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, 2006




OR




o
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
                OF 1934




For
      the
      transition period from ______________ to _____________




Commission
      file number: 0-11635




PHOTOMEDEX,
      INC.


(Exact
      name of registrant as specified in its charter)




Delaware
              (State
                or other jurisdiction
              of
                incorporation or organization)
            
            59-2058100
              (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
              None
            
            Name
                of each exchange
              on
                which registered
              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 if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act.




Yes
o No
x





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Exchange Act.




Yes
o No
x





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.  o





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of "accelerated
      filer and large accelerated filer" in Rule 12b-2 of the Exchange
      Act.




Large
      accelerated filer o  Accelerated
      filer x   Non-accelerated
      filer o




Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Act).





Yes
o No
      x




The
      number of shares outstanding of our common stock as of March 15, 2007, was
      62,536,054 shares. The aggregate market value of the common stock held by
      non-affiliates (53,064,354 shares), based on the closing market price ($1.15)
      of
      the common stock as of March 15, 2007 was $61,024,007.









**Table
      of Contents**




**Page****Part I**Item 1.
            
            Business
            
            1Item 1A.
            
            Risk
                Factors
            
            18Item 1B.
            
            Unresolved
                Staff Comments
            
            30Item 2.
            
            Properties
            
            30Item 3.
            
            Legal
                Proceedings
            
            31Item 4.
            
            Submission
                of Matters to a Vote of Security Holders
            
            32**Part II**Item 5.
            
            Market
                for the Registrant's Common Equity, Related Stockholder Matters and
                Issuer
                Purchases of Equity Securities
            
            32Item 6.
            
            Selected
                Financial Data
            
            34Item 7.
            
            Management's
                Discussion and Analysis of Financial Condition and Results of
                Operations
            
            36Item 7A.
            
            Quantitative
                and Qualitative Disclosures About Market Risk
            
            56Item 8.
            
            Financial
                Statements and Supplementary Data
            
            56Item 9.
            
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosure
            
            56Item 9A.
            
            Controls
                and Procedures
            
            56Item 9B.
            
            Other
                Information
            
            57**Part III**Item 10.
            
            Directors,
                Executive Officers and Corporate Governance
            
            58Item 11.
            
            Executive
                Compensation
            
            63Item 12.
            
            Security
                Ownership of Certain Beneficial Owners and Management and Related
                Stockholder Matters
            
            74Item 13.
            
            Certain
                Relationships and Related Transactions and Director
                Independence
            
            76Item 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." We undertake no
      obligation to update such forward- looking
      statements.***




**PART
      I**




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




We
      are a
      medical device and specialty pharmaceutical company focused on facilitating
      the
      cost-effective use of technologies for doctors, hospitals and surgery centers
      to
      enable their patients to achieve a higher quality of life.




Our
      business operates in five distinct business units: three in Dermatology and
      two
      in Surgical. Business units, or segments, and are distinguished by our
      management structure, products and services offered, markets served or types
      of
      customers.




The
      Domestic XTRAC® segment derives revenues principally from procedures performed
      by dermatologists in the United States. Our XTRAC system is generally placed
      in
      a dermatologist’s office without any initial capital cost and then we charge a
      fee-per-use to treat skin disease. On occasion, however, we sell XTRAC lasers
      to
      customers, due generally to customer circumstances and preferences. Our
      International Dermatology Equipment segment, in comparison, generates revenues
      from the sale of equipment to dermatologists outside the United States through
      a
      network of distributors. The Skin Care segment generates revenues by selling
      physician-dispensed skincare products worldwide and by earning royalties on
      licenses for our patented copper peptide compound.




The
      Surgical Services segment generates revenues by providing fee-based procedures
      typically 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 laser products and disposables
      to
      hospitals, surgery centers and doctors both domestically and internationally.




The
      XTRAC
      laser system is designed and manufactured by us to phototherapeutically treat
      psoriasis, vitiligo, atopic dermatitis and leukoderma. We have secured specific
      510(k) clearances from the United States Food and Drug Administration to market
      the XTRAC laser system for treatment of these conditions. Our first XTRAC
      phototherapy treatment systems were commercially distributed in the United
      States in August 2000 prior to any of its procedures being approved for medical
      insurance reimbursement. In the last several years, we have sought to obtain
      reimbursement for psoriasis and other inflammatory skin disorders. As a result
      of initiatives undertaken by the Company and the physician community, the
      ability for physicians to process claims efficiently and with positive payment
      decisions for use of the XTRAC system improved significantly during the latter
      part of 2005 and 2006. The XTRAC is approved by Underwriters’ Laboratories; it
      is also CE-marked, and accordingly a third party; regularly audits our quality
      system and manufacturing facility. Our manufacturing facility for the XTRAC
      is
      located in Carlsbad, California.




Our
      Skin
      Care business resulted from the acquisition of ProCyte Corporation (“ProCyte”)
      on March 18, 2005. ProCyte, located in Redmond, Washington, markets products
      for
      skin health, hair care and wound care generally distributed by dermatologists
      and plastic surgeons. Most of these products incorporate patented copper peptide
      technologies. In addition to a diversified product line, ProCyte has provided
      a
      national sales force and increased our marketing department.




1




The
      Surgical businesses were acquired on December 27, 2002 as a result of the
      acquisition of Surgical Laser Technologies, Inc. (“SLT”), located in
      Montgomeryville, Pennsylvania. In the surgical businesses, we also develop,
      manufacture and market proprietary lasers and delivery systems for both contact
      and non-contact surgery and provide surgical services utilizing these and other
      manufacturers’ products. The Montgomeryville facility also serves as our
      corporate headquarters.




**Our
      Business Strategy: The Dermatology Businesses**




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
      acquisition of ProCyte has added a skincare business to our Company and provided
      a broadened complementary product line marketed to the same customer base
      through a national sales force and marketing organization. Our longer-term
      goal
      is to be a world-class provider of the highest-quality, cost-effective, medical
      technologies, including phototherapy 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
      dermatologists in marketing our XTRAC system. As a result of improved
      reimbursement together, with the infusion of additional equity capital in
      November 2006, we have expanded our sales force, clinical specialists and
      marketing initiatives.




***Achieve
      Widespread Private Healthcare Reimbursement.*** The
      Centers for Medicare and Medicaid Services (CMS) published national Medicare
      rates, effective March 1, 2003, for the newly established laser reimbursement
      codes for inflammatory skin disorders such as psoriasis. We mailed a data
      compendium of clinical and economic evidence establishing the XTRAC system
      as
      safe, efficacious, and cost-effective, 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 system has proven to be outstanding for
      expected treatment-free days and remission days. Further, the data compendium
      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 the XTRAC system,
      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 economic and clinical data contained therein
      supports the establishment of medical policies by private healthcare
      reimbursement plans for the treatment of mild to moderate psoriasis. As of
      March
      15, 2007, we estimate that approximately 80% of people in the United States
      who
      are covered by a health insurance program have plans that reimburse for the
      treatment of psoriasis by means of the XTRAC system. We are continuing to try
      to
      develop wider private healthcare reimbursement arrangements through this
      marketing effort, but can give you no assurances to increasing such
      arrangements.




***Build
      Broad Consumer Awareness Program to Attract Those Not Currently Seeking
      Treatment*** .
      Of the
      7 million people in the United States who have been diagnosed with psoriasis,
      only about 1.5 million seek regular care. We believe that many do not seek
      care,
      largely due to the frustration caused by the limited effectiveness,
      inconvenience and negative side effects of treatment alternatives other than
      treatment with the XTRAC system. We have expended funds in print, radio and/or
      internet advertising to educate this frustrated segment of the population about
      how our XTRAC system enables more convenient and effective psoriasis treatment.
      As a result of recent substantive improvement in regional insurance
      reimbursement, we have initiated direct-to-consumer advertising efforts in
      targeted geographic regions that have benefited by this improvement. We are
      continually to evaluate the cost-effectiveness of the various components of
      the
      program.




2




***Increase
      Installed Base of Our XTRAC Systems by Minimizing Economic Risk to the
      Dermatologists*** .
      In the
      United States, we generally place our XTRAC system in dermatologists' offices
      on
      a fee-per-use basis to the physician. This creates an opportunity for
      dermatologists to utilize our system without any up-front capital costs, thereby
      eliminating an inherent economic risk to them. Occasionally, favorable economic
      circumstances influence our decision to sell the laser system directly to
      dermatologists. Longer term, we also intend to market our XTRAC system on a
      fee-per-use basis outside of the United States in combination with continuing
      to
      sell XTRAC systems directly to dermatologists in foreign markets through
      distributors.




***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 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. In addition, we have added a non-laser based product line to
      our
      international offering, called the VTRACTM. This product line is a result of
      licensed technologies from Stern Laser srl, our distributor in Italy. The
      purpose of this product offering is to provide a best-in-class non-laser
      purchase option to compete against lower-priced lamp-based international
      competitors.




**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 exposing normal skin to potentially detrimental exposure
                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 a 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 and even some severe 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.


3




·
            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 and 96922), as well as the
                establishment of Relative Value Units adopted by CMS. Since 2003,
                rates
                set by CMS have trended upward.




·
            Numerous
                private payers and CMS carriers have recognized the clinical and
                economic
                merits of excimer laser treatment and have adopted medical coverage
                policies endorsing its use. In addition, approximately 89,000 excimer
                laser psoriasis procedures have been performed in the United States
                in
                2006, approximately 60,000 in 2005 and 53,000 in 2004 (since the
                issuance
                of relevant CPT codes).




**Our
      Solution for Vitiligo**




In
      March
      2001, the FDA granted 501(k) clearance to market our XTRAC system for the
      treatment of vitiligo. In 2006, we secured exclusive rights to U.S. Patent
      No.
      6,979,327, from the Mount Sinai School of Medicine. The patent covers, among
      other things, treatment of vitiligo by means of an excimer laser system.
      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.
      As
      treatment levels of psoriasis increase, we intend to promote use of the XTRAC
      for treatment of vitiligo. As part of that promotion, we shall explore whether
      CPT codes specific to vitiligo can be established as well as whether CMS and/or
      private insurance plans will establish reimbursement rates for the treatment
      of
      vitiligo.




**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 system, large areas of healthy skin are not
      exposed to UVB light from the XTRAC system 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 and increased treatment levels 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. As with atopic dermatitis, we do not intend to undertake further
      clinical research for leukoderma that would clarify such an alternative protocol
      until we have secured our primary goal - wider private-payer reimbursement
      and
      treatment levels for psoriasis.




4




**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 and
      an
      aiming beam to psoriasis-affected skin. The XTRAC comes optionally with an
      adjustable hand-piece that can decrease the spot size of the operating beam
      to
      permit precise, operator-controlled irradiation of tissue.




Between
      March 1998 and November 1999, we initiated five seminal 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
      the
      following years, 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 49 clinical publications have validated
      the
      clinical efficacy of our phototherapy treatments for the cleared indications
      of
      use and have advanced the insurance reimbursement process.




**Background
      on Psoriasis**




Psoriasis
      is believed to be a non-contagious, autoimmune medical disorder and a chronic
      inflammatory skin disease diagnosed in 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.




5




**Domestic
      Commercialization of Our XTRAC System**




For
      the
      past five years, we have sought to clear the path of obstacles and barriers
      to a
      smooth and orderly roll-out of the XTRAC system in dermatology. In 2000, the
      technology, which was originally designed for cardiology applications, was
      found
      to have significant therapeutic advantages for psoriasis patients who were
      treated with the UVB light emitted from the excimer based laser system. For
      the
      first two years we invested in establishing the clinical efficacy of the product
      and mechanical reliability of the equipment. Starting in 2002, under the
      technical leadership of Jeffrey Levatter, Ph.D., our chief technical officer,
      we
      made numerous improvements and corrections to the design of the XTRAC laser
      system. In the last three years we pursued - and in a number of regions, have
      substantially achieved - widespread reimbursement commencing with obtaining
      newly created CPT reimbursement codes.




We
      believe, based on our analysis, that the XTRAC system should become a preferred
      treatment modality for patients 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.




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
      us
      and others supports the use of the 308-nm excimer laser as safe and effective
      for localized plaque-type psoriasis recalcitrant 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.




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. Although on occasion we may sell the
      laser outright to a dermatologist, typically 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
      fee-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 generally do not provide the
      dermatologist with any purchase options, but we may offer a purchase option
      when
      favorable economic conditions exist. Title to the lasers remains either in
      our
      name or in the name of a third-party who may hold title as collateral within
      the
      context of an equipment financing transaction. There is generally no fixed
      amount that is to be paid over pre-set intervals of time by a 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.




Our
      agreements do not require the purchase 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 system), but do not require the purchase of set
      amounts of such items. However, we require 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.
      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
      dermatologists retain any revenue received from patients or their medical
      insurance providers.




6




Generally,
      dermatologists who treat psoriasis patients refer their 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 under the physician’s supervision,
      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 dermatologists to
      use
      our XTRAC system.




We
      promote our XTRAC system through trade shows, advertising in scientific
      journals, industry magazines, radio, TV 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 technology. Starting in November 2005, we increased the level of our
      direct-to-consumer advertising initiatives, given that we had made substantive
      progress in obtaining private health plan reimbursement approvals.




**International
      Commercialization of Our Dermatology Equipment**




Our
      international dermatology equipment marketing plan is based on the sale of
      our
      XTRAC system and the newly developed VTRAC 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 the longer term,
      we
      anticipate developing relationships in some countries 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 and charge the doctor a
      per-treatment fee.




**Skin
      Care**




**General**




On
      March
      18, 2005, we completed the acquisition of ProCyte. ProCyte generates revenues
      from the sale of skin health, hair care and wound care products; the sale of
      copper peptide compound in bulk; and royalties on licenses for the patented
      copper peptide compound.




ProCyte’s
      focus since 1996 had been to bring unique products to selected markets,
      primarily based upon patented technologies such as GHK and AHK copper peptide.
      We currently sell products directly to the dermatology, plastic and cosmetic
      surgery, and spa markets. We have also expanded the use of our novel copper
      peptide technologies into the mass retail market for skin and hair care through
      specifically targeted technology licensing and supply agreements.




**Products**




Our
      products address the growing demand for skin health and hair care products,
      including products designed to mitigate the effects aging has on the skin and
      hair and to enhance appearance. Our products are formulated, branded and
      targeted for specific markets. Our initial products were developed to be
      dispensed by physicians in the dermatology, plastic and cosmetic surgery markets
      for use following various medical procedures. Anti-aging skin care products
      were
      added to form a comprehensive approach for a patient’s skincare regimen. Certain
      of these products incorporate our patented technologies, while others complement
      the product line such as our advanced sunscreen products that reduce the effects
      of sun damage and aging on the skin.




