erosion through expanding our surgical services. There was a decline in
surgical laser sales, but such sales vary from quarter to quarter. Some of this
decrease was related to the trend of hospitals to outsource their laser assisted
procedures to third parties, like our surgical services segment. With the
introduction of the CO2 and diode surgical lasers in the second quarter of 2004,
we hope to offset the decline in laser sales and have a further offset to the
erosion of disposables revenues.
  In the
second quarter 2004, we received from the FDA concurrence under a 510(k) to
market two new surgical lasers: the LaserPro Diode Laser System and the LaserPro
CO2 Laser System. Each system has been designed for rugged use in our Surgical
Services business; each system will also complement the Surgical Products
business, finding end-user buyers domestically and overseas. We are also
actively exploring opportunities for supplying the lasers on an OEM basis or
under manufacturing-marketing collaborations.
  Furthermore,
in July 2004, we entered into a Development Agreement with AzurTec, Inc. AzurTec
is a development-stage company based outside Philadelphia. AzurTec’s product in
development is a device that seeks to rapidly and accurately detect the presence
of cancerous cells in excised tissue. AzurTec’s target customer is generally the
dermatologist and particularly the MOHS surgeon. We intend to assist in the
development of FDA-compliant prototypes for AzurTec’s product. We have collected
payments under the agreement aggregating $240,000 through December 31, 2004.
Payments thereafter are to be made based on time spent on the project at agreed
billing rates. Through arrangements such as this, we hope to identify and
nurture opportunities that match our business strategy. In the year ended
December 31, 2004, we recognized $121,000 in revenue under this
agreement.
  In
December 2004, we embarked on the acquisition of ProCyte Corporation. This
acquisition is still pending as of March 15, 2005. See Item 9B, Other
Information for our discussion.
  **Overview
of Business Operations**
 
 We are
engaged in the development, manufacturing and marketing of our proprietary
XTRAC® excimer laser and delivery systems and techniques directed toward the
treatment of inflammatory skin disorders. In addition, through the acquisition
of SLT on December 27, 2002, we also engage in the development, manufacture and
sale of surgical products, including free-beam laser systems for surgery and in
the provision of surgical services on a turnkey procedural basis.
  In
connection with our current business plan, the initial medical applications for
our excimer laser technology are intended for the treatment of psoriasis,
vitiligo, atopic dermatitis and leukoderma. In January 2000, we received
approval of our 510(k) submission from the Food and Drug Administration, or FDA,
relating to the use
 
 36
 of our
XTRAC system for the treatment of psoriasis. The 510(k) establishes that our
XTRAC system has been determined to be substantially equivalent to currently
marketed devices for purposes of treating psoriasis.
  In
February 2002, the Current Procedural Terminology Editorial Board of the AMA
approved the request by the American Academy of Dermatology to issue
reimbursement codes for the laser therapies in the treatment of psoriasis and
other inflammatory diseases, which would include laser therapy using the XTRAC
system to treat such conditions. The AMA published three CPT code numbers
covering the treatment of psoriasis and other inflammatory skin diseases with
the XTRAC system. These new codes were effective in the first quarter of 2003.
We believe that the publication of these codes, together with a compilation of
clinical and economic studies (Data Compendium) mailed during the first quarter
of 2004 to almost all private healthcare insurers throughout the United States,
have and will facilitate our ability to obtain broader approvals for
reimbursement for treatment of psoriasis and other inflammatory skin diseases
using the XTRAC system. We secured in 2004 approval from four significant
insurance groups, and are under consideration by other groups and plans. We
anticipate that the approvals will positively influence other private plans to
adopt favorable reimbursement policies. Such influence and possible momentum
from it can help in 2005 to overcome resistance that we encountered in 2004 and
2003. However, there can be no assurance that these effects will
transpire.
  As part
of our commercialization strategy in the United States, we are providing the
XTRAC system to targeted dermatologists at no initial capital cost to them. We
believe that this strategy will create incentives for these dermatologists to
adopt the XTRAC system and will increase market penetration. This strategy will
require us to identify and target appropriate dermatologists and to balance the
placement of our XTRAC lasers during 2005 against uncertainties in acceptance by
physicians, patients and health plans and constraints on the number of XTRAC
systems we are able to provide. Our marketing force has limited experience in
dealing with such challenges. We also expect that we will face increasing
competition as more private insurance plans adopt favorable policies for
reimbursement for treatment of psoriasis. Outside of the United States, our
strategy includes selling XTRAC systems directly to dermatologists through
distributors and, now on a limited, introductory basis, placing XTRAC systems
with dermatologists to provide us with a usage-based revenue stream.
  In
similar fashion, we have growing, but still limited marketing experience in
expanding our surgical services business. The preponderance of this business is
in the southeastern part of the United States. New procedures and new
geographies together with new customers and different business habits and
networks will likely pose different challenges than the ones we have encountered
in the past. There can be no assurance that our experience will be sufficient to
overcome such challenges.
  **Critical
Accounting Policies**
  The
discussion and analysis of our financial condition and results of operations in
this Report are based upon our Consolidated Financial Statements, which have
been prepared in accordance with accounting principles generally accepted in the
United States. The preparation of financial statements requires management to
make estimates and judgments that affect the reported amounts of assets and
liabilities, revenues and expenses and disclosures at the date of the financial
statements. On an on-going basis, we evaluate our estimates, including, but not
limited to, those related to revenue recognition, accounts receivable,
inventories, impairment of property and equipment and of intangibles and
accruals for warranty claims. We use authoritative pronouncements, historical
experience and other assumptions as the basis for making estimates. Actual
results could differ from those estimates. Management believes that the
following critical accounting policies affect our more significant judgments and
estimates in the preparation of our Consolidated Financial Statements. These
critical accounting policies and the significant estimates made in accordance
with them have been discussed with our Audit Committee.
  ***Revenue
Recognition*** **.** We have
two distribution channels for our phototherapy treatment equipment. We will
either (i) sell the laser through a distributor or directly to a physician or
(ii) place the laser in a physician’s office (at no charge to the physician) and
charge the physician a fee for an agreed upon number of treatments. When we sell
an XTRAC laser to a distributor or directly to a physician, revenue is
recognized when the following four criteria under Staff Accounting Bulletin No.
104 have been met: the product has been shipped and we have no significant
remaining obligations; persuasive evidence of an arrangement exists; the price
to the buyer is fixed or determinable; and collection is probable. At times,
units are shipped but revenue is not recognized until all of the criteria are
met, and until that time, the unit is carried on our books as inventory. We ship
most of our products FOB shipping point, although from time to time certain
customers, for example governmental customers, will insist on
 
 37
 FOB
destination. Among the factors we take into account in determining the proper
time at which to recognize revenue are when title to the goods transfers and
when the risk of loss transfers. Shipments to the distributors that do not fully
satisfy the collection criteria are recognized when invoiced amounts are fully
paid.
  Under the
terms of the distributor agreements, our distributors do not have the right to
return any unit which they have purchased. However, we do allow products to be
returned by our distributors in redress of product defects or other claims.
  When we
place the laser in a physician’s office, we recognize service revenue based on
the number of patient treatments used by the physician. Treatments in the form
of laser-access codes that are sold to physicians but not yet used are deferred
and recognized as a liability until the physician performs the treatment. We
defer this portion of unused treatments even though the physician is not given
the right to seek a refund for unused treatments. Unused treatments remain an
obligation of ours inasmuch as the treatments can only be performed on our owned
equipment. Once the treatments are delivered to a patient, this obligation has
been satisfied.
  The
calculation of unused treatments has historically been based upon an estimate
that at the end of each accounting period, 15 unused treatments existed at each
laser location. This was based upon the reasoning that we generally sell
treatments in packages of 30 treatments. Fifteen treatments generally represents
about one-half the purchase quantity by a physician or approximately a one-week
supply for 6-8 patients. This policy had been used on a consistent basis. We
believed this approach to have been reasonable and systematic given that: (a)
physicians have little motivation to purchase quantities (which they are
obligated to pay for irrespective of actual use and are unable to seek a refund
for unused treatments) that will not be used in a relatively short period of
time, particularly since in most cases they can obtain incremental treatments
instantaneously over the phone; and (b) senior management regularly reviews
purchase patterns by physicians to identify unusual buildup of unused treatment
codes at a laser site. However, we continually look at our estimation model
based upon data received from our customers.
  In the
fourth quarter of 2004, we have updated the calculations for the estimated
amount of unused treatments to reflect recent purchasing patterns by physicians
near year-end. We have estimated the amount of unused treatments at December 31,
2004 to include all sales of treatment codes made within the last two weeks of
the end of the period. We believe this approach more closely approximates the
actual amount of unused treatments that existed at that date than the previous
method allowed. According to APB 20, accounting estimates change as new events
occur, as more experience is acquired, or as additional information is obtained
and that the effect of the change in accounting estimate should be accounted for
in the current period and the future periods that it affects. We have accounted
for this change in the estimate of unused treatments in accordance with SFAS No.
48 and APB 20. Accordingly, our change in accounting estimate is reported in
revenues for the fourth quarter and has not been accounted for by restating
amounts reported in financial statements of prior periods or by reporting
proforma amounts for prior periods.
  Had the
prior method of estimation been used to calculate unused treatments at December
31, 2004, the amount of unused treatments would have approximated $178,500.
Under the current method of estimation, the amount of unused treatments at
December 31, 2004 is estimated to approximate $306,000, thereby serving to
reduce XTRAC domestic revenues by $127,500 for the quarter and year ended
December 31, 2004.
  In the
first quarter of 2003, we implemented a program to support certain physicians in
addressing treatments with the XTRAC system that may be denied reimbursement by
private insurance carriers. We recognize service revenue during the program from
the sale of treatment codes to physicians participating in this program only if
and to the extent the physician has been reimbursed for the treatments. In the
year ended December 31, 2004, we recognized $531,631 of net revenues under this
program. At December 31, 2004, we deferred revenues of $169,692, net under this
program.
  Under
this program, qualifying doctors can be reimbursed for the cost of our fee only
if they are ultimately denied reimbursement after appeal of their claim with the
insurance company. The key components of the program are as
follows:
  38
 ·
    The
      physician practice must qualify to be in the program (i.e. it must be in
      an identified location where there is still an insufficiency of insurance
      companies reimbursing the procedure);
  ·
    The
      program only covers medically necessary treatments of psoriasis as
      determined by the treating physician;
  ·
    The
      patient must have medical insurance and a claim for the treatment must be
      timely filed with the patient’s insurance company;
  ·
    Upon
      denial by the insurance company (generally within 30 days of filing the
      claim), a standard insurance form called an EOB (Explanation of Benefits)
      must be submitted to our in-house appeals group, who will then prosecute
      the appeal. The appeal process can take 6-9
months;
  ·
    After
      all appeals have been exhausted by us, if the claim remains unpaid, then
      the physician is entitled to receive credit for the treatment he or she
      purchased from us (our fee only) on behalf of the patient;
    and
  ·
    Physicians
      are still obligated to make timely payments for treatments purchased,
      irrespective of whether reimbursement is paid or denied. Future sale of
      treatments to the physician can be denied if timely payments are not made,
      even if a patient’s appeal is still in
process.
  Historically,
we estimated this contingent liability for potential refund by estimating when
the physician was paid for the insurance claim. In the absence of a two-year
historical trend and a large pool of homogeneous transactions to reliably
predict the estimated claims for refund as required by Staff Accounting Bulletin
Nos. 101 and 104, we previously deferred revenue recognition of 100% of the
current quarter revenues from the program to allow for the actual denied claims
to be identified after processing with the insurance companies. After more than
83,000 treatments in the last 2 years and detailed record keeping of denied
insurance claims and appeals processed, we can reliably estimate that
approximately 11% of a current quarter’s revenues under this program are subject
to being credited back or refunded to the physician. As of December 31, 2004, we
updated our estimation procedure to reflect this level of estimated refunds.
This change from the past process of deferring 100% of the current quarter
revenues from the program represents a change in accounting estimate, and we
have recorded this change in accordance with the relevant provisions of SFAS No.
48 and APB 20. These pronouncements state that the effect of a change in
accounting estimate should be accounted for in the current period and the future
periods that it affects. A change in accounting estimate should not be accounted
for by restating amounts reported in financial statements of prior periods or by
reporting proforma amounts for prior periods.
  Had the
prior method of estimation been used to calculate potential credits or refunds
at December 31, 2004, the amount of deferred revenue would have increased by
$405,000 and the amount or revenue recognized for the XTRAC domestic segment for
the quarter and year ended December 31, 2004 would have decreased by
approximately $405,000.
  The net
impact on revenue recognized for the XTRAC domestic segment as a result of the
above two changes in accounting estimate was to increase revenues by
approximately $278,000 for the quarter and year ended December 31,
2004.
  Through
our surgical businesses, we generate revenues primarily from two channels. The
first is through product sales of laser systems, related maintenance service
agreements, recurring laser delivery systems and laser accessories; the second
is through the per-procedure surgical services. We recognize revenues from
surgical lasers and other product sales, including sales to distributors, when
the following four criteria under Staff Accounting Bulletin No. 104 have been
met: the product has been shipped and we have no significant remaining
obligations; persuasive evidence of an arrangement exists; the price to the
buyer is fixed or determinable; and collection is probable. At times, units are
shipped but revenue is not recognized until all of the criteria are met, and
until that time, the unit is carried on our books of as inventory. We ship most
of our products FOB shipping point, although from time to time certain
customers, for example governmental customers, will insist on FOB destination.
Among the factors we take into account in determining the proper time at which
to recognize revenue are when title to the goods transfers and when the risk of
loss transfers.
  39
 For
per-procedure surgical services, we recognize revenue upon the completion of the
procedure. Revenue from maintenance service agreements is deferred and
recognized on a straight-line basis over the term of the agreements. Revenue
from billable services, including repair activity, is recognized when the
service is provided.
  ***Inventory*** **.** We
account for inventory at the lower of cost (first-in, first-out) or market. Cost
is determined to be purchased cost for raw materials and the production cost
(materials, labor and indirect manufacturing cost) for work-in-process and
finished goods. Throughout the laser manufacturing process, the related
production costs are recorded within inventory. Work-in-process is immaterial,
given the typically short manufacturing cycle, and therefore is disclosed in
conjunction with raw materials. We perform full physical inventory counts for
XTRAC and cycle counts on the other inventory to maintain controls and obtain
accurate data.
  Our skin
disorder treatment equipment will either (i) be sold to distributors or
physicians directly or (ii) be placed in a physician's office and remain our
property. The cost to build a laser, whether for sale or for placement, is
accumulated in inventory. When a laser is placed in a physician’s office, the
cost is transferred from inventory to “lasers in service” within property and
equipment. At times, units are shipped to distributors, but revenue is not
recognized until all of the criteria of Staff Accounting Bulletin No. 104 have
been met, and until that time, the unit is carried on our books as inventory.
Revenue is not recognized from these distributors until payment is either
assured or paid in full. Until this time, the cost of these shipments continues
to be recorded as finished goods inventory.
  Reserves
for slow moving and obsolete inventories are provided based on historical
experience and product demand. Management evaluates the adequacy of these
reserves periodically based on forecasted sales and market trend.
  ***Allowance
for Doubtful Accounts*** **.** Accounts
receivable are reduced by an allowance for amounts that may become uncollectible
in the future. The majority of receivables related to phototherapy sales are due
from various distributors located outside of the United States and from
physicians located inside the United States. The majority of receivables related
to surgical sales and product sales are due from various customers and
distributors located inside the United States. From time to time, our customers
dispute the amounts due to us, and, in other cases, our customers experience
financial difficulties and cannot pay on a timely basis. In certain instances,
these factors ultimately result in uncollectible accounts. The determination of
the appropriate reserve needed for uncollectible accounts involves significant
judgment. A change in the factors used to evaluate collectibility could result
in a significant change in the reserve needed. Such factors include changes in
the financial condition of our customers as a result of industry, economic or
customer-specific factors.
  ***Property
and Equipment.*** As of
December 31, 2004 and 2003, we had net property and equipment of $4,996,688 and
$4,005,205, respectively. The most significant component of these amounts
relates to the XTRAC lasers placed by us in physicians’ offices. We own the
equipment and charge the physician on a per-treatment basis for use of the
equipment. The realizability of the net carrying value of the lasers is
predicated on increasing revenues from the physicians’ use of the lasers. We
believe that such usage will increase in the future based on the approved CPT
codes, recent approvals of private health plans of our XTRAC procedure and
expected increases in insurance reimbursement. XTRAC lasers-in-service are
depreciated on a straight-line basis over the estimated useful life of
three-years. Surgical lasers-in-service are depreciated on a straight-line basis
over an estimated useful life of seven years if new, five years or less if used
equipment. The straight-line depreciation basis for lasers-in-service is
reflective of the pattern of use. For other property and equipment, depreciation
is calculated on a straight-line basis over the estimated useful lives of the
assets, primarily three to seven years for computer hardware and software,
furniture and fixtures, automobiles, and machinery and equipment. Leasehold
improvements are amortized over the lesser of the useful lives or lease terms.
Useful lives are determined based upon an estimate of either physical or
economic obsolescence.
  ***Intangibles*** **.** Our
balance sheet includes goodwill and other intangible assets which affect the
amount of future period amortization expense and possible impairment expense
that we will incur. Management’s judgments regarding the existence of impairment
indicators are based on various factors, including market conditions and
operational performance of its business. As of December 31, 2004 and 2003, we
had $3,873,857 and $3,703,078, respectively, of goodwill and other intangibles,
accounting for 17% and 16% of our total assets at the respective dates. The
determination of the value of such intangible assets requires management to make
estimates and assumptions that affect our consolidated financial statements. We
test our goodwill for impairment, at least annually.
 
 40
 This test
is usually conducted in December of each year in connection with the annual
budgeting and forecast process. Also, on a quarterly basis, we evaluate whether
events have occurred that would negatively impact the realizable value of our
intangibles or goodwill. There has been no change to the carrying value of
goodwill in 2004 and 2003. Goodwill is allocated to the XTRAC domestic segment
and the XTRAC international segment in the amounts of $2,061,096 and $883,327,
respectively. The allocation of goodwill to each segment was based upon the
relative fair values of the two segments as of August 2000, when we bought out
the minority interest in Acculase and thus recognized the goodwill.
  ***Warranty
Accruals*** **.** We
establish a liability for warranty repairs based on estimated future claims for
XTRAC systems and based on historical analysis of the cost of the repairs for
surgical laser systems. However, future returns on defective laser systems and
related warranty liability could differ significantly from estimates, and
historical patterns, which would adversely affect our operating
results.
  **Results
of Operations**
 
 ***Revenues***
 **
 We
generated revenues of $17,745,181 during the year ended December 31, 2004, of
which $12,862,371 was from the surgical laser products and services operations.
The balance of revenues was from phototherapy products and services, including
$1,626,646 from XTRAC international sales of excimer systems and parts and
$3,256,164 from domestic XTRAC procedures. We generated revenues of $14,318,793
during the year ended December 31, 2003, of which $11,827,249 were from the
product and services operations of SLT. The balance of revenues was from
phototherapy products and services, including $1,166,520 from XTRAC
international sales of excimer systems and parts and $1,325,024 from domestic
XTRAC procedures. In 2002, total revenues were $3,274,458, including $2,531,063
from international XTRAC sales of excimer lasers and parts, $706,320 from
domestic XTRAC procedures, and $37,075 from SLT operations (for the 2 days after
the completion of the acquisition on December 27, 2002).
  The
following table illustrates revenues from our four business segments for the
periods listed below:
  For
      the Years Ended December 31,2004
    
    2003
    
    2002XTRAC
      Domestic Services
    
    $
    3,256,164
    
    $
    1,325,024
    
    $
    706,320XTRAC
      International Products
    
    
    1,626,646
    
    
    1,166,520
    
    
    2,531,063Total
      XTRAC Revenues
    
    $
    4,882,810
    
    $
    2,491,544
    
    $
    3,237,383Surgical
      Services
    
    $
    7,826,519
    
    $
    5,953,462
    
    $
    37,075Surgical
      Products
    
    
    5,035,852
    
    
    5,873,787
    
    
    -Total
      Surgical Revenues
    
    $
    12,862,371
    
    $
    11,827,249
    
    $
    37,075Total
      Revenues
    
    $
    17,745,181
    
    $
    14,318,793
    
    $
    3,274,458
  ***Domestic
XTRAC Segment***
  Recognized
revenue for the years ended December 31, 2004, 2003 and 2002 for domestic XTRAC
procedures was $3,256,164, $1,325,024 and $706,320, respectively. Total XTRAC
procedures for the same periods were approximately 53,000, 32,000 and 11,000,
respectively, of which 4,928, 2,566 and 0 procedures, respectively, were
performed by customers without billing from us. These procedures were performed
in connection with customer evaluations of the XTRAC laser as well as for
clinical research. The ramp in procedures in the years ended
 
 41
 December
31, 2004 and 2003 was related to our continuing progress in securing favorable
reimbursement policies from private insurance plans. Increases in these levels
are dependent upon more widespread adoption of the CPT codes with comparable
rates by private healthcare insurers.
  In the
first quarter of 2003, we implemented a program to support certain physicians in
addressing treatments with the XTRAC system that may be denied reimbursement by
private insurance carriers. Applying the requirements of Staff Accounting
Bulletin No. 104 to the program, we recognized service revenue during the
program from the sale of XTRAC procedures, or equivalent treatment codes, to
physicians participating in this program only if and to the extent the physician
has been reimbursed for the treatments. For the year ended December 31, 2004, we
recognized revenues of $303,027 from revenues (4,562 procedures) which had been
previously deferred under this program but which could be recognized as revenue
for the year as all the criteria for revenue recognition had been met. For the
year ended December 31, 2003, we deferred revenues of $744,830 (10,737
procedures) net, under this program.
  In the
fourth quarter of 2004, recognized revenues for the domestic XTRAC segment
increased by approximately $405,000 from a change in accounting estimate for
potential credits or refunds under the reimbursement program above. This amount
was offset by approximately $127,000 due to a change in accounting estimate for
unused physician treatments that existed at December 31, 2004. The net effect of
these two changes in accounting estimate as detailed in our Revenue Recognition
Policy above and as further detailed in our Summary of Significant Accounting
Policies in Note 1 to the financial statements was to increase revenue for this
segment for the quarter and year ended December 31, 2004 by approximately
$278,000.
  The
following table illustrates the above analysis for the Domestic XTRAC segment
for the periods reflected below:
  **XTRAC
      Domestic**
    
    For
      the Years Ended December 31,2004
    
    2003
    
    2002Recognized
      revenue
    
    $
    3,256,164
    
    $
    1,325,024
    
    $
    706,320Change
      in deferred program revenue
    
    
    (303,027
    )
    
    744,830
    
    
    -Change
      in deferred unused treatments
    
    
    229,300
    
    
    (50,225
    )
    
    -Net
      billed revenue
    
    $
    3,182,437
    
    $
    2,019,629
    
    $
    706,320Procedure
      volume total
    
    
    52,843
    
    
    31,679
    
    
    11,000Less:
      Non-billed procedures
    
    
    4,928
    
    
    2,566
    
    
    -Net
      billed procedures
    
    
    47,915
    
    
    29,113
    
    
    11,000Avg.
      price of treatments sold
    
    $
    66.42
    
    $
    69.37
    
    $
    64.21Procedures
      with deferred/(recognized)program
      revenue, net
    
    
    (4,562
    )
    
    10,737
    
    
    -Procedures
      with deferred(recognized) unused treatments, net
    
    
    3,452
    
    
    (724
    )
    
    -
  The
average price for a treatment can vary from quarter to quarter based upon the
mix of mild and moderate psoriasis patients treated by our physician partners.
We charge a higher price per treatment for moderate psoriasis patients due to
the increased body surface area required to be treated. As a percentage of the
psoriasis patient population, there are fewer patients with moderate psoriasis
than there are with mild psoriasis. Due to the amount of treatment time
required, it has not been generally practical to use our therapy to treat severe
psoriasis patients. This may change going forward, as our new product, the XTRAC
Ultra, has shorter treatment times.
  ***International
XTRAC Segment***
  International
XTRAC sales of our excimer laser system and related parts were $1,626,646 for
the year ended December 31, 2004 compared to $1,166,520 and $2,531,063 for
the years ended December 31, 2003 and 2002, respectively. We sold 26 laser
systems in the year ended December 31, 2004 compared to 18 and 32 laser
systems in the years ended December 31, 2003 and 2002, respectively. The
international XTRAC operations are more widely influenced by competition from
similar laser technology from other manufacturers and from non-laser
 
 42
 lamp
alternatives for treating inflammatory skin disorders. Over time, competition
has also served to reduce the prices we charge international distributors for
our excimer products. While the average revenue per laser was less in the year
ended December 31, 2004 than in the same period of 2003, the number of
lasers sold was greater than in the prior period. In addition, of the 26 lasers
recognized in the year ended December 31, 2004, six of those lasers had
been shipped in 2003, but not recognized as sales due to the application of the
recognition criteria of Staff Accounting Bulletin No. 104. Four of the six
lasers were recognized in the first quarter of 2004 and the other two lasers
were recognized in the second quarter of 2004.
  The
following table illustrates the key changes in the International XTRAC segment
for the periods reflected below:
  **XTRAC International Segment**
    
    For
      the Years Ended December 31,2004
    
    2003
    
    2002Revenues
    
    $
    1,626,646
    
    $
    1,166,520
    
    $
    2,531,063Laser
      systems sold
    
    
    26
    
    
    18
    
    
    32Average
      revenue per laser
    
    $
    62,563
    
    $
    64,807
    
    $
    79,096
  ***Surgical
Services Segment***
  In the
years ended December 31, 2004, 2003 and 2002, surgical service revenues
were $7,826,519, $5,953,462 and $37,075, respectively. Revenues in surgical
services grew for the year ended December 31, 2004 from 2003 by 31.5%,
primarily due to growth in urological procedures performed with laser systems
purchased from a third-party manufacturer. Such procedures included a charge for
the use of the laser and the technician to operate it, as well as a charge for
the third party’s proprietary fiber delivery system. There were only two days of
surgical services revenues for 2002, since the acquisition of SLT occurred on
December 27, 2002.
  The
following table illustrates the key changes in the Surgical Services segment for
the periods reflected below:
  **Surgical
      Services Segment**
    
    For
      the Years Ended December 31,2004
    
    2003
    
    2002Revenues
    
    $
    7,826,519
    
    $
    5,953,462
    
    $
    37,075Percent
      increase
    
    
    31.5
    %Cost
      of revenues
    
    
    5,000,226
    
    
    3,899,714
    
    
    18,492Gross
      profit
    
    $
    2,826,293
    
    $
    2,053,748
    
    $
    18,583Percent
      of revenue
    
    
    36.1
    %
    
    34.5
    %
    
    50.1
    %
  ***Surgical
Products Segment***
  For the
years ended December 31, 2004 and 2003, surgical product revenues were
$5,035,852 and $5,873,787, respectively. There were no surgical products
revenues in 2002, since the acquisition of SLT occurred on December 27, 2002.
Surgical products include revenues derived from the sales of surgical laser
systems together with sales of related laser fibers and laser disposables. Sales
of disposables and fibers are more profitable than laser systems; however, the
sale of laser systems creates recurring sales of laser fibers and laser
disposables.
  Revenues
for the year ended December 31, 2004 decreased by approximately $838,000
from the year ended December 31, 2003. A significant portion of this
decrease was related to the fact that fewer surgical laser system sales were
made in 2004 compared to 2003, although the average price of systems sold was
higher in 2004 compared to 2003. For the year ended December 31, 2004 there
were 18 laser systems sold for approximately $989,000 compared to 38 laser
systems sold for approximately $1,611,000 in the comparable period of the prior
year. The balance of the decrease between the periods occurred in the sales of
fibers and other disposables. The change in product mix (i.e. fewer laser sales)
contributed to a higher margin in the year ended December 31, 2004
 
 43
 compared
to the same period in the prior year.
  Sales of
surgical laser systems vary quarter by quarter. There is significant competition
for the types of surgical laser systems we offer for sale. Additionally, we have
expected that the disposables base might continue to erode over time as
hospitals continue to seek outsourcing solutions instead of purchasing lasers
and related disposables for their operating rooms. We have continued to seek an
offset to this erosion through expanding our surgical services. Similarly, some
of the decrease in laser system sales is related to the trend of hospitals to
outsource their laser-assisted procedures to third parties, such as our surgical
services business. With the introduction of our CO2 and diode surgical lasers in
the second quarter of 2004, we hope to offset the decline in lasers and have a
further offset to the erosion of disposables revenues.
  The
following table illustrates the key changes in the Surgical Products segment for
the periods reflected below:
  **Surgical
      Products Segment**
    
    For
      the Year Ended December 31,2004
    
    2003
    
    2002Revenues
    
    $
    5,035,832
    
    $
    5,873,787
    
    $
    -Percent
      decrease
    
    
    (14.3
    %)Laser
      systems sold
    
    
    18
    
    
    38
    
    
    -Laser
      system revenues
    
    $
    989,000
    
    $
    1,611,000
    
    $
    -Average
      revenue per laser
    
    $
    54,944
    
    $
    42,395
    
    $
    -
  ***Cost
of Revenues***
  Product
cost of revenues during the year ended December 31, 2004 were $3,324,564,
compared to $3,732,109 for the year ended December 31, 2003, a decrease of 11%.
Included in these costs were $2,147,193 and $2,915,033 related to surgical
product revenues for the years ended December 31, 2004 and 2003, respectively.
The remaining product cost of revenues during these periods of $1,177,371 and
$817,075, respectively, related primarily to the production costs of the XTRAC
laser equipment sold outside of the United States.
  The
decrease in the product cost of revenues for the year ended December 31,
2004, was primarily related to a decrease in surgical laser sales. This decrease
was offset by an increase in product cost of sales for the international XTRAC
revenues for the year ended December 31, 2004. This increase was primarily
related to an increase in sales for the year. Additionally, we implemented a
planned quality upgrade of all units in the field during 2003. The impact of
this upgrade served to reduce field service costs and warranty claims for 2004.
  Product
cost of revenues for the year ended December 31, 2003 were $3,732,109, compared
to $1,130,825 for the year ended December 31, 2002. Included in these costs were
$2,915,033 related to surgical product revenues for the year ended December 31,
2003; there were only $11,004 of comparable surgical product cost of revenues in
the year ended December 31, 2002 representing activity from the acquisition date
of SLT on December 27, 2002 through December 31, 2002. The remaining product
cost of revenues during these periods of $817,075 and $1,119,821, respectively,
related primarily to the production costs of the XTRAC laser equipment sold
outside of the United States. In 2003, we upgraded our XTRAC lasers to the XL
Plus model to address past reliability issues with existing customers. Although
the upgrade was largely accomplished in 2003, the cost for the upgrades had been
accrued in September 2002.
  Services
cost of revenues was $7,038,705 and $6,755,499 in the years ended December 31,
2004 and 2003, respectively. Included in these costs were $5,148,259 and
$3,959,714 related to surgical service revenues for the year ended December 31,
2004 and 2003, respectively. The remaining services cost of revenues during
these periods of $1,890,446 and $2,795,785, respectively, represented
manufacturing, depreciation and field service costs on the lasers in service.
  Services
cost of revenues was $6,755,499 and $3,294,609 in the years ended December 31,
2003 and 2002, respectively. Included in these costs were $3,959,714 related to
surgical service revenues for the year ended
 
 44
 December
31, 2003; there were only $18,492 of comparable surgical service cost of
revenues in the year ended December 31, 2002 representing activity from the
acquisition date of SLT on December 27, 2002 through December 31, 2002. The
remaining services cost of revenues during these periods of $2,795,785 and
$3,276,117, respectively, represented manufacturing, depreciation and field
service costs on the lasers in service.
  The
decreases in the services cost of sales, excluding surgical services’ costs,
relate to the improvements made to the lasers, with the result that field
service costs were less in the year ended December 31, 2003 compared to the year
ended December 31, 2002.
  Certain
allocable XTRAC manufacturing overhead costs are charged against the XTRAC
service revenues. The manufacturing facility in Carlsbad, California is used
exclusively for the production of the XTRAC lasers, which are placed in
physicians’ offices domestically or sold internationally. The unabsorbed costs
are allocated to the domestic XTRAC and the international XTRAC segments based
on actual production of lasers for each segment. Included in these allocated
manufacturing costs are unabsorbed labor and direct plant costs.
  ***Gross
Margin Analysis***
  Gross
margin increased to $7,381,912 during the year ended December 31, 2004 from
$3,831,185 during the same period in 2003, an increase of $3,550,727. Revenues
increased during the year ended December 31, 2004 to $17,745,181 from
$14,318,793 during the same period in 2003, an increase of $3,426,388. The cost
to produce those revenues decreased during the year ended December 31, 2004
to $10,363,269 from $10,487,608 during the same period in 2003, a decrease of
$124,339. Overall gross margin increased for the year ended December 31,
2004 to 41.6% from 26.8% for the same period in 2003.
  Gross
margin increased to $3,831,185 during the year ended December 31, 2003 from
a loss of $(1,150,976) during the same period in 2002, an increase of
$4,982,161. Revenues increased during the year ended December 31, 2003 to
$14,318,793 from $3,274,458 during the same period in 2002, an increase of
$11,044,335. Overall gross margin increased for the year ended December 31,
2003 to 26.8% from (35.2%) for the same period in 2002. The acquisition of SLT
occurred on December 27, 2002. Hence, only two business days of activity from
SLT operations are included for the year ended December 31, 2002, representing
$18,583 of gross margin.
  The
following table analyzes changes in our gross margin for the periods reflected
below:
  **Company
      Margin Analysis**
    
    For
      the Year Ended December 31,2004
    
    2003
    
    2002Revenues
    
    $
    17,745,181
    
    $
    14,318,793
    
    $
    3,274,458Percent
      increase
    
    
    23.9
    %
    
    337.3
    %Cost
      of revenues
    
    
    10,363,269
    
    
    10,487,608
    
    
    4,425,434Percent
      (decrease) increase
    
    
    (1.2
    %)
    
    137
    %Gross
      profit (loss)
    
    $
    7,381,913
    
    $
    3,831,185
    
    
    ($1,150,976
    )Percent
      of revenue
    
    
    41.6
    %
    
    26.8
    %
    
    (35.2
    %)
  The
primary reasons for improvement in gross margin for the year ended
December 31, 2004, compared to the same period in 2003 were as
follows:
  ·
    We
      increased treatment procedures and lowered field service costs for the
      XTRAC laser. The increase in procedure volume was a direct result of
      improving insurance reimbursement. The lower field service costs were a
      direct result of the planned quality upgrades in 2003 for all
      lasers-in-service.
  ·
    We
      continued to increase the volume of sales to existing customers and add
      new customers to our existing base.
  The
primary reasons for improvement in gross margin for the year ended
December 31, 2003, compared to the same period in 2002 was as
follows:
  45
 ·
    We
      acquired SLT on December 27, 2002, so there were only two business days of
      SLT activity in 2002 but a full year’s activity in
2003.
  The
following table analyzes our gross margin for our Domestic XTRAC segment for the
periods reflected below:
  **XTRAC
      Domestic Segment**
    
    For
      the Year Ended December 31,2004
    
    2003
    
    2002Revenues
    
    $
    3,256,164
    
    $
    1,325,024
    
    $
    706,320Percent
      increase
    
    
    145.7
    %
    
    87.6
    %Cost
      of revenues
    
    
    1,890,446
    
    
    2,795,786
    
    
    3,276,117Percent
      decrease
    
    
    (32.4
    %)
    
    (14.7
    %)Gross
      profit (loss)
    
    $
    1,365,718
    
    
    ($1,470,762
    )
    
    ($2,569,797
    )Percent
      of revenue
    
    
    41.9
    %
    
    (111.0
    %)
    
    (363.8
    %)
  The most
significant improvement for the year ended December 31, 2004 came from our
Domestic XTRAC segment. We increased the gross profit for this segment for the
year ended December 31, 2004 over the comparable periods in 2003 and 2002
by $2,836,480 and $3,936,463, respectively, primarily due to increases in
revenues and decreases in the costs in the two periods. The key factors were as
follows:
  ·
    A
      key driver in increased revenue in this segment is insurance
      reimbursement. In 2004, we focused on private health insurance plans’
      adopting the XTRAC laser therapy for psoriasis as an approved medical
      procedure. In 2004, several major health insurance plans instituted
      medical policies to pay claims for the XTRAC therapy including Regence,
      Wellpoint, Aetna and Anthem.
  ·
    Procedure
      volume increased 65% from 29,113 to 47,915 billed procedures in the year
      ended December 31, 2004 compared to the same period in
      2003.
  ·
    Price
      per procedure was not a meaningful component of the revenue change between
      the periods.
  ·
    In
      the first quarter of 2003, we implemented a limited program to support
      certain physicians in addressing treatments with the XTRAC system that may
      be denied reimbursement by private insurance carriers. We recognize
      service revenue under the program for the sale of treatment codes to
      physicians participating in this program only if and to the extent the
      physician has been reimbursed for the treatments. For the year ended
      December 31, 2004, we recognized revenues of $303,027, net, from
      revenues under the program which had been previously deferred but which
      could be recognized in the current year’s revenues as all the criteria for
      revenue recognition had been met. For the year ended December 31,
      2003, we deferred revenues of $744,830 under this program. There was no
      deferral at December 31, 2002 as the program started in the first quarter
      of 2003.
  ·
    The
      cost of revenues decreased by $905,340 for the year ended
      December 31, 2004. An incremental procedure at a physician’s office
      does not substantively increase our operating costs associated with that
      laser. This, combined with the improvement in the reliability of the
      lasers in 2004 from 2003 and the resulting reduction in field service
      costs, served to reduce costs associated with the domestic
      segment.
  ·
    Procedure
      volume also increased from 2002 to 2003. Billed procedures increased from
      approximately 11,000 in 2002 to 32,000 in 2003 which accounted for the
      increase in revenues from 2002 to 2003. Costs associated with these
      revenues dropped significantly as we implemented an upgrade program in
      2002 that was substantially completed in 2003 to improve the reliability
      and reduce operating costs.
  46
  The
following table analyzes our gross margin for our International XTRAC segment
for the periods reflected below:
  **XTRAC
      International Segment**
    
    For
      the Year Ended December 31,2004
    
    2003
    
    2002Revenues
    
    $
    1,626,646
    
    $
    1,166,520
    
    $
    2,531,063Laser
      systems sold
    
    
    26
    
    
    18
    
    
    32Average
      revenue per laser
    
    
    62,563
    
    
    64,807
    
    
    79,096Cost
      of revenues
    
    
    1,177,371
    
    
    817,075
    
    
    1,119,821Standard
      manufacturing cost per unit
    
    
    28,200
    
    
    28,200
    
    
    28,200Total
      standard cost of goods sold
    
    
    733,200
    
    
    507,600
    
    
    902,400Other
      cost of goods sold
    
    
    444,171
    
    
    309,475
    
    
    217,421Gross
      profit
    
    $
    449,275
    
    $
    349,445
    
    $
    1,411,242Percent
      of revenue
    
    
    27.6
    %
    
    30.0
    %
    
    55.8
    %
  The gross
profit for the year ended December 31, 2004 increased by $99,830 from the
comparable period in 2003. The key factors in this business segment were as
follows:
  ·
    We
      sold 26 XTRAC laser systems during the year ended December 31, 2004
      and 18 lasers in the comparable period in 2003. We shipped $541,000 of
      lasers to a master distributor in 2003, but did not recognize revenue at
      the time. We recognized revenue in the amount of $420,000 in 2004 when all
      collections from the shipments became
certain.
  ·
    The
      International XTRAC operations are more widely influenced by competition
      from similar laser technology from other manufacturers and from non-laser
      lamp alternatives for treating inflammatory skin disorders. Over time,
      competition has also served to reduce the prices we charge international
      distributors for our excimer products. The average revenue for the 26
      laser systems sold in the year ended December 31, 2004 was
      approximately $63,000 while the average revenue per laser in 2003 was
      $65,000.
  ·
    Although
      the overall cost was relatively level between the comparable periods,
      increased production levels served to reduce the average cost per laser
      produced. Lower production volume with steady manufacturing costs
      increases the overall cost of an individual laser. The difference between
      standard manufacturing costs and total cost of goods sold represents
      unabsorbed overhead costs charged to cost of goods sold in the period of
      the sale.
  ·
    Revenues
      decreased by approximately $1,364,000 from 2002 to 2003 as a result of
      fewer shipments at a lower average price per unit in 2003 compared to
      2002. In 2003, there were more international competitors selling
      alternative medical devices for the treatment of psoriasis that served to
      reduce our average price per laser in 2003. In addition, other
      manufacturing costs were higher in 2003 compared to 2002 as a result of
      additional upgrade costs to the XTRAC. These factors reduced our gross
      margin by $1,045,366.
  47
  The
following table analyzes the gross margin for our Surgical Services segment for
the periods reflected below:
  **Surgical
      Services Segment**
    
    For
      the Year Ended December 31,2004
    
    2003
    
    2002Revenues
    
    $
    7,826,519
    
    $
    5,953,462
    
    $
    37,075Percent
      increase
    
    
    31.5
    %Cost
      of revenues
    
    
    5,000,226
    
    
    3,899,714
    
    
    18,492Percent
      increase
    
    
    28.2
    %Gross
      profit
    
    $
    2,826,293
    
    $
    2,053,748
    
    $
    18,583Percent
      of revenue
    
    
    36.1
    %
    
    34.5
    %
    
    50.1
    %
  Gross
profit in the Surgical Services segment for the year ended December 31,
2004 increased by $775,545 from the comparable period in 2003. The key factors
impacting gross margin for the Surgical Services business were as
follows:
  ·
    Increased
      procedure volume was the primary reason for improvements in this business.
      We continue to experience growth in our surgical services business,
      particularly within existing customers and existing
      geographies.
  ·
    A
      significant part of the growth was an increase in urological procedures
      performed with laser systems we have purchased from a third party
      manufacturer. Such procedures included a charge for the use of the laser
      and the technician to operate it, as well as a charge for the third
      party’s proprietary fiber delivery system. In the year ended
      December 31, 2004, we increased the amount we charge customers for
      the fibers used with this procedure without a commensurate increase in the
      cost of these fibers. This accounted for the increase in the margin to
      36.1% from 34.5% in the year ended December 31, 2004 from the
      comparable period in 2003.
  ·
    For
      the year ended December 31, 2002, there were only two business days of
      activity from the SLT acquisition which occurred on December 27,
      2002.
  The
following table analyzes our gross margin for our Surgical Products segment for
the periods reflected below:
  **Surgical
      Products Segment**
    
    For
      the Year Ended December 31,2004
    
    2003
    
    2002Revenues
    
    $
    5,035,852
    
    $
    5,873,787
    
    $
    -Percent
      decrease
    
    
    (14.3
    %)Cost
      of revenues
    
    
    2,295,226
    
    
    2,975,034
    
    
    11,004Percent
      decrease
    
    
    (22.9
    %)Gross
      profit (loss)
    
    $
    2,740,626
    
    $
    2,898,753
    
    
    ($11,004
    )Percent
      of revenue
    
    
    54.4
    %
    
    49.4
    %
    
    -
  Gross
profit for the Surgical Products segment in the year ended December 31,
2004 compared to the same period in 2003 decreased by $158,127. The key factors
in this business segment were as follows:
  ·
    This
      segment includes product sales of surgical laser systems and laser
      disposables. Disposables are more profitable than laser systems. However,
      the sale of laser systems generates the sale of laser
      disposables.
  ·
    Revenues
      for the year ended December 31, 2004 decreased by $837,935 from the
      year ended December 31, 2003. Cost of revenues decreased by $679,808
      between the same periods. There were 20 fewer laser system sales in the
      year ended December 31, 2004 than in the comparable period ended
      December 31, 2003. However, those lasers sold in the 2004 period were
      at slightly higher prices than in the comparable period in 2003. This
      decrease in the number of lasers sold was the primary impact on the
      decrease in the gross margin.
  48
 ·
    Disposables,
      which have a higher gross margin than lasers, represented a higher
      percentage of revenue in the year ended December 31, 2004 compared to
      the year ended December 31, 2003.
  ·
    For
      the year ended December 31, 2002, there were only two business days of
      activity from the SLT acquisition which occurred on December 27,
      2002.
  ***Selling,
General and Administrative Expenses***
  Selling,
general and administrative expenses for the year ended December 31, 2004 were
$10,426,256, compared to $9,451,224 in 2003, an increase of 10%. The overall
increase related to several expenses during the 2004 year. We have incurred
$400,000 in expenses in order to become compliant with Sarbanes Oxley. We had
incremental bad debt expense and legal expense of $159,000 and $200,000,
respectively, over the 2003 levels. The bad debt expense relating to the
international XTRAC sales has been lower due to the lower sales volume which
contributes to lower potential sales at risk of collection. In addition, more of
our international sales have been paid with cash in advance or letters of credit
inasmuch as such payment terms are more suitable for the geographic mix of
countries where we presently do business. This decrease was offset by an
increase in bad debt expense relating to the domestic XTRAC. These expenses
related to prior insurance reimbursement issues.
  Selling,
general and administrative expenses specifically allocated to the International
XTRAC segment decreased for the year ended December 31, 2004 compared to
the same period in 2003 due to a decrease in warranty expenses, which were
driven by improved reliability in our XTRAC laser systems. In the Surgical
Services segment, the increase in specifically allocated selling, general and
administrative expenses for the year ended December 31, 2004 over 2003 was
primarily related to higher commission expense on increased revenues and
additional training and staff education.
  Selling,
general and administrative expenses for the year ended December 31, 2003 were
$9,451,224, compared to $6,190,836 for the year ended December 31, 2002, an
increase of 53%. Due to the acquisition of SLT on December 27, 2002, we absorbed
additional expenses of $3,724,992 in 2003. This increase was offset, in part, by
merger integration savings of duplicative expenses between PhotoMedex and SLT.
In addition, 2002 included $320,000 of refurbishment warranty expense and
$383,000 of incremental bad debt expense over the 2003 level.
  ***Engineering
and Product Development***
  Engineering
and product development expenses for the year ended December 31, 2004 increased
to $1,801,438 from $1,776,480, or generally level with the year ended December
31, 2003.
  Engineering
and product development expenses for the year ended December 31, 2003 increased
to $1,776,480 from $1,757,257 for the year ended December 31, 2002. This
increase related primarily to SLT’s engineering expenses of $539,300 for the
year ended December 31, 2003. The diode and CO2 surgical lasers which were
introduced in 2004 resulted from these expenditures. These expenses were offset,
in part, by clinical trial expenses of $173,000 and product development expenses
of $305,000, related to the improvements to the excimer laser, for the year
ended December 31, 2002. In 2003, the XTRAC XL Plus resulted from these
expenditures.
  Allocations
of the California facility engineering and product development expenses between
the Domestic and International XTRAC Segments are based upon the planned
manufactured output of XTRAC lasers for the year.
  ***Interest
Expense, Net***
  Net
interest expense for the year ended December 31, 2004 increased to $138,414, as
compared to $46,330 for the year ended December 31, 2003. The increase in net
interest expense is a direct result of the draws on our lease line of credit
during 2004. The initial draw on the lease line of credit in the second quarter
of 2004 was used to replace the expired $1,000,000 bank line of credit.
  49
 Net
interest expense for the year ended December 31, 2003 was $46,330, as compared
to net interest income of $25,669 for the year ended December 31, 2002. The
increases in net interest expense in the comparable periods related to the
interest on the line of credit and on long term-debt that was assumed with the
acquisition of SLT.
  ***Net
Loss***
  The
aforementioned factors resulted in a net loss of $4,984,196 during the year
ended December 31, 2004, as compared to a net loss of $7,442,849 for the year
ended December 31, 2003, a decrease of 33%. This decrease was primarily the
result of the increase in revenues and resulting gross margin.
  The
aforementioned factors resulted in a net loss of $7,442,849 during the year
ended December 31, 2003, as compared to a net loss of $9,072,313 during the year
ended December 31, 2002, a decrease of 18%. This decrease in net loss was
primarily the result of the acquisition of SLT along with a reduction of
operating and production costs.
  Income
taxes were immaterial, given our current period losses and operating loss
carryforwards.
  **Liquidity
And Capital Resources**
  We have
historically financed our operations through the use of working capital provided
from private placements of equity securities and lines of credit.
  On
December 27, 2002, we acquired SLT. The surgical products and services provided
by SLT increased revenues for 2004 and 2003. We also saved costs from the
consolidation of the administrative and marketing infrastructure of the combined
company. Additionally, with the consolidated infrastructure in place, our
revenues, both in phototherapy and surgical products and services, grew, without
commensurate growth in our fixed costs. The established revenues from surgical
products and services helped to absorb the costs of the infrastructure of the
combined company.
  At
December 31, 2004, the ratio of current assets to current liabilities was 1.88
to 1.00 compared to 2.37 to 1.00 at December 31, 2003. This ratio was higher in
2003 than in 2004 due to the use of funds for working capital from the private
placement in May 2003, as detailed above. As of December 31, 2004, we had
$6,119,248 of working capital.
  Set forth
below is a summary of liabilities, excluding payables and accruals. We expect to
be able to meet our obligations in the ordinary course. The obligations under
the credit facility from GE Capital Corporation are capital leases; the other
capital lease obligations are from transactions entered into before we entered
the credit facility with GE. Operating lease and rental obligations are
respectively for personal and real property which we use in our
business.
  Payments
      due by periodContractual
      Obligations
    
    Total
    
    Less
      than 1 year
    
    1 -
      3 years
    
    3 -
      5 yearsCredit
      facility obligations
    
    $
    1,881,338
    
    $
    731,489
    
    $
    1,149,849
    
    $
    -Other
      capital lease obligations
    
    
    630,502
    
    
    302,889
    
    
    327,613
    
    
    -Operating
      lease obligations
    
    
    28,724
    
    
    10,138
    
    
    18,586
    
    
    -Rental
      lease obligations
    
    
    458,049
    
    
    334,804
    
    
    123,245
    
    
    -Notes
      payable
    
    
    106,541
    
    
    77,478
    
    
    29,063
    
    
    -Total
    
    $
    3,105,154
    
    $
    1,456,798
    
    $
    1,648,356
    
    $
    -
  Cash and
cash equivalents were $3,997,017 as of December 31, 2004, as compared to
$6,633,468 as of December 31, 2003. $112,200 of cash or cash equivalents were
classified as restricted as of December 31, 2004. No cash or cash equivalents
were classified as restricted as of December 31, 2003.
  50
 We
believe that our existing cash balance together with our other existing
financial resources, including access to lease financing for capital
expenditures, and any revenues from sales, distribution, licensing and
manufacturing relationships, will be sufficient to meet our operating and
capital requirements into first quarter of 2006. The 2005 operating plan
reflects anticipated revenue growth from an increase in per-treatment fees for
use of the XTRAC system based on wider insurance coverage in the United States
and continuing costs savings from the integration of the combined companies.
However, the projected cost of our business plan may require us to obtain
additional equity or debt financing to meet our working capital requirements or
capital expenditure needs. Similarly, if our growth outstrips the business plan,
as from a major rollout of the XTRAC Ultra in the U. S., we may require
additional equity or debt financing. There can be no assurance that additional
financing, if needed, will be available when required or, if available, will be
on terms satisfactory to us.
  In
addition, there may be insufficient authorized shares available for issuance in
connection with additional equity financing. As of March 15, 2005, we have
75,000,000 shares of common stock authorized, 40,168,549 shares issued and
outstanding, and approximately 22,415,000 shares reserved for expected or
possible issuances. Expected and possible issuances include: (i) 13,320,000
shares reserved in the pending ProCyte acquisition for exchange with ProCyte
shareholders and issuance one exercise of options granted or grantable from the
ProCyte stock option plans; (ii) 8,500,000 shares reserved for issuance in
connection with outstanding PhotoMedex warrants and options granted or grantable
under the PhotoMedex stock option plans, (iii) 586,000 shares reserved for
issuance in connection with the technology license from Stern Laser, and (iv)
nearly 10,000 warrants that may be issued to GE Capital Corporation in
connection with additional draws under our lease line of credit. In any of such
events, we would be forced to modify our plans and operations to seek to balance
cash inflows and outflows.
  We
obtained a $2,500,000 leasing credit facility from GE Capital Corporation on
June 25, 2004. The credit facility has a commitment term of three years,
expiring on June 25, 2007. We account for each draw as funded indebtedness
taking the form of a capital lease. Each draw against the credit facility has a
self-amortizing repayment period of three years and is secured by specified
lasers, which we have sold to GE and leased back for continued deployment in the
field. The draw is set at an interest rate based on 522 basis points above the
three-year Treasury note rate. Each draw is discounted by 7.75%; the first
monthly payment is applied directly to principal. With each draw, we have agreed
to issue warrants to purchase shares of our common stock equal to 5% of the
draw. The number of warrants is determined by dividing 5% of the draw by the
average closing price of our common stock for the ten days preceding the date of
the draw. The warrants have a five-year term from the date of each issuance and
bear an exercise price set at 10% over the average closing price for the ten
days preceding the date of the draw.
  We
received a letter of intent from GE Capital Corporation to open a second line of
leasing credit. The second, supplemental line would be for $5 million, have a
term of three years and be secured by lasers used in our Domestic XTRAC and our
Surgical Services segments. The proposed terms seem favorable to us. However,
the second line is subject to and contingent on a due diligence review, to be
conducted in March 2005.
  As of
December 31, 2004, we had made three draws against the line.
  Draw
      1
    
    Draw
      2
    
    Draw
      3Date
      of draw
    June
      30, 2004
    
    September
      24, 2004
    
    December
      30, 2004Amount
      of draw
    $1,536,950
    
    $320,000
    
    $153,172Stated
      interest rate
    8.47%
    
    7.97%
    
    8.43%Effective
      interest rate
    17.79%
    
    17.41%
    
    17.61%Number
      of warrants issued
    23,903
    
    6,656
    
    3,102Exercise
      price of warrants per share
    $3.54
    
    $2.64
    
    $2.73Fair
      value of warrants
    $62,032
    
    $13,489
    
    $5,946
  51
  The fair
value of the warrants granted is estimated using the Black-Scholes
option-pricing model with the following weighted average assumptions applicable
to the warrants granted:
  Warrants
      granted under:Draw
      1
    
    Draw
      2
    
    Draw
      3Risk-free
      interest rate
    3.81%
    
    3.70%
    
    3.64%Volatility
    99.9%
    
    100%
    
    99.3%Expected
      dividend yield
    0%
    
    0%
    
    0%Expected
      option life
    5
      years
    
    5
      years
    
    5
      years
  For
reporting purposes, the carrying value of the liability is reduced at the time
of each draw by the value ascribed to the warrants. This reduction will be
amortized at the effective interest rate to interest expense over the term of
the draw.
  Concurrent
with the SLT acquisition, we assumed a $3,000,000 credit facility from a bank.
The credit facility had a commitment term of four years, which expired May 31,
2004, permitted deferment of principal payments until the end of the commitment
term, and was secured by SLT’s business assets, including collateralization
(until May 13, 2003) of $2,000,000 of SLT’s cash and cash equivalents and
short-term investments. The bank allowed us to apply the cash collateral to pay
down of the facility in 2003. The credit facility had an interest rate of the
30-day LIBOR plus 2.25%.
  Operating
cash flow for the year ended December 31, 2004 compared to the year ended
December 31, 2003 improved mostly due to a $3,550,727 increase in gross
profit. This resulted in net cash used in operating activities of $2,765,221,
for the year ended December 31, 2004, compared to $5,134,161 for the same period
in 2003. In the year ended December 31, 2004, changes in operating assets and
liabilities used $111,531 of cash compared to $247,434 usage of cash for the
same period in 2003.
  Operating
cash flow for the year ended December 31, 2003 compared to the year ended
December 31, 2002 improved mostly due to a $4,982,161 increase in gross profit.
This resulted in net cash used in operating activities of $5,134,161, for the
year ended December 31, 2003, compared to $6,071,819 for he same period in 2002.
In the year ended December 31, 2003, changes in operating assets and liabilities
used $247,434 of cash compared to cash provided of $672,025 for the same period
in 2002.
  Net cash
used in investing activities was $2,677,670 and $1,607,757 for the year ended
December 31, 2004 and 2003, respectively. During the year ended December 31,
2004 and 2003, we utilized $1,683,528 and $1,556,654, respectively, for
production of our lasers in service. In 2004, we had net acquisition costs of
$882,823 related to the Stern and ProCyte acquisitions.
  Net cash
used in investing activities was $1,607,757 and $205,948 for the year ended
December 31, 2003 and 2002, respectively. During the year ended December 31,
2003, we utilized $1,556,654 for production of our lasers in service compared to
the net retirement of lasers from service of $99,090 during the year ended
December 31, 2002. In 2002, we had net acquisition costs of $231,500 related to
the SLT acquisition.
  The
retirements of lasers from service have been minor or immaterial over the last
three years and therefore, we have reported them on a net basis.
  Net cash
provided by financing activities was $2,694,240 and $9,367,335 for the years
ended December 31, 2004 and 2003, respectively. In the year ended December 31,
2004, we received $3,296,751 from the exercise of stock options and warrants and
a net increase of $527,548 from the termination of the bank line of credit and
the initiation of the lease line of credit from GE. These increases were
partially offset by $879,001 for the payment of certain notes payable and
capital lease obligations and $138,858 in registration costs from the issuance
of common stock. In the year ended December 31, 2003, we received $9,477,546
from the issuance of common stock. In addition we received $2,000,000 from the
release of restrictions of cash related to SLT’s prior credit facility. These
receipts were offset by a net payment of $1,770,268 on the bank line of credit,
and $867,323 for the payment of certain debts.
  52
 Net cash
provided by financing activities was $9,367,335 and $6,218,998 for the years
ended December 31, 2003 and 2002, respectively. In the year ended December 31,
2003, we received net proceeds of $9,477,546 from the private placement in May
2003, $64,532 and $462,848 from the exercise of options and warrants,
respectively. We also received $2,000,000 from the release of restricted cash,
cash equivalents and short-term investments, which was offset by a net payment
of $1,770,268 on the line of credit, and $867,323 for the payment of certain
debts. In the year ended December 31, 2002, we received net proceeds of
$5,706,047 from the private placement in June 2002, $18,000 and $432,982 from
the exercise of options and warrants, respectively, and $60,905 in proceeds from
notes payable.
  We
expect, based on our current business plan, and our present outlook, that we
will have the resources to market our current products and services into first
quarter of 2006. Nevertheless, we cannot assure you that we will market any
products successfully, operate profitably in the future, or that we may not
require significant additional financing in order to accomplish our business
plan.
  Our
ability to expand our business operations is currently dependent in significant
part on financing from external sources. There can be no assurance that changes
in our manufacturing and marketing, research and development plans or other
changes affecting our operating expenses and business strategy will not require
financing from external sources before we will be able to develop profitable
operations. There can be no assurance that additional capital will be available
on terms favorable to us, if at all. To the extent that additional capital is
raised through the sale of additional equity or convertible debt securities, the
issuance of such securities could result in additional dilution to our
stockholders. Moreover, our cash requirements may vary materially from those now
planned because of marketing results, product testing, changes in the focus and
direction of our marketing programs, competitive and technological advances, the
level of working capital required to sustain our planned growth, litigation,
operating results, including the extent and duration of operating losses, and
other factors. In the event that we experience the need for additional capital,
and are not able to generate capital from financing sources or from future
operations, management may be required to modify, suspend or discontinue our
business plan.
  **Impact
of Inflation**
  We have
not operated in a highly inflationary period, and we do not believe that
inflation has had a material effect on sales or expenses.
  **Item
7A.**  **Quantitative
and Qualitative Disclosure About Market Risk**
  We are
not currently exposed to market risks due to changes in interest rates and
foreign currency rates and, therefore, we do not use derivative financial
instruments to address risk management issues in connection with changes in
interest rates and foreign currency rates.
  **Item
8.** **Financial
Statements and Supplementary Data.**
  The
financial statements required by this Item 8 are included elsewhere in this
Report and incorporated herein by this reference.
  **Item
9.** **Changes
in and Disagreements with Accountants on Accounting and Financial
Disclosure**
  At the
direction and approval of our Audit Committee, we terminated the engagement of
KPMG LLP (“KPMG”) as our principal independent accountants, to take effect June
9, 2004.
  In
connection with the audits for the years ended December 31, 2002 and 2003 and
the subsequent interim period through June 9, 2004, except as described in the
following paragraph, there were no disagreements with KPMG on any matter of
accounting principles or practices, financial statement disclosure, or auditing
scope or procedures, which if not resolved to the satisfaction of KPMG, would
have caused KPMG to make reference to the subject matter of such disagreements
in connection with its reports on our consolidated financial statements for such
years. Management and the Audit Committee have adhered, and will adhere, to the
policy to issue only financial reports which conform to the accounting positions
recommended by its independent accountants.
  53
 During
its review of our interim consolidated financial statements for the quarter
ended September 30, 2003, KPMG identified an issue related to material
transactions for which we had initially recorded revenue on shipments of lasers
to an international distributor. Based on its review and analysis of the
collectibility of the revenue from such shipments, KPMG determined that the
revenue related to these particular shipments should be accounted for utilizing
the “sell-through” method of accounting, provided the other criteria for revenue
recognition under applicable accounting standards were met. The issue was
discussed with management and with our Audit Committee. Upon consideration of
additional facts relevant to the issue, management and the Audit Committee
agreed with KPMG’s position. Consistent with our Company policy, this issue was
resolved to the satisfaction of KPMG, and, in accordance with the “sell-through”
method, we did not include the revenue under discussion in the reported
quarterly results. If this issue had not been resolved to the satisfaction of
KPMG, it would have caused KPMG to make reference to the subject matter of such
disagreement in connection with its reports on our consolidated financial
statements for applicable periods.
  There
were no reportable events as defined in Item 304(a)(1)(v) of Regulation S-K,
except for an event related to the “sell-through” method of accounting discussed
above. KPMG issued a letter identifying a material weakness in our internal
control as a result of our 2003 audit. The material weakness in our internal
controls related to recognition of revenue on the sale of lasers under the
collectibility criterion of Staff Accounting Bulletin No. 104. While we believed
that we had adequate policies for proper recognition of revenue, we agreed with
KPMG that our implementation of those policies, especially in evaluating the
collectibility of discrete sales of laser units, needed to be improved. We
re-evaluated the various factors, and the relative weights we ascribe to the
factors, which we take into account in determining collectibility. By December
31, 2003, we had implemented these and additional procedures to evaluate not
only new distributors and customers, but past customers as well.
  The
reports of KPMG on our consolidated financial statements, as of and for the
years ended December 31, 2002 and 2003, did not contain any adverse opinion or
disclaimer of opinion, nor were they qualified or modified as to uncertainty,
audit scope or accounting principles.
  The Audit
Committee of our Board of Directors recommended and approved the engagement of
Amper, Politziner & Mattia, P.C. as our independent accountants, effective
June 9, 2004. Accordingly, we have engaged Amper, Politziner & Mattia, P.C.
as our principal independent accountants. The stockholders ratified the
engagement of Amper, Politziner & Mattia at the annual meeting on December
28, 2004.
  During
the year ended December 31, 2003 and through June 9, 2004, neither we nor anyone
on our behalf consulted Amper, Politziner & Mattia, P.C. regarding the
application of accounting principles to a specified transaction, either
completed or proposed, or the type of audit opinion that might be rendered on
our financial statements, or any other matters or reportable events, as set
forth in Items 304(a)(2)(i) and (ii) of Regulation S-K.
  **Item
9A.**  **Controls
and Procedures**
  **Controls
and Procedures**
  ***Discussion
of Year Ended December 31, 2003***
  At the
end of October 2003 and prior to the release of our results and the filing of
the Form 10-Q for the quarter ended September 30, 2003, our independent
auditors identified an issue related to certain transactions for which we had
initially recorded revenue in our internal consolidated financial statements on
shipments of lasers to a master international distributor in the third quarter
of 2003. Following the same analysis we had made for shipments made in the
second quarter to the distributor, we initially had determined that such
shipments made in the third quarter were collectible, based on the reputations
of the principals of the distributor and on extensive conversations we had had
with other suppliers of the distributor. Our independent auditors noted,
however, that the adjustment in the third quarter of the contractual payment
terms provided to the distributor in the second quarter suggested that the
distributor might not have the ability to pay for the laser units until the
distributor had collected amounts due from its customers. Augmenting their
concern was that the total credit then extended to the distributor would be
material to the related financial statements.
  54
 Our
auditors requested additional information regarding the financial capability of
the distributor. We requested further assurance from the distributor that it had
independent means to pay the receivables. We obtained further relevant
information from the distributor, which had been initially unavailable to our
management. Based on our independent auditors’ review and analysis of
information provided by our distributor relating to the collectibility of the
revenue from shipments to this distributor, our independent auditors recommended
that the revenue related to these particular shipments should be accounted for
utilizing the “sell-through” method of accounting, provided the other criteria
for revenue recognition under applicable accounting standards were met. The
issue was discussed with management  and with
our Audit Committee. Upon consideration of the facts relevant to the issue,
management and the Audit Committee subscribed to the position of our auditors
that shipments should be accounted for under the “sell-through” method when
collection could not be demonstrated to be more probable than non-collection. We
therefore did not recognize $260,000 of sales for shipments made to this
distributor in the third quarter of 2003. Additionally, based upon the
guidelines of Staff Accounting Bulletin No. 99 and APB No. 28, we offset third
quarter 2003 revenues by $281,000 for shipments made in the second quarter of
2003. We applied the same analysis with respect to all laser shipments, both
foreign and domestic and imposed the “sell-through” method in appropriate cases.
Under such method, sales would be recognized only when we had been paid the full
amount due. We recognized revenue of $310,000 in the first quarter of 2004 and
$110,000 in the second quarter of 2004 as a result of collections from units
shipped in 2003 to the master distributor.
  Based on
the foregoing, during the fourth quarter of 2003, we immediately implemented a
revised internal control procedure to enhance the determination of the
collectibility of receivables from sales to all of our distributors - both for
our then current distributors and customers (including new and past distributors
and customers) and as a policy on an ongoing basis for prospective distributors
and customers. We determined going forward that, if we were to record revenues
other than on payment in full of receivables, we would rely primarily on strong,
objective evidence of a customer’s ability to pay on a case-by-case basis. We
determined that the best evidence with respect to discrete laser sales would be
a letter of credit or payment in advance. Other evidence could be in the form of
past payment records, third party credit reports, bank references, recent
customer financial statements and industry/trade references. We also
re-evaluated the various factors, and the relative weights we ascribe to these
factors, which we take into account in determining collectibility. Senior
management individually reviews each transaction.
  Our
auditors notified us that they had determined that there was a material weakness
in our internal controls related to recognition of revenue on the sale of lasers
under the collectibility criterion of Staff Accounting Bulletin No. 104
relating to the discrete sales of lasers. This material weakness related to the
revenue recognition policy in our dealings with the specific distributor which
had been raised in connection with the third quarter 2003 Form 10-Q. As
described in the preceding paragraph, we developed and implemented improvements
in our internal control procedures with respect to the analysis of the
collectibility of receivables from sales of our lasers, not only with the
specifically identified distributor, but also with respect to all of our then
current and prospective distributors and customers. These general policy
improvements in our internal control procedures were implemented as of
December 31, 2003.
  With
regard to the identified material weakness, we did not restate any financial
results for any prior periods and believe that the identified material weakness
did not have any material effect on the accuracy of our financial statements
prepared with respect to any prior fiscal period.
 ***Discussion
of Year Ended December 31, 2004***
  As of the
end of the period covered by this Annual Report on Form 10-K for the year ended
December 31, 2004, we carried out an evaluation, under the supervision and
with the participation of our chief executive officer and chief financial
officer, of the effectiveness of the design and operations of our disclosure
controls and procedures (as defined in Rule 13a-15(e) under the Securities
Exchange Act of 1934).
  In making
this evaluation, we considered the material weakness identified by our
independent auditors relating to our internal controls as they relate to
recognition of revenue on the sale of lasers under the collectibility criterion
of Staff Accounting Bulletin No. 104. In connection with this evaluation, we
also considered the development and implementation of improvements in our
internal control procedures described above with respect to the identified
weakness.
  Our chief
executive officer and chief financial officer concluded that as of the
evaluation date, such disclosure controls and procedures were effective to
ensure that information required to be disclosed by us in the reports we file or
submit under the Exchange Act are recorded, processed, summarized and reported
within the time periods specified in the rules and forms of the Securities and
Exchange Commission, and is accumulated and communicated to our management,
including our chief executive officer and chief financial officer, as
appropriate to allow timely decisions regarding required disclosure.
  55
 Except as
described above, there were no changes in our internal controls over financial
reporting during the year ended December 31, 2004 that materially affected,
or were reasonably likely to materially affect, our internal controls over
financial reporting.
  Management’s
report on our internal controls over financial reporting can be found with the
attached financial statements. The Independent Registered Public Accounting
Firm’s attestation report on management’s assessment of the effectiveness of our
internal control over financial reporting can also be found with the attached
financial statements.
  **Management's
Report on Internal Control Over Financial Reporting**
 
 Our
management is responsible for establishing and maintaining an adequate system of
internal control over financial reporting. Our system of internal control over
financial reporting is designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements
for external purposes in accordance with accounting principles generally
accepted in the United States of America.
  Our
internal control over financial reporting includes those policies and procedures
that:
  ·
    pertain
      to the maintenance of records that, in reasonable detail, accurately and
      fairly reflect our transactions and dispositions of  our
      assets;
   ·
    provide
      reasonable assurance that our transactions are recorded as necessary to
      permit preparation of our financial statements in accordance with
      accounting principles generally accepted in the United States of America,
      and that our receipts and expenditures are being made only in accordance
      with authorizations of our management and our directors;
    and
   ·
    provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use, or disposition of our assets that could
      have a material effect on the financial statements.
  Because
of its inherent limitations, a system of internal control over financial
reporting can provide only reasonable assurance and may not prevent or detect
misstatements. Further, because of changes in conditions, effectiveness of
internal controls over financial reporting may vary over time. Our system
contains self-monitoring mechanisms, and actions are taken to correct
deficiencies as they are identified.
  Our
management conducted an evaluation of the effectiveness of the system of
internal control over financial reporting based on the framework in *Internal Control-Integrated Framework* issued
by the Committee of Sponsoring Organizations of the Treadway Commission. Based
on this evaluation, our management concluded that our system of internal control
over financial reporting was effective as of December 31, 2004. Our management's
assessment of the effectiveness of our internal control over financial reporting
has been audited by Amper, Politziner & Mattia, P.C., an independent
registered public accounting firm, as stated in their report which is included
herein.
  **Item
9B.**  **Other
Information**
  ***Pending
Acquisition - ProCyte***
 
 ProCyte
Corporation (“ProCyte”) is a Washington corporation organized in 1986. 
ProCyte is a medical skin care company that develops, manufactures and markets
products for skin health, hair care and wound care.  Many of the Company’s
products incorporate its patented copper peptide technologies.
 