7




Our
      products are well-suited for use in the medical specialties of dermatology,
      plastic and cosmetic surgery. Several recent studies presented at the American
      Academy of Dermatology and other medical symposia have confirmed the advantages
      of products containing copper peptide formulations versus such other
      formulations as tretinoin, vitamin C, and other popular anti-aging and skin
      rejuvenation products. The actions of wound care gels and creams containing
      copper peptide have been documented in the scientific literature for their
      ability to stimulate collagen synthesis, new blood vessel growth and tissue
      repair. This has led to the development of a variety of products designed to
      treat the skin following certain cosmetic procedures such as microdermabrasion,
      laser resurfacing and hair transplantation. There are an increasing number
      of
      these cosmetic procedures performed each year as the baby boomer population
      ages
      and has a strong desire to look good and feel good. We have a series of products
      tailored to the needs of these types of procedures, including the
      GraftCyte ® System
      and the Complex Cu 3 ® System,
      and have developed a series of daily use products that contain our patented
      copper peptide compounds to aid in maintaining the quality of the skin and
      hair
      following these procedures.




*Skin
      Care.* Our
      GraftCyte System was created to address the special tissue repair needs of
      patients following hair transplant surgery. This system continues to be the
      only
      complete solution addressing post-procedure care in the hair restoration market.
      We have continued to emphasize our Complex Cu 3 ® Post
      Laser Lotion, Intensive Repair Crème, Cleanser and Hydrating Gel products used
      to treat patients following chemical peels, microdermabrasion and laser
      treatments. The Complex Cu 3 products
      provide a comprehensive approach to post-procedure care and allow us to
      differentiate our line of skincare products on the basis of our proprietary
      copper peptide technologies. Studies have indicated that the skin heals quicker
      with the use of copper peptide compounds.




We
      launched the successful Neova ® Therapy
      line of anti-aging products in response to demand from physician customers
      for a
      comprehensive approach to medically directed skincare. The Neova Therapy line
      of
      GHK Copper Peptide Complex ® products
      showcase elegant moisturizers and serums complemented by supporting cleansers,
      toners, and masks for an integrated approach to anti-aging skincare. Each year
      we have added new products to the product line, including Neova
      Microdermabrasion Scrub and Neova Therapy Crème de la Copper added in 2003 and
      the Neova Therapy Dual Action Lotion, a combination of GHK Copper Peptide
      Complex + Retinol in March 2004. The Neova Therapy line is designed to offer
      high-performance, cosmetically elegant lifestyle products that are
      premium-priced in the market.




Our
      line
      of advanced sun protection products, marketed under the brand names of
      Ti-Silc ® and
      Z-Silc ® ,
      are
      recommended by dermatologists and plastic surgeons to assist in the prevention
      of sun exposure that can lead to a number of problems including age spots,
      hyperpigmentation, premature aging and melanoma.




*Hair
      Care* .
      We have
      marketed our Tricomin ® line of
      Triamino Copper ComplexTM-containing hair care products since 1998 (Tricomin
      Shampoos, Conditioners and Follicle Therapy Solution) as a program for the
      maintenance of thinning hair in men and women. Hair follicles require high
      concentrations of biological copper and the Tricomin products deliver copper
      along with amino acids for nourishing and stimulating the hair and scalp for
      improved health, strength and appearance. These products provide physicians
      with
      a non-drug alternative to the problem of thinning hair care for their patients.
      We also sell Tricomin products directly via the website, www.tricomin.com.
      We
      are currently working on the next generation of products to increase the
      effectiveness of the Triamino Copper Nutritional ComplexTM delivery.




*Chronic
      Wound Care.* Our
      chronic wound care product, marketed under the Iamin ® name,
      has met with varying degrees of market success. The wound care market is highly
      fragmented, with many competitors, price constraints, and inadequate Medicare
      reimbursement. The wound care market also requires a significant investment
      in
      supporting a large sales organization. For these reasons, ProCyte had
      historically attempted to collaborate with partners to market its chronic wound
      care product and we will continue to do so. Additionally, we have looked for
      other methods of distribution and include Iamin as one of the products in the
      GraftCyte System used by patients following hair transplant surgery. A number
      of
      other programs have been initiated in an effort to increase utilization of
      the
      Iamin product; however, none have resulted in meaningful revenue increases
      to
      date.




**Markets
      and Distribution**




The
      markets for skincare, hair care and wound care products are global. There are
      numerous distinct markets where we have a presence through our own direct sales
      efforts or through agreements with others. These include dermatology, plastic
      and cosmetic surgery, spa, catalog, and direct mail. We sell our products to
      customers utilizing a direct sales force and also generate revenues from
      technology licensing.




8




We
      emphasize high-quality products and services, technical knowledge, and
      responsiveness to customer needs in our marketing activities. We educate our
      distributors, customers and prospective customers about our products through
      a
      series of detailed marketing brochures, technical bulletins and pamphlets,
      presentations, news releases and direct mail pieces. We also conduct a series
      of
      one-day educational symposia around the country to provide product updates
      and
      marketing ideas to current and potential physician customers. These activities
      are supplemented by advertising in industry publications, technical
      presentations, and exhibitions at over 30 local, national and international
      trade shows.




**Technology
      Licensing**




We
      are
      continuously seeking partners in the prestige, direct-to-consumer, specialty
      retail and home shopping categories. Our skincare business strategy is to
      identify skincare markets that would be best served by more established
      companies and then target a significant partner in each market to license our
      technology.




We
      have
      operated under a worldwide license agreement with Neutrogena Corporation, a
      Johnson & Johnson company (“Neutrogena”), for worldwide use of our patented
      copper peptide  technology
      in products for skin health in the mass retail market. Our current license
      agreement continues until April 2010. Neutrogena develops, manufactures and
      markets skin and hair care products domestically and internationally. Neutrogena
      launched its two initial products using our technology under the brand name
      of
      Visibly FirmTM with Active CopperTM in April 2001. Since that time, it has
      continued to add new products using ProCyte’s patented copper peptide
      technology. We receive royalty payments, based on product sales by Neutrogena
      and revenue from the sale of the copper peptide compound used in Neutrogena’s
      products.




**Our
      Business Strategy: Surgical Products and Services**




We
      market
      lasers used in surgery in such venues as hospitals, surgi-centers and doctors
      offices under the trademark of SLT and, to a lesser degree, the 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.




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 turnkey 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 has replaced the Nd:YAG
      laser.




9




Our
      surgical revenues will thus continue to be generated primarily
      from:




·  providing
      surgical services;




·  the
      sale
      of Contact Laser Delivery Systems and related accessories;




·  the
      sale
      of Diode laser units; and




·  the
      sale
      of CTH holmium and CO2 units, and related service.




Our
      Contact Laser Delivery Systems consist of proprietary fiberoptic delivery
      systems which deliver the laser beam from our Diode (or Nd:YAG) 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 Unimax® 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 that 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 the Milwaukee, Wisconsin,
      Baltimore-Washington DC and Philadelphia, Pennsylvania areas. We intend to
      continue to expand the 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. In 2006, we entered a services contract with a nationwide consortium
      of
      hospitals which provides for a staged roll-out over the various regions of
      the
      consortium; we have begun the roll-out and are currently providing our services
      in the first region designated under the roll-out.




**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.




10




***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*** *.* Our
      LaserPro Diode Laser System has replaced our CLMD line of Nd:YAG laser system.
      The CLMD line has been largely phased out, although we continue to handle
      maintenance and refurbishment of the existing base of Nd:YAG lasers. Like the
      Nd:YAG laser, the Diode lasers are designed for use with our Contact Laser
      Delivery Systems. 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 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 additional relationships in the
      future.




We
      market
      the LaserPro CTH holmium laser unit for use with fiber-optic laser delivery
      systems. The laser unit delivers 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
      LaserPro 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.




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 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 previously used to supply this product to Linvatec
      Corporation, but have now brought the line back for us to market.




**Our
      Operating Strategies:**




**Sales
      and Marketing**




As
      of
      March 15, 2007, our sales and marketing organization consists of 65 full-time
      positions. Of
      the 65
      direct sales personnel, they are directed to sales in the Dermatology and
      Surgical divisions by business segment as follows: Dermatology: A in Domestic
      XTRAC; B in Skin Care; C in International Dermatology Equipment; Surgical,
      E in
      Surgical Services and F in Surgical Products.






11




Our
      sales
      organization provides consultation and assistance to customers on the effective
      use of our products, whether in phototherapy or surgery. The consultative sales
      effort varies depending on many factors, which including the nature of the
      specialty involved and complexity of the procedures. We believe that 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 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.




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.




**Manufacturing**




We
      manufacture our phototherapy products at our new 8,000 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. We believe
      that
      our present manufacturing capacity at these facilities is sufficient to meet
      foreseeable demand for our products. We substantially outsource the manufacture
      of our Skin Care products. Our facility in Redmond, Washington is the final
      assembly center and primary warehouse for our skincare products, and likewise
      is
      operated in conformance with a quality system.




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, 2007, our research and development team included four full-time
      research employees and nine engineers. We conduct research and development
      activities at all three of our facilities. Our research and development
      expenditures were approximately $1.0 million in 2006, $1.1 million in 2005
      and
      $1.8 million in 2004.




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
                development of new skin health and hair care
                products;




12




·
            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.




**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 patents expire and expose our inventions to public use, we seek
      to
      mitigate the impact of such expirations by improvements on the inventions
      embodied in the expiring patents. The patents in our Skin Care segment relate
      to
      use of our copper peptide-based technology for a variety of healthcare
      applications, and to the composition of certain biologically active, synthesized
      compounds. Our strategy has been to apply for patent protection for certain
      compounds and their discovered uses that are believed to have potential
      commercial value in countries that offer significant market potential. As of
      March 15, 2007, we have more than 120 domestic and foreign issued patents,
      which
      serve to help protect the technology of our businesses in phototherapy, skin
      health and hair care, and surgical products and services. To the same purpose,
      we have 40 patent applications pending in the United States and abroad. We
      have
      retrenched some applications where we do not foresee meaningful value to us.




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. We have licensed our copper
      peptide technology to Neutrogena, for which we currently receive royalties.
      Conversely, from time to time, we seek licenses from third parties for
      technology that can broaden our product and service offerings, as for example
      a
      license we secured from the Mount Sinai School of Medicine granted us for
      exclusive rights to a patent covering the use of excimer lasers in the treatment
      of vitiligo.




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, especially in our skin care products. Accordingly, we have registered
      more than 30 of our trademarks in the United States. We have other registrations
      for our skincare products in foreign jurisdictions.




**Government
      Regulation**




Our
      products and research and development activities are regulated by numerous
      governmental authorities, principally the Federal Food and Drug Administration
      or 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.




13




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 through 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 Systems, 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. The range of clearances
      for
      our Diode laser system is similar to the range of clearances for the CLMD Nd:YAG
      laser systems. We have also received FDA clearance under Section 510(k) to
      market 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.




14




We
      have
      received ISO 13485/EN46001 certification for our XTRAC system and our, Diode,
      holmium, CO2 and Nd:YAG 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.




As
      to our
      products in the Skin Care business segment, the Federal Food, Drug and Cosmetic
      Act, and the regulations promulgated thereunder, and other federal and state
      statutes govern the testing, manufacture, safety, labeling, storage,
      record-keeping, advertising and promotion of cosmetic products as well. Our
      products and product candidates in the Skin Care segment may be regulated by
      any
      of a number of divisions of the FDA and in other countries by similar health
      and
      regulatory authorities. The process of obtaining and maintaining regulatory
      approvals for the manufacturing or marketing of our existing and potential
      skin
      care products is costly and time-consuming and is subject to unanticipated
      delays. Regulatory requirements ultimately imposed could also adversely affect
      our ability to clinically test, manufacture or market products.




In
      the
      United States, products that do not seek to make effectiveness claims based
      on
      human clinical evaluation may be subject to review and regulation under the
      FDA’s cosmetic, drug or 510(k) medical device guidelines. Similar guidelines
      exist for such products in other countries. Such 510(k) products, which include
      wound care dressings and certain ointments and gels, must show safety and
      substantial equivalency with predicate products already cleared by the FDA
      to be
      marketed. There can be no assurance that product applications submitted to
      the
      FDA or similar agencies in other countries will receive clearance to be
      marketed, or that the labeling claims sought will be approved, or that, if
      cleared, such products will be commercially successful or free from third-party
      claims relating to the effectiveness or safety of such products.




We
      are
      also or may become subject to various other federal, state, local and foreign
      laws, regulations and policies relating to, among other things, safe working
      conditions, good laboratory practices, and the use and disposal of hazardous
      or
      potentially hazardous substances used in connection with research and
      development. Failure to obtain regulatory approvals where appropriate for our
      product candidates or to attain or maintain compliance with quality system
      regulations or other manufacturing requirements would have a material adverse
      effect on our business, financial condition and results of
      operations.




**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 safer or more effective than
      the alternatives. Additionally, they may require changes to our pricing
      structure and revenue model before authorizing reimbursement.




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.
      Since the skincare products are primarily for cosmetic applications,
      reimbursement is not a critical factor in growing revenues for this product
      segment.




15




In
      2006,
      we continued our efforts to secure private, third-party reimbursement in our
      domestic XTRAC business segment. Our efforts began in February 2002 when 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
      2007 national payment of approximately $141.00 per treatment;




· 96921 -
      designated for: the total area 250 to 500 square centimeters. CMS assigned
      a
      2007 national payment of approximately $144.00 per treatment; and




· 96922 -
      designated for: the total area over 500 square centimeters. CMS assigned a
      2007
      national payment of approximately $213.00 per treatment.




The
      state
      rates will vary by overhead factors applicable to each state.




In
      addition to Medicare and Medicaid, consistent domestic private healthcare
      reimbursement is critical for significant growth in XTRAC system procedures.
      There were more than 89,000 XTRAC procedures in 2006, 60,000 XTRAC procedures
      in
      2005 and more than 50,000 XTRAC procedures in 2004 with the majority being
      covered by third-party reimbursement. Historically, it has been our belief
      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. We sponsored the completion
      of an economic and clinical study to review the clinical and economic
      effectiveness of the XTRAC laser as a second-step therapy for the treatment
      of
      psoriasis. The conclusions of the study are: there is no additional cost of
      adding XTRAC as second-line therapy in a managed care plan; XRAC is a
      cost-effective second-line treatment for mild-to-moderate plaque psoriasis;
      XTRAC provides the greatest number of treatment-free days in one year among
      all
      therapies, except for intralesional corticosteroid injections (“ICI”); XTRAC is
      the lowest cost per treatment-free-day with the exception of ICI; XTRAC has
      the
      lowest cost per remission day among all phototherapies; and XTRAC has the
      highest number of remission days among all therapies. The results of this study
      were compiled in a data compendium and distributed to all the major health
      insurers; the results have also been published in a peer-review journal. In
      2005
      substantive progress was made in connection with obtaining approvals for
      covering medically necessary targeted UVB therapy for psoriasis. As a result
      of
      certain national insurers approving the XTRAC excimer laser therapy in the
      latter part of 2005, we initiated– and have continued in 2006 – a
      direct-to-consumer advertising campaign in certain geographic regions.




We
      have
      been advised in February 2007 that the technology assessment branch of the
      Blue
      Cross Blue Shield Association has determined that among other things that
      phototherapy with the excimer laser is not experimental use in the treatment
      of
      up to 20% the skin surface area for psoriasis. We conjecture that this
      determination will positively influence some remaining subscribing private
      plans
      to cover treatment of psoriasis with the XTRAC laser. In addition, in 2007
      a
      bill was introduced in Congress, at the urging of NPF, to increase the patient’s
      awareness of available treatments of psoriasis. This too should positively
      influence patients suffering from psoriasis to seek treatment.




16




**Competition**




The
      market for our XTRAC 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
      favorably 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 former competitor 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. There have been
      at
      least three foreign-based companies which market 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. We expect that other devices will enter the market, too. All of
      these
      technologies will continue to evolve with time. We cannot say how much these
      technologies will impact us, but we anticipate that competitors that enter
      the
      US market will predominantly not use a fee-per-procedure model but will use
      an
      outright sales model, and will likely sell not on claims of superior quality,
      but on claims of lower prices and better economic returns.




Competition
      in the wound care, skin health and hair care markets is intense. Our competitors
      include well-established pharmaceutical, cosmetic and healthcare companies
      such
      as Obagi, La Roche Posay, Allergan, Pavonia, Declore and Murad. These
      competitors have substantially more financial and other resources, larger
      research and development staffs, and more experience and capabilities in
      researching, developing and testing products in clinical trials, in obtaining
      FDA and other regulatory approvals and in manufacturing, marketing and
      distribution than we do. In addition, a number of smaller companies are
      developing or marketing competitive products. Our competitors may succeed in
      developing and commercializing products or obtaining patent protection or other
      regulatory approvals for products more rapidly than we can. In addition,
      competitive products may be manufactured and marketed more successfully than
      our
      potential products. Such developments could render our existing or potential
      products less competitive or obsolete and could have a material adverse effect
      on our business, financial condition and results of operations.




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, 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.




17




In
      addition, our competitors compete with us in recruiting and retaining qualified
      scientific, management and marketing personnel.




**Employees**




As
      of
      March 15, 2007, we had 192 full-time employees, which consisted of 3 executive
      officers, 11 other senior officers or managers, 60 sales and marketing staff,
      82
      people engaged in manufacturing of lasers and laser-related products, 9
      customer-field service personnel, 4 people engaged in research and development,
      8 engineers and 15 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 nor 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.




**Item
      1A.**  **Risk
      Factors**




*The
      following discussion of risk factors contains forward-looking statements as
      discussed on page 1. These risk factors may be important to understanding any
      statements in this Annual Report on Form 10-K or elsewhere. Our business
      routinely encounters and addresses risks, some of which may cause our future
      results to be different - sometimes materially different - than we presently
      anticipate.*




**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 dedicated most of our
      financial resources to research and development and selling, general and
      administrative expenses. As of December 31, 2006, our accumulated deficit was
      approximately $87.7million.




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
      growth of the revenue from the skin health and hair care products of our
      skincare products and 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 losses as we move into fiscal 2007 because we plan to spend substantial
      amounts on expanding, in controlled fashion, our operations in phototherapy,
      and
      particularly in increasing our customers’ effective utilization of the XTRAC
      system. 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.




18


**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 activities through working capital provided from
      operations, 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 our operating and capital requirements beyond the second
      quarter of 2008. However, we may have to raise substantial additional capital
      if:




·
            operating
                losses continue, because anticipated demand for the XTRAC system
                for the
                treatment of psoriasis or surgical laser systems does not meet our
                current
                expectations;




·
            we
                fail to maintain existing or develop new customers or corporate partners
                for the marketing and distribution of our skincare products;




·
            the
                geographic expansion of our surgical services is stymied by competition
                and revenue increases do not materialize;




·
            we
                need to maintain or accelerate favorable, but costlier, growth of
                our
                revenues; or




·
            changes
                in our research and development plans necessitate unexpected, large
                future
                expenditures.




**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 of
      our
      securities 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, surgical services and skincare
                products;




·
            expand
                our manufacturing facilities, if necessary, based on increased demand
                for
                the XTRAC system or other surgical products or new skincare products,
                which may be introduced;




·
            take
                advantage of future opportunities, including synergistic
                acquisitions;




·
            respond
                to customers, competitors or violators of our proprietary and contractual
                rights; or




·
            remain
                in operation.




**Our
      laser treatments of psoriasis, vitiligo, atopic dermatitis and leukoderma,
      our
      skincare products and our surgical laser products and any of our future products
      or services may fail to gain market acceptance, which could 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. Skincare
        products sales are dependent on existing strategic partners for distributing
        and
        marketing our products. We may be unsuccessful in continuing existing, or
        developing new, strategic partners in order to maintain or expand the markets
        for the skincare business’ existing or future 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. Our efforts to help physicians increase patient awareness
        and interest in the XTRAC system may prove unavailing, as may also our efforts
        through our clinical specialists to improve and increase physicians’ effective
        utilization of the XTRAC system. We also face a risk that other companies,
        not
        necessarily direct competitors of ours, are vying for a dermatologist’s time and
        attention. If such other companies have products that require less time
        commitment from the dermatologist and yield an attractive return on the
        dermatologist’s time and investment (e.g. Botox injections may be such a
        product), we may find that our efforts to increase our base of users is
        hindered, or even if we place a laser with a dermatologist, we may find that
        insufficient time is devoted to increasing patient awareness of laser treatment
        of psoriasis. We therefore cannot assure you that the marketplace will be
        receptive to our excimer laser technology, skincare products, or our surgical
        services over competing products, services and therapies or that a cure will
        not
        be found for the underlying diseases we are focused on treating. Failure
        of our
        products and surgical services to achieve market acceptance could 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
      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 system as a second-line therapy
      for
      treating psoriasis or if patients do not elect to undergo psoriasis treatment
      using the XTRAC system. We have not had sufficient time to observe the long-term
      effectiveness or potential side effects of our treatment system for psoriasis,
      vitiligo, atopic dermatitis or leukoderma nor to gauge what marketing and sales
      programs, if any, are effective in increasing patients’ demand for the treatment
      of psoriasis with the XTRAC system.




19




In
      2003,
      we improved the reliability and functionality of the XTRAC system and upgraded
      such lasers both in the United States and overseas. In 2004, we obtained FDA
      510(k) marketing clearance for a smaller, faster and more powerful XTRAC system
      known as the UltraTM. These efforts should help us gain market acceptance for the
      XTRAC system both in the United States and abroad, but do not guarantee such
      acceptance or that we may not encounter further problems in reliability. We
      have
      designed the XTRAC system to be user-friendly, such that a properly in-serviced
      medical technician in a physician’s office may, under the physician’s
      supervision, safely and effectively administer treatments to a patient. In
      fact,
      the CMS reimbursement rates are based on the lower labor rates achieved through
      such delegation. Nevertheless, whether a treatment may be delegated, and if
      so
      to whom and to what extent, are matters that may vary state by state, as these
      matters are within the province of the state medical boards. In states that
      may
      be more restrictive in such delegation, a physician may decline to adopt the
      XTRAC system into his or her practice, deeming it to be fraught with too many
      constraints and finding other outlets for the physician’s time and staff time to
      be more remunerative. There can be no assurance that we will be successful
      in
      persuading such medical boards that a liberal standard for delegation is
      appropriate for the XTRAC system, based on its design for ease and safety of
      use. If we are not successful, we may find that even if a geographic region
      has
      wide insurance reimbursement, the region’s physicians may yet balk at adopting
      the XTRAC system into their practices.




**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 any assurances 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. Moreover,
      as our patents expire, competitors may utilize the technology found in such
      patents to commercialize their own laser systems. In offset to the expiring
      patents, we endeavor to secure additional patents on critical, commercially
      desirable improvements to the inventions of the expiring patents. There can
      be
      no assurance that we will be successful in securing such additional patents,
      or
      that such additional patents will adequately offset the effect of the expiring
      patents.




Of
      particular note is US Patent No. 4,891,818, the so-called “ ‘818 Patent”, which
      covers, among other things, the design of the gas chamber in the XTRAC laser.
      The ‘818 Patent will expire on August 31, 2007 and will thereafter no longer
      serve as a barrier to entry to the relatively reimbursement-rich US market.
      The
      additional patent rights we seek may serve less to bar competitors from entry
      and may serve more, when aggregated with other clinical and competitive
      strengths, to differentiate and distinguish our product (e.g. the Ultra), in
      both its utility and its range of applications, from those of competitors.
      We
      may therefore choose in the U.S. market to broaden our fee-per-procedure
      business model to include a standard direct sales option, as we have done and
      continue to do in the international market. Where a competitor infringes on
      our
      patent and other proprietary rights, we are prepared, our financial condition
      permitting, to defend those rights vigorously in the U.S. courts. If we unable
      through our technological innovations to preserve our proprietary rights, our
      ability to market the XTRAC system could be materially and adversely
      affected.




A
      U.S.
      patent relating to a copper peptide compound manufactured and used in products
      distributed by Neutrogena under the Neutrogena license agreement expired on
      February 5, 2005. Upon expiration of this patent, the agreement specifies that
      lower royalty percentages from sales of such products be used for the remaining
      term, the impact of which is a reduction in the average effective royalty rate.
      The actual amount of royalty income recognized in future periods is dependent
      upon the royalty percentages in effect during the period and the actual
      applicable sales reported by Neutrogena, which can vary from quarter to quarter.
      The expiration of the patent would also allow others, including Neutrogena,
      to
      apply the technology covered by that patent in their products.




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. In addition, costly and time-consuming litigation may be
      necessary to enforce and determine the scope of our proprietary rights; even
      should we prevail in such litigation, the party we prevail over may have scant
      resources available to satisfy a judgment.




20




Further,
      our skincare business seeks to establish customer loyalty, in part, by means
      of
      our use of trademarks. It can be difficult and costly to defend trademarks
      from
      encroachment or misappropriation overseas. Third parties may also challenge
      the
      validity of certain of our trademarks. In either eventuality, our customers
      may
      become confused and direct their purchases to competitors.




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,
      which may have a material adverse effect on our business and our
      prospects.




**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 or derivative rights 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 and prospects 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 or
                not
                covered by our insurance policies, whether we win or
                lose.




**Our
      success depends on third-party reimbursement of patients' costs for our XTRAC
      system, which could result in potentially reduced prices 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 or maintain favorable reimbursement policies or to accept the XTRAC system
      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.




21




As
      of
      March 15, 2007, we estimate, based on published coverage policies and on payment
      practices of private and Medicare insurance plans, that approximately 80% of
      the
      insured population in the United States is covered by the insurance coverage
      or
      payment policies that reimburse physicians for using the XTRAC system for
      treatment of psoriasis. Based on these reports and estimates, we are continuing
      the implementation of a roll-out strategy for the XTRAC system in the United
      States in selected areas of the country where reimbursement is widely available.
      The success of the roll-out depends on increasing physician and patient demand
      for the treatment. We can give no assurance that health 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 skincare products, and 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
      European Union 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 by us. 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 roll-out 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. Safety and efficacy data presented to the FDA for the XTRAC
      system was based on studies on these patients. For the treatment of vitiligo,
      atopic dermatitis and leukoderma, we have received clearance from the FDA for
      the use of the XTRAC system based primarily on equivalence of predicate devices;
      we may discover that physicians will expect clinical data on such treatments
      with the XTRAC system. 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. We can give no assurance
      that we may find that our data is not substantiated in studies involving more
      patients; in such a case we may never achieve significant revenues or
      profitability.




22




**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 technician technique. If physicians and technicians use the XTRAC
      system suboptimally or 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 reputation
      as a medical device company and our revenues 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
      may
      suffer adversely in our reputation and our revenues and our
      profitability.




**If
      revenue from a significant customer continues to decline, we may have difficulty
      replacing the lost revenue.**




Neutrogena,
      one of the customers for the skin health and hair care products segment that
      we
      acquired from ProCyte, accounts for a significant portion of our net revenue
      in
      that business segment. ProCyte’s net revenues from Neutrogena in 2004 were
      $2,768,072, or approximately 20.8% of ProCyte’s gross revenues of $13,320,200
      (revenues which pre-date our acquisition and which are not reflected in our
      financial statements). For the year ended December 31, 2005, Skin Care’s
      (ProCyte) net revenues from Neutrogena were $1,421,946, or approximately 10.9%
      of Skin Care’s (ProCyte) gross revenues of $13,011,694 (revenues which are
      reflected in our financial statements to the extent that they were earned since
      March 19, 2005). For the year ended December 31, 2006, Skin Care’s net revenues
      from Neutrogena were $972,400, approximately 7.7% of Skin Care’s gross revenues
      of $12,646,910. We receive royalty revenues on sales of products by Neutrogena
      under the terms of a license agreement with
      Neutrogena. The royalties from Neutrogena for 2004 and for our fiscal years
      ended December 31, 2005 and December 31, 2006, were $1,214,073, $609,946 and
      $300,000, respectively. The license agreement expires in April 2010. A U.S.
      patent related to the Neutrogena license agreement expired February 5, 2005,
      the
      effect of which was a reduction in the percentage paid as a royalty during
      the
      remaining royalty period under the license agreement. We also receive revenues
      from sales of copper peptide compound to Neutrogena pursuant to a related supply
      agreement. ProCyte’s sales to Neutrogena under the supply agreement for 2004 and
      for our fiscal years ended December 31, 2005 and December 31, 2006, were
      $1,553,999, $812,000 and $672,400, respectively. Neutrogena has agreed to an
      extension of the supply agreement through October 5, 2007, on terms that we
      regard as generally favorable to us. We have begun discussions with Neutrogena
      concerning continuation of our supply relationship to Neutrogena, although
      we
      cannot say that such discussions will be successful.




Excluding
      niche marketing efforts, the Skin Care segment targets its sales in the U.S.
      market to physicians, who then mark the products up for sale to their patients.
      No single practice in itself is generally responsible for a significant
      disproportion of our sales. However, a number of practices, specializing in
      hair
      transplants, are united under the management of a single group, and this group
      accounts for a disproportion of our hair care products aimed at the care of
      a
      scalp that has received a hair transplant. Revenues from this customer were
      $1,169,892 in 2006 and $811,223 in 2005. We find as well that a few physicians
      re-sell our products not just to their own patients, but also at discounted
      prices on the internet.




In
      the
      International Dermatology Equipment segment (as well as in the Surgical Products
      segment), we depend in the international arena for a material portion of our
      sales on several key distributors, as for example our master distributor in
      the
      Pacific Rim. If we lose one of these distributors, our sales of phototherapy
      and
      surgical lasers are likely to suffer in the short term.




In
      the
      Surgical Services segment, we find that our model works best if we have several
      accounts in a territory that have sufficient volume to allow us to be efficient
      in the delivery of our services. If we lose one of these anchor accounts, then
      we may become less efficient and therefore less competitive.




We
      have
      acted as contract developer of a system designed to detect cancerous cells
      in
      human tissue and act as an OEM manufacturer of surgical lasers and/or delivery
      systems. Development work is rife with financial risk and technological
      uncertainties. OEM work is usually limited to a contracted period of time,
      at
      the end of which there may be no extension or renewal. In either case, our
      aim
      to create a strategic partnership may be frustrated.