 ProCyte’s
focus since 1996 has been to bring unique products, primarily based upon
patented technologies such as GHK and AHK copper peptide technologies, to
selected markets.  ProCyte currently sells its products directly to the
dermatology, plastic and cosmetic surgery, and spa markets.  The Company
has also expanded the use of its novel copper peptide technologies into the mass
retail market for skin and hair care through specifically targeted technology
licensing and supply agreements.
 
 56
 ProCyte’s
products address the growing demand for skin health and hair care products,
including products designed to address the effects aging has on the skin and
hair and to enhance appearance.  ProCyte’s products are formulated, branded
for and targeted at specific markets.  The Company’s initial products in
this area addressed the dermatology, plastic and cosmetic surgery markets for
use following various procedures.  Anti-aging skin care products were added
to expand into a comprehensive approach for incorporation into a patients’ skin
care regimen.  Certain of these products incorporated their patented
technologies, while others, such as our advanced sunscreen products that reduce
the effects of sun damage and aging on the skin, complement the product
line.
 
 On
December 1, 2004, we entered into a definitive merger agreement with ProCyte
Corporation pursuant to which we agreed to acquire ProCyte in a stock-for-stock
transaction valued at approximately $24.4 million. Under the terms of the
agreement, we agreed to issue 0.6622 shares of our common stock in exchange for
each outstanding share of ProCyte common stock. We have agreed to assume certain
common stock options to purchase shares of ProCyte common stock which have an
exercise price of $2.00 per share or less. Each assumed option to purchase
shares of ProCyte common stock outstanding immediately before the completion of
the merger will automatically become a stock option to purchase shares of our
common stock. The number of shares of our common stock into which a stock option
is exercisable and the related exercise price will be adjusted for the exchange
ratio in the merger. In addition, some assumed stock options will become fully
vested and exercisable at the effective time of the merger. We have agreed to
assume the ProCyte stock option plans at the effective time of the merger.
  Assuming
the exercise of all assumed ProCyte stock options, we expect to issue
approximately 12,090,000 shares of our common stock in connection with the
merger and to reserve approximately 1,230,000 shares for options that may be
granted in the future out of the option plans assumed from ProCyte.
  On a pro
forma basis, assuming that all ProCyte shareholders exchange their ProCyte
shares for our shares, and giving effect to the shares underlying the ProCyte
stock options to be assumed by us, ProCyte's stockholders would own
approximately 21% of the combined company's common stock on a fully diluted
basis. Based on the closing prices of our common stock on November 30, 2004, the
day before the announcement of the agreement, the offer represents a purchase
price of $1.49 per share and a premium of 33%.
  Consummation
of the merger is subject to various terms and conditions, including the approval
at special shareholder meetings by our stockholders and by ProCyte shareholders
holding at least two-thirds of outstanding ProCyte shares. On March 3, 2005 the
ProCyte shareholders approved the adjournment of its special meeting of
shareholders in order for ProCyte to solicit additional proxies to vote on the
proposed merger between PhotoMedex, Inc. and ProCyte. The adjourned special
meeting will be reconvened on March 18, 2005.
  The
ProCyte special meeting was adjourned because an insufficient number of
shareholders were present or represented by proxy to approve the merger proposal
under applicable Washington law. Washington statute requires that the merger be
approved by the affirmative vote of at least two-thirds of the shares of ProCyte
common stock outstanding and entitled to vote on the merger. As of the
adjournment of its special meeting, ProCyte had received proxies representing
approximately 9,639,000 of the required 10,548,344 share votes needed to approve
the merger proposal. Over 92% of the proxies received by ProCyte had been in
favor of the merger proposal. Of the 9,639,000 shares represented at the special
meeting, 8,572,000 (88.9%) voted in favor of the adjournment of the meeting for
the purpose of soliciting additional proxies in favor of the merger
proposal. There can be no assurances that the ProCyte shareholders will
approve the proposed merger transaction.
  At a
separate special meeting of the stockholders held March 3, 2005, our
stockholders approved the proposal with respect to the issuance of our shares in
the proposed merger by a vote of 24,334,253 (99.1%) shares in favor and 209,302
shares opposed or abstaining.
 
 If the
merger is consummated, we will account for it as a purchase of ProCyte by us
under generally accepted accounting principles. We will allocate the purchase
price based on the fair value of ProCyte's acquired assets and assumed
liabilities. We will consolidate the operating results of ProCyte with our own
operating results, beginning as of the date the parties complete the merger. The
final allocation of the purchase price will be determined after the merger is
consummated, at which time the actual purchase price can be calculated, and
after
 
 57
 completion
of a post-closing analysis to determine the fair values of ProCyte's acquired
assets and assumed liabilities.
  Under
applicable Washington law, ProCyte shareholders have the right to dissent from
the merger and to receive payment in cash for the appraised value of their
shares of ProCyte common stock. The appraised value of the shares of ProCyte
common stock may be more than, less than or equal to the value of the merger
consideration. A dissenter must follow specific procedures in order to perfect
such rights *.*
  We have
agreed to pay a finder's fee of $150,000 to BIO-IB, LLC for introducing the
prospect of the ProCyte acquisition. The finder's fee will only be payable in
the event of the closing of the transactions contemplated by the merger
agreement. The investment banking fee to CIBC World Markets is payable
irrespective of whether the merger is consummated. As of March 15, 2005, we have
outstanding liabilities amounting to $752,382 which we have incurred and accrued
for in connection with the merger.
  ***Stern
Laser Transaction***
  On
September 7, 2004, we closed the transactions set forth in a Master Asset
Purchase Agreement, or the Master Agreement, with Stern Laser srl. As of
December 31, 2004, we have issued to Stern 113,877 shares of its restricted
common stock in connection with the execution of the Master Agreement. We registered
these shares with the SEC in January 2005. We also agreed to pay Stern up to an
additional $1,150,000 based on the achievement of certain remaining milestones
relating to the development and commercialization of certain licensed technology
and the licensed products which may be developed under such arrangement and may
have certain other obligations to Stern under these arrangements. We retain the
right to pay all of these conditional sums in cash or in shares of our
common stock, in our discretion. To secure the latter alternative, we have
reserved for issuance, and placed into escrow, 586,123 shares of our
unregistered stock. The per-share price of any future issued shares will be
based on the closing price of our common stock during the 10 trading days ending
on the achievement of a particular milestone under the terms of the Master
Agreement. As of March 15, 2005, we have accrued for the issuance of an
additional 43,668 shares of its stock, based upon a $100,000 milestone set forth
in the Master Agreement. Stern also has served as the distributor of our XTRAC
laser system in South Africa and Italy since 2000.
  **PART
III**
 **Item
10.**  **Directors
and Executive Officers of Registrant**
 
 Our
directors currently have terms which will end at our next annual meeting of the
stockholders or until their successors are elected and qualify, subject to their
prior death, resignation or removal. Officers serve at the discretion of the
Board of Directors. There are no family relationships among any of our directors
and executive officers. Our Board members are encouraged to attend meetings of
the Board of Directors and the Annual Meeting of Stockholders.
  The
following sets forth certain biographical information concerning our directors
and our current executive officers.
  **Name**
    **Position**
    **Age**Richard
      J. DePiano
    Non-Executive
      Chairman of the Board of Directors
    63Jeffrey
      F. O'Donnell
    Director,
      President and Chief Executive Officer
    45Dennis
      M. McGrath
    Chief
      Financial Officer and Vice President - Finance and
      Administration
    48Michael
      R. Stewart
    Executive
      Vice President of Corporate Operations
    47John
      J. McAtee, Jr.
    Director
    68Alan
      R. Novak
    Director
    70Warwick
      Alex Charlton
    Director
    45Anthony
      J. Dimun
    Director
    61David
      W. Anderson
    Director
    52
  58
 **Directors
and Executive Officers**
  ***Richard
J. DePiano*** was
appointed to our Board of Directors in May 2000 and was unanimously elected to
serve as Non-Executive Chairman of the Board on January 31, 2003. Mr. DePiano
has been a director of Escalon Medical Corp., a publicly traded healthcare
business specializing in the development and marketing of ophthalmic devices and
pharmaceutical and vascular access products, since February 1996, and has served
as its Chairman and Chief Executive Officer since March 1997. Mr. DePiano has
been the Chief Executive Officer of the Sandhurst Company, L.P. and Managing
Director of the Sandhurst Venture Fund since 1986. Mr. DePiano was also the
Chairman of the Board of Directors of SLT prior to our acquisition of
SLT.
  ***Jeffrey
F. O’Donnell*** joined
PhotoMedex in 1999 as President and CEO and has served as a member of the Board
of Directors since that date. Prior to PhotoMedex, he joined Radiance Medical
Systems (originally Cardiovascular Dynamics) as Vice President of Sales and
Marketing from 1995 to 1997; from 1997 to 1999 he served as its President and
CEO and subsequently assumed a role as non-executive chairman of the board.
Previously, from 1994 to 1995 Mr. O’Donnell held the position of President and
CEO of Kensey Nash Corporation. Additionally, he has held several senior sales
and marketing management positions at Boston Scientific, Guidant and Johnson
& Johnson Orthopedic. In addition to sitting on the Board of Directors for
PhotoMedex, Mr. O’Donnell is currently an outside Board Member of Endologix,
Inc., Cardiac Sciences and Replication Medical, Inc. and had served until
December 28, 2004 on the Board of Escalon Medical Corp. He had served as an
outside Board member of AzurTec, Inc. but resigned from that board in 2003. Mr.
O’Donnell graduated from LaSalle University in 1982 with a B.S. in business
administration.
  ***Dennis
M. McGrath*** was
appointed Chief Financial Officer and Vice President-Finance and Administration
in January 2000. Mr. McGrath has held several senior level positions including
from February 1999 to January 2000 serving as the Chief Operating Officer of
Internet Practice, the largest division for AnswerThink Consulting Group, Inc.,
a public company specializing in business consulting and technology integration.
Concurrently, from August 1999 until January 2000, Mr. McGrath assumed the role
of Chief Financial Officer of Think New Ideas, Inc., a public company
specializing in interactive marketing services and business solutions. In
addition to the financial reporting responsibilities, Mr. McGrath was
responsible for the merger integration of Think New Ideas, Inc. and AnswerThink
Consulting Group, Inc. From September 1996 to February 1999, Mr. McGrath was the
Chief Financial Officer and Executive Vice-President-Operations of TriSpan,
Inc., an internet commerce solutions and technology consulting company, which
was acquired by AnswerThink. Mr. McGrath is a certified public accountant and
graduated with a B.S. in accounting from LaSalle University in 1979. Mr. McGrath
holds a license from the states of Pennsylvania and New Jersey as a certified
public accountant.
  ***Michael
R. Stewart*** was
appointed as our Executive Vice President of Corporate Operations on December
27, 2002 immediately following the acquisition of SLT. From July 1999 to the
acquisition, Mr. Stewart was the President and Chief Executive Officer of SLT,
and from October 1990 to July 1999 he served as SLT’s Vice President Finance and
Chief Financial Officer. Mr. Stewart graduated from LaSalle University with a
B.S. in accounting and received an M.B.A. from LaSalle University in 1986. Mr.
Stewart passed the CPA examination in New York in 1986.
  ***John
J. McAtee, Jr*** *.* , has
been a member of our Board of Directors since March 4, 1998. From March 4, 1998
until March 8, 1999, Mr. McAtee served as the Non-Executive Chairman of the
Board of Directors. From 1990 to 1996, Mr. McAtee was Vice Chairman of Smith
Barney, Inc., now known as Salomon Smith Barney, one of the world’s largest
investment banking and brokerage firms. Before that, Mr. McAtee was a partner in
the New York law firm of Davis Polk & Wardwell for more than 20 years. Mr.
McAtee is a graduate of Princeton University and Yale Law School. Mr. McAtee is
also a director of Jacuzzi Brands, Inc., a diversified industrial corporation,
whose primary business is the manufacture and sale of bath and plumbing
products.
  ***Alan
R. Novak*** **** was
appointed to our Board of Directors in October 1997. Mr. Novak is Chairman of
Infra Group, L.L.C., an international project finance and development company.
He is also Chairman of Lano International, Inc., a real estate development
company. Mr. Novak is a graduate of Yale University, Yale Law School, and
Oxford University as a Marshall Scholar. Mr. Novak practiced law at Cravath,
Swaine & Moore and Swidler & Berlin, Chartered. His public service
includes three years as an officer in the United States Marine Corps, a U.S.
Supreme Court clerkship with Justice Potter Stewart, Senior Counsel to Senator
Edward M. Kennedy, Senior
 
 59
 Executive
Assistant to Undersecretary of State, Eugene Rostow, and the Executive Director
of President Johnson’s Telecommunications Task Force. Mr. Novak was appointed by
President Carter and served for five years as Federal Fine Arts Commissioner.
  ***Warwick
Alex Charlton*** was
appointed to our Board of Directors and served as the Non-Executive Chairman of
the Board of Directors from March 8, 1999 to January 31, 2003.
Mr. Charlton is the Managing Director of True North Partners L.L.C., a
venture capital firm with a specialty in the healthcare field. Mr. Charlton
has 20 years of business experience, of which ten years were line management
experience and nine years were in the consulting profession (previously with
Booz Allen & Hamilton and the Wilkerson Group). Mr. Charlton
received an honors degree in Marketing from the University of Newcastle and an
M.B.A. from Cranfield Institute of Technology. Mr. Charlton was formerly a
Vice President of CSC Healthcare, Inc. and serves as a member of the Board of
Directors of Intercure, Inc. and as an advisor to the Board of Directors of
Balance Pharmaceuticals, Inc. ****
  ***Anthony
J. Dimun*** was
appointed to our Board of Directors on October 3, 2003. He has served since May
2001 as Chairman of Nascent Enterprises, L.L.C., a medical device venture
advisory firm. He also has served since 1987 as the Managing Director and Chief
Executive Officer of Strategic Concepts, Inc., a financial advisory company with
specific focus on venture capital and acquisition transactions. From March 1991
to May 2001, Mr. Dimun served as Executive Vice President and Chief Financial
Officer of Vital Signs, Inc., a publicly held anesthesia and respiratory medical
device company and currently serves as a director of Vital Signs, Inc. Mr. Dimun
also serves as a member of the Board of Trustees of the New Jersey Center for
Biomaterials, a non-profit collaboration of the three leading New Jersey
universities. Prior to 1991, Mr. Dimun held positions as a Certified Public
Accountant with several national accounting firms and served as Senior Vice
President for an international merchant-banking firm.
  ***David
W. Anderson*** was
appointed to our Board of Directors on July 27, 2004. Mr. Anderson is the
President and Chief Executive Officer of Gentis, Inc since November 2004. He has
over twenty years of entrepreneurial management experience in the medical
device, orthopedics and pharmaceutical field. He has served as President and CEO
of Sterilox Technologies, Inc., the world’s leader in the development and
marketing of non-toxic biocides; Bionx Implants, Inc., a publicly traded
orthopedic sports medicine and trauma company, and Kensey Nash Corporation, a
publicly traded cardiology and biomaterials company. In addition, Mr. Anderson
was previously Vice President of LFC Financial Corp., a venture capital and
leasing company, where he was responsible for LFC’s entry into the healthcare
market; and was a founder and Executive Vice President of Osteotech, Inc., a
high-technology orthopedic start-up.
  **Director
Compensation**
  Directors
who are also our employees receive no separate compensation for serving as
directors or as members of Board committees. Directors who are not our employees
are compensated under the 2000 Non-Employee Director Plan. Each director
receives non-qualified options to purchase up to 35,000 shares of common stock
on an annual basis. Each outside director receives an annual cash retainer of
$20,000 and is also paid $1,000 for personal attendance at each meeting of the
Board and each committee meeting held not in conjunction with meetings of the
Board itself, and $500 for telephonic attendance at each Board or committee
meeting, excluding meetings of limited scope and duration. We pro-rate the
retainer for a director serving less than a full year.
  **Compensation,
Nominations and Corporate Governance and Audit Committees**
  **General** . The
Board maintains charters for select committees. In addition, the Board has
adopted a written set of corporate governance guidelines and a code of business
conduct and ethics and a code of conduct for our chief executive and senior
financial officers that generally formalize practices that we already have in
place. To view the charters of the Audit, Compensation and Nominations and
Corporate Governance Committees, the corporate governance guidelines and the
codes of conduct and our whistle blower policy, please visit our website at *www.photomedex.com* (this
website address is not intended to function as a hyperlink, and the information
contained on our website is not intended to be a part of this proxy statement).
The Board has determined that all members of the Board are independent under the
revised listing standards of The Nasdaq Stock Market, Inc. (“NASDAQ”), except
for Mr. O'Donnell, who is also our Chief Executive Officer.
  60
 **Compensation
Committee** . The
Board of Directors has a Compensation Committee. The members of the Compensation
Committee currently are Messrs. McAtee, Novak, Charlton and Dimun. Mr. Dimun
serves as the Chairman of the Compensation Committee. The Board has determined
that each member of the Compensation Committee is "independent" under the
revised listing standards of NASDAQ. Mr. Charlton was invited to rejoin the
Compensation Committee in October 2004.
  The
Compensation Committee reviews executive compensation from time to time and
reports to the Board of Directors, which makes all decisions. The Compensation
Committee adheres to several guidelines in carrying out its responsibilities,
including performance by the employees, our performance, enhancement of
stockholder value, growth of new businesses and new markets and competitive
levels of fixed and variable compensation. The Compensation Committee reviews
and approves the annual salary and bonus for each executive officer (consistent
with the terms of any applicable employment agreement), reviews, approves and
recommends terms and conditions for all employee benefit plans (and changes
thereto) and administers our stock option plans and such other employee benefit
plans as may be adopted by us from time to time. The report of the Compensation
Committee for 2004 is presented below.
  **Nominations
and Corporate Governance**  **Committee** . The
Board of Directors has a Nominations and Corporate Governance Committee. Messrs.
McAtee, DePiano, Novak and Anderson currently serve as members of the
Nominations and Corporate Governance Committee. Mr. McAtee serves as the
Chairman of the Committee. The Board has determined that each member of this
Committee is "independent" under the revised listing standards of NASDAQ.
  The
Nominations and Corporate Governance Committee oversees our corporate governance
and Board membership matters. The Nominations and Corporate Governance Committee
is responsible for developing and overseeing the Board’s corporate governance
principles and a code of conduct applicable to members of the Board, and our
officers and employees, and for monitoring the independence of the Board. The
Nominations and Corporate Governance Committee also determines Board membership
qualifications, selects, evaluates, and recommends to the Board nominees to fill
vacancies as they arise, reviews the performance of the Board, and is
responsible for director education.
  **Audit
Committee** . The
Board of Directors has an Audit Committee. Messrs. DePiano, McAtee, Dimun
and Anderson currently serve as members of the Audit Committee, with Mr.
Anderson joining on November 10, 2004. Mr. DePiano serves as the Chairman of the
Committee. The Board has determined that each member of the Audit Committee is
an "audit committee financial expert" as defined by the Commission and is
"independent" under the revised listing standards of NASDAQ. The Audit Committee
meets the NASDAQ composition requirements, including the requirements regarding
financial literacy and financial sophistication.
  The Audit
Committee reports to the Board of Directors regarding the appointment of our
independent auditors, the scope and fees of the prospective annual audit and the
results thereof, compliance with our accounting and financial policies and
management’s procedures and policies relative to the adequacy of our system of
internal accounting controls.
  **Committee
Interlocks and Insider Participation**
 
 No
interlocking relationship exists between any member of our Board or Compensation
Committee and any member of the board of directors or compensation committee of
any other companies, nor has such interlocking relationship existed in the past.
However, Mr. DePiano, the Chief Executive Officer of Escalon Medical Corp. and
Mr. O’Donnell, our Chief Executive Officer, also have served on the board of
directors of Escalon Medical Corp. Neither of Mr. DePiano nor Mr. O'Donnell has
served on the compensation committee of the board of directors of either
PhotoMedex, Inc. or Escalon Medical Corp. Mr. O’Donnell resigned from the board
of directors of Escalon on December 28, 2004.
  61
 **Compliance
with Section 16 of the Securities Exchange Act of 1934**
 
 Section
16(a) of the Securities Exchange Act of 1934, as amended, (the "Exchange Act")
requires our directors and executive officers and beneficial holders of more
than 10% of our common stock to file with the Commission initial reports of
ownership and reports of changes in ownership of our equity securities. As of
March 15, 2005, we believe that all reports needed to be filed have been filed
for the year ended December 31, 2004. In one instance, a report evidencing a
director’s exercise of warrants was not filed within the two business days
prescribed by SEC rules.
  **Item
11.**  **Executive
Compensation**
 ****
 **Summary
Compensation Table**
 
 The
following table sets forth certain information concerning compensation of our
executive officers, including our Chief Executive Officer, Chief Financial
Officer and Executive Vice President of Corporate Operations, for the years
ended December 31, 2004, 2003 and 2002:
  **Annual
      Compensation**
    
    **Long
      Term Compensation Awards****Name**
    
    **Year**
    
    **Salary
      ($)**
    
    **Bonus ($)**
    
    **Other**
      **Annual
      Compensation ($)**
    
    **Restricted
      Stock Awards ($)**
    
    **Securities**
      **Underlying**
      **Options/**
      **SARs
      (#)**
    
    **LTIP
      Payouts ($)**
    
    **Payouts**
      **All
      other**
      **Compensation**
      **($)**Jeffrey
      F. O'Donnell (CEO)
    
    
    2004
    
    
    350,000
    
    
    150,000
    
    
    12,000
    
    
    0
    
    
    150,000
    
    
    0
    
    
    02003
    
    
    350,000
    
    
    150,000
    
    
    12,000
    
    
    0
    
    
    125,000
    
    
    0
    
    
    02002
    
    
    350,000
    
    
    100,000
    
    
    12,000
    
    
    0
    
    
    0
    
    
    0
    
    
    0Dennis
      M. McGrath
    
    
    2004
    
    
    285,000
    
    
    100,000
    
    
    12,000
    
    
    0
    
    
    125,000
    
    
    0
    
    
    02003
    
    
    285,000
    
    
    100,000
    
    
    12,000
    
    
    0
    
    
    110,000
    
    
    0
    
    
    02002
    
    
    285,000
    
    
    79,800
    
    
    12,000
    
    
    0
    
    
    0
    
    
    0
    
    
    0Michael
      R. Stewart
    
    
    2004
    
    
    235,000
    
    
    70,000
    
    
    12,000
    
    
    0
    
    
    75,000
    
    
    0
    
    
    02003
    
    
    235,000
    
    
    70,000
    
    
    12,000
    
    
    0
    
    
    75,000
    
    
    0
    
    
    02002
    
    
    1,808
    
    
    0
    
    
    0
    
    
    0
    
    
    150,000
    
    
    0
    
    
    0
  “Bonus”
in the foregoing table is the bonus earned in the period, even though it will
have been paid in a subsequent period. “Other Annual Compensation” includes a
car allowance. **** “Stock
Options” are reflected in the year in which the options were granted.
  **Employment
Agreement with Jeffrey F. O'Donnell** ***.*** In
November 1999, we entered into an employment agreement with Jeffrey F. O'Donnell
to serve as our President and Chief Executive Officer and amended and restated
that agreement in August 2002. This agreement has been renewed through December
31, 2005 and will expire then if due notice is given by December 1, 2005. If due
notice is not given, then the agreement will renew for an additional year and
thereafter on an annual basis. **** Mr.
O'Donnell's current base salary is $350,000 per year. If we terminate Mr.
O'Donnell other than for "cause" (which definition includes nonperformance of
duties or competition of the employee with our business), then he will receive
severance pay equal to $350,000, payable over 12 months. If a change of control
occurs, Mr. O’Donnell becomes entitled to severance pay by virtue of provisions
related to the change of control, then he may become entitled to severance equal
to 200% of his then base salary in a lump sum.
  62
 In
January 2004, we granted to Mr. O’Donnell options to purchase up to 150,000
shares of common stock. In January 2004, we also agreed to extend the life, by
one year, of 525,000 options granted to Mr. O’Donnell in November 1999 as part
of a block of 650,000 options, bearing an exercise price of $4.625 per
share.
  **Employment
Agreement with Dennis M. McGrath** *.* In
November 1999, we entered into an employment agreement with Dennis M. McGrath to
serve as our Chief Financial Officer and Vice President-Finance and
Administration and amended and restated that agreement in August 2002. This
agreement has been renewed through December 31, 2005 and will expire then if due
notice is given by December 1, 2005. If due notice is not given, then the
agreement will renew for an additional year and thereafter, on an annual
basis... Mr. McGrath's current base salary is $285,000 per year. **** If we
terminate Mr. McGrath other than for "cause" (which definition includes
nonperformance of duties or competition of the employee with our business), then
he will receive severance pay equal to $285,000, payable over 12 months. If a
change of control occurs, Mr. McGrath becomes entitled to severance pay by
virtue of provisions related to the change of control, then he may become
entitled to severance equal to 200% of his then base salary in a lump
sum.
  In
January 2004, we granted to Mr. McGrath options to purchase up to 125,000 shares
of common stock, respectively. In January 2004, we also agreed to extend the
life, by one year, of 350,000 options granted to Mr. McGrath in November 1999,
bearing an exercise price of $5.50 per share.
  **Employment
Agreement with Michael R. Stewart.** Effective
December 27, 2002, Michael R. Stewart became the Company’s Executive Vice
President of Corporate Operations, pursuant to an employment agreement. Mr.
Stewart’s current base salary is $235,000 per year. This agreement has renewed
through December 31, 2005 **** and will
expire then if due notice is given by December 1, 2005. If due notice is not
given, then the agreement will renew for an additional year and thereafter on an
annual basis. If we terminate Mr. Stewart other than for “cause” (which
definition includes nonperformance of duties or competition of the employee with
our business), then he will receive severance pay equal to $235,000, payable
over 12 months. If a change of control occurs, Mr. Stewart becomes entitled to
severance pay by virtue of provisions related to the change of control, then he
may become entitled to severance equal to 200% of his then base salary, payable
over 12 months.
  **Option/SAR
Grants Table**
  The
following table sets forth certain information concerning grants of stock
options to our executive officers for the year ended December 31,
2004:
  63
 **Individual
      Grants**
    
    
    
    
    
    **Potential
      Realizable Value at Assumed Annual Rate of Stock Price Appreciation**
      **For
      Option Term (1)****(a)**
    
    **(b)**
    
    **(c)**
    
    **(d)**
    
    **(e)**
    
    **(f)**
    
    **(g)****Name**
    
    **Number
      of Securities Underlying Options/SARs Granted (#)**
    
    **%
      of Total Options/SARs Granted to Employees In Fiscal
      Year**
    
    **Exercise
      Or Base Price ($/Share) (1)**
    
    **Expiration
      Date (1)**
    
    **5%
      ($)**
    
    **10%
      ($)**Jeffrey
      F. O’Donnell
    
    
    150,000
    
    
    19.33
    %
    $
    2.14
    
    
    1/22/09
    
    $
    171,280
    
    $
    271,961Dennis
      M. McGrath
    
    
    125,000
    
    
    16.11
    %
    $
    2.14
    
    
    1/22/09
    
    $
    142,733
    
    $
    226,634Michael
      R. Stewart
    
    
    75,000
    
    
    9.66
    %
    $
    2.14
    
    
    1/22/09
    
    $
    85,640
    
    $
    135,980
 **___________________**
  1.
    This
      chart assumes a market price of $2.70 for the common stock, the closing
      sale price for our common stock in the Nasdaq National Market System as of
      December 31, 2004, as the assumed market price for the common stock with
      respect to determining the "potential realizable value" of the shares of
      common stock underlying the options described in the chart, as reduced by
      any lesser exercise price for such options. Further, the chart assumes the
      annual compounding of such assumed market price over the relevant periods,
      without giving effect to commissions or other costs or expenses relating
      to potential sales of such securities. Our common stock has a limited
      trading history. These values are not intended to forecast the possible
      future appreciation, if any, price or value of the common
      stock.
  **Option
Exercises and Year-End Values**
 
 The
following table sets forth information with respect to the exercised and
unexercised options to purchase shares of common stock for our executive
officers held by them at December 31, 2004:
  **Shares**
    
    
    