23




The
      loss
      or reduction of business from any of our significant customers or strategic
      partners in that business segment, Neutrogena in particular, or the failure
      to
      develop new significant customers or strategic partners could have a material
      adverse effect on the results of operations and our overall financial
      condition.




**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 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 resources, 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 and adversely affect our future business,
      prospects, operating results and financial 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.
      In
      addition, certain of our skincare products and product candidates may be
      regulated by any of a number of divisions of the FDA and in other countries
      by
      similar health and regulatory authorities. Unless an exemption applies, each
      medical device that we wish to market in the United States and certain skincare
      products that we may wish to market 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 extensive 510(k)
      clearances for our surgical products, our clearances may be subject to
      revocation 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 and prospects.




**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.




24




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. We may seek international
      reimbursement approvals for our products, but 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 or growth of our products in that market or
      others.




**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.**




While
      we
      now have greater financial resources due to the private placement of our
      securities in November 2006, we must still use those resources prudently as
      we
      expand our marketing efforts. Our prudence is heavily influenced by our
      marketing experience, which is still relatively limited. To increase acceptance
      and utilization of our XTRA system, we may have to expand the number of our
      sales and marketing personnel for marketing programs in the United States.
      Different programs may call for different strategies and talents. While we
      may
      be able to draw on currently available personnel within our organization, we
      also expect that we will have to increase the number of representatives devoted
      to the sales and marketing programs and broaden, through such representatives,
      the talents we have at our disposal. In some cases, we may look outside our
      organization for assistance in marketing our products, as for example in a
      program to market our surgical diode laser through the internet. We cannot
      predict whether the anticipated sales and marketing programs will be successful,
      either in design or implementation.




In
      similar fashion, we cannot predict how successful we may be in expanding our
      skincare products or surgical services in the United States, nor can we predict
      the success of new skincare or surgical products that we may introduce. There
      are, for example, skincare products and diode and CO2 lasers already in the
      market against which our comparable products must compete. No assurance can
      be
      given that we will be successful in marketing and selling our skin health and
      hair care products or our diode and CO2 lasers.




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, our skincare
                products and our surgical products services
                effectively;




·
            to
                adequately train our marketing force in the use and benefits of our
                products and services, making them more effective promoters;




·
            to
                set the prices and other terms and conditions for treatments using
                an
                XTRAC system and our surgical services in a complex legal environment
                so
                that they will be accepted as attractive and appropriate alternatives
                to
                conventional service modalities and treatments; and




·
            to
                cope with employee turnover among the sales force in the skincare
                business, which is highly competitive for talented sales
                representatives.




**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 significant
                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 or restructure 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, to maintain the benefits of vertical integration in the
      delivery of our surgical services or to achieve market acceptance and growth
      for
      our skincare products. Our inability to manufacture or commercialize our devices
      successfully could have a material adverse effect on our revenue.




25




**We
      may have difficulty managing our growth.**




If
      additional private carriers approve favorable reimbursement policies for
      psoriasis and our marketing programs are successful in increasing utilization
      of
      the XTRAC system, 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 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.




In
      addition, we may acquire additional companies in the medical products and
      services industry. Accordingly, in the ordinary course of our business, we
      regularly consider, evaluate and enter into negotiations related to potential
      acquisition opportunities. We may pay for these acquisitions in cash or
      securities, including equity securities, or a combination of both. We cannot
      assure you that attractive acquisition targets will be available at reasonable
      prices, that we will have sufficient authorized but unissued securities
      available to effect an acquisition, or that we will be successful in any such
      transaction. Acquisitions involve a number of special risks,
      including:




·
            diversion
                of our management’s attention;




·
            integration
                of the acquired business with our business;
                and




·
            unanticipated
                legal liabilities and other circumstances or
                events.




**The
      XTRAC system and other 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. Our skincare
      products may require compounds that can be efficiently produced by a limited
      number of suppliers.**




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 a system ages.
      Similarly, our skincare products may require compounds that can be efficiently
      produced only by a limited number of suppliers. 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 thwarted 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
      devices 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 or prospects.




26




In
      addition, competition in the skin health and hair care markets is intense.
      Our
      skincare competitors include well-established pharmaceutical, cosmetic and
      healthcare companies such as Obagi, La Roche Posay, Allergan, Pevonia, Declore
      and Murad. These competitors have substantially more financial and other
      resources, larger research and development staffs, and more experience and
      capabilities in researching, developing and testing products in clinical trials,
      in obtaining FDA and other regulatory approvals and in manufacturing, marketing
      and distribution than we do. Further, a number of smaller companies are
      developing or marketing competitive products. Our skincare competitors may
      succeed in developing and commercializing products or obtaining patent
      protection or other regulatory approvals for products more rapidly than we
      can.
      Further, competitive products may be manufactured and marketed more successfully
      than our potential skincare products. Such developments could render our
      existing or potential skincare products less competitive or obsolete and could
      have a material adverse effect on our business, financial condition and results
      of operations.




As
      we
      develop new products or improve our existing products, we may accelerate the
      economic obsolescence of the existing, unimproved products, and their
      components. The obsolescent products and related components may have little
      to
      no resale value, leading to an increase in the reserves we have against our
      inventory. On the other side, there is a risk that the new products or improved
      existing products may not achieve market acceptance and therefore also lead
      to
      an increase in the reserves against our inventory.




**Our
      products may be found defective or physicians and technicians may misuse our
      products and damages may exceed our insurance coverage, or we may be subject
      to
      claims that are not covered by insurance.**




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 when patients are treated and that we train and provide
      our
      technicians as part of our surgical services business may expose us to
      third-party claims if those doing the training are accused of providing
      inadequate training or if a technician is accused of negligently applying such
      training. We presently maintain liability insurance with coverage limits of
      at
      least $5,000,000 per occurrence. However, continuing insurance coverage may
      not
      be available at an acceptable cost, if at all. We thus may not be able to obtain
      insurance coverage that will be adequate to satisfy a liability that may arise.
      Regardless of merit or eventual outcome, product liability claims may result
      in
      decreased demand for a product, injury to its reputation, withdrawal of clinical
      trial volunteers and loss of revenues. As a result, regardless of whether we
      are
      insured, a product liability claim or product recall may result in losses that
      could have a material adverse effect upon our business, financial condition
      and
      results of operations.




Similarly,
      we may be subjected to third-party claims in the course of our business for
      which we have no insurance coverage. If we should be found liable for any such
      claim, we may suffer a material adverse effect on the business. We are presently
      defending ourselves against a claim of malicious prosecution, for which our
      insurance carrier has denied a duty to indemnify us.




**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;




27




·
            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 and Chief Operating
                Officer;




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
      adversely affect our ability to develop and introduce our new
      products.




**We
      may be unsuccessful in integrating the businesses we acquired, including the
      operations of ProCyte, with our other business segments.**




As
      a part
      of our strategy to grow our business, we seek to make strategic acquisitions
      of,
      or significant investments in, complementary companies, products or
      technologies, although no significant acquisition or investments are currently
      pending. We may not be successful in the future in identifying companies that
      meet out acquisition criteria. The failure to identify such companies may limit
      the rate at which we are able to grow our business. Furthermore, any future
      acquisitions that we do undertake could be accompanied by risks such
      as:





·
            Difficulties
                in integrating the operations and personnel of acquired
                companies;




·
            Diversion
                of our management's attention from ongoing business
                concerns;




·
            Our
                potential inability to maximize our financial and strategic position
                through the successful incorporation of acquired technology and rights
                into our products and services;




·
            Additional
                expense associated with amortization of acquired
                assets;




·
            Maintenance
                of uniform standards, controls, procedures and policies;
                and




·
            Impairment
                of existing relationships with employees, suppliers and customers
                as a
                result of the integration of new management
                personnel.




We
      cannot
      guarantee that we will be able to successfully integrate any business, products,
      technologies or personnel that we might acquire in the future, and our failure
      to do so could harm our business.




28





In
      particular, with respect to our acquisition of ProCyte, our goals
      were:





·
            that
                ProCyte's presence in the skin health and hair care products market
                would
                present a growth opportunity for PhotoMedex to market its existing
                products;




·
            that
                the addition of ProCyte's sales and marketing personnel would enhance
                our
                ability to market the XTRAC system;




·
            that
                the addition of ProCyte's operations and existing cash balances would
                enhance PhotoMedex's operating results and balance
                sheet;




·
            that
                the combination of the senior management of ProCyte and PhotoMedex
                would
                allow complementary skills to strengthen the overall management team;
                and




·
            that
                the combined company might reap short-term cost savings and have
                the
                opportunity for additional longer-term cost efficiencies, thus providing
                additional cash flow for
                operations.




We
      have
      realized on some, but not all of the goals. We have recently engaged a new
      senior officer to direct the operations of the skincare business. For the time
      being, we shall concentrate less on the cross-integration of the Skin Care
      sales
      personnel into sales of the XTRAC system and more on focusing the Skin Care
      sales personnel on growth of the skincare sales.




**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;




·
            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;




·
            the
                termination or expiration of significant royalty-generating licensing
                contracts to which we are party;




·
            the
                expiration of certain of our key
                patents;




·
            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.




29




**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
                system or to our efforts to increase utilization of the XTRAC
                system;




·
            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.




**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 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. In addition, we have agreed to indemnify the past and present
      directors, officers and employees of ProCyte for certain matters, to the same
      extent such individuals are indemnified by ProCyte, for a period of six years
      following the effective date of the merger.




**Item
      1B.**  **Unresolved
      Staff Comments**




There
      are
      no unresolved comments from the staff of the Securities and Exchange
      Commission.




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




We
      lease
      an 8,000 sq. ft. facility consisting of office, manufacturing and warehousing
      space located at 2375 Camino Vida Roble, Suite B, Carlsbad, California 92009.
      The lease expires on June 15, 2012. We have a right to cancellation after 5
      years, provided that we pay off any remaining obligation for tenant
      improvements. The base rent is $6,640 per month. 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 2011. In addition to this facility, we also lease several
      offices throughout the southeastern United States and other locations elsewhere.
      Our marketing and 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. The base rent is
      $20,475 per month.




30




We
      lease
      a 12,182 sq. ft facility consisting of office and warehousing space located
      at
      8511 154 th Avenue
      NE, Building A, Redmond, Washington 98052. The lease expires on June 30, 2007,
      but we are presently negotiating an extension of the lease term. The base rent
      is $15,240 per month. Our Redmond facility houses the warehousing operations
      for
      our skincare business.




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




In
      the
      matter brought by us against RA Medical Systems, Inc. and Dean Irwin in the
      United States District Court for the Southern District of California, the trial
      judge declined to issue to defendants summary judgment based on their theory
      of
      res judicata. On the other hand, the trial judge declined to issue to us partial
      summary judgment for unfair competition, which had been based on the fact that
      RA Medical did not have the requisite permission from the State of California
      to
      market its medical device. The declination of our claim for relief was based
      on
      reasons that we believe will not bar this claim for relief in the other
      pending Federal action, discussed in the paragraph below. The trial judge
      further declined to consolidate this Federal action brought by us with the
      Federal action brought by RA Medical and Mr. Irwin, discussed below. Pretrial
      is
      scheduled for the Spring of 2007, but no trial date has been set. In this
      action, there are no counterclaims that we must defend against.




In
      the
      matter brought in California Superior Court by RA Medical and Mr. Irwin against
      us for unfair competition, we removed the State action to Federal court.
      Plaintiffs claim we did not have the requisite permission from the State of
      California to market our excimer medical device from our new facility in
      Carlsbad. We counterclaimed for, among other things, contractual interference,
      misappropriation of our technology and unfair competition under Federal and
      State statutes. The plaintiffs have brought a motion to dismiss the latter
      two
      counterclaims, based in part on an alleged bar under the applicable statutes
      of
      limitations. The trial judge has not ruled on the motion. Discovery has been
      stayed, pending the judge’s ruling. Among our claims of unfair competition is a
      claim based on RA Medical’s lack of requisite permission from the State of
      California to market its medical device.




In
      the
      matter brought for malicious prosecution in California Superior Court by RA
      Medical Systems and Mr. Irwin against us, Jenkens & Gilchrist, LLP (our then
      outside counsel) and Michael R. Matthias, Esq. (the litigation partner at
      Jenkens & Gilchrist), trial is set for May 2007. The parties are conducting
      discovery. Morgan, Lewis & Bockius has been engaged to defend us.




In
      June
      2006, the insurance carrier that had undertaken to indemnify us in the malicious
      prosecution action, discussed in the paragraph above, and that had for 18 months
      been defending us, recanted its undertaking to indemnify us. The carrier
      recanted on two grounds: first, that malicious prosecution is an intentional
      tort and therefore is non-indemnifiable, and second, that the alleged tort
      occurred after the period of coverage of its underlying policy had expired.
      We
      notified the subsequent insurance carrier in whose coverage period the alleged
      tort occurred. That carrier has undertaken to defend us, but has denied its
      duty
      to indemnify us, based on the same ground that malicious tort is a
      non-indemnifiable tort. We have rejected this ground and brought an action
      in
      the U.S. District Court for the Eastern District of Pennsylvania for breach
      of
      contract and for declaratory judgment on the issue whether malicious prosecution
      is indemnifiable under our insurance policy.




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 likely be resolved without a material effect
      on
      our consolidated financial position, results of operations or
      liquidity.




31




**Item
      4.**  **Submission
      of Matters to a Vote of Security Holders**




None.




**PART
      II**




**Item
      5.**  **Market
      for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases
      of Equity Securities**




As
      of
      March 15, 2007, we had 62,536,054 shares of common stock issued and outstanding.
      This included 860,000 shares of issued and outstanding restricted stock, options
      to purchase 6,730,475 shares of common stock, of which 4,368,516 were vested
      as
      of March 15, 2007, and warrants to purchase up to 4,746,657 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, 2006:Fourth
                Quarter
            
            $
            1.85
            
            $
            1.04Third
                Quarter
            
            
            1.65
            
            
            0.99Second
                Quarter
            
            
            1.99
            
            
            1.46First
                Quarter
            
            
            2.34
            
            
            1.70Year
                Ended December 31, 2005:Fourth
                Quarter
            
            $
            2.33
            
            $
            1.50Third
                Quarter
            
            
            2.82
            
            
            1.98Second
                Quarter
            
            
            3.09
            
            
            2.00First
                Quarter
            
            
            2.88
            
            
            2.16




On
      March 15, 2007, the closing market price for our common stock in The Nasdaq
      National Market System was $1.15 per share. As of March 15, 2007, we had
      approximately 968 stockholders of record, without giving effect to determining
      the number of stockholders who held shares in “street name” or other nominee
      accounts.




**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.




32


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, 2006.
      See Notes 1 and 12 to the consolidated financial statements for additional
      discussion.




**(A)**
              **Number
                of Securities to be Issued Upon Exercise of Outstanding Options,
                Warrants
                and Rights**
            
            **(B)**
              **Weighted-Average
                Exercise Price of Outstanding Options, Warrants and
                Rights**
            
            **(C)**
              **Number
                of Securities Remaining Available for Future Issuance Under Equity
                Compensation Plans (excluding securities reflected in column
                (A))****Equity
                compensation plans****approved
                by security holders**
            
            
            10,789,382
            
            $
            1.94
            
            
            1,356,250**Equity
                compensations plan not****approved
                by security holders**
            
            
            51,000
            
            $
            1.66
            
            
            -**Total**
            
            
            10,840,382
            
            $
            1.94
            
            
            1,356,250




As
      of
      January 1, 2006, no options will be granted to employees or consultants out
      of
      any plans except the 2005 Equity Compensation Plan. Options to our outside
      directors will be made from the 2000 Non-Employee Director Stock Option Plan;
      options under the 2005 Investment Plan may be made only to executive officers.
      Most warrants issued by us have been to investors or placement agents, and
      none
      of them, and nor was any of the warrants issued to GE Capital Corporation,
      have
      been issued pursuant to equity compensation plans. Additionally, all outstanding
      options were granted 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




**Recent
      Issuances of Unregistered Securities**




On
      November 3, 2006, we completed a private placement for 9,760,000 shares of
      common stock at $1.17 per share resulting in gross proceeds of $11,419,200.
      The
      closing price of our common stock on November 1, 2006 was $1.27 per share,
      the
      date we agreed to the private placement. In connection with this private
      placement, we paid commissions and other expenses of $864,308, resulting in
      net
      proceeds of $10,554,892. In addition, the investors received warrants to
      purchase 2,440,000 shares of common stock at an exercise price of $1.60 per
      share, and Cowen & Company, the placement agent, received warrants to
      purchase 244,000 shares of common stock, under the same terms and conditions
      as
      the warrants issued to the investors. All such the warrants have a five-year
      term and will first become exercisable on May 1, 2007. Cowen & Company is
      entitled to a **** 6.5%
      commission on any proceeds to us from future exercises by the investors of
      their
      warrants. The warrants issued to Cowen & Company were in consideration of
      its services as the placement agent and have a value under the Black Scholes
      method of approximately $200,000. We have used 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.




On
      March
      31, 2006, we issued to Stern Laser srl (“Stern”) 101,010 of our restricted
      common stock, pursuant to a Master Asset Purchase Agreement (the “Master
      Agreement”) dated September 7, 2004 with Stern. As of December 31, 2006, we have
      issued to Stern an aggregate 589,864 shares of our restricted common stock
      in
      connection with the Master Agreement. We have also agreed to pay Stern up to
      an
      additional $250,000 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 its common
      stock, at our discretion. To secure the latter alternative, we have
      reserved for issuance, and placed into escrow, 110,136 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 date of achievement of a particular milestone under the terms of the
      Master Agreement. Stern also has served as the distributor of the XTRAC laser
      system in South Africa and Italy since 2000. The primary asset, which we have
      acquired from Stern, is a license, which was carried on our books at $1,013,009,
      net as of December 31, 2006. Amortization of this intangible is on a
      straight-line basis over 10 years, which began in January 2005. As Stern
      completes further milestones under the Master Agreement, we expect that the
      carrying value of the license will increase.




33




On
      March
      30, 2006, we closed the transaction provided for in the Investment Agreement
      with AzurTec. We issued 200,000 restricted shares of our common stock in
      exchange for 6,855,141 shares of AzurTec common stock and 181,512 shares of
      AzurTec Class A preferred stock, which represent a 14% interest in AzurTec,
      on a
      fully diluted basis. In accordance with APB No. 18, and related interpretations,
      we account for our investment in AzurTec on the cost basis.




In
      2006,
      we issued to GE Capital Corporation 20,545; 24,708;, 25,038; and 32,057 warrants
      to purchase our common stock issued on March 29, 2006, June 30, 2006, September
      29, 2006 and December 28, 2006, respectively, in connection with draws we made
      against a Master Lease Agreement.




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.




**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 statements of operations data for the years ended December 31,
      2006, December 31, 2005 and December 31, 2004, and the selected historical
      consolidated balance sheet data as of December 31, 2006 and December 31, 2005,
      are derived from our audited consolidated financial statements included in
      this
      Annual Report on Form 10-K. The selected historical consolidated statements
      of
      operations data for the years ended December 31, 2003 and December 31, 2002
      and
      the selected historical consolidated balance sheet data as of December 31,
      2004,
      December 31, 2003 and December 31, 2002 are derived from our audited
      consolidated financial statements not included in this Annual Report on Form
      10-K. The historical results presented here are not necessarily indicative
      of
      future results.




34




**Year
      Ended December 31,**


**(In
      thousands, except per- share data)**




**2006**
            
            **2005**
            
            **2004**
            
            **2003**
            
            **2002****Statement
                of Operations Data:**Revenues
            
            $
            33,190
            
            $
            28,384
            
            $
            17,745
            
            $
            14,319
            
            $
            3,274Costs
                of revenues
            
            
            18,472
            
            
            15,675
            
            
            10,363
            
            
            10,488
            
            
            4,425Gross
                profit (loss)
            
            
            14,718
            
            
            12,709
            
            
            7,382
            
            
            3,831
            
            
            (1,151
            )Selling,
                general and administrative
            
            
            20,682
            
            
            16,477
            
            
            10,426
            
            
            9,451
            
            
            6,191Engineering
                and product development
            
            
            1,006
            
            
            1,128
            
            
            1,802
            
            
            1,777
            
            
            1,757Loss
                from operations before interest and other income, net
            
            
            (6,970
            )
            
            (4,896
            )
            
            (4,846
            )
            
            (7,397
            )
            
            (9,099
            )Interest
                income
            
            
            149
            
            
            61
            
            
            43
            
            
            50
            
            
            42Interest
                expense
            
            
            (671
            )
            
            (403
            )
            
            (181
            )
            
            (96
            )
            
            (16
            )Other
                income, net
            
            
            -
            
            
            1,302
            
            
            -
            
            
            -
            
            
            1Net
                loss
            
            
            ($7,492
            )
            
            ($3,936
            )
            
            ($4,984
            )
            
            ($7,443
            )
            
            ($9,072
            )Basic
                and diluted net loss per share
            
            
            ($0.14
            )
            
            ($0.08
            )
            
            ($0.13
            )
            
            ($0.21
            )
            
            ($0.34
            )Shares
                used in computing basic and diluted net loss per share (1)
            
            
            54,189
            
            
            48,786
            
            
            38,835
            
            
            35,134
            
            
            26,566**Balance
                Sheet Data (At Period End):**Cash
                and cash equivalents
            
            $
            12,886
            
            $
            5,610
            
            $
            3,997
            
            $
            6,633
            
            $
            4,008Working
                capital
            
            
            16,070
            
            
            11,151
            
            
            6,119
            
            
            8,678
            
            
            6,578Total
                assets
            
            
            57,482
            
            
            48,675
            
            
            22,962
            
            
            22,753
            
            
            21,513Long-term
                debt (net of current portion)
            
            
            3,727
            
            
            2,437
            
            
            1,399
            
            
            457
            
            
            900Stockholders’
                equity
            
            $
            44,103
            
            $
            38,417
            
            $
            14,580
            
            $
            15,978
            
            $
            13,309




(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.




35





**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.***




**Overview**




We
      view
      our business as comprised of the following five business segments:




·
            Domestic
                XTRAC,




·
            International
                Dermatology Equipment,




·
            Skin
                Care (ProCyte),




·
            Surgical
                Services, and




·
            Surgical
                Products.




**Domestic
      XTRAC**




Our
      Domestic XTRAC segment is a U.S. business with revenues primarily derived from
      procedures performed by dermatologists. We are engaged in the development,
      manufacturing and marketing of our proprietary XTRAC® excimer laser and delivery
      systems and techniques used in the treatment of inflammatory skin
      disorders, **** including
      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, establishing that our XTRAC laser system is
      substantially equivalent to currently marketed devices for the treatment of
      psoriasis.




As
      part
      of our commercialization strategy in the United States, we provide the XTRAC
      laser system to targeted dermatologists at no initial capital cost to them.
      Unlike our international strategy, we generally do not sell the laser system
      domestically, but maintain ownership of the laser and earn revenue each time
      a
      dermatologist treats a patient with the equipment. We believe that this strategy
      will create incentives for physicians to adopt the XTRAC laser system and will
      increase market penetration. On occasion we have sold and will sell the laser
      directly to a dermatologist for certain reasons, including the costs of
      logistical support and customer preference.




For
      the
      past six years, we have sought to clear the path of obstacles and barriers
      to a
      roll-out of the XTRAC laser system in dermatology. In 2000, the laser system,
      which was originally designed for cardiology applications, was found to have
      significant therapeutic advantages for psoriasis patients who were treated
      with
      the UVB light emitted from the excimer-based laser system. For the first two
      years, we invested in establishing the clinical efficacy of the product and
      mechanical reliability of the equipment. In the last three years, we have
      pursued widespread reimbursement commencing with obtaining newly created Current
      Procedure Terminology (“CPT”) reimbursement codes that became effective in 2003.
      This was followed by a lengthy process of persuading private medical insurers
      to
      adopt a positive reimbursement policy for the procedure. Substantive progress
      on
      reimbursement was achieved in the second half of 2005. In June 2006, we received
      approval from Blue Cross and Blue Shield of Florida.




We
      increased our dermatology sales force and marketing department as part of the
      acquisition of ProCyte in March 2005. We now have 12 sales representatives
      in
      the domestic XTRAC segment (not including the 9 clinical specialists that we
      have recently hired to train and support our customers) and 19 sales
      representatives in the Skin Care segment. The sales representatives of each
      segment provide follow-up sales support and share sales leads to enhance
      opportunities for cross-selling. Our marketing department has been instrumental
      in expanding the advertising campaign for the XTRAC laser system. In November
      2005, we commenced an advertising campaign in selected regions that have
      attained certain levels of reimbursement in order to make consumers aware of
      the
      technology and therapeutic benefits of targeted UVB laser treatment for
      psoriasis. We continue to analyze and adjust this campaign for effectiveness.




We
      do,
      however, see that some of our sales and marketing expenses have grown faster
      than the revenues on which the expenses are targeted to have positive impact.
      For example, we have tried various direct-to-consumer marketing programs that
      have positively influenced utilization, but the payback in utilization is
      expected to be attained over more periods than in just the period in which
      we
      incurred the expense. We have also increased the number of sales representatives
      and also established a cadre of clinical support specialists to optimize
      utilization levels and better secure the willingness and interest of patients
      to
      seek follow-up courses of treatment after the effect of the first battery of
      treatment sessions starts to wear off. The efforts of this cadre, if successful,
      will likely see the fruits of success over an extended horizon of several fiscal
      quarters.






36




**International
      Dermatology Equipment**




In
      the
      international market, we derive revenues by selling our dermatology laser
      systems to distributors and directly to physicians. In this market, we have
      benefited from both our clinical studies and from the improved reliability
      and
      functionality of the XTRAC laser system.  Compared
      to the domestic segment, the sales of laser systems in the international segment
      is influenced to a greater degree by competition from similar laser technologies
      as well as non-laser lamp alternatives. Over time, this competition has reduced
      the prices we are able to charge to international distributors for our XTRAC
      products. In 2005, as a result of the acquisition of worldwide rights to certain
      proprietary light-based technology from Stern, we also explored new product
      offerings in the treatment of dermatological conditions. We have expanded the
      international marketing of this product, called the VTRACTM, in 2006. The VTRAC
      is a lamp-based UVB targeted therapy, positioned at a price point lower than
      the
      XTRAC laser system so that it will effectively compete with other
      non-laser-based therapies for psoriasis and vitiligo.




Due
      to
      the significant financial investment requirements,  we
      did
      not implement an international XTRAC and/or VTRAC fee-per-use revenue model,
      similar to our domestic revenue model. However, as reimbursement in the domestic
      market has become more widespread, we have made available a version of this
      model overseas.




**Skin
      Care (ProCyte)**




On
      March
      18, 2005, we completed the acquisition of ProCyte Corporation. ProCyte generates
      revenues from the sale of skin health, hair care and wound care products; the
      sale of copper peptide compound in bulk; and royalties on licenses for the
      patented copper peptide compound.




The
      operating results of ProCyte for the year ended December 31, 2005 are included
      from March 19, 2005 through December 31, 2005. Under purchase accounting rules,
      the operating results of ProCyte for prior periods are not included in our
      Statement of Operations. A description of transaction and pro-forma operating
      results are disclosed as part of Note 2, “ *Acquisitions”,* to the
      financial statements.




ProCyte’s
      focus has been to provide unique products, primarily based upon patented
      technologies for selected applications in the dermatology, plastic and cosmetic
      surgery and spa markets. ProCyte has also expanded the use of its novel copper
      peptide technologies into the mass retail market for skin and hair care through
      targeted technology licensing and supply agreements.




ProCyte’s
      products are aimed at the growing demand for skin health and hair care products,
      including products to enhance appearance and address the effects of aging on
      skin and hair. ProCyte’s products are formulated, branded and targeted at
      specific markets. ProCyte’s initial products addressed the dermatology, plastic
      and cosmetic surgery markets for use after various procedures. Anti-aging skin
      care products were added to offer a comprehensive approach for a patient’s
      skincare regimen.




ProCyte’s
      financial and administrative functions were transferred from Redmond, Washington
      to Montgomeryville, Pennsylvania in June 2005.




**Surgical
      Services**




The
      Surgical Services segment generates revenues by providing fee-based procedures
      typically using our mobile surgical laser equipment delivered and operated
      by a
      technician at hospitals and surgery centers in the United States. Although
      we
      intend to increase our investment in this business segment, we will continue
      to
      pursue a cautious growth strategy in order to conserve our cash resources for
      the XTRAC business segments.




We
      have
      limited marketing experience in expanding our surgical services business. The
      majority of this business is in the southeastern part of the United States.
      New
      procedures and geographical expansion, together with new customers and different
      business habits and networks, will likely pose different challenges compared
      to
      those that we have encountered in the past. In 2006, we secured a contract
      to
      provide our surgical services through a national hospital network, where the
      roll-out would be done serially, region by region, each with its own challenges.




37




**Surgical
      Products**




The
      Surgical Products segment generates revenues by selling laser products and
      disposables to hospitals and surgery centers both inside and outside of the
      United States. Also included are various non-laser surgical products (e.g.
      the
      ClearEss® II suction-irrigation system). Although surgical product revenues
      increased in 2006 compared to 2005, we expect that sales of surgical laser
      systems and the related disposable base may begin to erode as hospitals continue
      to seek outsourcing solutions instead of purchasing lasers and related
      disposables for their operating rooms. We are working to offset this erosion
      by
      cautiously expanding our surgical services segment and by increasing sales
      from
      the Diode surgical laser introduced in 2004.




**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 these policies have been discussed with our Audit Committee.




***Revenue
      Recognition***




*XTRAC-Related
      Operations*




We
      have
      two distribution channels for our phototherapy treatment equipment. We either
      (i) sell the laser through a distributor or directly to a physician or (ii)
      place the laser in a physician’s offices (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 foreign or domestic physician,
      revenue is recognized when the following four criteria under Staff Accounting
      Bulletin No. 104 have been met: (i) the product has been shipped and we have
      no
      significant remaining obligations; (ii) persuasive evidence of an arrangement
      exists; (iii) the price to the buyer is fixed or determinable; and (iv)
      collection is probable (the “SAB 104 Criteria”). At times, units are shipped,
      but revenue is not recognized until all of the SAB 104 criteria have been 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 upon 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 distributors or physicians that do not fully
      satisfy the collection criteria are recognized when invoiced amounts are fully
      paid.