    **Number
      of Securities**
    
    **Value
      of Unexercised****Acquired**
    
    **Value**
    
    **Underlying
      Unexercised**
    
    **In
      the Money Options at****Name**
    
    **On
      Exercise**
    
    **Realized(1)**
    
    **Options
      at December 31, 2004**
    
    **December
      31, 2004(2)****Exercisable**
    
    **Unexercisable**
    
    **Exercisable**
    
    **Unexercisable**Jeffrey
      F. O’Donnell
    
    
    0
    
    
    0
    
    
    775,000
    
    
    275,000
    
    $
    187,188
    
    $
    233,063Dennis
      M. McGrath
    
    
    0
    
    
    0
    
    
    585,000
    
    
    235,000
    
    $
    164,725
    
    $
    201,175Michael
      R. Stewart
    
    
    0
    
    
    0
    
    
    150,000
    
    
    150,000
    
    $
    128,250
    
    $
    106,500
 _________________
  (1)
    Represents an amount equal to the number of options
      multiplied by the difference between the closing price for the common
      stock in the Nasdaq National Market System on the date of exercise and any
      lesser exercise price.
  (2)
    Represents
      an amount equal to the number of options multiplied by the difference
      between the closing price for the common stock in the Nasdaq National
      Market System on December 31, 2004 ($2.70 per share) and any lesser
      exercise price.
  64
 **Compensation
Committee Report on Executive Compensation**
  The
Compensation Committee of the Board of Directors is composed solely of directors
who are not our current or former employees, and each is independent under the
revised listing standards of The NASDAQ Stock Market, Inc. The Board of
Directors has delegated to the Compensation Committee the responsibility to
review and approve our compensation and benefits plans, programs and policies,
including the compensation of the chief executive officer and our other
executive officers as well as middle-level management and other key employees.
The Compensation Committee administers all of our executive compensation
programs, incentive compensation plans and equity-based plans and all of our
other compensation and benefit programs.
  The
Compensation Committee intends to govern and administer compensation plans to
support the achievement of our long-term strategic objectives, to enhance
stockholder value, to attract, motivate and retain highly qualified employees by
paying them competitively and rewarding them for their own and our success, and,
to the extent consistent with these objectives, to maximize the deductibility of
compensation for tax purposes. However, the Compensation Committee may decide to
exceed the tax deductible limits established under Section 162(m) of the
Internal Revenue Code of 1986, as amended (the "Code") when such a decision
appears to be warranted based upon competitive and other factors.
  The key
components of the compensation program for executive officers are base salary
and bonus, and long-term incentives in the form of stock options. These
components are administered with the goal of providing total compensation that
is competitive in the marketplace, recognizes meaningful differences in
individual performance and offers the opportunity to earn superior rewards when
merited by individual and corporate performance.
  ***Base
Salaries*** Base
salaries for our executive officers are designed to provide a base pay
opportunity that is appropriately competitive within the marketplace. As an
officer's level of responsibility increases, a greater proportion of his or her
total compensation will be dependent upon our financial performance and stock
price appreciation rather than base salary. Adjustments to each individual’s
base salary are made in connection with annual performance reviews in addition
to the assessment of market competitiveness.
  ***Bonus*** At the
outset of a fiscal year, the Compensation Committee establishes a bonus program
for executive officers and other managers and key employees eligible to
participate in the program. The program is based on a financial plan for the
fiscal year and other business factors. The amount of bonus, if any, hinges on
corporate performance and financial condition and on the performance of the
participant in the program. A program will typically allow some partial or
discretionary awards based on an evaluation of the relevant factors. Provision
for bonus expense is typically made over the course of a fiscal year. The
provision becomes fixed based on the final review of the Committee, which is
usually made after the financial results of the fiscal year have been reviewed
by our independent accountants.
  ***Long-Term
Incentives*** **** Grants of
stock options under our stock option plans are designed to provide executive
officers and other managers and key employees with an opportunity to share,
along with stockholders, in our long-term performance. Stock option grants are
generally made annually to all executive officers, with additional grants being
made following a significant change in job responsibility, scope or title or a
significant achievement. The size of the option grant to each executive officer
is set by the Compensation Committee at a level that is intended to create a
meaningful opportunity for stock ownership based upon the individual's current
position with us, the individual's personal performance in recent periods and
his or her potential for future responsibility and promotion over the option
term. The Compensation Committee also takes into account the number of unvested
options held by the executive officer in order to maintain an appropriate level
of equity incentive for that individual. The relevant weight given to each of
these factors varies from individual to individual. Stock options granted under
the various stock option plans generally have a four-year vesting schedule
depending upon the size of the grant, and generally expire five years from the
date of grant. The exercise price of options granted under the stock option
plans is 100% of the fair market value of the underlying stock on the date of
grant. The number of stock options granted to each executive officer is
determined by the Compensation Committee based upon several factors, including
the executive officer’s salary grade, performance and the estimated value of the
stock at the time of grant, but the Compensation Committee has the flexibility
to make adjustments to those factors at its discretion.
  65
 ***CEO
Compensation*** **** For 2004,
Mr. O'Donnell's base salary and stock option grant were determined in accordance
with the criteria described above. Mr. O'Donnell earned $350,000 in base salary
compensation during 2004. He was awarded a bonus of $150,000 for
2004.
  In
January 2004, Mr. O'Donnell was granted an option to purchase 150,000 shares of
our common stock at 100% of fair market value on the date of grant, or $2.14 per
share. The grant reflects the Compensation Committee’s assessment of the
substantial contributions made by Mr. O'Donnell to the long-term growth and
performance of the Company. The Committee also extended by one year the life of
525,000 options which were granted to Mr. O’Donnell in November 1999 and which
bear an exercise price of $4.625.
  ***Tax
Deductibility Considerations*** Section
162(m) of the Code places a $1,000,000 limit on the amount of other than
performance-based compensation for the chief executive officer and each of the
other four most highly compensated executed officers that we may deduct for tax
purposes. It is the Compensation Committee's general objective to administer
compensation programs that are in compliance with the provisions of Section
162(m). The Compensation Committee has been advised that based upon prior
stockholder approval of the material terms of our stock option plans,
compensation under these plans is excluded from this limitation, provided that
the other requirements of Section 162(m) are met. However, when warranted based
upon competitive and other factors, the Compensation Committee may decide to
exceed the tax deductible limits established under Section 162(m) Code. The base
salary provided to Mr. O'Donnell in 2004 did not exceed the limits under Section
162(m) for tax deductibility, and he exercised no options in 2003 or 2004.
  **Compensation
Committee**
 
 Anthony
J. Dimun  John J.
McAtee, Jr.  Warwick Alex
Charlton  Alan R.
Novak
  **2000
Stock Option Plan**
  **General** . The
2000 Stock Option Plan was adopted by the Board of Directors on May 15, 2000,
and was approved by our stockholders on July 18, 2000. We initially reserved for
iss5ance an aggregate of 1,000,000 shares of common stock under the 2000 Stock
Option Plan. We increased this to 2,000,000 shares of common stock, pursuant to
the affirmative vote of the stockholders on June 10, 2002 and increased this
number to 3,350,000 shares of common stock, pursuant to the affirmative vote of
the stockholders on December 16, 2003, and increased this number to 4,350,000
shares of common stock pursuant to the affirmative vote of the stockholders on
March 3, 2005. The 2000 Stock Option Plan provides for the grant to our
employees of incentive stock options within the meaning of Section 422 of the
Internal Revenue Code of 1986, as amended, or the Code, and for the grant to
employees and consultants of non-statutory stock options.
  A
description of the 2000 Stock Option Plan is set forth below. The description is
intended to be a summary of the material provisions of the 2000 Stock Option
Plan and does not purport to be complete.
  The
general purposes of the 2000 Stock Option Plan are to attract and retain the
best available personnel for positions of substantial responsibility, to provide
additional incentive to our employees and consultants and to promote the success
of our business. It is intended that these purposes will be effected through the
granting of stock options, which may be either "incentive stock options" as
defined in Section 422 of the Code or “non-qualified stock
options.”
  The 2000
Stock Option Plan provides that options may be granted to our employees
(including officers and directors who are employees) and consultants, or any of
our parents or subsidiaries. Incentive stock options may be granted only to
employees. An employee or consultant who has been granted an option may, if
otherwise eligible, be granted additional options.
  **Administration
of and Eligibility under the 2000 Stock Option Plan** . The
2000 Stock Option Plan, as adopted, provides for the issuance of options to
purchase shares of common stock to our officers, directors,
 
 66
 employees,
independent contractors and consultants and those of our subsidiaries as an
incentive to remain in our employ or otherwise to provide services to us. The
2000 Stock Option Plan authorizes the issuance of incentive stock options, or
ISOs, non-qualified stock options, or NSOs, and stock appreciation rights, or
SARs, to be granted by a committee to be established by the Board of Directors,
to administer the 2000 Stock Option Plan, or if no such committee is
established, then by the Board of Directors, either of which will consist of at
least two non-employee directors, as such term is defined under Rule 16b-3 of
the Exchange Act, and shall qualify as outside directors, for purposes of
Section 162(m) of the Code. The Compensation Committee has been charged by the
Board of Directors to administer this option plan.
  Subject
to the terms and conditions of the 2000 Stock Option Plan, the Committee will
have the sole authority to: (a) determine the persons, or optionees, to whom
options to purchase shares of common stock and SARs will be granted, (b)
determine the number of options and SARs to be granted to each such optionee,
(c) determine the price to be paid for each share of common stock upon the
exercise of each option and the manner in which each option may be exercised,
(d) determine the period within which each option and SAR will be exercised and
any extensions thereof, (e) determine the type of stock options to grant, (f)
interpret the 2000 Stock Option Plan and award agreements under the 2000 Stock
Option Plan, and (g) determine the terms and conditions of each such stock
option agreement and SAR agreement which may be entered into between us and any
such optionee.
  All of
our officers, directors and employees, and those of our subsidiaries and certain
of our consultants and other persons providing significant services to us will
be eligible to receive grants of options and SARs under the 2000 Stock Option
Plan. However, only our employees are eligible to be granted ISOs.
  As of
March 15, 2005, we had 2,999,915 options outstanding under the 2000 Stock Option
Plan, and we had 1,228,762 shares of common stock available for grant under the
2000 Stock Option Plan.
  **Stock
Option Agreements** . All
options granted under the 2000 Stock Option Plan will be evidenced by an option
agreement or SAR agreement between us and the optionee receiving such option or
SAR. Provisions of such agreements entered into under the 2000 Stock Option Plan
need not be identical and may include any term or condition which is not
inconsistent with the 2000 Stock Option Plan and which the Committee deems
appropriate for inclusion.
  **Incentive
Stock Options** . Except
for ISOs granted to stockholders possessing more than ten percent (10%) of the
total combined voting power of all classes of our securities to whom such
ownership is attributed on the date of grant, or Ten Percent Stockholders, the
exercise price of each ISO must be at least 100% of the fair market value of our
common stock, based on the closing sales price of our common stock, as
determined on the date of grant. ISOs granted to Ten Percent Stockholders must
be at an exercise price of not less than 110% of such fair market
value.
  Each ISO
must be exercised, if at all, within 10 years from the date of grant or such
lesser period as the Committee may determine, but, within 5 years of the date of
grant in the case of ISO's granted to Ten Percent Stockholders.
  The
aggregate fair market value (determined as of date of grant of the ISO) of the
common stock with respect to which the ISOs are exercisable for the first time
by the optionee during any calendar year shall not exceed $100,000.
  **Non-Qualified
Stock Options** . The
exercise price of each NSO will be determined by the Committee on the date of
grant. We have undertaken not to grant any non-qualified stock options under the
2000 Stock Option Plan at an exercise price less than 85% of the fair market
value, based on the closing sales price of the common stock on the date of grant
of any non-qualified stock option under the 2000 Stock Option Plan.
  The
exercise period for each NSO will be determined by the committee at the time
such option is granted, but in no event will such exercise period exceed 10
years from the date of grant.
  67
 **Stock
Appreciation Rights** . Each
SAR granted under the 2000 Stock Option Plan will entitle the holder thereof,
upon the exercise of the SAR, to receive from us, in exchange therefore an
amount equal in value to the excess of the fair market value of the common stock
on the date of exercise of one share of common stock over its fair market value
on the date of grant (or in the case of a SAR granted in connection with an
option, the excess of the fair market of one share of common stock at the time
of exercise over the option exercise price per share under the option to which
the SAR relates), multiplied by the number of shares of common stock covered by
the SAR or the option, or portion thereof, that is surrendered.
  SARs will
be exercisable only at the time or times established by the Committee. If a SAR
is granted in connection with an option, the SAR will be exercisable only to the
extent and on the same conditions that the related option could be exercised.
The Committee may withdraw any SAR granted under the 2000 Stock Option Plan at
any time and may impose any conditions upon the exercise of a SAR or adopt rules
and regulations from time to time affecting the rights of holders of
SARs.
  **Limit
to Options Granted under the 2000 Stock Option Plan** . Under
Section 162(m) of the Code, which was enacted in 1993, the deductibility for
federal income tax purposes of compensation paid to our Chief Executive Officer
and the four other most highly compensated executive officers who receive salary
and bonus in excess of $100,000 in a particular year is limited to $1,000,000
per year per individual. For purposes of this legislation, compensation expense
attributable to stock options and SARs would be subject to this limitation
unless, among other things, the option plan under which the options and SARs is
granted includes a limit on the number of shares with respect to which awards
may be made to any one employee in a fiscal year. Such a potential compensation
expense deduction could arise, for example, upon the exercise by one of these
executives of a non-statutory option, i.e., an option that is not an incentive
stock option qualifying for favorable tax treatment, or upon a disqualifying
disposition of stock received upon exercise of an incentive stock
option.
  In order
to exclude compensation resulting from options granted under the 2000 Stock
Option Plan from the $1,000,000 limit on deductibility, the Board of Directors
has approved a provision in the 2000 Stock Option Plan which will place a
150,000 share limit on the number of options that may be granted under the 2000
Stock Option Plan to an employee in any fiscal year. This limit is subject to
appropriate adjustment in the case of stock splits, reverse stock splits and the
like. The purpose of this provision, which is intended to comply with Section
162(m) of the Code and the regulations thereunder, is to preserve our ability to
deduct in full any compensation expense related to stock options.
  **Termination
of Options and Transferability** . In
general, any unexpired options and SARs granted under the 2000 Stock Option Plan
will terminate: (a) in the event of death or disability, pursuant to the terms
of the option agreement or SAR agreement, but not less than 6 months or more
than 12 months after the applicable date of such event, (b) in the event of
retirement, pursuant to the terms of the option agreement or SAR agreement, but
not less than 30 days or more than 3 months after such retirement date, or (c)
in the event of termination of such person other than for death, disability or
retirement, until 30 days after the date of such termination. However, the
Committee may in its sole discretion accelerate or extend the exercisability of
any or all options or SARs upon termination of employment or cessation of
services.
  The
options and SARs granted under the 2000 Stock Option Plan generally will be
non-transferable, except by will or the laws of descent and distribution, except
that the Plan Committee may permit additional transfers, on a general or
specific basis, and may impose conditions and limitations on any such
transfers.
  **Adjustments
Resulting from Changes in Capitalization** . The
number of shares of common stock reserved under the 2000 Stock Option Plan and
the number and price of shares of common stock covered by each outstanding
option or SAR under the 2000 Stock Option Plan will be proportionately adjusted
by the Committee for any increase or decrease in the number of issued and
outstanding shares of common stock resulting from any stock dividends,
split-ups, consolidations, recapitalizations, reorganizations or like
events.
  **Termination
of Options and SARs on Merger, Reorganization or
Liquidation** . In the
event of our merger, consolidation or other reorganization in which we are not
the surviving or continuing corporation (as determined by the Committee) or in
the event of our liquidation or dissolution, all options and SARs granted under
the 2000 Stock Option Plan will terminate on the effective date of the merger,
consolidation, reorganization,
 
 68
 liquidation
or dissolution, unless there is an agreement with respect to such transition
which expressly provides for the assumption of such options and SARs by the
continuing or surviving corporation.
  **Amendment
or Discontinuance of Stock Option Plan** . The
Board of Directors has the right to amend, suspend or terminate the 2000 Stock
Option Plan at any time. Unless sooner terminated by the Board of Directors, the
2000 Stock Option Plan will terminate on May 14, 2010, the 10th anniversary date
of the effectiveness of the 2000 Stock Option Plan.
  **2000
Non-Employee Director Stock Option Plan**
  **General** . The
2000 Non-Employee Director Stock Option Plan, or the Non-Employee Director Plan,
was adopted by the Board of Directors on May 15, 2000, to be effective as of
June 1, 2000, and was approved by our stockholders on July 18, 2000. We
initially reserved for issuance an aggregate of 250,000 shares of common stock
under the Non-Employee Direct Plan. We increased this to 650,000 shares of
common stock, pursuant to the affirmative vote of the stockholders on June 10,
2002 and increased this number to 1,000,000 shares of common stock, pursuant to
the affirmative vote of the stockholders on December 16, 2003.
  A
description of the Non-Employee Director Plan is set forth below. The
description is intended to be a summary of the material provisions of the
Non-Employee Director Plan and does not purport to be complete.
  **Purpose
of the Plan** . The
purposes of the Non-Employee Director Plan are to enable us to attract, retain,
and motivate our non-employee directors and to create a long-term mutuality of
interest between the non-employee directors and our stockholders by granting
options to purchase common stock.
  **Administration** . The
Non-Employee Director Plan will be administered by a committee of the Board of
Directors, appointed from time to time by the Board of Directors. The
Nominations and Corporate Governance Committee has been charged with this task.
The Committee has full authority to interpret the Non-Employee Director Plan and
decide any questions under the Non-Employee Director Plan and to make such rules
and regulations and establish such processes for administration of the
Non-Employee Director Plan as it deems appropriate subject to the provisions of
the Non-Employee Director Plan.
  **Available
Shares** . The
Non-Employee Director Plan authorizes the issuance of up to 1,000,000 shares of
common stock upon the exercise of non-qualified stock options granted to our
non-employee directors. In general, if options are for any reason canceled, or
expire or terminate unexercised, the shares covered by such options will again
be available for the grant of options.
  The
Non-Employee Director Plan provides that appropriate adjustments will be made in
the number and kind of securities receivable upon the exercise of options in the
event of a stock split, stock dividend, merger, consolidation or
reorganization.
  **Eligibility** . All of
our non-employee directors are eligible to be granted options under the
Non-Employee Director Plan. A non-employee director is a director serving on the
Board of Directors who is not then one of our current employees, as defined in
Sections 424(e) and 424(f) of the Code.
  **Grant
of Options** . As of
each January 1 following the effective date of the Non-Employee Director Plan,
commencing January 1, 2001, or the Initial Grant Date, each non-employee
director was automatically granted an option to purchase 20,000 shares of common
stock in respect of services to be rendered to us as a director during the
forthcoming calendar year, subject to the terms of the Non-Employee Director
Plan. Each non-employee director who was first elected to the Board of Directors
after June 1, 2000, but prior to January 1, 2001, was granted, as of the date of
his election, or First Grant Date, an option to purchase that number of shares
equal to the product of (i) 5,000 and (ii) the number of fiscal quarters
remaining in our then current fiscal year (including the quarter in which the
date of such director's election falls), subject to the terms of the
Non-Employee Director Plan. As of January 1, 2002 or the First Grant Date, as
the case may be, each non-employee director was automatically granted an option
to purchase 20,000 shares of common stock, or the Annual Grant. Commencing
January 1, 2003, the annual grant was to be a nonqualified stock option of
35,000 shares of common stock, pursuant to the approval of the stockholders on
 
 69
 June 10,
2002. In other respects, the Plan will operate as before January 1, 2003. As of
March 15, 2005, we have granted 711,250 options to our eligible directors under
the Non-Employee Director Plan. We have 233,750 shares available for grant under
option under the plan as of the date of this Report.
  The
purchase price per share deliverable upon the exercise of an option will be 100%
of the fair market value of such shares as follows:
  (i)  For
options issued on the Initial Grant Date, the fair market value will be measured
by the closing sales price of the common stock as of the last trading date of
the fiscal quarter prior to the Initial Grant Date;
  (ii)  For
options issued on the First Grant Date, the fair market value will be measured
by the closing sales price of the common stock as of the First Grant Date;
and
  (iii)  For
grants of options issued as of January 1 of any fiscal year, the fair market
value will be measured by the closing sales price of the common stock as of the
last trading date of the prior year.
  **Vesting
of Options** . Options
granted under the Non-Employee Director Plan will vest and become exercisable to
the extent of 5,000 shares for each fiscal quarter prior to fiscal 2003, in
which such director shall have served at least one day as our director and 8,750
shares for each quarter in fiscal 2003 and beyond.
  Options
that are exercisable upon a non-employee director's termination of directorship
for any reason excluding termination for cause or in the event of a
reorganization (both as described below) prior to the complete exercise of an
option (or deemed exercise thereof), will remain exercisable following such
termination for the remaining term of the option.
  Upon a
non-employee director's removal from the Board of Directors for cause or failure
to be re-nominated for cause, or if we obtain or discover information after
termination of directorship that such non-employee director had engaged in
conduct during such directorship that would have justified a removal for cause
during such directorship, all outstanding options of such non-employee director
will immediately terminate and will be null and void.
  The 2000
Non-Employee Director Plan also provides that all outstanding options will
terminate effective upon the consummation of a merger, liquidation or
dissolution, or consolidation in which we are not the surviving entity, subject
to the right of non-employee director to exercise all outstanding options prior
to the effective date of the merger, liquidation, dissolution or
consolidation.
  All
options granted to a non-employee director and not previously exercisable become
vested and fully exercisable immediately upon the occurrence of a change in
control (as defined in the 2000 Non-Employee Director Plan) **.**
  **Amendments** . The
Non-Employee Director Plan provides that it may be amended by the Committee or
the Board of Directors at any time, and from time to time to effect (i)
amendments necessary or desirable in order that the Non-Employee Director Plan
and the options granted thereunder conform to all applicable laws, and (ii) any
other amendments deemed appropriate. Notwithstanding the foregoing, to the
extent required by law, no amendment may be made that would require the approval
of our stockholders under applicable law or under any regulation of a principal
national securities exchange or automated quotation system sponsored by the
National Association of Securities Dealers unless such approval is obtained. The
Non-Employee Director Plan may be amended or terminated at any time by our
stockholders.
  **Miscellaneous** .
Non-employee directors may be limited under Section 16(b) of the Exchange Act to
certain specific exercise, election or holding periods with respect to the
options granted to them under the Non-Employee Director Plan. Options granted
under the Non-Employee Director Plan are subject to restrictions on transfer and
exercise. No option granted under the Non-Employee Director Plan may be
exercised prior to the time period for exercisability, subject to acceleration
in the event of our change in control (as defined in the Non-Employee Director
Plan). Although options will generally be nontransferable (except by will or the
laws of descent and distribution), the Committee may determine at the time of
grant or thereafter that an option that is otherwise
 
 70
 nontransferable
is transferable in whole or in part and in such circumstances, and under such
conditions, as specified by the committee.
  **1995
Non-Qualified Option Plan**
  On
January 2, 1996, we adopted our 1995 Non-Qualified Option Plan for key
employees, officers, directors and consultants, and reserved up to 500,000
options to be granted thereunder. The option exercise price is not less than
100% of market value on the date granted; 40% of granted options vest
immediately; 30% vest beginning one year after grant; and the remaining 30% vest
and may be exercised beginning two years from grant.
  No
options may be exercised more than 10 years after grant, options are not
transferable (other than at death), and in the event of complete termination for
cause (other than death or disability) or voluntary termination, all unvested
options automatically terminate. Options are no longer granted out of this Plan
and as of March 15, 2005 49,000 options remain outstanding under this plan,
which is otherwise inactive.
  **Other
Non-Employee Director Stock Option Plan**
  On April
10, 1998, our Board of Directors adopted a resolution creating a stock option
plan for outside/non-employee members of the Board of Directors. Pursuant to the
stock plan, each outside/non-employee director is to receive an annual grant of
options, in addition to any other consideration he or she may receive, to
purchase up to 20,000 shares of common stock as compensation, at an exercise
price equal to the market price of the common stock on the last trading day of
the preceding year. The options granted pursuant to this plan vest at the rate
of 5,000 options per quarter during each quarter in which such person has served
as a member of the Board of Directors. Since we have adopted the 2000
Non-Employee Director Stock Option Plan, we no longer grant options to members
of our Board of Directors under this plan, and as of March 15, 2005, 15,000
options remain outstanding under this plan, which is otherwise
inactive.
  **Other
Stock Options**
  As of
March 15, 2005, we had granted outstanding and unexpired options to purchase up
to 2,614,397 shares of common stock to certain of our employees, directors and
consultants outside of a formal plan, of which 1,435,397 had been exercised and
1,179,000 remained unexercised. There were no grants of options outside of a
formal plan in 2004.
  **Limitation
on Directors' Liabilities; Indemnification of Officers and
Directors**
  Our
Certificate of Incorporation and Bylaws designate the relative duties and
responsibilities of our officers, establish procedures for actions by directors
and stockholders and other items. Our Certificate of Incorporation and Bylaws
also contain extensive indemnification provisions, which will permit us to
indemnify our officers and directors to the maximum extent, provided by Delaware
law. Pursuant to our Certificate of Incorporation and under Delaware law, our
directors are not liable to us or our stockholders for monetary damages for
breach of fiduciary duty, except for liability in connection with a breach of
duty of loyalty, for acts or omissions not in good faith or which involve
intentional misconduct or a knowing violation of law, for dividend payments or
stock repurchases illegal under Delaware law or any transaction in which a
director has derived an improper personal benefit.
  We have
adopted a form of indemnification agreement, which provides the indemnitee with
the maximum indemnification allowed under applicable law. Since the Delaware
statutes are non-exclusive, it is possible that certain claims beyond the scope
of the statute may be indemnifiable. The indemnification agreement provides a
scheme of indemnification, which may be broader than that specifically provided
by Delaware law. It has not yet been determined, however, to what extent the
indemnification expressly permitted by Delaware law may be expanded, and
therefore the scope of indemnification provided by the indemnification agreement
may be subject to future judicial interpretation.
  71
 The
indemnification agreement provides that we are to indemnify an indemnitee, who
is or was a party or becomes a party or is threatened to be made a party to any
threatened, pending or completed action or proceeding whether civil, criminal,
administrative or investigative by reason of the fact that the indemnitee is or
was one of our directors, officers, key employees or agents. We are to advance
all expenses, judgments, fines, penalties and amounts paid in settlement
(including taxes imposed on indemnitee on account of receipt of such payouts)
incurred by the indemnitee in connection with the investigation, defense,
settlement or appeal of any civil or criminal action or proceeding as described
above. The indemnitee is to repay such amounts advanced only if it shall be
ultimately determined that he or she is not entitled to be indemnified by us.
The advances paid to the indemnitee by us are to be delivered within 20 days
following a written request by the indemnitee. Any award of indemnification to
an indemnitee, if not covered by insurance, would come directly from our assets,
thereby affecting a stockholder's investment.
  At
present, there is no pending litigation or proceeding involving an indemnitee
where indemnification would be required or permitted under the indemnification
agreements, except as follows: In the action brought by RA Medical Systems and
Dean Stewart Irwin for malicious prosecution, Jeffrey Levatter, Ph.D., our Chief
Technology Officer, has been named as a defendant. The Board of Directors has
determined that we will indemnify Dr. Levatter under the applicable provisions
of the Bylaws.
  **Termination
of Employment and Change of Control Agreements**
  We have
employment agreements with Messrs. O'Donnell, McGrath and Stewart. These
agreements provide for severance upon termination of employment, whether in
context of a change of control or not. We also have arrangements with other key
employees under which we would be obliged to pay compensation upon their
termination outside a context of change of control, and, for a lesser number of
key employees, by virtue of a change of control. If all such executive officers
and key employees were terminated other than for cause and not within a change
of control, we would have had an aggregate commitment of approximately
$1,406,000 at December 31, 2004 for severance and related compensation. However,
the obligation for such compensation that would arise in favor of the executive
officers and certain key employees by virtue of a change of control would have
been approximately $1,992,000 at December 31, 2004.
  **Directors'
and Officers' Liability Insurance**
  We have
obtained directors' and officers' liability insurance which expires on February
24, 2006.
  72
 **Item
12.**  **Security
Ownership of Certain Beneficial Owners and
Management**
  The
following table reflects, as of March 15, 2005, the beneficial common stock
ownership of: (a) each of our directors, (b) each executive officer (See Item
11, "Executive Compensation"), (c) each person known by us to be a beneficial
holder of five percent (5%) or more of our common stock, and (d) all of our
executive officers and directors as a group:
  **Name
      and Address Of Beneficial Owner****(1)**
    
    **Number
      of Shares Beneficially Owned**
    
    **Percentage
      of Shares Beneficially Owned****(1)**Richard
      J. DePiano(2)
    
    
    165,550
    
    
    *Jeffrey
      F. O’Donnell(3)
    
    
    853,563
    
    
    2.08Dennis
      M. McGrath(4)
    
    
    654,625
    
    
    1.60Michael
      R. Stewart(5)
    
    
    188,940
    
    
    *Alan
      R. Novak(6)
    
    
    147,351
    
    
    *John
      J. McAtee, Jr.(7)
    
    
    463,750
    
    
    1.15David
      Anderson(8)
    
    
    26,250
    
    
    *Warwick
      Alex Charlton(9)
    
    
    288,750
    
    
    *Anthony
      J. Dimun(10)
    
    
    97,500
    
    
    *Cooper
      Hill Reporting Persons(11)
    
    
    2,050,883
    
    
    5.05Corsair
      Reporting Persons(12)
    
    
    3,215,166
    
    
    7.86JLF
      Reporting Persons(13)
    
    
    2,733,498
    
    
    6.81Valor
      Capital Management, L. P.(14)
    
    
    3,142,512
    
    
    7.82Joseph
      Gallo(15)
    
    
    2,069,943
    
    
    5.15All
      directors and officers as a group (9 persons)(16)
    