Under
      the
      terms of our distributor agreements, distributors do not have a unilateral
      right
      to return any unit that they have purchased. However, we do allow products
      to be
      returned by our distributors for product defects or other claims.




When
      we
      place a laser in a physician’s office, we recognize service revenue based on the
      number of patient treatments performed by the physician. Treatments in the
      form
      of random 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. Unused treatments remain an obligation of ours because the treatments
      can only be performed on our equipment. Once the treatments are delivered to
      a
      patient, this obligation has been satisfied.




38




We
      exclude all sales of treatment codes made within the last two weeks of the
      period in determining the amount of procedures performed by our
      physician-customers. Our management believes this approach closely approximates
      the actual amount of unused treatments that existed at the end of a period.
      For
      the years ended December 31, 2006 and 2005, we deferred $506,440 and $311,571,
      respectively, under this approach.




In
      the
      first quarter of 2003, we implemented a program to support certain physicians
      in
      addressing treatments with the XTRAC laser system that may be denied
      reimbursement by private insurance carriers. We recognize service revenue 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. For
      the
      year ended December 31, 2006, we deferred an additional $124,427 less credits
      issued of $151,590, under this program, as all the SAB 104 Criteria for revenue
      recognition had not been met. At December 31, 2006, we had net deferred revenues
      of $80,697 under this program.




Under
      this program, we may reimburse qualifying doctors for the cost of our fee but
      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 be in an identified location where there
                is an
                insufficiency of insurance companies reimbursing the procedure or
                where a
                particular practice faces similar insurance
                obstacles;




·
            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
                a
                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 to
                9
                months;




·
            After
                all appeals have been exhausted by us and the claim remains unpaid,
                the
                physician is entitled to receive credit for the fee for the treatment
                he
                or she purchased from us 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
                  sales of
                  treatments to a physician can be denied if timely payments are
                  not made,
                  even if a patient’s appeal is still in process.




We
      estimate a contingent liability for potential refunds under this program by
      reviewing the history of denied insurance claims and appeals processed. We
      estimate that approximately 4% of the revenues under this program for the
      quarter ended December 31, 2006 are subject to being credited or refunded to
      the
      physician. We estimated that 11% of the revenues under this program for the
      quarter ended December 31, 2005 were subject to being credited or refunded
      to
      the physician.




*Skin
      Care Operations*




We
      generate revenues from our Skin Care business primarily through three channels.
      The first is through product sales for skin health, hair care and wound care;
      the second is through sales of the copper peptide compound, primarily to
      Neutrogena Corporation, a Johnson & Johnson company; and the third through
      royalties generated by our licenses, principally to Neutrogena. We recognize
      revenues on the products and copper peptide compound when they are shipped,
      net
      of returns and allowances. We ship the products FOB shipping point. Royalty
      revenues are based upon sales generated by our licensees. We recognize royalty
      revenue at the applicable royalty rate applied to shipments reported by our
      licensee.




*Surgical
      Products and Service Operations*




We
      generate revenues from our Surgical businesses primarily from two channels.
      The
      first is through product sales of laser systems, related maintenance service
      agreements, recurring laser delivery systems and laser accessories, and the
      second is through per-procedure surgical services. We recognize revenues from
      surgical laser and other product sales, including sales to distributors and
      other customers, when the SAB 104 Criteria have been met.




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
      XTRAC
      laser is either (i) sold to distributors or physicians directly or (ii) placed
      in a physician's office and remains 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 SAB 104 Criteria
      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.




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 trends.




***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 skincare products, surgical services and surgical products 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. Such factors include changes in the financial
      condition of our customers as a result of industry, economic or
      customer-specific factors. A change in the factors used to evaluate
      collectibility could result in a significant change in the reserve needed.




***Property
      and Equipment.*** As of
      December 31, 2006 and 2005, we had net property and equipment of $9,054,098
      and
      $7,044,713, 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 recoverability of the net carrying value of the lasers is
      predicated on increasing revenues from the physicians’ use of the lasers. In
      reflection of their improved reliability, XTRAC lasers placed in service after
      December 31, 2005 are depreciated on a straight-line basis over the estimated
      useful life of five-years; other XTRAC lasers-in-service continue to be
      depreciated over the original 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, including property and
      equipment acquired from ProCyte, 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, or
      both.




***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 our business. As of December 31, 2006 and 2005,
      we
      had $22,151,160 and $22,420,563, respectively, of goodwill and other
      intangibles, accounting for 39% and 46% of our total assets at the respective
      dates. The goodwill is not amortizable; the other intangibles are. 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. 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.




40




There
      has
      been no change in 2006 and 2005 to the carrying value of goodwill that 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, Inc.
      and
      thus recognized the goodwill. In connection with the acquisition of ProCyte
      on
      March 18, 2005, we acquired certain intangibles recorded at fair value as of
      the
      date of acquisition and allocated fully to the Skin Care (ProCyte) segment.
      In
      2006, we adjusted the carrying value of the goodwill from the ProCyte
      acquisition reflecting management’s best estimate of pre-acquisition
      contingencies based upon plans entered into prior to March 18, 2005. Included
      in
      these acquired intangibles were the following:




ProCyte
                Neutrogena Agreement
            
            $
            2,400,000ProCyte
                Customer Relationships
            
            
            1,700,000ProCyte
                Tradename
            
            
            1,100,000ProCyte
                Developed Technologies
            
            
            200,000Goodwill
            
            
            13,973,385Total
            
            $
            19,373,385




***Deferred
      Income Taxes.*** We
      have a
      deferred tax asset that is fully reserved by a valuation allowance. We have
      not
      recognized the deferred tax asset, given our historical losses and the lack
      of
      certainty of future taxable income. However, if and when we become profitable
      and can reasonably foresee continuing profitability, then under SFAS No. 109
      we
      may recognize some of the deferred tax asset. The **** recognized
      portion may variously reduce acquired goodwill, increase stockholders’ equity
      directly and/or benefit the statement of operations.




***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***




The
      following table illustrates revenues from our five business segments for the
      periods listed below:




For
                the Year Ended December 31,2006
            
            
            2005
            
            
            2004Dermatology:XTRAC
                Domestic Services
            
            $
            5,611,387
            
            $
            3,498,235
            
            $
            3,256,164International
                Dermatology Equipment Revenues
            
            
            2,186,424
            
            
            1,404,096
            
            
            1,626,646Skin
                Care (ProCyte) Revenues
            
            
            12,646,910
            
            
            10,042,132
            
            
            -Total
                Dermatology Revenues
            
            $
            20,444,721
            
            $
            14,944,463
            
            $
            4,882,810Surgical:Surgical
                Services
            
            $
            6,944,292
            
            $
            7,719,529
            
            $
            7,826,519Surgical
                Products
            
            
            5,800,864
            
            
            5,720,514
            
            
            5,035,852Total
                Surgical Revenues
            
            $
            12,745,156
            
            $
            13,440,043
            
            $
            12,862,371Total
                Revenues
            
            $
            33,189,877
            
            $
            28,384,506
            
            $
            17,745,181




41




***Domestic
      XTRAC Segment***




Recognized
      revenue for the years ended December 31, 2006, 2005, and 2004 were $5,611,387,
      $3,498,235 and $3,256,164, respectively. This included treatment revenue for
      the
      years ended December 31, 2006, 2005 and 2004 for domestic XTRAC procedures
      of
      $5,142,022, $3,498,235 and $3,256,164, respectively, reflecting billed
      procedures of 83,272, 54,255 and 47,915, respectively. In addition, 5,168,
      6,371
      and 4,928 procedures were performed for the years ended December 31, 2006,
      2005
      and 2004, respectively, without billing from us, in connection with clinical
      research and customer evaluations of the XTRAC laser. The increase in procedures
      in the year ended December 31, 2006 compared to the comparable periods in 2005
      and 2004 was largely related to our continuing progress in securing favorable
      reimbursement policies from private insurance plans and to our increased
      marketing programs. Increases in revenues are dependent upon more widespread
      adoption of the CPT codes with comparable rates by private healthcare insurers
      and on instilling confidence in our physician partners that the XTRAC procedures
      will benefit their patients and be generally reimbursed to their
      practices.




In
      the
      first quarter of 2003, we implemented a program to support certain physicians
      who may be denied reimbursement by private insurance carriers for XTRAC
      treatments. In accordance with the requirements of SAB No. 104, we recognize
      service revenue during the program only to the extent the physician has been
      reimbursed for the treatments. For the year ended December 31, 2006, we deferred
      revenues of $124,427 (1,897 procedures) net, under this program, compared to
      deferred revenues of $57,302 (873 procedures) net, under this program for the
      year ended December 31, 2005. For the year ended December 31, 2004, we
      recognized revenues of $303,027, (4,562 procedures) net, under this program
      that
      were previously deferred. The change in deferred revenue under this program
      is
      presented in the table below.




For
      the
      year ended December 31, 2006, domestic XTRAC laser sales were $469,365. There
      were 11 lasers sold which were made for various reasons, including costs of
      logistical support and customer preferences. We expect we shall continue to
      offer XTRAC lasers for sale in 2007.




The
      following table illustrates the above analysis for the Domestic XTRAC segment
      for the periods reflected below:




For
                the Year Ended December 31,2006
            
            
            2005
            
            
            2004Total
                revenue
            
            $
            5,611,387
            
            $
            3,498,235
            
            $
            3,256,164Less:
                laser sales revenue
            
            
            (469,365
            )
            
            -
            
            
            -Recognized
                treatment revenue
            
            
            5,142,022
            
            
            3,498,235
            
            
            3,256,164Change
                in deferred program revenue
            
            
            124,427
            
            
            57,302
            
            
            (303,027
            )Change
                in deferred unused treatments
            
            
            194,869
            
            
            5,371
            
            
            229,300Net
                billed treatment revenue
            
            
            5,461,318
            
            $
            3,560,908
            
            $
            3,182,437Procedure
                volume total
            
            
            88,440
            
            
            60,626
            
            
            52,843Less:
                Non-billed procedures
            
            
            5,168
            
            
            6,371
            
            
            4,928Net
                billed procedures
            
            
            83,272
            
            
            54,255
            
            
            47,915Avg.
                price of treatments sold
            
            $
            65.58
            
            $
            65.63
            
            $
            66.42Procedures
                with deferred/(recognized)
              program
                revenue, net
            
            
            1,897
            
            
            873
            
            
            (4,562
            )Procedures
                with deferred unused treatments, net
            
            
            2,971
            
            
            82
            
            
            3,452




The
      average price for a treatment varies 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, although there are fewer patients with moderate
      psoriasis than there are with mild psoriasis. Due to the length 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. A study undertaken with the
      guidance of John Koo, MD, of the University of California at San Francisco,
      is
      evaluating the effectiveness of the Ultra in treating patients suffering from
      severe psoriasis.




42




***International
      Dermatology Equipment Segment***




International
      sales of our XTRAC and VTRAC laser systems and related parts were $2,186,424
      for
      the year ended December 31, 2006 compared to $1,404,096 and $1,626,646 for
      the years ended December 31, 2005 and 2004, respectively. We sold 46 laser
      systems in the year ended December 31, 2006 compared to 26 laser systems in
      each of the years ended December 31, 2005 and 2004. Compared to the
      domestic business, the international dermatology equipment operations are more
      influenced by competition from similar laser technology from other manufacturers
      and from non-laser lamps. Such competition has caused us to reduce the prices
      we
      charge to international distributors. Furthermore, average selling prices for
      international dermatology equipment are influenced by the following two
      factors:




·
            We
                began selling refurbished domestic XTRAC laser systems into the
                international market in 2005. The selling price for used equipment
                is
                substantially less than new equipment. We sold six of these used
                lasers,
                in each year, at an average price of $28,000 and $27,000 for the
                years
                ended December 31, 2006 and 2005, respectively;
                and




·
            We
                began selling the new VTRAC, a lamp-based, alternative UVB light
                source
                that has a wholesale sales price that is substantially below our
                competitors’ international dermatology equipment and below our XTRAC
                laser. In the year ended December 31, 2006, we sold 12 VTRAC
                systems.




The
      following table illustrates the key changes in the International XTRAC segment
      for the periods reflected below:




For
                the Year Ended December 31,2006
            
            
            2005
            
            
            2004Revenues
            
            $
            2,186,424
            
            $
            1,404,096
            
            $
            1,626,646Laser
                systems sold
            
            
            46
            
            
            26
            
            
            26Average
                revenue per laser
            
            $
            47,531
            
            $
            54,004
            
            $
            62,563




***Skin
      Care (ProCyte) Segment***




For
      the
      year ended December 31, 2006, ProCyte revenues were $12,646,910 compared to
      $10,042,132 for the year ended December 31, 2005. Inasmuch as ProCyte was
      acquired on March 18, 2005, the operating results of ProCyte for the year ended
      December 31, 2005 include activity from ProCyte from March 19, 2005 through
      December 31, 2005 and there are no corresponding revenues accruing to us for
      the
      year ended December 31, 2004. Skin Care revenues are generated from the sale
      of
      various skin and hair care products, from the sale of copper peptide compound
      and from royalties on licenses, mainly from Neutrogena. For the full year 2005,
      unaudited Skin care revenues were approximately $13 million compared to
      unaudited revenues of $13.3 million for 2004.




·
            Physician
                dispensed product revenues, our most strategic and most profitable
                revenues, increased approximately 13% in 2006 over 2005, or about
                $1,240,000.




·
            Spa
                products revenue decreased approximately 31% in 2006 over 2005, or
                about
                $215,000.




·
            OEM
                products revenue decreased approximately 76% in 2006 over 2005, or
                about
                $718,000.




·
            Bulk
                product and royalty revenues decreased approximately 41% in 2006
                over
                2005, or about $691,000.




43




The
      following table illustrates the key changes in the Skin Care (ProCyte) segment
      for the periods reflected below:




For
                the Year Ended December 31,2006
            
            
            2005
            
            
            2004Product
                sales
            
            $
            11,674,510
            
            $
            8,902,615
            
            $
            -Bulk
                compound sales
            
            
            672,400
            
            
            679,550
            
            
            -Royalties
            
            
            300,000
            
            
            459,967
            
            
            -Total
                Skin Care revenue
            
            $
            12,646,910
            
            $
            10,042,132
            
            $
            -




***Surgical
      Services Segment***




In
      the
      years ended December 31, 2006, 2005 and 2004, surgical service revenues
      were $6,944,292, $7,719,529 and $7,826,519, respectively, representing a 10%
      decrease and a 1.4% decrease from the comparable prior year periods. The 2006
      decrease was primarily due to the six territories that we closed since January
      1, 2005, the largest of which was in the fourth quarter of 2005, and business
      interruption in New Orleans and Alabama from the hurricanes in August and
      September 2005. Two of our territories were closed on the western side of
      Florida due to the termination of a customer contract. We closed the other
      four
      territories for insufficient profitability. During the first quarter of 2006,
      we
      have begun to work with a regional hospital system in central Florida, which
      we
      believe will generate annual revenue exceeding the annual revenue lost in the
      western side of the state.




***Surgical
      Products Segment***




Surgical
      Products revenues include revenues derived from the sales of surgical laser
      systems together with sales of related laser fibers and laser disposables.
      Sales
      of laser systems create recurring sales of laser fibers and laser disposables
      that are more profitable than laser systems.




For
      the
      year ended December 31, 2006, surgical products revenues were $5,800,864
      compared to $5,720,514 in the year ended December 31, 2005. The increase was
      almost entirely due to $207,000 in additional laser system revenues reflecting
      the increase in the number of systems sold (80 vs. 47), partially offset by
      a
      decline in the average price per laser sold. This was offset, in part, by a
      decrease in disposable and fiber sales of approximately 5%.




For
      the
      year ended December 31, 2005, surgical products revenues were $5,720,514
      compared to $5,035,852 in the year ended December 31, 2004. The increase was
      almost entirely due to $685,000 in additional laser system revenues reflecting
      the increase in the number of systems sold (47 vs. 17), partially offset by
      a
      decline in the average price per laser sold.




As
      set
      forth in the table below, the decrease in average price per laser between the
      period was largely due to the mix of lasers sold and partly due to the trade
      level at which the lasers were sold (i.e. wholesale versus retail). Our diode
      laser has replaced our Nd:YAG laser, which had a higher sales price. Included
      in
      laser sales during the years ended December 31, 2006, 2005 and 2004 were sales
      of 65, 28 and 1 diode lasers, respectively. The diode lasers have lower sales
      prices than our other types of lasers, and thus the increase in the number
      of
      diodes sold reduced the average price per laser. We expect that we will continue
      to sell more diode lasers than our other types of lasers into the near
      future.




Disposables
      and fiber sales decreased approximately 5% from the comparable year ended
      December 31, 2005. We have expected that the disposables base may 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 to offset this erosion through expansion of our surgical
      services. Similarly, we believe there will be continuing pressure on laser
      system sales as hospitals continue 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 have
      sought to offset the decline in laser and disposables revenues.




44




The
      following table illustrates the key changes in the Surgical Products segment
      for
      the periods reflected below:




For
                the Year Ended December 31,2006
            
            
            2005
            
            
            2004Revenues
            
            $
            5,800,864
            
            $
            5,720,514
            
            $
            5,035,832Percent
                increase
            
            
            1.4
            %
            
            13.6
            %Laser
                systems sold
            
            
            80
            
            
            47
            
            
            17Laser
                system revenues
            
            $
            1,801,000
            
            $
            1,594,000
            
            $
            989,000Average
                revenue per laser
            
            $
            22,513
            
            $
            33,915
            
            $
            58,176




***Cost
      of Revenues***




Cost
      of
      revenues divides into product cost of revenues and service cost of revenues
      .
      Within product cost of revenues are the costs of products sold in the
      International Dermatology Equipment segment, the Skin Care segment (with
      royalties being transferred over to the services side), and the Surgical
      Products segment (with laser maintenance being transferred over to the services
      side). Within services cost of revenues are the costs associated with the
      Domestic XTRAC segment and the Surgical Services segment, as well as costs
      associated with the royalties and maintenance.




Product
      cost of revenues during the year ended December 31, 2006 were $8,628,651,
      compared to $7,219,504 for the year ended December 31, 2005. The $1,409,147
      increase reflected the cost of sales for the domestic XTRAC laser sales of
      $128,840, an increase of $726,412 in costs for the ProCyte business acquired
      on
      March 18, 2005, and therefore the operating results of ProCyte for the year
      ended December 31, 2005 include activity from ProCyte from March 19, 2005
      through December 31, 2005. Additionally there was an increase of $216,389 for
      surgical products, due to increased laser system sales and a $337,506 increase
      in costs associated with sales of XTRAC laser equipment sold outside the United
      States.




Product
      cost of revenues during the year ended December 31, 2005 were $7,219,504,
      compared to $3,324,564 for the year ended December 31, 2004. The $3,894,940
      increase reflected $3,132,532 of costs for the ProCyte business acquired on
      March 18, 2005. Additionally there was an increase of $1,009,204 for surgical
      products, due to increased laser system sales, which was offset, in part by
      a
      decrease of $246,796 in product cost of sales for the international XTRAC
      revenues for the year ended December 31, 2004.




Services
      cost of revenues was $9,843,199 and $8,456,001 in the years ended December
      31,
      2006 and 2005, respectively. Contributing to the $1,387,198 increase was a
      $1,345,853 increase in the Domestic XTRAC business segment due to increased
      depreciation on the lasers of $629,000, an increase in excess and obsolete
      inventory reserve and abnormal gas consumption, which has been corrected by
      software modifications. Additionally there was an increase of $41,345 in the
      cost of revenues for the Surgical Services business.




Services
      cost of revenues was $8,456,001 and $7,038,705 in the years ended December
      31,
      2005 and 2004, respectively. Contributing to the $1,417,296 increase was a
      $616,236 increase in the Surgical Services business associated with the increase
      in urological procedures performed with laser systems purchased from a
      third-party manufacturer, which carry a higher cost of sale due to the
      disposable fiber purchased from the third-party manufacturer than a fiber which
      we manufacture. In addition, cost of revenues in the Domestic XTRAC business
      segment increased $801,060 due to manufacturing inefficiencies, an increase
      in
      excess and obsolete inventory reserve and increased depreciation on the lasers
      compared to the same period in 2004.




45




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. The unabsorbed costs, relating to
      excess capacity, are allocated to the Domestic XTRAC and the International
      Dermatology Equipment segments based on actual production of lasers for each
      segment. Included in these allocated manufacturing costs are unabsorbed labor
      and direct plant costs.




The
      following table illustrates the key changes in cost of revenues for the periods
      reflected below:




For
                the Year Ended December 31,2006
            
            
            2005
            
            
            2004Product:XTRAC
                Domestic
            
            $
            128,840
            
            $
            -
            
            $
            -International
                Dermatology Equipment
            
            
            1,268,080
            
            
            930,574
            
            
            1,177,370Skin
                Care
            
            
            3,858,944
            
            
            3,132,532
            
            
            -Surgical
                products
            
            
            3,372,787
            
            
            3,156,398
            
            
            2,147,194Total
                Product costs
            
            $
            8,628,651
            
            $
            7,219,504
            
            $
            3,324,564Services:XTRAC
                Domestic
            
            $
            4,037,359
            
            $
            2,691,506
            
            $
            1,890,446Surgical
                Services
            
            
            5,805,840
            
            
            5,764,495
            
            
            5,148,259Total
                Services costs
            
            $
            9,843,199
            
            $
            8,456,001
            
            $
            7,038,705Total
                Costs of Revenues
            
            $
            18,471,850
            
            $
            15,675,505
            
            $
            10,363,269




***Gross
      Margin Analysis***




Gross
      margin increased to $14,718,027 during the year ended December 31, 2006
      from $12,709,001 during the same period in 2005. As a percentage of revenues,
      the gross margins for the year ended December 31, 2006, decreased to 44.3%
      compared to 44.8% for the same period in 2005.




Gross
      margin increased to $12,709,001 during the year ended December 31, 2005
      from $7,381,912 during the same period in 2004, primarily reflecting the impact
      of the ProCyte acquisition on March 18, 2005. As a percentage of revenues,
      the
      gross margins for the year ended December 31, 2005, increased to 44.8% compared
      to 41.6% for the same period in 2004, largely as a result of the ProCyte’s gross
      margin contribution which approximates 68.8%.




The
      following table analyzes changes in our gross margin for the periods reflected
      below:




**Company
                Margin Analysis**
            
            For
                the Year Ended December 31,2006
            
            
            2005
            
            
            2004Revenues
            
            $
            33,189,877
            
            $
            28,384,506
            
            $
            17,745,181Percent
                increase
            
            
            16.9
            %
            
            60.0
            %Cost
                of revenues
            
            
            18,471,850
            
            
            15,675,505
            
            
            10,363,269Percent
                increase
            
            
            17.8
            %
            
            51.3
            %Gross
                profit
            
            $
            14,718,027
            
            $
            12,709,001
            
            $
            7,381,913Percent
                of revenue
            
            
            44.3
            %
            
            44.8
            %
            
            41.6
            %


The
        primary reasons for changes in gross profit for the year ended December 31,
        2006, compared to the same period in 2005 were as follows:
  ·
              Our
                  Skin Care business has the highest gross profit percentage of any
                  of our
                  business segments. However, we acquired ProCyte on March 18, 2005,
                  and, as
                  such, the operating results of ProCyte for the year ended December
                  31,
                  2005 only included activity from March 19, 2005 through December
                  31, 2005.


46




·
            We
                sold a greater number of treatment procedures for the XTRAC laser
                systems
                in 2006 than in 2005. Each incremental treatment procedure carries
                negligible variable cost. The increase in procedure volume was a
                direct
                result of improving insurance reimbursement and increased marketing
                efforts.




·
            We
                sold a greater number of surgical laser systems due to the increased
                marketing of the Diode laser. These units were primarily sold to
                our
                master distributor at a gross margin of approximately
                36%.




·
            We
                sold XTRAC lasers domestically during the year ended December 31,
                2006.
                The gross margin on these sales is higher, approximately 72%, since
                certain of the lasers were previously being
                depreciated.




·
            Offsetting
                the above was an increase in depreciation of $629,000 included in
                the
                XTRAC Domestic cost of sales as a result of increasing the overall
                placements of new lasers since the year ended December 31,
                2005.




·
            In
                the Surgical Products segment, unabsorbed labor and overhead plant
                costs,
                due to lower production levels, accounted for $387,000 of the increase
                in
                cost of goods sold for the year ended December 31,
                2006.




·
            Surgical
                services revenues decreased due to lost contracts, while costs related
                to
                laser repairs increased during the period. Some revenues were lost
                due to
                hurricanes. While we believe a portion of the loss will be covered
                by
                insurance, we will not record any expected recovery until we have
                greater
                assurance of such recovery.




The
      primary reasons for changes in gross profit for the year ended December 31,
      2005, compared to the same period in 2004, were as follows:




·
            We
                acquired ProCyte on March 18, 2005, so only the activity after that
                date
                is recorded in our financial statements. Consequently, there was
                no
                activity recorded in our financial statements in 2004 and 2003 from
                the
                Skin Care business. Additionally, the Skin Care business has the
                highest
                gross profit margin percentage of any of our business
                segments.




·
            We
                increased sales on surgical laser systems due to the introduction
                of the
                diode laser.




·
            Offsetting
                the above was an increase in depreciation included with the XTRAC
                Domestic
                cost of sales as a result of increasing the overall placements of
                new
                lasers in 2005. In addition, the XTRAC plant was relocated in the
                middle
                of 2005 causing some inefficiencies in the third quarter. Further,
                we
                introduced the XTRAC Ultra, a smaller, faster excimer laser. As a
                result
                of this introduction we increased our reserve for obsolete inventory
                related to the older generation
                laser.




The
      following table analyzes the gross profit for our Domestic XTRAC segment for
      the
      periods reflected below:




**XTRAC
                Domestic Segment**
            
            For
                the Year Ended December 31,2006
            
            
            2005
            
            
            2004Revenues
            
            $
            5,611,387
            
            $
            3,498,235
            
            $
            3,256,164Percent
                increase
            
            
            60.4
            %
            
            7.4
            %Cost
                of revenues
            
            
            4,166,199
            
            
            2,691,506
            
            
            1,890,446Percent
                increase
            
            
            54.8
            %
            
            42.4
            %Gross
                profit
            
            
            1,445,188
            
            $
            806,729
            
            $
            1,365,718Percent
                of revenue
            
            
            25.8
            %
            
            23.1
            %
            
            41.9
            %


The
        gross
        margin increased for this segment for the year ended December 31, 2006 from
        the
        comparable periods in 2005 by $638,459. The key factors were as
        follows:
  ·
              We
                  sold XTRAC lasers domestically during the year ended December 31,
                  2006.
                  The gross margin on these sales was approximately 72%, which is
                  higher
                  than overall gross margin of 25.8% in this segment and which is
                  largely
                  due to the fact that certain of the lasers were previously being
                  depreciated.


47




·
            A
                key driver in increased revenue in this segment is insurance reimbursement
                and increased direct-to-consumer advertising in targeted territories.
                In
                2005, several private health insurance plans adopted a favorable
                policy to
                cover the medically necessary treatment of psoriasis using our XTRAC
                laser
                system (e.g. United Healthcare, Highmark, Independence Blue Cross,
                Empire
                BCBS, Cigna, Premera, Blue Cross of Michigan). These insurers added
                to the
                group of companies that had already adopted a favorable policy in
                2004. In
                2006, we increased our level of direct-to-consumer advertising to
                recruit
                patients to dermatologists’ office to seek treatment with the XTRAC laser
                system. While the advertising helped increase revenues, the advertising
                is
                also costly. We continue to analyze and adjust the advertising campaigns
                for cost-effectiveness.




·
            Procedure
                volume increased 46% from 60,626 to 88,440 procedures in the year
                ended
                December 31, 2006 compared to the same period in 2005. Price per
                procedure
                did not change significantly between the
                periods.




·
            Price
                per procedure was not a meaningful component of the revenue change
                between
                the periods.




·
            The
                cost of revenues increased by $1,474,693 for the year ended December
                31,
                2006. This increase is due to the cost of sales for the lasers of
                $128,840
                and to an increase in depreciation on the lasers-in-service of $629,000
                over the comparable prior year period, an increase in excess and
                obsolete
                inventory reserve and abnormal gas consumption, which has been corrected
                by software modification. The depreciation costs will continue to
                increase
                in subsequent periods as the business grows. In addition, there was
                an
                increase in certain allocable XTRAC manufacturing overhead costs
                that are
                charged against the XTRAC service
                revenues.




The
      gross
      margin decreased for this segment for the year ended December 31, 2005 from
      the
      comparable period in 2004 by $558,989. The key factors were as
      follows:




·
            A
                key driver in increased revenue in this segment is insurance
                reimbursement. In 2004, we focused on encouraging private health
                insurance
                plans to adopt the XTRAC laser therapy as an approved medical procedure
                for the treatment of psoriasis. Since January 2004, several major
                health
                insurance plans instituted medical policies to pay claims for the
                XTRAC
                therapy, including Regence, Wellpoint, Aetna, Anthem, Cigna, United
                Healthcare, Highmark Blue Cross and Independence Blue Cross of
                Pennsylvania.




·
            Procedure
                volume increased 14.7% from 52,843 to 60,626 billed procedures in
                the year
                ended December 31, 2005 compared to the same period in 2004.




·
            Price
                per procedure was not a meaningful component of the revenue change
                between
                the periods.