    
    2,860,029
    
    
    6.75
 ___________
  *  Less than
1%.
  (1)
    Beneficial
      ownership is determined in accordance with the rules of the SEC. Shares of
      common stock subject to options or warrants currently exercisable or
      exercisable within 60 days of March 15, 2005, are deemed outstanding for
      computing the percentage ownership of the stockholder holding the options
      or warrants, but are not deemed outstanding for computing the percentage
      ownership of any other stockholder. Unless otherwise indicated in the
      footnotes to this table, we believe stockholders named in the table have
      sole voting and sole investment power with respect to the shares set forth
      opposite such stockholder's name. Unless otherwise indicated, the
      officers, directors and stockholders can be reached at our principal
      offices. Percentage of ownership is based on 40,168,549 shares of common
      stock outstanding as of March 15, 2005.
  (2)
    Includes
      31,800 shares and options to purchase up to 133,750 shares of common
      stock. Does not include options to purchase up to 26,250 shares of common
      stock, which may vest more than 60 days after March 15, 2005. Mr.
      DePiano's address is 351 East Conestoga Road, Wayne, Pennsylvania
      19087.
  (3)
    Includes
      2,000 shares and options to purchase up to 851,563 shares of common stock.
      Does not include options to purchase up to 348,438 shares of common stock,
      which may vest more than 60 days after March 15, 2005.
  (4)
    Includes
      4,000 shares and options to purchase up to 654,625 shares of common stock.
      Does not include options to purchase up to 294,375 shares of common stock,
      which may vest more than 60 days after March 15,
2005.
  (5)
    Includes
      1,440 shares and options to purchase 187,500 shares of common stock. Does
      not include options to purchase up to 187,500 shares of common stock,
      which may vest more than 60 days after March 15,
2005.
  73
 (6)
    Includes
      28,601 shares of common stock and options to purchase up to 118,750 shares
      of common stock. Does not include options to purchase up to 26,250 shares
      of common stock, which may vest more than 60 days after March 15, 2005.
      Mr. Novak's address is 3050 K Street, NW, Suite 105, Washington, D.C.
      20007.
  (7)
    Includes
      345,000 shares and options to purchase up to 118,750 shares of common
      stock. Does not include options to purchase up to 26,250 shares of common
      stock, which may vest more than 60 days after March 15, 2005. Mr. McAtee's
      address is 209 Banyan Road, Palm Beach, Florida
33480.
  (8)
    Includes
      26,250 shares of common stock. Does not include options to purchase up to
      26,250 shares of common stock, which may vest more than 60 days after
      March 15, 2005. Mr. Anderson's address is 147 Keystone Drive,
      Montgomeryville, PA 18936.
  (9)
    Includes
      170,000 shares of common stock owned by True North Partners, L.L.C., of
      which Mr. Charlton may be deemed to be an affiliate, and options to
      purchase 118,750 shares of common stock. Does not include options to
      purchase up to 26,250 shares of common stock, which may vest more than 60
      days after March 15, 2005. Mr. Charlton's address is 444 Madison
      Avenue, Suite 605, New York, New York
10022.
  (10)
    Includes
      45,000 shares of common stock owned by Mr. Dimun and his wife and options
      to purchase up to 52,500 shares of common stock. Does not include options
      to purchase up to 26,250 shares of common stock, which may vest more than
      60 days after March 15, 2005. Mr. Dimun’s address is 46 Parsonage Hill
      Road, Short Hills, New Jersey 07078.
  (11)
    Includes
      1,609,706 shares of common stock and warrants to purchase up to 441,177
      shares. Certain of these shares are held in various denominations by CLSP,
      L.P., CLSP II, L.P., CLSP/SBS I, L.P. and CLSP/SBS II, L.P. (the "CLSP
      Partnerships"), each of which are private investment partnerships, the
      sole general partner of which is Cooper Hill Partners, LLC ("Cooper Hill
      LLC"). As the sole general partner of the CLSP Partnerships, Cooper Hill
      LLC has the power to vote and/or dispose of those shares of common stock
      held by each of the CLSP Partnerships and, accordingly, may be deemed to
      be the beneficial owner of such shares. Pursuant to an investment advisory
      contract, Cooper Hill Partners, L.P. ("Cooper Hill LP") has the power to
      vote and/or dispose of additional shares of common stock held for the
      account of CLSP Overseas, Ltd. ("CLSP Ltd.") and, accordingly, may be
      deemed to be the beneficial owner of such additional shares. Jeffrey
      Casdin ("Casdin," and collectively with the CLSP Partnerships, Cooper Hill
      LLC and Cooper Hill LP, the "Cooper Hill Reporting Persons") is the
      managing member of Cooper Hill LLC and Casdin Capital, LLC, the managing
      member of Cooper Hill LP. Neither the use of the term "Cooper Hill
      Reporting Persons" nor the aggregation of ownership interests by the
      Cooper Hill Reporting Persons, as described herein, necessarily implies
      the existence of a group for purposes of Section 13(d)(3) of the Exchange
      Act or any other purpose. The foregoing information has been derived from
      a Schedule 13G/A filed on behalf of the Cooper Hill Reporting Persons, on
      February 14, 2005.
  (12)
    Includes
      2,954,872 shares of common stock and warrants to purchase up to 260,294
      shares. Certain of the shares are held in various denominations by Corsair
      Capital Partners, L.P., a Delaware limited partnership ("Corsair Capital
      Partners"), Corsair Long Short International, Ltd., a Cayman Islands
      exempted company ("Corsair International"), Corsair Select, L.P., a
      Delaware limited partnership ("Corsair Select"), Corsair Capital Partners
      100, L.P., a Delaware limited partnership ("Corsair 100"), Corsair Capital
      Investors, Ltd., a Cayman Islands exempted company ("Corsair Investors",
      and together with Corsair Capital Partners, Corsair International, Corsair
      Select and Corsair 100, the "Corsair Entities"), each of which are private
      investment funds. Corsair Capital Management, L.L.C. ("Corsair Capital
      Management") is the investment manager of each of the Corsair Entities,
      and also is the manager of certain other separately managed accounts which
      hold additional shares. As the investment manager of the Corsair Entities,
      and the manager of such other separate accounts, Corsair Capital
      Management has the power to vote and/or dispose of those shares of common
      stock held by such persons and accordingly, may be deemed to be the
      beneficial owner of such shares. Jay R. Petschek ("Petschek") and Steven
      Major ("Major," and together with the Corsair Entities, Corsair Capital
      Management and Petschek, the "Corsair Reporting Persons") are the
      controlling principals of Corsair Capital Management. Mr. Major
      beneficially owns or manages in separate accounts certain of these shares
      of common stock. Accordingly, the Corsair Reporting Persons may
      collectively be deemed to be the beneficial owners of 2,103,013 shares of
      common stock, including 1,842,719 shares of common stock and warrants to
      purchase up to 260,294 shares. Neither the use of the terms "Corsair
      Entities" or "Corsair Reporting Persons" nor the aggregation of ownership
      interests by the Corsair Reporting Persons, as described herein,
      necessarily implies the existence of a group forpurposes
      of Section 13(d)(3) of the Exchange Act or any other purpose. The
      foregoing information has been derived from a Schedule 13G filed on behalf
      of certain of the Corsair Reporting Persons, on February 15, 2005.
  74
 (13)
    Includes
      2,733,498 shares. The shares are held in various denominations by: (i) a
      separately managed account managed by Jeffrey L. Feinberg, and (ii) JLF
      Partners I, L.P., JLF Partners II, L.P., and JLF Offshore Fund, Ltd., to
      which JLF Asset Management, L.L.C. serves as the management company and/or
      investment manager. Jeffrey L. Feinberg is the managing member of JLF
      Asset Management, L.L.C. Collectively, these are the "JLF Reporting
      Persons." As the investment manager of such accounts and funds, JLF Asset
      Management, L.L.C. has the power to vote and/or dispose of those shares of
      common stock held by such persons and accordingly, may be deemed to be the
      beneficial owner of such shares. Neither the use of the term "JLF
      Reporting Persons" nor the aggregation of ownership interests by the JLF
      Reporting Persons, as described herein, necessarily implies the existence
      of a group for purposes of Section 13(d)(3) of the Exchange Act or any
      other purpose. The foregoing information has been derived from a Schedule
      13G/A filed on behalf of the JLF Reporting Persons, on February 4,
      2005.
  (14)
    Valor
      Capital Management L.P. ("Valor Capital") is an investment vehicle formed
      for the purpose of investing and trading in a wide variety of securities
      and financial instruments. Kratky Management, LLC is the general partner
      and control person of Valor Capital. John M. Kratky III is the managing
      member and control person of Kratky Management, LLC. The foregoing
      information has been derived from a Schedule 13G filed on behalf of Valor
      Capital, on October 1, 2004.
  (15)
    Joseph
      E. Gallo has sole voting and dispositive powers over 2,069,943 shares of
      common stock held in the name of certain trusts, of which he serves as
      trustee.The
      foregoing information has been derived from a Schedule 13G filed on behalf
      of Mr. Gallo on December 10, 2004.
  (16)
    Includes
      627,841
      shares and options to purchase 2,232,188 shares of common stock. Does not
      include options to purchase up to 961,562 shares of common stock, which
      may vest more than 60 days after March 15,
2005.
  **Item
13.**  **Certain
Relationships and Related Transactions**
  In the
year ended December 31, 2002, we engaged True North Partners, LLC, or True
North Partners, to perform marketing consulting services for us, and we also
engaged True North Capital Ltd., or True North Capital, to perform financial
consulting services for us. In the year ended December 31, 2003, we incurred
charges of $18,128 and $20,000 for the marketing and financial services from
True North Partners and True North Capital, respectively. We are advised that
the aggregate fees paid to True North Partners and True North Capital in the
year December 31, 2003 constituted less than 5% of the consolidated revenues of
each of True North Partners and True North Capital during the same period. We
did not pay any fees to True North Partners or True North Capital in 2004. True
North Capital is a fund management group which provides management and
acquisition advisory services with a specialty in the healthcare industry, and
True North Partners is a consulting group which has served as the fund advisor
for True North Capital. We are advised that True North Partners and True North
Capital have common equity ownership, but separate management groups and
operations.
  We
entered into an agreement with True North Capital (the "TNC Agreement"), dated
as of October 28, 2003, pursuant to which True North Capital agreed to assist us
in identifying and evaluating proposed strategic growth transactions relating to
the healthcare industry and under that agreement TNC North Capital could earn a
“success fee.” In 2003, we paid True North Capital a one-time $20,000 expense
reimbursement for the deployment of its personnel and resources in the
fulfillment of the goals set forth in the TNC Agreement. In May 2004, the TNC
Agreement was modified to provide that any success fee under the agreement would
be divided equally between True North Capital and True North Partners. However,
we canceled the TNC Agreement in October 2004 in accordance with the terms of
the agreement. No success fee was earned or paid under the TNC Agreement. We
have no plans to enter such an agreement in the future with True North Capital
or True North Partners.
  During
the relevant periods from 2002 through 2004, one of our directors, Warwick Alex
Charlton, was a senior member of the executive management staff of True North
Partners and also of True North Capital until November 10, 2003. Mr. Charlton
also held approximately 20.3% equity interests in each of True North Partners
and True North Capital. During the relevant periods from 2002 through 2004,
another of our directors, John J.
 
 75
 McAtee,
Jr., held equity interests of less than 1.0% in each of True North Partners and
True North Capital. Mr. McAtee resigned from the Investment Advisory Board of
True North Capital on April 14, 2003.
  As of
March 15, 2005, Messrs. Michael R. Matthias and Jeffrey P. Berg, shareholders in
Jenkens & Gilchrist, LLP, our outside counsel, held in the aggregate hold
43,563 shares of our common stock. Messrs. Matthias and Berg acquired such
shares through the exercise of stock options which they accepted from us in
exchange for legal services performed from July 1998 to May 2000.
  We
believe that all transactions with our affiliates have been entered into on
terms no less favorable to us than could have been obtained from independent
third parties. We intend that any transactions with officers, directors and 5%
or greater stockholders will be on terms no less favorable to us than could be
obtained from independent third parties and will be approved by a majority of
our independent, disinterested directors and will comply with the Sarbanes Oxley
Act and other securities laws and regulations.
  **Item
14.**  **Principal
Accountant Fees and Services**
  ***Audit
Fees*** *.* The
aggregate fees billed to us in 2004 by the independent auditors, Amper,
Politziner & Mattia, P.C., for professional services rendered in connection
with our Quarterly Reports on Form 10-Q for the quarters ended June 30, 2004 and
September 30, 2004 and for the audits of our financial statements and internal
controls included in this Annual Report on Form 10-K for 2004 , totaled
approximately $201,000. The aggregate fees billed to us in 2004 by the
independent auditors, KPMG LLP, or KPMG, for professional services rendered in
connection with the review of our Quarterly Report on Form 10-Q for the first
quarter ended March 31, 2004, totaled approximately $23,000.
  We
incurred the following fees to KPMG for services rendered for the year ended
December 31, 2003: a total of (i) $79,000 incurred in fiscal 2003 for the audit
of our financial statements for fiscal 2003 and the reviews of the financial
statements included in each of our Quarterly Reports on Form 10-Q for the year
ended December 31,2003, and (ii) approximately as additional $122,000 incurred
in fiscal 2004 to complete the audit and review work for the year ended December
31, 2003.
  ***Audit-Related
Fees.*** ** The
aggregate fees billed to us by KPMG for assurance and related services that are
reasonably related to the performance of the audit and review of our financial
statements that are not already reported in the paragraph immediately above
totaled approximately $74,000 and $15,000 for 2004 and 2003, respectively. These
costs primarily related to services provided in connection with the filing of
registration statements.
  ***All
Other Fees.*** ** The
aggregate fees billed to us by Amper, Politziner & Mattia for products and
services rendered by Amper, Politziner & Mattia for tax consulting were
negligible for 2004 and zero for 2003. The aggregate fees billed to us by KPMG
for products and services rendered by KPMG for tax consulting were negligible
for 2004 and 2003.
  ***Engagement
of the Independent Auditor*** *.* The
Audit Committee is responsible for approving every engagement of Amper,
Politziner & Mattia to perform audit or non-audit services for us before
Amper, Politziner & Mattia is engaged to provide those services. The Audit
Committee’s pre-approval policy provides as follows:
  ·
    First,
      once a year when the base audit engagement is reviewed and approved,
      management will identify all other services (including fee ranges) for
      which management knows it will engage Amper, Politziner & Mattia for
      the next 12 months. Those services typically include quarterly reviews,
      specified tax matters, certifications to the lenders as required by
      financing documents, consultation on new accounting and disclosure
      standards and, in future years, reporting on management’s internal
      controls assessment.
  ·
    Second,
      if any new “unlisted” proposed engagement arises during the year, the
      engagement will require approval of the Audit
Committee.
  76
 ***Auditor
Selection for Fiscal 2005.*** Amper,
Politziner & Mattia **** has been
selected to serve as our independent auditors for the year ending December 31,
2005, subject to conclusion of an engagement letter.
 
 **PART
IV**
 
 **Item
15**  **Exhibits**
  (a)(1) Financial
Statements
  Consolidated
balance sheet of PhotoMedex, Inc. and subsidiaries as of December 31, 2004 and
2003, and the related consolidated statements of operations, stockholders'
equity, and cash flows for each of the years in the 3-year period ended December
31, 2004.
 
 (a)(2)  
Financial Statement Schedules
 
 All
schedules have been omitted because they are not required, not applicable, or
the information is otherwise set forth in the consolidated financial statements
or notes thereto.
  (a)(3) Other
Exhibits
  2.1
    
    Agreement
      and Plan of Merger, dated September 25, 2002, between PhotoMedex, Inc., J
      Merger Corp., Inc. and Surgical Laser Technologies, Inc.
    (1)2.2
    
    Agreement
      and Plan of Merger, dated December 1, 2004, between PhotoMedex, Inc., Gold
      Acquisition Merger Corp. and ProCyte Corporation (2)3.1(a)
    
    Certificate
      of Incorporation, filed on November 3, 1987 (3)3.1(b)
    
    Amendment
      to Certificate of Incorporation, filed on July 19, 1999
  (3)3.1(c)
    
    Amendment
      to Certificate of Incorporation, filed on July 22, 1999
  (3)3.1(d)
    
    Restated
      Certificate of Incorporation, filed on August 8, 2000
  (4)3.1(e)
    
    Amendment
      to Restated Certificate of Incorporation, filed on January 6, 2004.
      (11)3.2
    
    Amended
      and Restated Bylaws (5)10.1
    
    Lease
      Agreement (Carlsbad, California) dated August 4, 1998
    (3)10.2
    
    Patent
      License Agreement between the Company and Patlex Corporation
      (6)10.3
    
    Clinical
      Trial Agreement between Massachusetts General Hospital, R. Rox Anderson
      and the Company, dated March 17, 1998 (3)10.4
    
    Consulting
      Agreement dated as of January 21, 1998 between the Company and R. Rox
      Anderson, M.D. (3)10.5
    
    Amended
      and Restated Employment Agreement with Jeffrey F. O'Donnell, dated August
      1, 2002 (1)10.6
    
    Amended
      and Restated Employment Agreement with Dennis M. McGrath, dated August 1,
      2002 (1)
  77
 10.7
    
    Lease
      between the Company and Radnor Center Associates, dated April 1, 2000
      (3)10.8
    
    Healthworld
      Agreement, dated May 11, 1999 (3)10.9
    
    Clinical
      Trial Agreement, dated July 27, 1999 (Scalp Psoriasis)
      (3)10.10
    
    Clinical
      Trial Agreement, dated July 27, 1999, and Amendment dated
      March 1, 2000(Plaque
      Psoriasis) (3)10.11
    
    Clinical
      Trial Agreement, dated July 27, 1999 (High Fluence)
    (3)10.12
    
    Clinical
      Trial Agreement, dated November 15, 1999 (Vitiligo)
    (3)10.13
    
    Massachusetts
      General Hospital License Agreement, dated November 26, 1997
      (3)10.14
    
    Asset
      Purchase Agreement with Laser Components GmbH, dated February 29,
      2000 (3)10.15
    
    Amended
      and Restated 2000 Stock Option Plan (1)10.16
    
    Amended
      and Restated 2000 Non-Employee Director Stock Option Plan
    (1)10.17
    
    Revolving
      Loan Agreement, dated May 31, 2000, between Surgical Laser Technologies,
      Inc. and AmSouth Bank (7)10.18
    
    First
      Amendment to Revolving Loan Agreement, dated February 20, 2002, between
      Surgical Laser Technologies, Inc. and AmSouth Bank (7)10.19
    
    Second
      Amendment to Revolving Loan Agreement, dated June 26, 2002, between
      Surgical Laser Technologies, Inc. and AmSouth Bank (7)10.20
    
    Third
      Amendment to Revolving Loan Agreement, dated February 27, 2003, between
      Surgical Laser Technologies, Inc. and AmSouth Bank (7)10.21
    
    Fourth
      Amendment to Revolving Loan Agreement, dated February 27, 2003, between
      Surgical Laser Technologies, Inc. and AmSouth Bank (7)10.22
    
    Fifth
      Amendment to Revolving Loan Agreement, dated February 27, 2003, between
      Surgical Laser Technologies, Inc. and AmSouth Bank (7)10.23
    
    Sixth
      Amendment to Revolving Loan Agreement, dated February 27, 2003, between
      Surgical Laser Technologies, Inc. and AmSouth Bank (7)10.24
    
    Note
      for Business and Commercial Loans, dated March 26, 2003, made by Surgical
      Laser Technologies, Inc. in favor of AmSouth Bank (7)10.25
    
    Addendum
      to Note for Business and Commercial Loans LIBOR rate, dated March 26,
      2003, made by Surgical Laser Technologies, Inc. in favor of AmSouth Bank
      (7)10.26
    
    Security
      Agreement (Accounts, Inventory and General Intangibles), dated May 31,
      2000, granted by Surgical Laser Technologies, Inc. to AmSouth Bank
      (7)10.27
    
    Security
      Agreement for Tangible Personal Property, dated May 31, 2000, granted by
      Surgical Laser Technologies, Inc. to AmSouth Bank (7)10.28
    
    Limited
      Security Agreement (Alabama), dated May 31, 2000, granted by Surgical
      Laser Technologies, Inc. to AmSouth Bank (7)10.29
    
    Letter
      of waiver from AmSouth Bank, dated February 27, 2003
(6)10.30
    
    Continuing
      Guaranty Agreement, dated March 26, 2003, by PhotoMedex, Inc. in favor of
      AmSouth Bank (7)10.31
    
    Lease
      Agreement dated May 29, 1996, between Surgical Laser Technologies, Inc.
      and Nappen & Associates (Montgomeryville, Pennsylvania)
      (7)10.32
    
    Lease
      Renewal Agreement, dated January 18, 2001, between Surgical Laser
      Technologies, Inc. and Nappen & Associates (7)10.33
    
    License
      and Development Agreement, dated May 22, 2002, between Surgical Laser
      Technologies, Inc. and Reliant Technologies, Inc. (7)10.34
    
    Secured
      Promissory Note, dated May 22, 2002, between Surgical Laser Technologies,
      Inc. and Reliant Technologies, Inc. (7)10.35
    
    Security
      Agreement, dated May 22, 2002, between Surgical Laser Technologies, Inc.
      and Reliant Technologies, Inc. (7)10.36
    
    Agreement
      as to Collateral, dated May 22, 2002, among Surgical Laser Technologies,
      Inc., Reliant Technologies, Inc. and AmSouth Bank (7)10.37
    
    Employment
      Agreement of Michael R. Stewart, dated December 27, 2002
    (7)10.38
    
    Seventh
      Amendment to Revolving Loan Agreement and related agreements, dated March
      10, 2004, among Surgical Laser Technologies, Inc., PhotoMedex, Inc and
      AmSouth Bank (11)10.39
    
    Note
      for Business and Commercial Loans, dated May 13, 2003, made by Surgical
      Laser Technologies, Inc. in favor of AmSouth Bank (8)10.40
    
    Addendum
      to Note for Business and Commercial Loans, LIBOR rate, dated May 13, 2003,
      made by Surgical Laser Technologies, Inc. in favor of AmSouth Bank
      (8)
  78
 10.41
    
    Letter
      Agreement dated October 28, 2003 between PhotoMedex and True North Capital
      Ltd. (9)16.1
    
    Letter
      re Change in Certifying Accountant (10)22.1
    
    List
      of subsidiaries of the Company23.1
    
    Consent
      of Amper, Politziner & Mattia, P.C.23.2
    
    Consent
      of KPMG LLP31.1
    
    Rule
      13a-14(a) Certificate of Chief Executive Officer31.2
    
    Rule
      13a-14(a) Certificate of Chief Financial Officer32.1
    
    Certificate
      of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  200232.2
    
    Certificate
      of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002
 ___________
  (1)
    Filed
      as part of our Registration Statement on Form S-4, as filed with the
      Commission on October 18, 2002, and as
amended.
  (2)
    Filed
      as part of our Registrations Statement on Form S-4/A filed with the
      Commission on January 21, 2005, and as
amended.
  (3)
    Filed
      as part of our Registration Statement on Form S-1, as filed with the
      Commission on January 28, 1998, and as
amended.
  (4)
    Filed
      as part of our Quarterly Report on Form 10-Q for the quarter ended June
      30, 2000.
  (5)
    Filed
      as part of our Quarterly Report on Form 10-Q for the quarter ended March
      31, 2003.
  (6)
    Filed
      as part of our Annual Report on Form 10-K for the year ended
      December 31, 1987.
  (7)
    Filed
      as part of our Annual Report on Form 10-K for the year ended December 31,
      2002.
  (8)
    Filed
      as part of our Quarterly Report on Form 10-Q for the quarter ended June
      30, 2003.
  (9)
    Filed
      as part of our Quarterly Report on Form 10-Q for the quarter ended
      September 30, 2003.
  (10)
    Filed
      as part of our Current Report on Form 8-K, dated May 9, 2000, and as
      amended.
  (11)
    Filed
      as part of our Annual Report on Form 10-K for the year ended December 31,
      2003.
  **AVAILABLE
INFORMATION**
 
 We are a
reporting company and file annual, quarterly and special reports, proxy
statements and other information with the Commission. You may inspect and copy
these materials at the Public Reference Room maintained by the Commission at
Room 1024, 450 Fifth Street, N.W., Washington, D.C. 20549. Please call the
Commission at 1-800-SEC-0330 for more information on the Public Reference Room.
You can also find our Commission filings at the Commission's website at
www.sec.gov. You may also inspect reports and other information concerning us at
the offices of the Nasdaq Stock Market at 1735 K Street, N.W., Washington, D.C.
20006. We intend to furnish our stockholders with annual reports containing
audited financial statements and such other periodic reports as we may determine
to be appropriate or as may be required by law.
  79
 Our
primary Internet address is www.photomedex.com .
Corporate information can be located by clicking on the “Investor Relations”
link in the top-middle of the page, and then clicking on “SEC Filing” in the
menu. We make our periodic Commission Reports (Forms 10-Q and Forms 10-K) and
current reports (Form 8-K) available free of charge through our Web site as soon
as reasonably practicable after they are filed electronically with the
Commission. We may from time to time provide important disclosures to investors
by posting them in the Investor Relations section of our Web site, as allowed by
Commission’s rules.
  
  **DOCUMENTS
INCORPORATED BY REFERENCE**
  Certain
documents listed above in Part IV, Item 15 of this Report, as exhibits to this
Report on Form 10-K, are incorporated by reference from other documents
previously filed by us.
 
 80
  **SIGNATURES**
 
 Pursuant
to the requirements of Section 13 or 15(d) of the Securities Act of
1934, the registrant has duly caused this Report to be signed on its behalf by
the undersigned, thereunto duly authorized.
 
 PHOTOMEDEX,
    INC.Date: March 15,
2005
    By:
    /s/ Jeffrey F.
      O’DonnellJeffrey F. O’DonnellPresident, Chief Executive Officer
      and Director
 
 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 and on the dates indicated.
  Signature
    
    Capacity
      in Which Signed
    
    Date/s/
      Richard J. DePiano
    
    Chairman
      of the Board of Directors
    
    March
      15, 2005Richard
      J. DePiano/s/ Jeffrey F. O'Donnell
    
    President,
      Chief Executive Officer and Director
    
    March
      15, 2005Jeffrey
      F. O'Donnell/s/ Dennis M. McGrath
    
    Chief
      Financial Officer
    
    March
      15, 2005Dennis
      M. McGrath/s/ Alan R. Novak
    
    Director
    
    March
      15, 2005Alan
      R. Novak/s/ John J. McAtee, Jr.
    
    Director
    
    March
      15, 2005John
      J. McAtee, Jr./s/ David W. Anderson
    
    Director
    
    March
      15, 2005David
      W. Anderson/s/ Warwick
      Alex Charlton
    
    Director
    
    March
      15, 2005Warwick
      Alex Charlton/s/ Anthony
      J. Dimun
    
    Director
    
    March
      15, 2005Anthony
      J. Dimun
 
 81
 
 PHOTOMEDEX,
INC. AND SUBSIDIARIES
  Index to
Consolidated Financial Statements
 
 PageReport
      of Independent Registered Public Accounting Firm
    
    
    F-2Report
      of Independent Registered Public Accounting Firm
    
    
    F-3Report
      of Independent Registered Public Accounting Firm
    
    
    F-4Consolidated
      Balance Sheets, December 31, 2004 and 2003
    
    
    F-5Consolidated
      Statements of Operations, Years ended December 31, 2004, 2003 and
      2002
    
    
    F-6Consolidated
      Statements of Stockholders’ Equity, Years ended December 31,
      2004,2003
      and 2002
    
    
    F-7Consolidated
      Statements of Cash Flows, Years ended December 31, 2004, 2003 and
      2002
    
    
    F-8Notes
      to Consolidated Financial Statements
    
    
    F-9
 
 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 Board of
Directors and shareholders
 PhotoMedex,
Inc. and Subsidiaries
 
 We have
audited the accompanying consolidated balance sheet of PhotoMedex, Inc. and
Subsidiaries as of December 31, 2004, and the related consolidated statements of
operations, stockholders’ equity, and cash flows for the year ended December 31,
2004. These financial statements are the responsibility of the Company’s
management. Our responsibility is to express an opinion on these financial
statements based on our audit.
 
 We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether 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 audit provides a
reasonable basis for our opinion.
 
 In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of PhotoMedex, Inc. and
Subsidiaries as of December 31, 2004, and the results of its operations and its
cash flows for the year ended December 31, 2004, in conformity with United
States generally accepted accounting principles.
 
 We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the effectiveness of PhotoMedex, Inc. and
Subsidiary’s internal control over financial reporting as of December 31, 2004,
based on criteria established in Internal Control—Integrated Framework issued by
the Committee of Sponsoring Organizations of the Treadway Commission and our
report dated March 10, 2005 expressed an unqualified opinion
thereon.
 
 /s/
Amper, Politziner & Mattia, P.C.
 
 March 10,
2005
 Edison,
New Jersey
 F-2
  REPORT OF
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
  Board of
Directors and shareholders
 PhotoMedex,
Inc. and Subsidiaries
 
 We have
audited management’s assessment, included in the accompanying Management’s 2004
Annual Report on Internal Controls, that PhotoMedex, Inc. and Subsidiaries (the
Company) maintained effective internal control over financial reporting as of
December 31, 2004, based on criteria established in Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO). The Company’s management is responsible for maintaining
effective internal control over financial reporting and for its assessment of
the effectiveness of internal control over financial reporting. Our
responsibility is to express an opinion on management’s assessment, and an
opinion on the effectiveness of the Company’s internal control over financial
reporting based on our audit.
 
 We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, evaluating management’s assessment, testing and evaluating
the design and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.
 
 A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company’s internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the Company’s
assets that could have a material effect on the financial
statements.
 
 Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
 
 In our
opinion, management’s assessment that the Company maintained effective internal
control over financial reporting as of December 31, 2004, is fairly stated, in
all material respects, based on control criteria established in Internal
Control—Integrated Framework issued by the Committee of Sponsoring Organizations
of the Treadway Commission (COSO). Also in our opinion, the Company maintained,
in all material respects, effective internal control over financial reporting as
of December 31, 2004, based on the criteria established in Internal
Control—Integrated Framework issued by the Committee of Sponsoring Organizations
of the Treadway Commission (COSO).
 
 We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheet of PhotoMedex,
Inc. and Subsidiaries as of December 31, 2004 and the related consolidated
statements of operations, stockholders’ equity and cash flows for the year ended
December 31, 2004 in our report dated March 10, 2005, expressed an unqualified
opinion.
 
 /s/
Amper, Politziner & Mattia, P.C.
 
 March 10,
2005
 Edison,
New Jersey
 F-3
 
 REPORT OF
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
  To Board
of Directors and Stockholders
 PhotoMedex,
Inc. and Subsidiaries:
  We have
audited the 2003 and 2002 consolidated financial statements of PhotoMedex, Inc.
and subsidiaries as listed in the accompanying index. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
  We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
  In our
opinion, the 2003 and 2002 consolidated financial statements referred to above
present fairly, in all material respects, the financial position of PhotoMedex,
Inc. and subsidiaries as of December 31, 2003 and 2002, and the results of their
operations and their cash flows for the years then ended in conformity with
United States generally accepted accounting principles.
  As
discussed in Note 1 to the consolidated financial statements,
effective January 1, 2002, the Company adopted Statement of Financial Accounting
Standards No. 142, “Goodwill and Other Intangible Assets.”
  /s/ KPMG
LLP
 
 Philadelphia,
Pennsylvania
 February
18, 2004 (except with respect to the seventh paragraph
 of note
9, as to which the date is March 10, 2004)
 F-4
 
 PHOTOMEDEX,
INC. AND SUBSIDIARIES
  CONSOLIDATED
BALANCE SHEETS
 
 ASSETS
    
    December
      31,2004
    
    2003Current
      assets:Cash
      and cash equivalents
    
    $
    3,884,817
    
    $
    6,633,468Restricted
      cash
    
    
    112,200
    
    
    -Accounts
      receivable, net of allowance for doubtful accounts of $736,505 and
      $698,044
    
    
    4,117,399
    
    
    3,483,030Inventories
    
    
    4,585,631
    
    
    4,522,462Prepaid
      expenses and other current assets
    
    
    401,989
    
    
    334,002Total
      current assets
    
    
    13,102,036
    
    
    14,972,962Property
      and equipment, net
    
    
    4,996,688
    
    
    4,005,205Patents
      and licensed technologies, net
    
    
    929,434
    
    
    758,655Goodwill,
      net
    
    
    2,944,423
    
    
    2,944,423Capitalized
      acquisition costs
    
    
    762,477
    
    
    -Other
      assets
    
    
    226,868
    
    
    71,486Total
      assets
    
    $
    22,961,926
    
    $
    22,752,731LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilities:Current
      portion of notes payable
    
    $
    69,655
    
    $
    101,066Current
      portion of long-term debt
    
    
    873,754
    
    
    1,269,759Accounts
      payable
    
    
    3,515,293
    
    
    2,218,993Accrued
      compensation and related expenses
    
    
    963,070
    
    
    940,352Other
      accrued liabilities
    
    
    924,054
    
    
    975,536Deferred
      revenues
    
    
    636,962
    
    
    811,712Total
      current liabilities
    
    
    6,982,788
    
    
    6,317,418Notes
      payable
    
    
    26,736
    
    
    51,489Long-term
      debt
    
    
    1,372,119
    
    
    405,749Total
      liabilities
    
    
    8,381,643
    
    
    6,774,656Commitment
      and contingenciesStockholders'
      Equity:Common
      Stock, $.01 par value, 75,000,000 shares authorized; 40,075,019 and
      37,736,139 shares issued and outstanding at December 31, 2004 and 2003,
      respectively
    
    
    400,750
    
    
    377,361Additional
      paid-in capital
    
    
    90,427,632
    
    
    86,871,415Accumulated
      deficit
    
    
    (76,246,562
    )
    
    (71,262,366
    )Deferred
      compensation
    
    
    (1,537
    )
    
    (8,335
    )Total
      stockholders' equity
    
    
    14,580,283
    
    
    15,978,075Total
      liabilities and stockholders’ equity
    
    $
    22,961,926
    
    $
    22,752,731
  The
accompanying notes are an integral part of these consolidated financial
statements.
 
 F-5
   PHOTOMEDEX,
INC. AND SUBSIDIARIES
  CONSOLIDATED
STATEMENTS OF OPERATIONS
 
 For
      the Year Ended December 31,2004
    
    2003
    
    2002Revenues:Product
      sales
    
    $
    6,497,397
    
    $
    6,870,570
    
    $
    2,531,063Services
    
    
    11,247,784
    
    
    7,448,223
    
    
    743,39517,745,181
    
    
    14,318,793
    
    
    3,274,458Cost
      of revenues:Product
      cost of revenues
    
    
    3,324,564
    
    
    3,732,109
    
    
    1,130,825Services
      cost of revenues
    
    
    7,038,705
    
    
    6,755,499
    
    
    3,294,60910,363,269
    
    
    10,487,608
    
    
    4,425,434Gross
      profit (loss)
    
    
    7,381,912
    
    
    3,831,185
    
    
    (1,150,976
    )Operating
      expenses:Selling,
      general and administrative
    
    
    10,426,256
    
    
    9,451,224
    
    
    6,190,836Engineering
      and product development
    
    
    1,801,438
    
    
    1,776,480
    
    
    1,757,25712,227,694
    
    
    11,227,704
    
    
    7,948,093Loss
      from operations
    
    
    (4,845,782
    )
    
    (7,396,519
    )
    
    (9,099,069
    )Interest
      expense (income), net
    
    
    138,414
    
    
    46,330
    
    
    (25,669
    )Other
      income, net
    
    
    -
    
    
    -
    
    
    1,087Net
      loss
    
    $
    (4,984,196
    )
    $
    (7,442,849
    )
    $
    (9,072,313
    )Basic
      and diluted net loss per share
    
    $
    (0.13
    )
    $
    (0.21
    )
    $
    (0.34
    )Shares
      used in computing basic and diluted net loss per share
    
    
    38,835,356
    
    
    35,134,378
    
    
    26,565,685
  The
accompanying notes are an integral part of these consolidated financial
statements
  F-6
   PHOTOMEDEX,
INC. AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY
 AdditionalCommon
      Stock
    
    Paid-In
    
    Accumulated
    
    DeferredShares
    
    Amount
    
    Capital
    
    Deficit
    
    Compensation
    
    TotalBALANCE,
      DECEMBER 31, 2001
    
    
    24,179,953
    
    $
    241,800
    
    $
    67,245,367
    
    
    ($54,747,204
    )
    
    ($30,283
    )
    $
    12,709,680Sale
      of stock, net of expenses
    
    
    4,115,000
    
    
    41,150
    
    
    5,664,897
    
    
    -
    
    
    -
    
    
    5,706,047Exercise
      of warrants
    
    
    409,751
    
    
    4,097
    
    
    428,885
    
    
    -
    
    
    -
    
    
    432,982Exercise
      of stock options
    
    
    18,000
    
    
    180
    
    
    17,820
    
    
    -
    
    
    -
    
    
    18,000Stock
      options issued to consultants for services
    
    
    -
    
    
    -
    
    
    34,296
    
    
    -
    
    
    -
    
    
    34,296Reversal
      of unamortized portion of deferred compensation for terminated
      employees
    
    
    -
    
    
    -
    
    
    (6,336
    )
    
    -
    
    
    6,336
    
    
    -Amortization
      of deferred compensation
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    9,113
    
    
    9,113Issuance
      of stock for SLT acquisition, net of expenses
    
    
    2,716,354
    
    
    27,164
    
    
    3,443,653
    
    
    -
    
    
    -
    
    
    3,470,817Net
      loss
    
    
    -
    
    
    -
    
    
    -
    
    
    (9,072,313
    )
    
    -
    
    
    (9,072,313
    )BALANCE,
      DECEMBER 31, 2002
    
    
    31,439,058
    
    
    314,391
    
    
    76,828,582
    
    
    (63,819,517
    )
    
    (14,834
    )
    
    13,308,622Sale
      of stock, net of expenses
    
    
    5,982,352
    
    
    59,824
    
    
    9,417,722
    
    
    -
    
    
    -
    
    
    9,477,546Exercise
      of warrants
    
    
    253,271
    
    
    2,532
    
    
    460,316
    
    
    -
    
    
    -
    
    
    462,848Exercise
      of stock options
    
    
    61,458
    
    
    614
    
    
    63,918
    
    
    -
    
    
    -
    
    
    64,532Stock
      options issued to consultants for services
    
    
    -
    
    
    -
    
    
    38,164
    
    
    -
    
    
    -
    
    
    38,164Stock
      options issued to former employee
    
    
    -
    
    
    -
    
    
    62,713
    
    
    -
    
    
    -
    
    
    62,713Amortization
      of deferred compensation
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    6,499
    
    
    6,499Net
      loss
    
    
    -
    
    
    -
    
    
    -
    
    
    (7,442,849
    )
    
    -
    
    
    (7,442,849
    )BALANCE,
      DECEMBER 31, 2003
    
    
    37,736,139
    
    
    377,361
    
    
    86,871,415
    
    
    (71,262,366
    )
    
    (8,335
    )
    
    15,978,075Exercise
      of warrants
    
    
    2,104,138
    
    
    21,041
    
    
    3,065,427
    
    
    -
    
    
    -
    
    
    3,086,468Exercise
      of stock options
    
    
    120,865
    
    
    1,209
    
    
    209,074
    
    
    -
    
    
    -
    
    
    210,283Stock
      options issued to consultants for services
    
    
    -
    
    
    -
    
    
    98,435
    
    
    -
    
    
    -
    
    
    98,435Reversal
      of unamortized portion of deferred compensation for terminated
      employee
    
    
    -
    
    
    -
    
    
    (532
    )
    
    -
    
    
    532
    
    
    -Amortization
      of deferred compensation
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    6,266
    
    
    6,266Issuance
      of stock for Stern acquisition, net of expenses
    
    
    113,877
    
    
    1,139
    
    
    218,066
    
    
    -
    
    
    -
    
    
    219,205Registration
      expense for acquisition
    
    
    -
    
    
    -
    
    
    (125,914
    )
    
    -
    
    
    -
    
    
    (125,914
    )Sale
      of stock, net of expenses
    
    
    -
    
    
    -
    
    
    11,199
    
    
    -
    
    
    -
    
    
    11,199Issuance
      of warrants for draws under line of credit
    
    
    -
    
    
    -
    
    
    80,462
    
    
    -
    
    
    -
    
    
    80,462Net
      loss
    
    
    -
    
    
    -
    
    
    -
    
    
    (4,984,196
    )
    
    -
    
    
    (4,984,196
    )BALANCE,
      DECEMBER 31, 2004
    
    
    40,075,019
    
    $
    400,750
    
    $
    90,427,632
    
    
    ($76,246,562
    )
    
    ($1,537
    )
    $
    14,580,283
  The
accompanying notes are an integral part of these consolidated financial
statements.
 
 F-7
   PHOTOMEDEX,
INC. AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
  For
      the Year Ended December 31,2004
    
    2003
    
    2002**Cash
      Flows From Operating Activities:**Net
      loss
    
    
    ($4,984,196
    )
    
    ($7,442,849
    )
    
    ($9,072,313
    )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      and amortization
    
    
    1,765,944
    
    
    2,186,743
    
    
    1,647,203Loss
      on disposal of property and equipment
    
    
    -
    
    
    7,574
    
    
    -Provision
      for doubtful accounts
    
    
    459,861
    
    
    254,429
    
    
    637,857Stock
      options issued to former employee
    
    
    -
    
    
    62,713
    
    
    -Stock
      options and warrants issued toconsultants
      for services
    
    
    98,435
    
    
    38,164
    
    
    34,296Amortization
      of deferred compensation
    
    
    6,266
    
    
    6,499
    
    
    9,113Changes
      in operating assets and liabilities:Accounts
      receivable
    
    
    (1,094,230
    )
    
    (1,201,125
    )
    
    28,762Inventories
    
    
    (628,257
    )
    
    485,694
    
    
    234,874Prepaid
      expenses and other assets
    
    
    541,170
    
    
    436,672
    
    
    98,587Accounts
      payable
    
    
    1,273,300
    
    
    (443,368
    )
    
    (113,193
    )Accrued
      compensation and related expenses
    
    
    22,718
    
    
    117,353
    
    
    222,214Other
      accrued liabilities
    
    
    (51,482
    )
    
    (270,897
    )
    
    243,756Deferred
      revenues
    
    
    (174,750
    )
    
    628,237
    
    
    (42,975
    )Net
      cash used in operating activities
    
    
    (2,765,221
    )
    
    (5,134,161
    )
    
    (6,071,819
    )**Cash
      Flows From Investing Activities:**Purchases
      of property and equipment
    
    
    (111,319
    )
    
    (51,103
    )
    
    (73,538
    )Lasers
      (placed into) or retired from service
    
    
    (1,683,528
    )
    
    (1,556,654
    )
    
    99,090Acquisition
      costs, net of cash received
    
    
    (882,823
    )
    
    -
    
    
    (231,500
    )Net
      cash used in investing activities
    
    
    (2,677,670
    )
    
    (1,607,757
    )
    
    (205,948
    )**Cash
      Flows From Financing Activities:**Proceeds
      from issuance of common stock, net
    
    
    (138,858
    )
    
    9,477,546
    
    
    5,706,047Proceeds
      from exercise of options
    
    
    210,283
    
    
    64,532
    
    
    18,000Proceeds
      from exercise of warrants
    
    
    3,086,468
    
    
    462,848
    
    
    432,982Proceeds
      from issuance of notes payable
    
    
    -
    
    
    -
    
    
    60,905Payments
      on long-term debt
    
    
    (291,840
    )
    
    (218,829
    )
    
    -Payments
      on notes payable
    
    
    (587,161
    )
    
    (648,494
    )
    
    (104,129
    )Net
      advances (repayments) on line of credit
    
    
    527,548
    
    
    (1,770,268
    )
    
    105,193(Increase)
      decrease in restricted cash, cash equivalents and short-term
      investments
    
    
    (112,200
    )
    
    2,000,000
    
    
    -Net
      cash provided by financing activities
    
    
    2,694,240
    
    
    9,367,335
    
    
    6,218,998Net
      (decrease) increase in cash and cash equivalents
    
    
    (2,748,651
    )
    
    2,625,417
    
    
    (58,769
    )Cash
      and Cash Equivalents, Beginning of Year
    
    
    6,633,468
    
    
    4,008,051
    
    
    4,066,820Cash
      and Cash Equivalents, End of Year
    
    $
    3,884,817
    
    $
    6,633,468
    
    $
    4,008,051
  The
accompanying notes are an integral part of these consolidated financial
statements.
 
 F-8
 PHOTOMEDEX,
INC. AND SUBSIDIARIES
  NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 
 *Note
1*
 **The
Company and Summary of Significant Accounting Policies:**
  **The
Company:**
  ***Background***
 PhotoMedex,
Inc. and subsidiaries (the “Company”) is a medical device company focused on
facilitating the cost-effective use of technologies for doctors, hospitals and
surgery centers. The Company develops, manufactures and markets
excimer-laser-based instrumentation designed to phototherapeutically treat
psoriasis, vitiligo, atopic dermatitis and leukoderma. In January 2000, the
Company received the first Food and Drug Administration (“FDA”) clearance to
market an excimer laser system, the XTRAC® system, for the treatment of
psoriasis. In March 2001, the Company received FDA clearance to treat vitiligo;
in August 2001, the Company received FDA clearance to treat atopic dermatitis,
and in May 2002, the FDA granted 510(k) clearance to market the XTRAC system for
the treatment of leukoderma. The Company introduced the XTRAC phototherapy
treatment system commercially in the United States in August 2000.
  Beginning
with the acquisition of Surgical Laser Technologies, Inc. (“SLT”) on December
27, 2002 (see Note 2), the Company also develops, manufactures and markets
proprietary surgical lasers and delivery systems for both contact and
non-contact surgery and provides surgical services utilizing these and other
manufacturers’ products. The Company has a pending acquisition of ProCyte
Corporation. See *Note
2* .
  ***Liquidity
and Going Concern***
 The
Company has incurred significant losses and has had negative cash flows from
operations since emerging from bankruptcy in May 1995. As of December 31, 2004,
the Company had an accumulated deficit of $76,246,562. The Company has
historically financed its activities from the private placement of equity
securities. To date, the Company has dedicated most of its financial resources
to research and development and selling, general and administrative expenses. To
increase patient acceptance of targeted UVB therapy for skin disorders using the
excimer laser required obtaining newly established current procedural
terminology (“CPT”) codes. It further required adoption by private health
insurance carriers of a medical policy to reimburse patients for the treatment.
During the first quarter of 2003, the Company re-launched the marketing of its
XTRAC system in the United States following the issuance of CPT codes and
associated reimbursement rates by the Center of Medicare and Medicaid Services
(“CMS”). The Company has focused its recent efforts on securing approval by
various private health plans to reimburse for treatments of psoriasis using the
XTRAC.
  The
Company expects to incur operating losses into 2005 as it plans to continue to
focus on securing reimbursement from more private insurers and to devote sales
and marketing efforts in the areas where such reimbursement has become
available. Once favorable momentum has been achieved, the Company contemplates
spending substantial amounts on the marketing of its psoriasis, vitiligo, atopic
dermatitis and leukoderma treatment products and expansion of its manufacturing
operations. Notwithstanding the approval by CMS for Medicare and Medicaid
reimbursement and recent approvals by certain private insurers, the Company may
continue to face resistance from private healthcare insurers to adopt the
excimer-laser-based therapy as an approved procedure. Management cannot provide
assurance that the Company will market the product successfully, operate
profitably in the future, or that it will not require significant additional
financing in order to accomplish its business plan. Nevertheless, the Company
was successful in reducing its net loss for the year ended December 31, 2004 by
$2,458,653 compared to the year ended December 31, 2003.
  The
Company’s future revenues and success depend upon increased patient acceptance
of its excimer-laser-based systems for the treatment of a variety of skin
disorders. The Company’s excimer-laser-based system for the treatment of
psoriasis, vitiligo, atopic dermatitis and leukoderma is currently generating
revenues in both the United States and abroad. The Company’s ability to
introduce successful new products based on its business focus and the expected
benefits to be obtained from these products may be adversely affected by a
number of factors, such as unforeseen costs and expenses, technological change,
economic downturns, competitive factors or other events beyond the Company’s
control. Consequently, the Company’s historical operating results cannot be
relied upon as indicators of future performance, and management cannot predict
whether the Company will obtain or sustain positive operating cash flow or
generate net income in the future.
  F-9
 Cash and
cash equivalents were $3,997,017, including restricted cash of $112,200 as of
December 31, 2004. Management believes that the existing cash balance together
with its existing financial resources, including leasing credit line facility
(Note 9), and any revenues from sales, distribution, licensing and manufacturing
relationships, will be sufficient to meet the Company’s operating and capital
requirements into 2006. The 2005 operating plan is based on anticipated revenue
growth from the use of the XTRAC system based on growing private insurance
coverage in the United States and continuing cost savings from the manufacturing
efficiencies of its newly designed excimer technology. However, depending upon
the Company’s rate of growth and other operating factors, the Company may
require additional equity or debt financing to meet its working capital
requirements or capital expenditure needs. There can be no assurance that
additional financing, if needed, will be available when required or, if
available, on terms satisfactory to the Company.
  **Summary
of Significant Accounting Policies:**
  ***Principles
of Consolidation***
 The
consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiaries. All significant intercompany balances and
transactions have been eliminated.
  ***Use
of Estimates***
 The
preparation of the consolidated financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect amounts reported in the
financial statements and accompanying notes. Actual results could differ from
those estimates and be based on events different from those assumptions. Future
events and their effects cannot be perceived with certainty; estimating,
therefore, requires the exercise of judgment. Thus, accounting estimates change
as new events occur, as more experience is acquired, or as additional
information is obtained. See ***Revenue
Recognition*** for
discussion of updates and changes in estimates for XTRAC domestic revenues in
accordance with Staff Accounting Bulletin 101 and 104 and SFAS 48.
  ***Cash
and Cash Equivalents***
 The
Company invests its excess cash in highly liquid short-term investments. The
Company considers short-term investments that are purchased with an original
maturity of three months or less to be cash equivalents. Cash and cash
equivalents consisted of cash and money market accounts at December 31, 2004 and
2003. Cash that is pledged to secure obligations is disclosed separately as
restricted cash. The Company maintains its cash and cash equivalents in accounts
in several banks, the balances which at times may exceed federally insured
limits.
  ***Accounts
Receivable*** **.**
 The
majority of the Company’s accounts receivables are due from distributors
(domestic and international), hospitals, universities and physicians and other
entities in the medical field. Credit is extended based on evaluation of a
customers’ financial condition and, generally, collateral is not required.
Accounts receivable are most often due within 30 to 90 days and are stated at
amounts due from customers net of an allowance for doubtful accounts. Accounts
outstanding longer than the contractual payment terms are considered past due.
The Company determines its allowance by considering a number of factors,
including the length of time trade accounts receivable are past due, the
Company’s previous loss history, the customer’s current ability to pay its
obligation to the Company, and the condition of the general economy and the
industry as a whole. The Company writes-off accounts receivable when they become
uncollectible, and payments subsequently received on such receivables are
credited to the allowance for doubtful accounts. The Company does not accrue
interest on accounts receivable past due.
  ***Inventories***
 Inventories
are stated at the lower of cost (first-in, first-out basis) or market. Cost is
determined to be purchased cost for raw materials and the production cost
(materials, labor and indirect manufacturing cost) for work-in-process and
finished goods. Throughout the laser manufacturing process, the related
production costs are recorded within inventory. Work-in-process is immaterial,
given the typically short manufacturing cycle, and therefore is disclosed in
conjunction with raw materials. The Company performs full physical inventory
counts for XTRAC and cycle counts on the other inventory to maintain controls
and obtain accurate data.
  The
Company's skin disorder treatment equipment will either (i) be sold to
distributors or physicians directly or (ii) be placed in a physician's office
and remain the property of the Company. The cost to build a laser, whether for
sale or for placement, is accumulated in inventory. When a laser is placed in a
physician’s office, the cost is transferred from inventory to “lasers in
service” within property and equipment. At times, units are shipped to
distributors, but revenue is not recognized until all of the criteria of Staff
Accounting Bulletin No. 104 have been met, and until that
 
 F-10
 time, the
unit is carried on the books of the Company as inventory. Revenue is not
recognized from these distributors until payment is either assured or paid in
full. Until this time, the cost of these shipments continues to be recorded as
finished goods inventory.
  Reserves
for slow moving and obsolete inventories are provided based on historical
experience and product demand. Management evaluates the adequacy of these
reserves periodically based on forecasted sales and market trend.
  ***Property,
Equipment and Depreciation***
 Property
and equipment are recorded at cost. Excimer lasers-in-service are depreciated on
a straight-line basis over the estimated useful life of three years. Surgical
lasers-in-service are depreciated on a straight-line basis over an estimated
useful life of seven years if new, and five years or less if used equipment. The
straight-line depreciation basis for lasers-in-service is reflective of the
pattern of use. For other property and equipment, depreciation is calculated on
a straight-line basis over the estimated useful lives of the assets, primarily
three to seven years for computer hardware and software, furniture and fixtures,
automobiles, and machinery and equipment. Leasehold improvements are amortized
over the lesser of the useful lives or lease terms. Expenditures for major
renewals and betterments to property and equipment are capitalized, while
expenditures for maintenance and repairs are charged to operations as incurred.
Upon retirement or disposition, the applicable property amounts are deducted
from the accounts and any gain or loss is recorded in the consolidated
statements of operations. Useful lives are determined based upon an estimate of
either physical or economic obsolescence.
  Laser
units and laser accessories located at medical facilities for sales evaluation
and demonstration purposes or those units/accessories used for development and
medical training are included in property and equipment under the caption
“machinery and equipment”. These units and accessories are being depreciated
over a period of up to five years. Laser units utilized in the provision of
surgical services are included in property and equipment under the caption
“lasers in service” and are depreciated over a five year life, given the
additional wear and tear that is incurred with movement from site to site.
  Management
evaluates the realizability of property and equipment based on estimates of
undiscounted future cash flows over the remaining useful life of the asset. If
the amount of such estimated undiscounted future cash flows is less than the net
book value of the asset, the asset is written down to the net realizable value.
As of December 31, 2004, no such write-down was required (see ***Impairment
of Long-Lived Assets*** below).
  ***Patent
Costs and Licensed Technologies***
 Costs
incurred to obtain or defend patents and licensed technologies are capitalized
and amortized over the shorter of the remaining estimated useful lives or eight
to 12 years. Developed technology was recorded in connection with the purchase
in August 2000 of the minority interest of Acculase, a former subsidiary of the
Company, and is being amortized on a straight-line basis over seven
years.
  Management
evaluates the realizability of intangible assets based on estimates of
undiscounted future cash flows over the remaining useful life of the asset. If
the amount of such estimated undiscounted future cash flows is less than net
book value of the asset, the asset is written down to fair value. As of December
31, 2004, no such write-down was required (see ***Impairment
of Long-Lived Assets*** below).
  ***Goodwill***
 Goodwill
represents the excess of costs over the fair value of assets of business
acquired. The Company adopted the provisions of SFAS No. 142, “Goodwill and
Other Intangible Assets,” as of January 1, 2002. Goodwill and intangible assets
acquired in a purchase business combination and determined to have an indefinite
useful life are not amortized, but instead tested for impairment at least
annually. As of December 31, 2004, no such impairment exists.
 ***Accrued
Warranty Costs***
 The
Company offers a warranty on product sales generally for a one to two-year
period. The Company provides for the estimated future warranty claims on the
date the product is sold. The activity in the warranty accrual during the year
ended December 31, 2004 and 2003 is summarized as follows:
  December
      31,2004
    
    2003Accrual
      at beginning of year
    
    $
    316,714
    
    $
    415,463Additions
      charged to warranty expense
    
    
    408,093
    
    
    372,204Claims
      paid and expiring warranties
    
    
    (527,917
    )
    
    (470,953
    )Accrual
      at end of year
    
    $
    196,890
    
    $
    316,714
  ***Revenue
Recognition***
 The
Company has two distribution channels for its phototherapy treatment equipment.
The Company will either (i) sell the laser through a distributor or directly to
a physician or (ii) place the laser in a physician’s office (at no charge
 
 F-11
 to the
physician) and charge the physician a fee for an agreed upon number of
treatments. When the Company sells an XTRAC laser to a distributor or directly
to a physician, revenue is recognized when the following four criteria under
Staff Accounting Bulletin No. 104 have been met: the product has been shipped
and the Company has no significant remaining obligations; persuasive evidence of
an arrangement exists; the price to the buyer is fixed or determinable; and
collection is probable. At times, units are shipped but revenue is not
recognized until all of the criteria are met, and until that time, the unit is
carried on the books of the Company as inventory. The Company ships most of its
products FOB shipping point, although from time to time certain customers, for
example governmental customers, will insist on FOB destination. Among the
factors we take into account in determining the proper time at which to
recognize revenue are when title to the goods transfers and when the risk of
loss transfers. Shipments to the distributors that do not fully satisfy the
collection criteria are recognized when invoiced amounts are fully
paid.
  Under the
terms of the distributor agreements, the Company’s distributors do not have a
unilateral right to return any unit which they have purchased. However, the
Company does allow products to be returned by its distributors in redress of
product defects or other claims.
  When the
Company places the laser in a physician’s office, it recognizes service revenue
based on the number of patient treatments used by the physician. Treatments in
the form of laser-access codes that are sold to physicians but not yet used are
deferred and recognized as a liability until the physician performs the
treatment. The Company defers this portion of unused treatments even though the
physician is not given the right to seek a refund for unused treatments. Unused
treatments remain an obligation of the Company inasmuch as the treatments can
only be performed on Company-owned equipment. Once the treatments are delivered
to a patient, this obligation has been satisfied.
  The
calculation of unused treatments has historically been based upon an estimate
that at the end of each accounting period, 15 unused treatments existed at each
laser location. This was based upon the reasoning that the Company generally
sells treatments in packages of 30 treatments. Fifteen treatments generally
represents about one-half the purchase quantity by a physician or approximately
a one-week supply for 6-8 patients. This policy had been used on a consistent
basis. The Company believed this approach to have been reasonable and systematic
given that: physicians have little motivation to purchase quantities (which they
are obligated to pay for irrespective of actual use and are unable to seek a
credit or refund for unused treatments) that will not be used in a relatively
short period of time, particularly since in most cases they can obtain
incremental treatments instantaneously over the phone; and senior management
regularly reviews purchase patterns by physicians to identify unusual buildup of
unused treatment codes at a laser site. However, the Company continually looks
at our estimation model based upon data received from our
customers.
  In the
fourth quarter of 2004, the Company has updated the calculations for the
estimated amount of unused treatments to reflect recent purchasing patterns by
physicians near year-end. The Company has estimated the amount of unused
treatments at December 31, 2004 to include all sales of treatment codes made
within the last two weeks of the end of the period. Management believes this
approach more closely approximates the actual amount of unused treatments that
existed at that date than the previous method allowed. According to APB 20,
accounting estimates change as new events occur, as more experience is acquired,
or as additional information is obtained and that the effect of the change in
accounting estimate should be accounted for in the current period and the future
periods that it affects. The Company has accounted for this change in the
estimate of unused treatments in accordance with SFAS No. 48 and APB 20.
Accordingly, the Company’s change in accounting estimate is reported in revenues
for the fourth quarter, and has not been accounted for by restating amounts
reported in financial statements of prior periods or by reporting proforma
amounts for prior periods.
  Had the
prior method of estimation been used to calculate unused treatments at December
31, 2004, the amount of unused treatments would have approximated $178,500.
Under the current method of estimation, the amount of unused treatments at
December 31, 2004 is estimated to approximate $306,000 thereby serving to reduce
XTRAC domestic revenues by $127,500 for the quarter and year ended December 31,
2004.
  In the
first quarter of 2003, the Company implemented a program to support certain
physicians in addressing treatments with the XTRAC system that may be denied
reimbursement by private insurance carriers. The Company recognizes service
revenue during the program from the sale of treatment codes to physicians
participating in this program only if and to the extent the physician has been
reimbursed for the treatments. The Company must estimate the extent to which a
physician participating in the program has been reimbursed. In the year ended
December 31,
 
 F-12
 2004, the
Company recognized $531,631 of net revenues under this program. At December 31,
2004, the Company deferred revenues of $169,692, net under this
program.
  Under
this program, qualifying doctors can be reimbursed for the cost of the Company’s
fee only if they are ultimately denied reimbursement after appeal of their claim
with the insurance company. The key components of the program are as
follows:
  ·
    The
      physician practice must qualify to be in the program (i.e. it must be in
      an identified location where there is still an insufficiency of insurance
      companies reimbursing the procedure);
  ·
    The
      program only covers medically necessary treatments of psoriasis as
      determined by the treating physician;
  ·
    The
      patient must have medical insurance and a claim for the treatment must be
      timely filed with the patient’s insurance company;
  ·
    Upon
      denial by the insurance company (generally within 30 days of filing the
      claim), a standard insurance form called an EOB (Explanation of Benefits)
      must be submitted to the Company’s in-house appeals group, who will then
      prosecute the appeal. The appeal process can take 6-9
    months;
  ·
    After
      all appeals have been exhausted by the Company, if the claim remains
      unpaid, then the physician is entitled to receive credit for the treatment
      he or she purchased from the Company (the Company’s fee only) on behalf of
      the patient; and
  ·
    Physicians
      are still obligated to make timely payments for treatments purchased,
      irrespective of whether reimbursement is paid or denied. Future sale of
      treatments to the physician can be denied if timely payments are not made,
      even if a patient’s appeal is still in
process.
  Historically,
the Company estimated this contingent liability for potential refund by
estimating when the physician was paid for the insurance claim. In the absence
of a two-year historical trend and a large pool of homogeneous transactions to
reliably predict the estimated claims for refund as required by Staff Accounting
Bulletin Nos. 101 and 104, the Company previously deferred revenue recognition
of 100% of the current quarter revenues from the program to allow for the actual
denied claims to be identified after processing with the insurance companies.
After more than 83,000 treatments in the last two years and detailed record
keeping of denied insurance claims and appeals processed, the Company can
reliably estimate that approximately 11% of a current quarter’s revenues under
this program are subject to being refunded to the physician. As of December 31,
2004, the Company updated its estimation procedure to reflect this level of
estimated refunds. This change from the past process of deferring 100% of the
current quarter revenues from the program represents a change in accounting
estimate and we have recorded this change in accordance with the relevant
provisions of SFAS No. 48 and APB 20. These requirements state that the effect
of a change in accounting estimate should be accounted for in the current period
and the future periods that it affects. A change in accounting estimate should
not be accounted for by restating amounts reported in financial statements of
prior periods or by reporting proforma amounts for prior periods.
  Had the
prior method of estimation been used to calculate potential credits or refunds
at December 31, 2004, the amount of deferred revenue would have increased by
$405,000 and the amount or revenue recognized for the XTRAC domestic segment for
the quarter and year ended December 31, 2004 would have decreased by
approximately $405,000.
  The net
impact on revenue recognized for the XTRAC domestic segment as a result of the
above two changes in accounting estimate was to increase revenues by
approximately $278,000 for the quarter and year ended December 31,
2004.
  Through
its surgical businesses, the Company generates revenues primarily from two
channels. The first is through product sales of laser systems, related
maintenance service agreements, recurring laser delivery systems and laser
accessories; the second is through the per-procedure surgical services. The
Company recognizes revenues from surgical lasers and other product sales,
including sales to distributors, when the following four criteria under Staff
Accounting Bulletin No. 104 have been met: the product has been shipped and the
Company has no significant remaining obligations; persuasive evidence of an
arrangement exists; the price to the buyer is fixed or determinable; and
collection is probable. At times, units are shipped but revenue is not
recognized until all of the criteria are met, and until that time, the unit is
carried on the books of the Company as inventory. The Company ships most of its
 
 F-13
 products
FOB shipping point, although from time to time certain customers, for example
governmental customers, will insist on FOB destination. Among the factors the
Company takes into account in determining the proper time at which to recognize
revenue are when title to the goods transfers and when the risk of loss
transfers.
  For
per-procedure surgical services, the Company recognizes revenue upon the
completion of the procedure. Revenue from maintenance service agreements is
deferred and recognized on a straight-line basis over the term of the
agreements. Revenue from billable services, including repair activity, is
recognized when the service is provided.
  ***Product
Development Costs***
 Costs of
research, new product development and product redesign are charged to expense as
incurred.
  ***Income
Taxes***
 The
Company accounts for income taxes in accordance with Statement of Financial
Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes.” Under SFAS
No. 109, the liability method is used for income taxes. Under this method,
deferred tax assets and liabilities are determined based on differences between
the financial reporting and tax basis of assets and liabilities and are measured
using enacted tax rates and laws that are expected to be in effect when the
differences reverse (see Note 13).
  The
Company’s deferred tax asset has been fully reserved under a valuation
allowance, reflecting the uncertainties as to realizability evidenced by the
Company’s historical results and restrictions on the usage of the net operating
loss carryforwards.
  ***Net
Loss Per Share***
 The
Company computes net loss per share in accordance with SFAS No. 128, "Earnings
per Share." In accordance with SFAS No. 128, basic net loss per share is
calculated by dividing net loss available to common stockholders by the weighted
average number of common shares outstanding for the period. Diluted net loss per
share reflects the potential dilution from the conversion or exercise of
securities into common stock, such as stock options and warrants.
  In these
consolidated financial statements, diluted net loss per share is the same as
basic net loss per share. No additional shares for the potential dilution from
the conversion or exercise of securities into common stock are included in the
denominator since the result would be anti-dilutive. Common stock options and
warrants of 6,464,140, 8,381,279 and 6,837,849 as of December 31, 2004, 2003 and
2002, respectively, were excluded from the calculation of fully diluted earnings
per share since their inclusion would have been anti-dilutive.
  ***Reclassifications***
 The 2003
consolidated statements of operations have been revised to present product and
services cost of revenues and operating expenses to the current presentation
format.
  The 2003
property and equipment footnote has been revised to reallocate the categories to
the current year format. No change to the net book value was made.
  ***Fair
Value of Financial Instruments***
 The
estimated fair values for financial instruments under SFAS No. 107, “Disclosures
about Fair Value of Financial Instruments,” are determined at discrete points in
time based on relevant market information. These estimates involve uncertainties
and cannot be determined with precision. The fair value of cash is based on its
demand value, which is equal to its carrying value. The fair values of notes
payable are based on borrowing rates that are available to the Company for loans
with similar terms, collateral and maturity. The estimated fair values of notes
payable approximate the carrying values. Additionally, the carrying value of all
other monetary assets and liabilities is equal to its fair value due to the
short-term nature of these instruments.
  ***Impairment
of Long-Lived Assets***
 In
accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of
Long-Lived Assets,” long-lived assets, such as property and equipment, and
purchased intangibles subject to amortization, are reviewed for impairment
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable. Recoverability of assets to be held and used is
measured by a comparison of the carrying amount of an asset to estimated
undiscounted future cash flows expected to be generated by the asset. If the
carrying amount of an asset exceeds its estimated future cash flows, an
impairment charge is recognized by the amount by which the carrying amount of
the asset exceeds the fair value of the asset. Assets to be disposed of would be
separately
 
 F-14
 presented
in the balance sheet and reported at the lower of the carrying amount or fair
value less costs to sell, and would no longer be depreciated. The assets and
liabilities of a disposed group classified as held for sale would be presented
separately in the appropriate asset and liability sections of the balance sheet.
As of December 31, 2004, no such impairment exists.
  ***Stock
Options***
 The
Company applies the intrinsic-value-based method of accounting prescribed by
Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued
to Employees,” and related interpretations, to account for its fixed-plan stock
options. Under this method, compensation expense is recorded on the date of
grant only if the current market price of the underlying stock exceeded the
exercise price. In accordance with SFAS No. 123 (revised 2004), “Share Based
Payment”, the Company will begin to recognize compensation expense for stock
options in the third quarter of 2005.
  Had stock
compensation cost for the Company’s common stock options been determined based
upon the fair value of the options at the date of grant, as prescribed under
SFAS No. 123, “Accounting for Stock-Based Compensation”, the Company’s net loss
and net loss per share would have been increased to the following pro forma
amounts:
  Year
      Ended December 31,2004
    
    2003
    
    2002Net
      loss:As
      reported
    
    
    ($4,984,196
    )
    
    ($7,442,849
    )
    
    ($9,072,313
    )Less:
      stock-based employee compensation expense included in reported net
      loss
    
    
    6,266
    
    
    6,499
    
    
    9,113Impact
      of total stock-based compensation expense determined under fair value
      based method for all awards
    
    
    (1,540,636
    )
    
    (1,485,378
    )
    
    (2,727,153
    )Pro-forma
    
    
    ($6,518,566
    )
    
    ($8,921,728
    )
    
    ($11,790,353
    )Net
      loss per share:As
      reported
    
    
    ($0.13
    )
    
    ($0.21
    )
    
    ($0.34
    )Pro-forma
    
    
    ($0.17
    )
    
    ($0.25
    )
    
    ($0.44
    )
  The above
pro forma amounts may not be indicative of future amounts because future options
are expected to be granted.
  The fair
value of the options granted is estimated using the Black-Scholes option-pricing
model with the following weighted average assumptions applicable to options
granted during the years:
  Year
      Ended December 31,2004
    
    2003
    
    2002Risk-free
      interest rate
    
    
    3.20
    %
    
    2.98
    %
    
    3.70
    %Volatility
    
    
    99.3
    %
    
    98.9
    %
    
    100
    %Expected
      dividend yield
    
    
    0
    %
    
    0
    %
    
    0
    %Expected
      option life
    
    
    5
      years
    
    
    5
      years
    
    
    5
      years
  ***Supplemental
Cash Flow Information***
 During
the year ended December 31, 2004, the Company financed insurance policies
through notes payables for $530,977, financed vehicle purchases of $181,578
under capital leases, financed certain credit facility costs for $217,695 and
issued warrants to a leasing credit facility which were valued at $80,462, and
which offset the carrying value of debt. In connection with the purchase of the
Stern license and prototypes, the Company issued 113,877 shares of common
stock.
  During
the year ended December 31, 2003, the Company financed vehicle and equipment
purchases of $703,482 under capital leases, financed insurance policies through
notes payable for $479,788 and financed certain acquisition costs which were
included in accounts payable at December 31, 2002, through a note payable for
$171,000.
  For the
years ended December 31, 2004, 2003 and 2002, the Company paid interest of
$181,115, $105,634, and $15,892, respectively. Income taxes paid in 2004, 2003
and 2002 were immaterial. In connection with the acquisition of SLT  in
December 2002, the Company issued 2,716,354 shares of common stock (see Note 2).
  F-15
 ***Recent
Accounting Pronouncements***
 On
December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS
No. 123(R), “Share-Based Payment”, which is a revision of SFAS No. 123 and
supersedes APB Opinion 25. SFAS No. 123(R) requires all share-based payments to
employees, including grants of employee stock options, to be valued at fair
value on the date of grant, and to be expensed over the applicable vesting
period. Pro forma disclosure of the income statement effects of share-based
payments is no longer an alternative. SFAS No. 123(R) is effective for all
stock-based awards granted on or after July 1, 2005. In addition, companies must
also recognize compensation expense related to any awards that are not fully
vested as of the effective date. Compensation expense for the unvested awards
will be measured based on the fair value of the awards previously calculated in
developing the pro forma disclosures in accordance with the provisions of SFAS
No. 123.
  The
Company plans to adopt SFAS No. 123(R) on July 1, 2005. This change in
accounting is not expected to materially impact our financial position. We have
not completed the calculation of this impact. However, because we currently
account for share-based payments to our employees using the intrinsic value
method, our results of operations have not included the recognition of
compensation expense for the issuance of stock option awards.
  On
December 16, 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary
Assets”, which is an amendment to APB Opinion No. 29. It states that the
exchanges of nonmonetary assets should be measured based on the fair value of
the assets exchanged. Further, FSAS No. 153 eliminates the narrow exception for
nonmonetary exchanges of similar productive assets and replaces it with a
broader exception for exchanges of nonmonetary assets that do not have
“commercial substance”. FSAS No. 153 is effective for financial statements for
fiscal years beginning after June 15, 2005. Earlier application is permitted for
nonmonetary asset exchanges incurred during fiscal years beginning after the
date that this statement is issued. Management believes the adoption of this
Statement will not have an effect on the consolidated financial
statements.
  On
November 24, 2004, FASB issued SFAS No. 151, “Inventory Costs”, which is an
amendment to ARB No. 43, Chapter 4. It clarifies the accounting for abnormal
amounts of idle facility expense, freight, handling costs, and wasted material
(spoilage). The FASB states that these costs should be expensed as incurred and
not included in overhead. Further, SFAS No. 151 requires that allocation of
fixed production overheads to conversion costs should be based on normal
capacity of the production facilities. SFAS No. 151 is effective for inventory
costs incurred during fiscal years beginning after June 15, 2005. Management
believes the adoption of this Statement will not have an effect on the
consolidated financial statements.
  In
December 2003, the FASB issued FASB Interpretation No. 46 (revised December
2003), “Consolidation of Variable Interest Entities,” (“VIEs”) (“FIN 46R”) which
addresses how a business enterprise should evaluate whether it has a controlling
financial interest in an entity through means other than voting rights and
accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation
No. 46, “Consolidation of Variable Interest Entities,” which was issued in
January 2003. The Company has adopted FIN 46R as of March 31, 2004 for variable
interests in VIEs. For any VIEs that must be consolidated under FIN 46R that
were created before January 1, 2004, the assets, liabilities and noncontrolling
interests of the VIE initially would be measured at their carrying amounts with
any difference between the net amount added to the balance sheet and any
previously recognized interest being recognized as the cumulative effect of an
accounting change. If determining the carrying amounts is not practicable, fair
value at the date FIN 46R first applies may be used to measure the assets,
liabilities and noncontrolling interest of the VIE. The adoption of FIN 46R did
not have an effect on the consolidated financial statements inasmuch as the
Company has no interests in any VIEs.
  In May
2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity." This Statement
establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. SFAS
No. 150 is effective for financial instruments entered into or modified after
May 31, 2003, and otherwise is effective July 1, 2003. The adoption of SFAS No.
150 did not have a material impact on the Company's consolidated financial
statements, as the Company does not have the types of financial instruments
which would require consideration under this Statement.
  F-16
 *Note
2*
 **Acquisitions:**
  ***Pending
Acquisition - ProCyte***
 ProCyte
Corporation (“ProCyte”) is a Washington corporation organized in 1986. 
ProCyte is a medical skin care company that develops, manufactures and markets
products for skin health, hair care and wound care.  Many of the Company’s
products incorporate its patented copper peptide technologies.
 
 ProCyte’s
focus since 1996 has been to bring unique products, primarily based upon
patented technologies such as GHK and AHK copper peptide technologies, to
selected markets.  ProCyte currently sells its products directly to the
dermatology, plastic and cosmetic surgery, and spa markets.  The Company
has also expanded the use of its novel copper peptide technologies into the mass
retail market for skin and hair care through specifically targeted technology
licensing and supply agreements.
 
 ProCyte’s
products address the growing demand for skin health and hair care products,
including products designed to address the effects aging has on the skin and
hair and to enhance appearance.  ProCyte’s products are formulated, branded
for and targeted at specific markets.  ProCyte’s initial products in this
area addressed the dermatology, plastic and cosmetic surgery markets for use
following various procedures.  Anti-aging skin care products were added to
expand into a comprehensive approach for incorporation into a patients skin care
regimen.  Certain of these products incorporated their patented
technologies, while others complement the product line such as ProCyte’s
advanced sunscreen products that reduce the effects of sun damage and aging on
the skin.
 
 On
December 1, 2004, the Company and ProCyte Corporation entered into a definitive
merger agreement pursuant to which PhotoMedex agreed to acquire ProCyte in a
stock-for-stock transaction valued at approximately $24,400,000. Under the terms
of the agreement, PhotoMedex agreed to issue 0.6622 shares of its common stock
in exchange for each outstanding share of ProCyte common stock. The Company has
agreed to assume certain common stock options to purchase shares of ProCyte
common stock which have an exercise price of $2.00 per share or less. Each
assumed option to purchase shares of ProCyte common stock outstanding
immediately before the completion of the merger will automatically become a
stock option to purchase shares of PhotoMedex common stock. The number of shares
of PhotoMedex common stock into which a stock option is exercisable and the
related exercise price will be adjusted for the exchange ratio in the merger. In
addition, some assumed stock options will become fully vested and exercisable at
the effective time of the merger. The Company has agreed to assume the ProCyte
stock option plans at the effective time of the merger.
  Assuming
the exercise of all assumed ProCyte stock options, the Company expects to issue
approximately 12,090,000 shares of PhotoMedex common stock in connection with
the merger and to reserve for approximately 1,230,000 shares for options that
may be granted in the future out of the option plans assumed from
ProCyte.
  On a pro
forma basis, assuming that all ProCyte shareholders exchange their ProCyte
shares for PhotoMedex shares, and giving effect to the shares underlying the
ProCyte stock options to be assumed by PhotoMedex, ProCyte's stockholders would
own approximately 21% of the combined company's common stock on a fully diluted
basis. Based on the closing prices of the companies' common stock on November
30, 2004, the day before the announcement of the agreement, the offer represents
a purchase price of $1.49 per share and a premium of 33%.
  Consummation
of the merger is subject to various terms and conditions, including the approval
at special stockholder meetings by its stockholders and the by ProCyte
shareholders holding at least two-thirds of outstanding ProCyte shares, of
ProCyte. On March 3, 2005 the ProCyte shareholders approved the adjournment of
its special meeting of shareholders in order for ProCyte to solicit additional
proxies to vote on the proposed merger between PhotoMedex, Inc. and ProCyte. The
adjourned special meeting will be reconvened on March 18, 2005.
  The
ProCyte special meeting was adjourned because an insufficient number of
shareholders were present or represented by proxy to approve the merger proposal
under applicable Washington law. Washington statute requires that the merger be
approved by the affirmative vote of at least two-thirds of the shares of ProCyte
common stock outstanding and entitled to vote on the merger. As of the
adjournment of its special meeting, ProCyte had received proxies representing
approximately 9,639,000 of the required 10,548,344 share votes needed to approve
the merger proposal. Over 92% of the proxies received by ProCyte had been in
favor of the merger proposal. Of the 9,639,000 shares represented at the special
meeting, 8,572,000 (88.9%) voted in favor of the adjournment of the meeting for
the purpose of soliciting additional proxies in favor of the merger
proposal. There can be no assurance that the ProCyte shareholders will
approve the proposed transaction.
  F-17
 At a
separate special meeting of the PhotoMedex stockholders held March 3, 2005,
PhotoMedex stockholders approved the proposal with respect to the issuance of
PhotoMedex shares in the proposed merger by a vote of 24,334,253 (99.1%) shares
in favor and 209,302 shares opposed or abstaining.
 
 If the
merger is consummated, the Company will account for it as a purchase of ProCyte
by PhotoMedex under generally accepted accounting principles. The Company will
allocate the purchase price based on the fair value of ProCyte's acquired assets
and assumed liabilities. The Company will consolidate the operating results of
ProCyte with its own operation results, beginning as of the date the parties
complete the merger. The final allocation of the purchase price will be
determined after the merger is consummated, at which time the actual purchase
price can be calculated, and after completion of a post-closing analysis to
determine the fair values of ProCyte's acquired assets and assumed
liabilities.
  Under
applicable Washington law, ProCyte shareholders have the right to dissent from
the merger and to receive payment in cash for the appraised value of their
shares of ProCyte common stock. The appraised value of the shares of ProCyte
common stock may be more than, less than or equal to the value of the merger
consideration. A dissenter must follow specific procedures in order to perfect
such rights *.*
  The
Company has agreed to pay a finder's fee of $150,000 to BIO-IB, LLC for
introducing the prospect of the ProCyte acquisition. The finder's fee will only
be payable in the event of the closing of the transactions contemplated by the
merger agreement. The investment banking fee to CIBC World Markets is payable
irrespective of whether the merger is consummated. As of December 31, 2004, the
Company has outstanding liabilities amounting to $752,382 which the Company has
incurred and accrued for in connection with the merger.
  ***Stern
Laser Transaction***
 On
September 7, 2004, the Company closed the transactions set forth in a Master
Asset Purchase Agreement, or the Master Agreement, with Stern Laser srl. As of
December 31, 2004, the Company has issued to Stern 113,877 shares of its
restricted common stock in connection with the execution of the Master
Agreement. The Company registered these shares with the SEC in January 2005. The
Company also agreed to pay Stern up to an additional $1,150,000 based on the
achievement of certain remaining milestones relating to the development and
commercialization of certain licensed technology and the licensed products which
may be developed under such arrangement and may have certain other obligations
to Stern under these arrangements. The Company retains the right to pay all of
these conditional sums in cash or in shares of its common stock, in its
discretion. To secure the latter alternative, the Company has reserved for
issuance, and placed into escrow, 586,123 shares of its unregistered stock. The
per-share price of any future issued shares will be based on the closing price
of the Company’s common stock during the 10 trading days ending on the
achievement of a particular milestone under the terms of the Master Agreement.
As of March 10, 2005, the Company has accrued for the issuance of an additional
43,668 shares of its stock, based upon a $100,000 milestone set forth in the
Master Agreement. Stern also has served as the distributor of the Company’s
XTRAC laser system in South Africa and Italy since 2000.
  The
Company assigned $340,569 as to the fair value of the license it acquired from
Stern. Amortization of this intangible is on a straight-line basis over 10
years, which will begin in January 2005. As Stern completes further milestones
under the Master Agreement, the Company expects to increase the carrying value
of the license.
 
 ***Completed
Acquisition - SLT***
 On
December 27, 2002, the Company acquired all of the outstanding common shares of
SLT. The results of SLT’s operations since that date have been included in the
consolidated financial statements. The Company acquired SLT in order to gain
market share in surgical products and services markets through a business model
that is compatible with the Company’s own approach to the dermatology market.
The Company also acquired SLT with an expectation that it could reduce costs
through economies of scale.
  SLT had
focused on lasers used in surgery in such venues as hospitals, surgi-centers and
doctors’ offices. SLT employed a similar business model to the Company’s
domestic services by charging a per-procedure fee. With the addition of SLT, the
Company now offers laser services over a wide range of specialties, including
urology, gynecology, orthopedics, and general and ENT surgery. Surgical services
are offered using such lasers as the holmium, diode, Nd:YAG Contact and CO2
lasers. In addition, the Company now develops, manufactures and markets
healthcare lasers and their disposables.
  F-18
 The
aggregate purchase price was $3,822,818 and was paid through the issuance of
2,716,354 shares of common stock at $1.32 per share and the incurrence of
$237,000 of transaction costs. The merger consideration resulted in the
equivalent of a fixed ratio of 1.12 shares of PhotoMedex common stock for each
share of SLT common stock. As the exchange ratio was fixed, the fair value of
PhotoMedex common stock for accounting purposes was based upon the average stock
price of $1.32 per share on the date of the acquisition and the two days prior
and afterwards.
  Based on
the purchase price allocation, the following table summarizes the estimated fair
value of the assets acquired and liabilities assumed at the date of acquisition.
  Cash
      and cash equivalents
    
    $
    120,500Restricted
      cash, cash equivalents and short-term investments
    
    
    2,000,000Accounts
      receivable
    
    
    1,508,460Inventories
    
    
    2,731,811Prepaid
      expenses and other current assets
    
    
    148,506Property
      and equipment
    
    
    1,910,674Patents
      and licensed technologies
    
    
    317,346Other
      assets
    
    
    43,020Total
      assets acquired
    
    
    8,780,317Current
      portion of notes payable
    
    
    (53,470
    )Current
      portion of long-term debt
    
    
    (2,143,425
    )Accounts
      payable
    
    
    (1,084,055
    )Accrued
      compensation and related expenses
    
    
    (250,356
    )Other
      accrued liabilities
    
    
    (575,410
    )Deferred
      revenues
    
    
    (56,350
    )Long-term
      debt
    
    
    (794,433
    )Total
      liabilities assumed
    
    
    (4,957,499
    )Net
      assets acquired
    
    $
    3,822,818
  The fair
value of the net assets acquired, excluding the debt assumed, exceeded the
purchase price by $1,825,819, resulting in negative goodwill. In accordance with
SFAS No. 142, “Goodwill and Other Intangible Assets,” the negative goodwill was
recorded as a reduction of intangibles and property and equipment of $773,604
and $1,052,215, respectively.
  The
accompanying consolidated financial statements do not include any revenues or
expenses related to the acquisition prior to December 27, 2002, the closing
date. Following are the Company’s unaudited proforma results for the years ended
December 31, 2002, assuming the acquisition had occurred on January 1,
2002.
  Year
      Ended December 31, 2002Net
      revenues
    
    $
    14,327,000Net
      loss
    
    
    (8,254,000
    )Basic
      and diluted loss per share
    
    
    ($0.28
    )Shares
      used in calculating basic and diluted loss per share
    
    
    29,244,828
  These
unaudited proforma results have been prepared for comparative purposes only and
do not purport to be indicative of the results of operations which would have
actually resulted had the acquisition occurred on January 1, 2002, or of future
results of operations.
  F-19
  *Note
3*
 **Inventories:**
  Set forth
below is a detailed listing of inventories.
  December
      31,2004
    
    2003Raw
      materials and work-in-process
    
    $
    2,968,728
    
    $
    2,586,347Finished
      goods
    
    
    1,616,903
    
    
    1,936,115Total
      inventories
    
    $
    4,585,631
    
    $
    4,522,462
  Work-in-process
is immaterial, given the typically short manufacturing cycle, and therefore is
disclosed in conjunction with raw materials. Finished goods includes $84,000 and
$282,000 as of December 31, 2004 and 2003, respectively, for laser systems
shipped to distributors, but not recognized as revenue until all the criteria of
Staff Accounting Bulletin No. 104 have been met. At times, units are shipped but
revenue is not recognized until all of the criteria are met, and until that
time, the unit is carried on the books of the Company as inventory. The Company
ships most of its products FOB shipping point, although from time to time
certain customers, for example governmental customers, will insist on FOB
destination. Among the factors the Company takes into account in determining the
proper time at which to recognize revenue are when title to the goods transfers
and when the risk of loss transfers. Shipments to the distributors that do not
fully satisfy the collection criteria are recognized when invoiced amounts are
fully paid.
  *Note
4*
 **Property
and Equipment:**
  Set forth
below is a detailed listing of property and equipment.
  December
      31,2004
    
    2003Lasers
      in service
    
    $
    9,333,591
    
    $
    7,266,707Computer
      hardware and software
    
    
    256,340
    
    
    256,340Furniture
      and fixtures
    
    
    239,520
    
    
    327,575Machinery
      and equipment
    
    
    522,643
    
    
    237,777Autos
      and trucks
    
    
    400,570
    
    
    224,135Leasehold
      improvements
    
    
    110,441
    
    
    110,44110,863,105
    
    
    8,422,975Accumulated
      depreciation and amortization
    
    
    (5,866,417
    )
    
    (4,417,770
    )Property
      and equipment, net
    
    $
    4,996,688
    
    $
    4,005,205
  Depreciation
expense was $1,596,154 in 2004, $2,011,596 in 2003 and $1,510,838 in 2002. At
December 31, 2004 and 2003, net property and equipment included $666,326 and
$716,651, respectively, of assets recorded under capitalized lease arrangements,
of which $565,245 and $675,508, respectively, of the capital lease obligation
was included in long-term debt at December 31, 2004 and 2003 (see Note 9).
  *Note
5*
 **Patents
and Licensed Technologies:**
  Set forth
below is a detailed listing of patents and licensed technology.
  December
      31,2004
    
    2003Patents,
      owned and licensed, at gross costs of $403,023 net of accumulated
      amortization of $155,522 and $113,744
    
    $
    247,501
    
    $
    289,279Other
      licensed and developed technologies, at gross costs of $1,177,568 and
      $837,000, net of accumulated amortization of $495,635 and $367,624,
      respectively
    
    
    681,933
    
    
    469,376Total
      patents and licensed technologies, net
    
    $
    929,434
    
    $
    758,655
  F-20
 The
Company assigned $340,569 to the license it acquired from Stern Laser, which is
included in other licensed and developed technologies. Amortization of this
intangible is on a straight-line basis over 10 years, which will begin in
January 2005. As Stern Laser completes further milestones under the Master
Agreement, the Company expects to increase the carrying value of the license.
Amortization expense was $169,790 in 2004, $175,147 in 2003 and $136,365 in
2002. Estimated amortization expense for amortizable intangible assets for the
next five years is $201,000 in 2005, $199,000 in 2006, $156,000 in 2007, $70,000
in 2008, $70,000 in 2009 and $233,000 thereafter.
  *Note
6*
 **Capitalized
Acquisition Costs:**
  Pursuant
to the merger agreement with ProCyte Corporation (“ProCyte”), the Company has
incurred $888,391 of expenses of which $762,477 has been capitalized as
acquisition costs and $125,914 has been included in Additional Paid in Capital
as registration costs. At December 31, 2004, $752,382 of these expenses remains
unpaid and is recorded in current liabilities.
  *Note
7*
 **Other
Accrued Liabilities:**
  Set forth
below is a detailed listing of other accrued liabilities.
  December
      31,2004
    
    2003Accrued
      professional and consulting fees
    
    $
    412,019
    
    $
    203,699Accrued
      warranty
    
    
    196,890
    
    
    316,714Accrued
      liability from matured notes
    
    
    245,849
    
    
    247,108Cash
      deposits on sales
    
    
    -
    
    
    125,500Other
      accrued expenses
    
    
    69,296
    
    
    82,515Total
      other accrued liabilities
    
    $
    924,054
    
    $
    975,536
  During
2002, SLT resumed direct control of $223,000 of funds previously set aside for
the payment of SLT’s subordinated notes, which matured and ceased to bear
interest on July 30, 1999, and $31,000 of funds set aside to pay related accrued
interest. As of December 31, 2004 and 2003, the matured principal and related
interest was $245,849 and $247,108, respectively.
 F-21
  *Note
8*
 **Notes
Payable:**
  Set forth
below is a detailed listing of notes payable. The stated interest rate
approximates the effective cost of funds from the notes.
  December
      31,2004
    
    2003Note
      payable - unsecured creditor, interest at 5.75%,payable
      in monthly principal and interest installmentsof
      $44,902 through January 2005.
    
    $
    44,902
    
    $
    -Note
      payable - secured creditor, interest at 16.47%, payable in monthly
      principal and interest installments of $2,618 through December
      2006.
    
    
    51,489
    
    
    72,382Note
      payable - unsecured creditor, interest at 7.47%, payable in monthly
      principal and interest installments of $7,827 through June
      2004.
    
    
    -
    
    
    40,907Note
      payable - unsecured creditor, interest at 7.37%, payable in monthly
      principal and interest installments of $37,640 through January
      2004.
    
    
    -
    
    
    37,409Note
      payable - unsecured creditor, interest at 6.63%, payable in monthly
      principal and interest installments of $1,868 through January
      2004.
    
    
    -
    
    
    1,85796,391
    
    
    152,555Less:
      current maturities
    
    
    (69,655
    )
    
    (101,066
    )Notes
      payable, net of current maturities
    
    $
    26,736
    
    $
    51,489
  Aggregate
maturities of the notes payable as of December 31, 2004 are $69,655 due in 2005
and $26,736 due in 2006.
  *Note
9*
 **Long-term
Debt:**
  Set forth
below is a detailed listing of the Company’s long-term debt.
  December
      31,2004
    
    2003Borrowings
      on a credit facility
    
    $
    1,680,627
    
    $
    1,000,000Capital
      lease obligations (see Note 4)
    
    
    565,246
    
    
    675,508Less:
      current portion
    
    
    (873,754
    )
    
    (1,269,759
    )Total
      long-term debt
    
    $
    1,372,119
    
    $
    405,749
  The
Company obtained a $2,500,000 leasing credit facility from GE Capital
Corporation on June 25, 2004. The credit facility has a commitment term of three
years, expiring on June 25, 2007. The Company accounts for each draw as funded
indebtedness taking the form of a capital lease, with equitable ownership in the
lasers remaining with the Company. GE retains title as a means of retaining a
form of security over the lasers. The Company continues to depreciate the lasers
over their remaining useful lives, as established when originally placed into
service. Each draw against the credit facility has a self-amortizing repayment
period of three years and is secured by specified lasers, which the Company has
sold to GE and leased back for continued deployment in the field. The draw is
set at an interest rate based on 522 basis points above the three-year Treasury
note rate. Each draw is discounted by 7.75%; the first monthly payment is
applied directly to principal. With each draw, the Company has agreed to issue
warrants to purchase shares of the Company’s common stock equal to 5% of the
draw. The number of warrants is determined by dividing 5% of the draw by the
average closing price of the Company’s common stock
 
 F-22
 for the
ten days preceding the date of the draw. The warrants have a five-year term from
the date of each issuance and bear an exercise price set at 10% over the average
closing price for the ten days preceding the date of the draw.
  As of
December 31, 2004, the Company had made three draws against the line.
  Draw
      1
    
    Draw
      2
    
    Draw
      3Date
      of draw
    June
      30, 2004
    
    September
      24, 2004
    
    December
      30, 2004Amount
      of draw
    $1,536,950
    
    $320,000
    
    $153,172Stated
      interest rate
    8.47%
    
    7.97%
    
    8.43%Effective
      interest rate
    17.79%
    
    17.41%
    
    17.61%Number
      of warrants issued
    23,903
    
    6,656
    
    3,102Exercise
      price of warrants per share
    $3.54
    
    $2.64
    
    $2.73Fair
      value of warrants
    $62,032
    
    $13,489
    
    $5,946
 
  The fair
value of the warrants granted is estimated using the Black-Scholes
option-pricing model with the following weighted average assumptions applicable
to the warrants granted:
  Warrants
      granted under:Draw
      1
    
    Draw
      2
    
    Draw
      3Risk-free
      interest rate
    3.81%
    
    3.70%
    
    3.64%Volatility
    99.9%
    
    100%
    
    99.3%Expected
      dividend yield
    0%
    
    0%
    
    0%Expected
      option life
    5
      years
    
    5
      years
    
    5
      years
 
 For
reporting purposes, the carrying value of the liability is reduced at the time
of each draw by the value ascribed to the warrants. This reduction will be
amortized at the effective interest rate to interest expense over the term of
the draw.
  The
Company has received a letter of intent from GE Capital Corporation to open a
second line of leasing credit. The second, supplemental line would be for
$5,000,000, have a term of three years and be secured by lasers used in the
Company’s Domestic XTRAC and Surgical Services segments. The proposed terms seem
favorable to the Company. However, the second line is subject to and contingent
upon a due diligence review, to be completed in March 2005.
  Concurrent
with the SLT acquisition, the Company assumed a $3,000,000 credit facility from
a bank. The credit facility had a commitment term of four years, which expired
May 31, 2004, permitted deferment of principal payments until the end of the
commitment term, and was secured by SLT’s business assets, including
collateralization (until May 13, 2003) of $2,000,000 of SLT’s cash and cash
equivalents and short-term investments. The bank agreed to allow the Company to
apply the cash collateral to a paydown of the facility in 2003. The credit
facility had an interest rate of the 30-day LIBOR plus 2.25%. The
credit facility was subject to certain restrictive covenants at the SLT level
and at the group level and borrowing base limitations. The group did not meet
the covenants set by the bank at December 31, 2003. On March 10, 2004, the bank
waived the non-compliance with the covenants as of December 31, 2003.
  Future
minimum payments for property under capital leases are as follows:
  Year
      Ending December 31,2005
    
    $
    302,8892006
    
    
    196,9192007
    
    
    89,7422008
    
    
    40,952Total
      minimum lease obligation
    
    
    630,502Less:
      interest
    
    
    (65,256
    )Present
      value of total minimum lease obligation
    
    $
    565,246
  F-23
  Future
minimum payments for draws under the lease credit facility are as
follows:
  Year
      Ending December 31,2005
    
    $
    731,4892006
    
    
    732,3362007
    
    
    417,5132008
    
    
    -Total
      minimum lease obligation
    
    
    1,881,338Less:
      interest
    
    
    (200,711
    )Present
      value of total minimum lease obligation
    
    $
    1,680,627
  *Note
10*
 **Warrant
Exercises:**
  In the
year ended December 31, 2004, 2,104,147 warrants on the common stock of the
Company were exercised, resulting in an increase to the Company’s shares
outstanding as of the end of the period by the same amount. The Company received
$3,086,468 in cash proceeds from the exercises. Of these proceeds, $803,456 was
from the exercise of warrants that were exercisable at $1.77 per share and were
set to expire on March 31, 2004 and $1,226,112 was from the exercise of warrants
that were exercisable at $1.16 per share and were set to expire on
September 30, 2004. See also ***Common
Stock Warrants*** in *Note
12* .
  *Note
11*
 **Commitments
and Contingencies:**
  ***Leases***
 The
Company has entered into various non-cancelable operating leases for personal
property that expire at various dates through 2007. Rent expense was $456,077,
$517,662 and $190,763 for the years ended December 31, 2004, 2003 and 2002,
respectively. The future annual minimum payments under these non-cancelable
operating leases are as follows:
  Year
      Ending December 31,2005
    
    $
    344,9422006
    
    
    133,3832007
    
    
    8,448Total
    
    $
    486,773
  ***Litigation***
 The
Company is a defendant in an action filed by City National Bank of Florida,
which had been the Company’s landlord in Orlando, Florida. The action was
brought in December 2000 in the Circuit Court of the Ninth Judicial Circuit, in
and for Orange County, Florida. The complaint seeks to recover unpaid rent for
the facility the Company had occupied prior to the sale to Lastec of assets
related to the operations of the Company’s former facility in Orlando, Florida.
City National has alleged that the Company and Lastec owe it $143,734, primarily
for rent that was unpaid for the period after the sale of the assets to Lastec
up to an abandonment of the facility by Lastec. The Company has denied liability
and have asserted that City National neglected to mitigate its damages by
repossessing the facility after it was abandoned by Lastec and further that the
Company’s obligations to City National ceased on the effective date of the asset
sale to Lastec. In connection with the settlement and dismissal of a separate
action filed by the Company against Lastec and its principals related to the
asset sale, Lastec and its principals agreed in writing to be responsible to pay
any settlement or monetary judgment to City National and, if necessary, to post
a surety bond of $100,000 to secure such a payment. Lastec and its principals
defaulted in their undertakings, so the Company is maintaining its own defense.
Attempts to mediate a settlement with the Bank have been so far unsuccessful.
Based on information currently available, the Company cannot evaluate the
likelihood of an unfavorable outcome.
  On or
about April 29, 2003, the Company brought an action against RA Medical Systems,
Inc. and Dean Stewart Irwin in the Superior Court for San Diego County,
California. Mr. Irwin had been the Company’s Vice President of Research and
Development until July 2002, when the Company terminated his employment. Shortly
after his termination, Mr. Irwin founded RA Medical Systems. The Company alleged
claims for misappropriation of trade secrets, unfair competition, intentional
interference with contractual relationships, breach of contract and conversion.
Defendants brought a motion for summary judgment on all counts in the complaint.
On November 13, 2003, the Court denied
 
 F-24
 summary
judgment on the counts of misappropriation and unfair competition, but granted
summary judgment on the other counts. The Company dismissed the remaining counts
for misappropriation and unfair competition without prejudice on December 31,
2003. The defendants filed a motion for costs and attorneys’ fees. The Superior
Court granted costs; the Court denied attorneys’ fees on grounds of bad faith
but granted attorneys’ fees based on a provision in the confidentiality
agreement which the Company asserted Mr. Irwin had breached. The Company
appealed this ruling to the Court of Appeals, which on February 23, 2005 upheld
the lower court’s ruling.
  The
Company brought an action against RA Medical Systems and Mr. Iwrin in the United
States District Court for the Southern District of California on Federal and
California claims for false advertising and unfair competition. The complaint in
the Federal action was filed on January 6, 2004. The defendants have answered
the complaint with general denials. Attempts at settlement have failed. The case
is now in the discovery phase.
  On
January 25, 2005, RA Medical Systems, Inc. and Dean Stewart Irwin brought an
action against PhotoMedex, Inc., Jeffrey Levatter Ph.D. (the Company’s Chief
Technology Officer), Jenkens & Gilchrist, LLP (the Company’s outside
counsel) and Michael R. Matthias, Esq. (litigation partner at the Company’s
outside counsel). The action was brought in the Superior Court for San Diego
County, California and is based on an allegation that the defendants had engaged
in malicious prosecution in bringing and maintaining the action brought by
PhotoMedex in April 2003. The defendants have filed a motion to strike the
action, based on California Code of Civil Procedure section 425.16, the
so-called SLAPP statute. The Company’s motion to strike was denied.
  The
Company brought an action against Edwards Lifesciences Corporation and Baxter
Healthcare Corporation on January 29, 2004 in the Superior Court for Orange
County, California. The complaint states claims for breach of contract and under
a claim known as “money had and received.” The Company has moved to amend the
complaint to include a claim of unjust enrichment. The motion to amend is set
for hearing on April 1, 2005. The Company seeks recovery of the sum of
$4,000,000 paid to the defendants in connection with a series of agreements
between the parties, costs incurred in raising the $4,000,000, interest thereon
and attorneys’ fees and costs incurred in the action. Defendants answered the
complaint with several denials, multiple defenses and no counterclaims.
Defendants filed a demurrer, which was denied. Defendants have filed a motion
for summary judgment, to which the Company is preparing its opposition. Hearing
on the summary judgment motion is set for April 18, 2005. Discovery in this
action is continuing. A trial date is set for May 23, 2005.
  The
Company is involved in certain other legal actions and claims arising in the
ordinary course of business. Management believes, based on discussions with
legal counsel, that such litigation and claims will be resolved without a
material effect on the Company's consolidated financial position, results of
operations or liquidity.
  ***Employment
Agreements***
 The
Company has severance agreements with certain key executives and employees which
create certain liabilities in the event of their termination of employment
without cause, or following a change in control of the Company. The aggregate
commitment under these executive severance agreements, should all covered
executives and employees be terminated other than for cause, was approximately
$1,406,000 as of December 31, 2004. Should all covered executives be terminated
following a change in control of the Company, the aggregate commitment under
these executive severance agreements at December 31, 2004 was approximately
$1,992,000.
  *Note
12*
 **Stockholders’
Equity:**
  ***Common
Stock***
 As of
September 30, 2004, the Company had issued 113,877 shares of its restricted
common stock in connection with the Asset Purchase agreement with Stern Laser
Srl, or Stern.
  On May
28, 2003, the Company closed on a private placement for 5,982,352 shares of
common stock at $1.70 per share resulting in gross proceeds of $10,170,000. The
closing price of the Company’s common stock on May 28, 2003 was $2.07 per share.
In connection with this private placement, the Company paid commissions and
other expenses of $692,454, resulting in net proceeds of $9,477,546. In
addition, the investors received warrants to purchase 1,495,588 shares of common
stock at an exercise price of $2.00 per share. The warrants have a five-year
term and became exercisable on November 29, 2003 (see ***Common
Stock Warrants*** below).
The Company is using the proceeds of this financing to pay for working capital
and other general corporate purposes. The shares sold in the private placement,
including the shares underlying the warrants, have been registered with the
Securities and Exchange Commission.
  F-25
 On
December 27, 2002, the Company acquired all of the common stock of SLT for
2,716,354 shares of common stock and the assumption of 89,600 warrants on SLT’s
common stock. The warrants expired unexercised on December 31, 2002.
  On June
13, 2002, the Company completed a private offering of 4,115,000 shares of common
stock at $1.50 per share for gross proceeds of $6,172,500. The closing price of
the Company’s common stock on June 13, 2002 was $1.68 per share. In connection
with this offering, the Company paid a commission of $434,075, as well as other
costs of $32,378, resulting in net proceeds of $5,706,047. In addition, the
investors received warrants to purchase 1,028,750 shares of common stock at an
exercise price of $1.90 per share, which became exercisable on December 12,
2002. The warrants have a five-year term. The proceeds from this financing have
been used for working capital and other general corporate purposes.
  ***Common
Stock Options***
 In
January 1996, the Company adopted the 1995 Non-Qualified Option Plan (the “1995
Plan”) for key employees, officers, directors, and consultants, and initially
provided for up to 500,000 options to be issued thereunder. The exercise price
of each option granted under the 1995 Plan could not be less than the fair
market value on the date granted. Options under the Plan generally vested 40%
upon grant, 30% on the first anniversary of the grant; and the remaining 30% on
the second anniversary. No options could be exercised more than 10 years after
the grant date. Options are not transferable (other than at death), and in the
event of termination for cause (other than death or disability) or voluntary
termination, all unvested options automatically terminate. The plan is inactive
at December 31, 2004 and had 49,000 options outstanding.
  On April
10, 1998, the Company created a stock option plan for outside/non-employee
members of the Board of Directors. Pursuant to the stock plan, each
outside/non-employee director was to receive an annual grant of options, in
addition to any other consideration he or she may receive, to purchase up to
20,000 shares of common stock as compensation, at an exercise price equal to the
market price of the common stock on the last trading day of the preceding year.
The options granted pursuant to this plan vested at the rate of 5,000 options
per quarter during each quarter in which such person had served as a member of
the Board of Directors. Since the date of adoption of the Non-Employee Director
Stock Option Plan (discussed below), the Company no longer grants options to
members of the Board of Directors under this plan. At December 31, 2004, the
plan had 75,000 options outstanding.
  In May
2000, the Company adopted the 2000 Stock Option Plan (the “2000 Plan”). The 2000
Plan initially reserved for issuance up to 1,000,000 shares of the Company’s
common stock, which was increased to 2,000,000 shares pursuant to the
affirmative vote of the stockholders on June 10, 2002 and to 3,350,000 shares on
December 16, 2003. The reserved shares are to be used for granting of incentive
stock options (“ISOs”) to employees of the Company and for granting of
non-qualified stock options (“NSOs”) and other stock-based awards to employees
and consultants. The option exercise price for ISOs shall not be less than the
fair market value of the Company’s stock on the date of grant. All ISOs granted
to less than ten-percent stockholders may have a term of up to 10 years, while
ISOs granted to greater than ten-percent stockholders shall have a term of up to
five years. The option exercise price for NSOs shall not be less than 85% of the
fair market value of the Company’s stock on the date of grant. No NSOs shall be
exercisable for more than 10 years after the date of the respective grant. The
plan is active, and had 2,401,291 options outstanding at December 31, 2004.
  In May
2000, the Company also adopted the Non-Employee Director Stock Option Plan (the
“Non-Employee Director Plan”). The Non-Employee Director Plan reserved for
issuance up to 250,000 shares of the Company’s common stock for the granting of
non-qualified options to members of the Company’s Board of Directors. In
consideration for services rendered, each director received on each of January
1, 2001 and 2002 an option to purchase 20,000 shares of the Company’s common
stock. The Company’s stockholders voted on June 10, 2002 to increase the number
of reserved shares to 650,000 and also to increase the annual grant to each
director from 20,000 to 35,000. On December 16, 2003, the stockholders voted to
increase the number of reserved shares to 1,000,000. The plan is active and had
501,250 options outstanding at December 31, 2004.
  In
January 2004, the Company agreed to extend the life, by one year, of 525,000
options granted to Mr. O’Donnell in November 1999 as part of a bloc of 650,000
options, bearing an exercise price of $4.65 per share. In January 2004, the
Company also agreed to extend the life, by one year, of 350,000 options granted
to Mr. McGrath in November 1999, bearing an exercise price of $5.50 per share.
Neither extension had any impact on the consolidated financial
statements.
  F-26
 In
January 2004, the Company issued 210,000 options to purchase common stock to
non-employee directors, in accordance with the terms of the Non-Employee
Director Plan. In September 2004, 17,500 options were issued to a new
non-employee director in accordance with the terms of the Non-Employee Director
Plan.
  Also in
January, July, September and December 2004, the Company granted an aggregate of
776,000 options to purchase common stock to a number of employees. The options
vest over four years and expire five years from the date of grant.
  In
January 2004, the Company granted 30,000 options to purchase common stock to the
various members of the Company’s Scientific Advisory Board for services
rendered. The options have an exercise price of $2.14 per share. The options
vested on grant and will expire five years from the date of the grant. The
Company recorded $48,192 of expense relating to these options for the year ended
December 31, 2004.
  In
December 2004, the Company granted 27,000 options to purchase common stock to
the various consultants and members of the Company’s Scientific Advisory Board
for services rendered. The options have an exercise price of $2.46 per share.
The options vested immediately and will expire 5 years from the date of the
grant. The Company recorded $50,243 of expense relating to these options for the
year ended December 31, 2004.
  In
January 2003, the Company issued 175,000 options to purchase common stock to
non-employee directors, in accordance with the terms of the Non-Employee
Director Plan. In October 2003, 8,750 options were issued to a new non-employee
director in accordance with the terms of the Non-Employee Director
Plan.
  Also in
January and April 2003, the Company granted an aggregate of 614,000 options to
purchase common stock to several employees. The options vest over four years and
expire five years from the date of grant.
  In April
2003, the Company granted 30,000 options to purchase common stock to the various
members of the Company’s Scientific Advisory Board for services rendered. The
options have an exercise price of $1.53 per share. The options vested
immediately and will expire 10 years from the date of the grant. The Company
recorded $38,164 of expense relating to these options for the year ended
December 31, 2003.
  In
January 2002, the Company issued 100,000 options to purchase common stock to
non-employee directors, in accordance with the terms of the Non-Employee
Director Plan.
  Also in
January 2002, the Company granted 24,000 options to purchase common stock to the
various members of the Company’s Scientific Advisory Board for services rendered
at an exercise price of $1.85 per share. The options vested immediately and will
expire 10 years from the date of the grant. The Company recorded $34,296 of
expense relating to these options for the year ended December 31,
2002.
  Over the
course of 2002, the Company granted an aggregate of 48,000 options to purchase
common stock to five employees. The options vest over four years and expire five
years from the date of grant.
  In April
2002, the Company granted 105,000 options at fair market value to an employee.
No expense was recorded as a result of the grant. The options will vest over two
years and expire five years from the date of grant.
  In
December 2002, the Company granted 204,480 options to purchase common stock to
two former executives of SLT. No expense was recorded as a result of the grants.
The options vested 25% on grant date, with the balance vesting over three years;
the options will expire five years from the date of grant.
  F-27
 A summary
of option transactions for all of the Company’s options during the years ended
December 31, 2004, 2003 and 2002 is as follows:
  Number
      of Shares
    
    Weighted
      Average Exercise PriceOutstanding
      at January 1, 2002
    
    
    3,451,515
    
    $
    5.48Granted
    
    
    481,480
    
    
    1.74Exercised
    
    
    (18,000
    )
    
    1.00Expired/cancelled
    
    
    (37,950
    )
    
    3.26Outstanding
      at December 31, 2002
    
    
    3,877,045
    
    
    4.65Granted
    
    
    827,750
    
    
    1.73Exercised
    
    
    (61,458
    )
    
    1.05Expired/cancelled
    
    
    (513,141
    )
    
    5.77Outstanding
      at December 31, 2003
    
    
    4,130,196
    
    
    3.87Granted
    
    
    1,127,166
    
    
    2.50Exercised
    
    
    (120,865
    )
    
    1.75Expired/cancelled
    
    
    (925,957
    )
    
    6.39Outstanding
      at December 31, 2004
    
    
    4,210,540
    
    $
    3.48
  As of
December 31, 2004, 2,905,108 options to purchase common stock were vested and
exercisable at prices ranging from $0.95 to $11.75 per share. As of December 31,
2003, 2,937,042 options to purchase common stock were vested and exercisable at
prices ranging from $0.95 to $13.50 per share. Options are issued with exercise
prices equal to the market price on the date of issue, so the weighted-average
exercise price equals the weighted-average fair value price.
  The
outstanding options, including options exercisable at December 31, 2004, have a
range of exercise prices and associated weighted remaining contractual life and
weighted average exercise price as follows:
 
 Options
      Range of ExercisePrices
    
    Outstanding
      Number ofShares
    
    Weighted
      Average Remaining Contractual Life(years)
    
    Weighted
      AverageExercise
      Price
    
    Options
      Number ofShares
    
    Exercisable
      Weighted Avg.Exercise
      Price$0
      - $2.50
    
    
    2,530,865
    
    
    4.00
    
    $
    1.82
    
    
    1,374,953
    
    $
    1.76$2.51
      - $5.00
    
    
    760,375
    
    
    1.61
    
    $
    4.19
    
    
    614,701
    
    $
    4.56$5.01
      - $7.50
    
    
    465,000
    
    
    0.90
    
    $
    6.85
    
    
    461,896
    
    $
    5.64$7.51
      - $11.75
    
    
    454,300
    
    
    0.65
    
    $
    9.30
    
    
    453,558
    
    $
    9.30Total
    
    
    4,210,540
    
    
    2.86
    
    $
    3.48
    
    
    2,905,108
    
    $
    4.15
  The
outstanding options will expire as follows:
 
 Year
      Ending
    
    Number
      of Shares
    
    Weighted
      Average Exercise Price
    
    Exercise
      Price2005
    
    
    1,444,300
    
    
    6.22
    
    $1.50
      - $11.752006
    
    
    594,760
    
    
    2.26
    
    $0.95
      - $8.002007
    
    
    337,480
    
    
    1.71
    
    $1.26
      - $1.852008
    
    
    573,250
    
    
    1.67
    
    $1.53
      - $2.702009
      and later
    
    
    1,260,750
    
    
    2.20
    
    $1.77
      - $2.704,210,540
    
    $
    3.48
    
    $0.95
      - $11.75
  F-28
 ***Common
Stock Warrants***
 The
Company issued warrants to purchase common stock to GE Capital Corporation
related to the leasing credit facility in the following manner: on June 30,
2004, 23,903 shares at an exercise price of $3.54 per share; on September 24,
2004, 6,656 shares at an exercise price of $2.64 per share; on December 30,
2004, 3,102 at an exercise price of $2.73 per share. The warrants have a
five-year term.
  In May
2003, in addition to receiving common stock in the Company’s private placement,
the investors received warrants to purchase 1,495,588 shares of common stock at
an exercise price of $2.00 per share. The warrants have a five-year term,
expiring in November 2008.
  In June
2002, in addition to receiving common stock in the Company’s private placement,
the investors received warrants to purchase 1,028,750 shares of common stock at
an exercise price of $1.90 per share. The warrants have a five-year term
expiring in December 2007.
  A summary
of warrant transactions for the years ended December 31, 2004, 2003 and 2002 is
as follows:
  Number
      of Warrants
    
    Weighted
      Average
      Exercise
      PriceOutstanding
      at January 1, 2002
    
    
    2,348,680
    
    $
    1.75Issued
    
    
    1,028,750
    
    
    1.90Exercised
    
    
    (409,751
    )
    
    1.06Expired
    
    
    (6,875
    )
    
    1.05Outstanding
      at December 31, 2002
    
    
    2,960,804
    
    
    1.62Issued
    
    
    1,551,302
    
    
    1.93Exercised
    
    
    (253,271
    )
    
    1.85Expired/cancelled
    
    
    (7,752
    )
    
    2.00Outstanding
      at December 31, 2003
    
    
    4,251,083
    
    
    1.90Issued
    
    
    33,661
    
    
    3.29Exercised
    
    
    (2,104,147
    )
    
    1.47Expired/cancelled
    
    
    (11,998
    )
    
    2.08Outstanding
      at December 31, 2004
    
    
    2,168,599
    
    $
    2.34
  At
December 31, 2004, all outstanding warrants were exercisable at prices ranging
from $1.90 to $16.53 per share.
  If not
previously exercised, the outstanding warrants will expire as
follows:
  Year
      Ending December 31,
    
    Number
      of Warrants
    
    Weighted
      Average
      Exercise
      Price2005
    
    
    40,275
    
    $
    13.512006
    
    
    -
    
    
    -2007
    
    
    886,602
    
    
    2.272008
    
    
    1,208,061
    
    
    2.002009
    
    
    33,661
    
    
    3.292,168,599
    
    $
    2.34
  F-29
 ***Reserved
Shares***
 As of
March 10, 2005, the Company has reserved 13,320,000 shares of its common stock
for the following purposes:
 
 Purpose
    
    Shares
      ReservedIssuance
      to ProCyte shareholders in the pending acquisition
    
    
    10,541,000Issuance
      to holders of outstanding ProCyte options in the pending
      acquisition
    
    
    1,549,000Future
      option grants from ProCyte option plans in the pending
      acquisition
    
    
    1,230,00013,320,000
  *Note
13*
 **Income
Taxes:**
  The
Company accounts for income taxes pursuant to SFAS No. 109, "Accounting for
Income Taxes" ("SFAS No. 109"). SFAS No. 109 is an asset-and-liability approach
that requires the recognition of deferred tax assets and liabilities for the
expected tax consequences of events that have been recognized in the Company's
financial statements or tax returns.
  Income
tax expense (benefit) consists of the following.
  Year
      Ended December 31,2004
    
    2003
    
    2002Federal,
      including AMT tax:Current
    
    $
    -
    
    $
    -
    
    $
    -Deferred
    
    
    (2,114,000
    )
    
    1,536,000
    
    
    3,013,000State:Current
    
    
    -
    
    
    -
    
    
    -Deferred
    
    
    (174,000
    )
    
    179,000
    
    
    353,000(2,288,000
    )
    
    1,715,000
    
    
    3,366,000Change
      in valuation allowance, excluding SLT deferred asset in
    2002
    
    
    (2,288,000
    )
    
    1,715,000
    
    
    3,366,000Income
      tax expense
    
    $
    -
    
    $
    -
    
    $
    -
  The
Company has no income that is subject to foreign taxes.
  A
reconciliation of the effective tax rate with the Federal statutory tax rate
follows:
  Year
      Ended December 31,2004
    
    2003
    
    2002Expected
      Federal tax benefit at statutory rate
    
    $
    1,701,000
    
    $
    2,512,000
    
    $
    3,085,000Gross
      change in valuation allowance
    
    
    2,288,000
    
    
    (1,715,000
    )
    
    (3,366,000
    )Adjustments
      of temporary differences and net operating loss expirations and
      limitations
    
    
    (3,792,000
    )
    
    (950,000
    )
    
    (55,000
    )State
      income taxes
    
    
    (174,000
    )
    
    178,000
    
    
    353,000Other
    
    
    (23,000
    )
    
    (25,000
    )
    
    (17,000
    )Income
      tax expense
    
    $
    -
    
    $
    -
    
    $
    -
  F-30
 As of
December 31, 2004, the Company had approximately $90,671,000 of federal net
operating loss carryforwards. Included in the aggregate net operating loss
carryforward are approximately $23,364,000 of losses sustained by SLT prior to
the tax-free acquisition on December 27, 2002. Under Federal rules applicable to
that acquisition, the SLT losses can only be utilized at the rate of
approximately $300,000 per year over the life of the losses and accordingly
losses that cannot be utilized are ascribed no value in the deferred tax asset.
The utilizable net operating carryforwards are thus approximately $71,807,000.
There have been no other changes of ownership identified by management that are
expected to materially constrain the Company’s utilization of loss
carryforwards. If the Company undergoes a change of ownership in the future, the
utilization of the Company’s loss carryforwards may be materially
constrained.
  In
addition, the Company had approximately $745,000 of Federal tax credit
carryforwards as of December 31, 2004. The credit carryforwards began to expire
in 1999 and have continued to expire thereafter. Under Federal rules applicable
to the acquisition of SLT, the research credit carryforwards from SLT amounting
to $954,000 from years prior to the acquisition are subject to severe
utilization constraints and accordingly have been ascribed no value in the
deferred tax asset and are not reflected in the carryforwards.
  Net
deductible, or favorable, temporary differences were approximately $15,500,000
at December 31, 2004.
  The
changes in the deferred tax asset are as follows.
  December
      31,2004
    
    2003Beginning
      balance, gross
    
    $
    43,383,000
    
    $
    41,668,000Net
      changes due to:Operating
      loss carryforwards, valued at 38%
    
    
    (1,521,000
    )
    
    1,103,000Temporary
      differences, valued at 38%
    
    
    (128,000
    )
    
    592,000Carryforward
      and AMT credits
    
    
    (639,000
    )
    
    20,000Ending
      balance, gross
    
    
    41,095,000
    
    
    43,383,000Less:
      valuation allowance
    
    
    41,095,000
    
    
    43,383,000Ending
      balance, net
    
    $
    -
    
    $
    -
  The
ending balances of the deferred tax asset have been fully reserved, reflecting
the uncertainties as to realizability evidenced by the Company’s historical
results and restrictions on the usage of the net operating loss carryforwards.
 
 F-31
  Deferred
tax assets (liabilities) are comprised of the following. The deferred tax asset
from the SLT acquisition is reflected in the activity in each of the
years.
  December
      31,2004
    
    2003Loss
      carryforwards, at 38%
    
    $
    34,455,000
    
    $
    35,976,000Carryforward
      and AMT credits
    
    
    745,000
    
    
    1,384,000Accrued
      employment expenses
    
    
    202,000
    
    
    218,000Bad
      debts
    
    
    378,000
    
    
    364,000Deferred
      R&D costs
    
    
    2,368,000
    
    
    2,050,000Deferred
      revenues
    
    
    242,000
    
    
    308,000Depreciation
    
    
    1,064,000
    
    
    876,000Inventoriable
      costs
    
    
    118,000
    
    
    125,000Inventory
      reserves
    
    
    302,000
    
    
    672,000License
      write-off
    
    
    802,000
    
    
    934,000Other
      accruals and reserves
    
    
    419,000
    
    
    476,000Gross
      deferred tax asset
    
    
    41,095,000
    
    
    43,383,000Less:
      Valuation allowance
    
    
    (41,095,000
    )
    
    (43,383,000
    )Net
      deferred tax asset
    
    $
    -
    
    $
    -
 
 Benefits
that may be realized from components in the deferred tax asset from SLT’s
periods prior to the acquisition in December 2002 will be reflected in the
Company’s Statement of Operations inasmuch as no goodwill was recorded as part
of that acquisition. However, benefits that may be realized from components in
the deferred tax asset that were contributed by Acculase from periods prior to
the buy-out of the minority interest in August 2000 will first be taken to
reduce the carrying value of goodwill and developed technology that were
recorded in the transaction. Only after such values have been fully reduced will
any remaining benefit be reflected in the Company’s Statement of Operations. As
of December 31, 2004, those carrying values were $3,358,936. As of the same
date, the deferred tax asset had $5,993,000 of components that came from
Acculase and arose prior to the buy-out of the minority interest. The components
were $5,464,000 of net operating loss carryforwards and $247,000 of tax credit
carryforwards. As of the buy-out date, there were temporary differences
approximating $282,000, but those differences are treated as having been
recognized for tax purposes in the subsequent fiscal year and therefore are
taken as part of the net operating loss carryforward.
  *Note
14*
 **Significant
Alliances/Agreements:**
  ***Edwards
Agreement***
 In
August 1997, the Company entered into an agreement with Edwards
LifeSciences Corporation, or Edwards. Under the terms of this agreement, the
Company granted Edwards exclusive worldwide rights to sell our modified excimer
laser and associated disposable products, known as the AL5000M, for the
treatment of cardiovascular and vascular disease using the surgical procedure
known as transmyocardial revascularization, or TMR. Under the terms of the
agreement, Edwards
had agreed, among other things, to: absorb
many of the significant expenses of bringing the Company’s TMR products to
market; fund the total cost of obtaining regulatory approvals worldwide for the
use of the AL5000M for the treatment of cardiovascular and vascular disease; and
fund all sales and marketing costs related to the introduction and marketing of
the AL5000M to treat cardiovascular and vascular disease. In September 1997,
Edwards purchased from LaserSight Inc., or LaserSight, rights to related patents
for the use of an excimer laser to ablate tissue in vascular and cardiovascular
applications for $4,000,000. In December 1997, the Company reimbursed Edwards
for the $4,000,000 purchase price of the rights from LaserSight.
  The
Company’s strategic relationship with Edwards has terminated, which termination
has been the subject of certain disputes between Edwards and the Company. From a
business perspective, the Company no longer has a strategic partner to develop
and market the TMR system. As it wound down its performance under the agreement
with the Company, Edwards granted a non-exclusive sublicense of the LaserSight
license to Spectranetics, Inc., or Spectranetics, without our consent. The
Company believes that the grant of this sublicense violated certain agreements
between Edwards and the Company. The Company understands that in connection with
the sublicense, Edwards received consideration approximating $4,000,000. The
Company recently has brought an action against Edwards, seeking, among other
things, a return of the $4,000,000 it paid Edwards for the LaserSight license.
See *Litigation* in Note
11.
  F-32
 *Note
15*
 **Significant
Customer Concentration:**
  No one
customer represented 10% or more of revenues for the year ended December 31,
2004 and 2003. The Company derived approximately 29% of its revenue from two
customers for the year ended December 31, 2002. At December 31, 2002,
approximately 11% of the total accounts receivable balance was due from its two
major customers. **
  *Note
16*
 **Business
Segment and Geographic Data:**
  Segments
are distinguished primarily by the organization of the
Company's management structure. The industry considerations and the
business model used to generate revenues also influence distinctions. The
Domestic XTRAC segment is a procedure-based business model used to date only in
the United States with revenues derived from procedures performed by
dermatologists. The International XTRAC segment presently generates revenues
from the sale of equipment to dermatologists through a network of distributors
outside the United States. The Surgical Services segment generates revenues by
providing fee-based procedures generally using the Company’s mobile surgical
laser equipment delivered and operated by a technician at hospitals and surgery
centers in the United States. The Surgical Products segment generates revenues
by selling laser products and disposables to hospitals and surgery centers on
both a domestic and international basis.
  Unallocated
operating expenses include costs incurred for administrative and accounting
staff, general liability and other insurance, professional fees, and other
similar corporate expenses. Unallocated assets include cash, prepaid expenses,
and deposits. Goodwill at December 31, 2004 and 2003 is $2,944,423. It has been
allocated to the domestic and international XTRAC segments in the amounts of
$2,061,096 and $883,327, respectively. The allocation of goodwill to each
segment was based upon the relative fair values of the two segments as of August
2000, when the Company bought out the minority interest in Acculase and thus
recognized the goodwill.
  
 Year
      Ended December 31, 2004DOMESTIC
      XTRAC
    
    INTERN’L
      XTRAC
    
    SURGICAL
      SERVICES
    
    SURGICAL
      PRODUCTS
      AND
      OTHER
    
    TOTALRevenues
    
    $
    3,256,164
    
    $
    1,626,646
    
    $
    7,826,519
    
    $
    5,035,852
    
    $
    17,745,181Costs
      of revenues
    
    
    1,890,446
    
    
    1,177,371
    
    
    5,000,226
    
    
    2,295,226
    
    
    10,363,269Gross
      profit
    
    
    1,365,718
    
    
    449,275
    
    
    2,826,293
    
    
    2,740,626
    
    
    7,381,912Allocated
      operating expenses:Selling,
      general and administrative
    
    
    1,836,165
    
    
    314,849
    
    
    1,364,684
    
    
    642,751
    
    
    4,158,449Engineering
      and product development
    
    
    711,384
    
    
    445,338
    
    
    -
    
    
    644,716
    
    
    1,801,438Unallocated
      operating expenses
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    6,267,8072,547,549
    
    
    760,187
    
    
    1,364,684
    
    
    1,287,467
    
    
    12,227,694Loss
      from operations
    
    
    (1,181,831
    )
    
    (310,912
    )
    
    1,461,609
    
    
    1,453,159
    
    
    (4,845,782
    )Interest
      expense, net
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    138,414Net
      loss
    
    $
    (1,181,831
    )
    $
    (310,912
    )
    $
    1,461,609
    
    $
    1,453,159
    
    $
    (4,984,196
    )Segment
      assets
    
    $
    6,160,831
    
    $
    2,934,306
    
    $
    5,012,728
    
    $
    4,440,260
    
    $
    18,547,510Capital
      expenditures
    
    $
    873,723
    
    $
    4,090
    
    $
    826,242
    
    $
    90,793
    
    $
    1,794,848
  F-33
  
 Year
      Ended December 31, 2003DOMESTIC
      XTRAC
    
    INTERN’L
      XTRAC
    
    SURGICAL
      SERVICES
    
    SURGICAL
      PRODUCTS
      AND
      OTHER
    
    TOTALRevenues
    
    $
    1,325,024
    
    $
    1,166,520
    
    $
    5,953,462
    
    $
    5,873,787
    
    $
    14,318,793Costs
      of revenues
    
    
    2,795,785
    
    
    817,075
    
    
    3,899,714
    
    
    2,975,034
    
    
    10,487,608Gross
      profit (loss)
    
    
    (1,470,761
    )
    
    349,445
    
    
    2,053,748
    
    
    2,898,753
    
    
    3,831,185Allocated
      operating expenses:Selling,
      general and administrative
    
    
    1,668,819
    
    
    666,131
    
    
    1,108,878
    
    
    659,812
    
    
    4,103,640Engineering
      and product development
    
    
    893,277
    
    
    347,386
    
    
    -
    
    
    535,817
    
    
    1,776,480Unallocated
      operating expenses
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    5,347,5842,562,096
    
    
    1,013,517
    
    
    1,108,878
    
    
    1,195,629
    
    
    11,227,704Loss
      from operations
    
    
    (4,032,857
    )
    
    (664,072
    )
    
    944,870
    
    
    1,703,124
    
    
    (7,396,519
    )Interest
      expense (income), net
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    46,330Other
      income, net
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -Net
      loss
    
    $
    (4,032,857
    )
    $
    (664,072
    )
    $
    944,870
    
    $
    1,703,124
    
    $
    (7,442,849
    )Segment
      assets
    
    $
    5,758,496
    
    $
    2,924,131
    
    $
    3,493,914
    
    $
    3,704,781
    
    $
    15,881,322Capital
      expenditures
    
    $
    1,436,109
    
    $
    5,417
    
    $
    121,451
    
    $
    44,780
    
    $
    1,607,757
 
 
 Year
      Ended December 31, 2002DOMESTIC
      XTRAC
    
    INTERN’L
      XTRAC
    
    SURGICAL
      SERVICES
    
    SURGICAL
      PRODUCTS
      AND
      OTHER
    
    TOTALRevenues
    
    $
    706,320
    
    $
    2,531,063
    
    $
    37,075
    
    $
    -
    
    $
    3,274,458Costs
      of revenues
    
    
    3,276,117
    
    
    1,119,821
    
    
    18,492
    
    
    11,004
    
    
    4,425,434Gross
      profit (loss)
    
    
    (2,569,797
    )
    
    1,411,242
    
    
    18,583
    
    
    (11,004
    )
    
    (1,150,976
    )Allocated
      operating expenses:Selling,
      general and administrative
    
    
    1,248,040
    
    
    968,757
    
    
    9,462
    
    
    1,051
    
    
    2,227,310Engineering
      and product development
    
    
    1,228,180
    
    
    526,363
    
    
    -
    
    
    2,714
    
    
    1,757,257Unallocated
      operating expenses
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    3,963,5262,476,220
    
    
    1,495,120
    
    
    9,462
    
    
    3,765
    
    
    7,948,093Loss
      from operations
    
    
    (5,046,017
    )
    
    (83,878
    )
    
    9,121
    
    
    (14,769
    )
    
    (9,099,069
    )Interest
      expense (income), net
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (25,669
    )Other
      income, net
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    1,087Net
      loss
    
    $
    (5,046,017
    )
    $
    (83,878
    )
    $
    9,121
    
    $
    (14,769
    )
    $
    (9,072,313
    )Segment
      assets
    
    $
    5,806,770
    
    $
    2,970,820
    
    $
    2,714,300
    
    $
    3,463,951
    
    $
    14,955,841Capital
      expenditures
    
    $
    51,477
    
    $
    22,061
    
    $
    -
    
    $
    -
    
    $
    73,538
 
 
 December
      31,Assets:
    
    
    2004
    
    
    2003Total
      assets for reportable segments
    
    $
    18,547,510
    
    $
    15,881,322Other
      unallocated assets
    
    
    4,414,416
    
    
    6,871,409Consolidated
      total
    
    $
    22,961,926
    
    $
    22,752,731
  F-34
 For the
years ended December 31, 2004, 2003 and 2002, there were no material net
revenues attributed to an individual foreign country. Net revenues by geographic
area were as follows:
  Year
      Ended December 31,2004
    
    2003
    
    2002Domestic
    
    $
    15,460,793
    
    $
    12,011,280
    
    $
    743,395Foreign
    
    
    2,284,388
    
    
    2,307,513
    
    
    2,531,063$
    17,745,181
    
    $
    14,318,793
    
    $
    3,274,458
  *Note
17*
 **Quarterly
Financial Data (Unaudited):**
  *For
      the Quarter Ended***2004**
    
    Mar.
      31
    
    Jun.
      30
    
    Sep.
      30
    
    Dec.
      31Revenues
    
    $
    4,025,000
    
    $
    4,323,000
    
    $
    4,455,000
    
    $
    4,942,000Gross
      profit
    
    
    1,531,000
    
    
    1,692,000
    
    
    1,954,000
    
    
    2,205,000Net
      loss
    
    
    (1,363,000
    )
    
    (1,207,000
    )
    
    (1,156,000
    )
    
    (1,258,000
    )Basic
      and diluted net loss per share
    
    
    ($0.04
    )
    
    ($0.03
    )
    
    ($0.03
    )
    
    ($0.03
    )Shares
      used in computing basic and diluted net loss per share
    
    
    37,773,301
    
    
    38,546,338
    
    
    38,960,250
    
    
    40,059,503**2003**
    
    
    Mar.
      31
    
    
    Jun.
      30
    
    
    Sep.
      30
    
    
    Dec.
      31Revenues
    
    $
    3,473,000
    
    $
    3,843,000
    
    $
    3,299,000
    
    $
    3,704,000Gross
      profit
    
    
    1,063,000
    
    
    1,176,000
    
    
    812,000
    
    
    780,000Net
      loss
    
    
    (1,674,000
    )
    
    (1,686,000
    )
    
    (1,913,000
    )
    
    (2,170,000
    )Basic
      and diluted net loss per share
    
    
    ($0.05
    )
    
    ($0.05
    )
    
    ($0.05
    )
    
    ($0.06
    )Shares
      used in computing basic and diluted net loss per share
    
    
    31,439,058
    
    
    33,644,326
    
    
    37,622,358
    
    
    37,735,242
 
 *Note
18*
 **Valuation
and Qualifying Accounts:**
  Additions
      Charged to
  Description
    
    Balance
      at Beginning of Period
    
    Cost
      and Expenses
    
    Other
      Accounts (1)
    
    Deductions
      (2)
    
    Balance
      at End of PeriodFOR
      THE YEAR ENDED DECEMBER 31, 2004:Reserve
      for Doubtful Accounts
    
    $
    698,044
    
    $
    459,861
    
    $
    -
    
    $
    421,400
    
    $
    736,505FOR
      THE YEAR ENDED DECEMBER 31, 2003:Reserve
      for Doubtful Accounts
    
    $
    1,169,486
    
    $
    254,429
    
    $
    -
    
    $
    725,871
    
    $
    698,044FOR
      THE YEAR ENDED DECEMBER 31, 2002:Reserve
      for Doubtful Accounts
    
    $
    996,396
    
    $
    637,857
    
    $
    493,224
    
    $
    957,991
    
    $
    1,169,486
 
 (1)
    Represents
      allowance for doubtful accounts related to the acquisition of
      SLT.
 (2)
    Represents
      write-offs of specific accounts receivable.
 
  F-35