·
            The
                cost of revenues increased by $801,060 for the year ended December
                31,
                2005. This increase was due to the fact that in 2004, our California
                engineering resources dedicated much of their time to product development
                for the Ultra, the new, smaller and faster excimer laser. For the
                year
                ended December 31, 2005, the development of the Ultra was completed,
                thus
                allowing these California resources to devote more time to manufacturing
                (included in cost of revenues).




48


The
      following table analyzes the gross profit for our International Dermatology
      Equipment segment for the periods reflected below:




**International
                Dermatology Equipment Segment**
            
            For
                the Year Ended December 31,2006
            
            
            2005
            
            
            2004Revenues
            
            $
            2,186,424
            
            $
            1,404,096
            
            $
            1,626,646Percent
                increase (decrease)
            
            
            55.7
            %
            
            (13.7
            %)Cost
                of revenues
            
            
            1,268,080
            
            
            930,574
            
            
            1,177,371Percent
                increase (decrease)
            
            
            36.3
            %
            
            (21.0
            %)Gross
                profit
            
            
            918,344
            
            $
            473,522
            
            $
            449,275Percent
                of revenue
            
            
            42.0
            %
            
            33.7
            %
            
            27.6
            %




The
      gross
      profit for the year ended December 31, 2006 increased by $444,822 from the
      comparable prior year period. The key factors in this business segment were
      as
      follows:





·
                  We
                      sold 34 XTRAC laser systems and 12 VTRAC lamp-based excimer
                      systems during
                      the year ended December 31, 2006 and 26 XTRAC laser systems
                      in the
                      comparable period in 2005. The VTRAC systems have a higher
                      gross margin
                      than the XTRAC laser
                      systems.




·
                  The
                      International Dermatology Equipment operations are influenced
                      by
                      competition from similar laser technology from other manufacturers
                      and
                      from non-laser lamp alternatives for treating inflammatory
                      skin disorders,
                      which has served to reduce the prices we charge international
                      distributors
                      for our excimer products. Partially offsetting the increase
                      in the number
                      of laser systems sold was a decrease in the average price of
                      the laser
                      systems sold. After adjusting the revenue for parts sales of
                      approximately
                      $323,000, the average price for lasers sold during this period
                      was
                      approximately $40,500 in the year ended December 31, 2006,
                      down from
                      $46,000 in the comparable period in 2005. Contributing to the
                      overall
                      decrease in the average selling price in the year ended December
                      31, 2006
                      was the sale of certain used lasers which were previously deployed
                      in the
                      U.S. operations and sold at a discount to the list price for
                      new
                      equipment. We sold six of these used lasers in each year at
                      an average
                      price of $28,000 and $27,000, respectively for the years ended
                      December
                      31, 2006 and 2005. Each of these lasers had a net book value
                      that was less
                      than the cost of a new XTRAC laser
                      system.




The
      gross
      profit for the year ended December 31, 2005 increased by $24,247 from the
      comparable prior year period. The key factors in this business segment were
      as
      follows:




·
                We
                    sold 26 XTRAC systems during both the years ended December 31,
                    2005 and
                    2004.




·
                  TheInternational
                      Dermatology Equipment 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,
                      which has
                      served to reduce the prices we charge international distributors
                      for our
                      excimer products. After adjusting the revenue for parts sales
                      of
                      approximately $209,000, the average price for lasers sold in
                      the year
                      ended December 31, 2005 was approximately $46,000, down from
                      $56,800 in
                      the comparable period in 2004. Contributing to the overall
                      average selling
                      price decrease in 2005 was the sale of certain used lasers
                      which were
                      previously deployed in the U.S. operations and sold at a discount
                      to the
                      list price for new equipment. We sold six of these used lasers
                      at an
                      average price of $27,000. Each of these lasers had a net book
                      value of
                      less than standard cost of a new XTRAC system.




49




The
      following table analyzes our gross margin for our Skin Care (ProCyte) segment
      for the periods presented below:




**Skin
                Care (ProCyte) Segment**
            
            For
                the Year Ended December 31,2006
            
            
            2005
            
            
            2004Product
                revenues
            
            $
            11,674,510
            
            $
            8,902,615
            
            $
            -Bulk
                compound revenues
            
            
            672,400
            
            
            679,550
            
            
            -Royalties
            
            
            300,000
            
            
            459,967
            
            
            -Total
                revenues
            
            
            12,646,910
            
            
            10,042,132
            
            
            -Percent
                increase
            
            
            25.9
            %Product
                cost of revenues
            
            
            3,441,636
            
            
            2,664,959
            
            
            -Bulk
                compound cost of revenues
            
            
            417,308
            
            
            467,573
            
            
            -Total
                cost of revenues
            
            
            3,858,944
            
            
            3,132,532
            
            
            -Percent
                increase
            
            
            23.2
            %Gross
                profit
            
            $
            8,787,966
            
            $
            6,909,600
            
            $
            -Percent
                of revenue
            
            
            69.5
            %
            
            68.8
            %
            
            -




Gross
      margin for the year ended December 31, 2006 increased by $1,878,366 over the
      comparable period in 2005. The key factors impacting gross margin were as
      follows:




·
            Skin
                Care (ProCyte) business was acquired on March 18, 2005 and, as such,
                the
                operating results of ProCyte for the year ended December 31, 2005
                only
                included activity from March 19, 2005 through December 31,
                2005.




·
            Copper
                peptide bulk compound is sold at a substantially lower gross margin
                than
                skincare products, while revenues generated from licensees have no
                significant costs associated with this revenue
                stream.




The
      following table analyzes the gross profit for our Surgical Services segment
      for
      the periods reflected below:




**Surgical
                Services Segment**
            
            For
                the Year Ended December 31,2006
            
            
            2005
            
            
            2004Revenues
            
            $
            6,944,292
            
            $
            7,719,529
            
            $
            7,826,519Percent
                decrease
            
            
            (10.0
            %)
            
            (1.4
            %)Cost
                of revenues
            
            
            5,703,925
            
            
            5,675,787
            
            
            5,000,226Percent
                increase
            
            
            0.5
            %
            
            13.5
            %Gross
                profit
            
            $
            1,240,367
            
            $
            2,043,742
            
            $
            2,826,293Percent
                of revenue
            
            
            17.9
            %
            
            26.5
            %
            
            36.1
            %




Gross
      margin in the Surgical Services segment for year ended December 31, 2006
      decreased by $803,375, from the comparable period in 2005. The key factors
      impacting gross margin for the Surgical Services business were as
      follows:




·
            We
                have closed six territories of business due to unacceptable operating
                profit and one territory due to competition. Although closing these
                unprofitable territories will save costs and improve profitability
                over
                time, the overall costs saved for the year ended December 31, 2006
                have
                not kept pace with the revenues lost. Nevertheless, in the case of
                the
                territory lost to competition, we have opened a new, contiguous territory
                in which we have secured a long-term contract from which we anticipate
                significant procedure volume. For that reason, we have relocated
                our
                personnel and materiel from the lost territory to the new
                one.




50




·
            Our
                product cost percentage has increased due to a change in the mix
                of
                procedures performed. A certain urological procedure performed on
                a laser
                purchased from an unrelated party has increased as a percentage of
                revenue
                from 2005. This procedure has a lower gross margin than margins obtained
                from procedures performed on lasers manufactured by
                us.




Gross
      margin in the Surgical Services segment for year ended December 31, 2005
      decreased by $782,551, from the comparable period in 2004. The key factors
      impacting gross margin for the Surgical Services business were as
      follows:




·
            A
                significant part of the revenue was in urological procedures performed
                with laser systems we 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. This procedure has a lower gross margin as a percent
                of
                revenues than other types of procedures. As the volume of these procedures
                increases, the overall gross margin percentage decreases. In 2005,
                there
                was a 25% price increase on the third party’s proprietary fiber delivery
                system, which also contributed to the decrease in gross margin in
                2005.
                Revenues for this procedure were $2.4 million for the year ended
                December
                31, 2005 compared to $1.7 million for the same period in
                2004.




·
            We
                closed four geographic areas of business due to unacceptable operating
                profit. Although closing these territories will save costs and improve
                profitability over time, the costs saved for the year ended December
                31,
                2005 have not kept pace with the revenues lost by closing these
                territories during the year ended December 31, 2005.




·
            We
                suffered business interruption due to hurricanes in the New Orleans
                and
                Alabama territories during 2005.




The
      following table analyzes our gross profit for our Surgical Products segment
      for
      the periods reflected below:




**Surgical
                Products Segment**
            
            For
                the Year Ended December 31,2006
            
            
            2005
            
            
            2004Revenues
            
            $
            5,800,864
            
            $
            5,720,514
            
            $
            5,035,852Percent
                increase
            
            
            1.4
            %
            
            13.6
            %Cost
                of revenues
            
            
            3,474,702
            
            
            3,245,103
            
            
            2,295,226Percent
                increase
            
            
            7.1
            %
            
            41.4
            %Gross
                profit
            
            $
            2,326,162
            
            $
            2,475,411
            
            $
            2,740,626Percent
                of revenue
            
            
            40.1
            %
            
            43.3
            %
            
            54.4
            %




The
      gross
      profit for the year ended December 31, 2006 decreased by $149,249 from the
      comparable prior year period. 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,
                but the
                sale of laser systems generates the subsequent recurring sale of
                laser
                disposables.




·
                    Revenues
                        for the year ended December 31, 2006 increased by $80,350
                        from the year
                        ended December 31, 2005 while cost of revenues increased
                        by $229,599
                        between the same periods. There were 33 more laser systems
                        sold in the
                        year ended December 31, 2006 than in the comparable period
                        of 2005.
                        However, the lasers sold in the 2005 period were at higher
                        prices than in
                        the comparable period in 2006. The decrease in average price
                        per laser was
                        largely due to the mix of lasers sold. Included in the laser
                        sales for the
                        year ended December 31, 2006 and 2005 were sales of $1,120,000
                        and
                        $605,000 of diode lasers, respectively, which have substantially
                        lower
                        list sales prices than the other types of surgical
                        lasers.




51





·
            Unabsorbed
                labor and overhead plant costs, due to lower production levels, accounted
                for $387,000 of the increase in cost of goods sold for the year ended
                December 31, 2006.




·
            This
                revenue increase was partly offset by a decrease in AzurTec project
                revenues of $156,000 and a decrease in sales of disposables between
                the
                periods. The AzurTec revenues recognized in 2005 had substantially
                no
                associated direct costs. Disposables, which have a higher gross margin
                as
                a percent of revenues than lasers, represented a higher percentage
                of
                revenue in the year ended December 31, 2006 compared to the same
                period in
                2005.




The
      gross
      profit for the year ended December 31, 2005 decreased by $265,215 from the
      comparable prior-year period. 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 future recurring sales of laser
                disposables.




·
            Revenues
                for the year ended December 31, 2005 increased by $684,662 from the
                year
                ended December 31, 2004 while cost of revenues increased by $949,877
                between the same periods. There were 30 more laser systems sold in
                the
                year ended December 31, 2005 than in the comparable period of 2004.
                However, the lasers sold in the 2004 period were at higher prices
                than in
                the comparable period in 2005. The decrease in average price per
                laser was
                largely due to the mix of lasers sold. Included in the laser sales
                for the
                years ended December 31, 2005 and 2004 were sales of $532,995 and
                $40,000
                diode lasers, respectively, which have substantially lower list sales
                prices than the other types of surgical lasers.




·
            The
                laser revenue increase was partly offset by a decrease in sales of
                disposables between the periods. Disposables, which have a higher
                gross
                margin than lasers, represented a lower percentage of revenue in
                the year
                ended December 31, 2005 compared to the year ended December 31,
                2004.




***Selling,
      General and Administrative Expenses***




For
      the
      year ended December 31, 2006, selling, general and administrative expenses
      increased to $20,682,056 from $16,477,322 for the year ended December 31, 2005.




·
            Selling,
                general and administrative expenses related to the ProCyte business
                accounted for $1,360,000 of the increase. This is due to the acquisition
                which occurred on March 18, 2005, so only expenses from March 19,
                2005
                through December 31, 2005 were
                included.




·
            The
                remaining increase related to a $387,000 increase in salaries, benefits
                and travel expenses associated with an increase in the sales force,
                particularly in the Domestic XTRAC
                segment;




·
            An
                increase in direct-to-consumer advertising of
                $676,000;




·
            An
                increase in royalties to Mount Sinai of
                $112,000;




·
            An
                increase in bonus accrual of
                $255,000;




·
            An
                increase of $210,000 for legal expenses;
                and




·
            An
                increase of $1,304,546 for stock-based compensation expense following
                adoption of SFAS No. 123R (see Note 1, “*Stock-Based
                Compensation*”)
                and $132,624 for stock options issued to consultants.




·
            These
                increases were partially offset by a reduction in bad debt expense
                of
                $213,000.


For
        the
        year ended December 31, 2005, selling, general and administrative expenses
        increased to $16,477,322 from $10,426,256 for the year ended December 31,
        2004.




52




·
            Selling,
                general and administrative expenses related to the Skin Care business
                accounted for $5,331,764 of the increase. This is due to the acquisition
                which occurred on March 18, 2005, so only expenses from March 19,
                2005
                through December 31, 2005 were
                included.




·
            The
                remaining increase related to a $485,000 increase in salaries, benefits
                and travel expenses associated with an increase in the sales force,
                particularly in the Domestic XTRAC segment;




·
            A
                $151,000 increase in salaries and benefits for general and administrative
                expenses;




·
            An
                increase in consulting expenses of $161,000;
                and




·
            An
                increase in corporate insurance of $229,000.




·
            Offsetting
                some of the increases for the year ended December 31, 2005, were
                reductions in bonus expense of $134,000 and in bad debt expense of
                $117,000 in the current year compared to the prior-year
                period.




***Engineering***  ***and
      Product Development***




Engineering
      and product development expenses for the year ended December 31, 2006 decreased
      to $1,006,600 from $1,127,961 for the year ended December 31, 2005. The decrease
      is primarily due to a decrease in salaries due to reduced headcount of $117,000.
      During the 2006 and 2005 periods, the engineers at the Carlsbad plant were
      primarily focused on manufacturing efforts, and therefore, their costs have
      been
      reflected in cost of goods sold.




Engineering
      and product development expenses for the year ended December 31, 2005 decreased
      to $1,127,961 from $1,801,438 for the year ended December 31, 2004. The decrease
      was mainly in the XTRAC segments due to product development expenses in 2004
      for
      the Ultra. In 2005, the development of the Ultra was completed, thus allowing
      these California resources to devote more time to manufacturing. This decrease
      was offset, in part, by the engineering and product development expenses related
      to the Skin Care business of $442,368.




***Other
      Income***




Other
      income for the year ended December 31, 2005 was $1,302,537 reflecting the
      following components: a litigation settlement, net of expenses, of $968,882,
      a
      non-monetary exchange of assets during June 2005 of two depreciable engineering
      development prototypes in exchange for four product units to be held for sale
      for $88,667 and the expiration, and therefore reversal, of the liability for
      SLT
      subordinated notes of $244,988. There was no other income in the comparable
      periods in 2006 and 2004.




***Interest
      Expense, Net***




Net
      interest expense for the year ended December 31, 2006 increased to $521,768,
      as
      compared to $342,299 for the year ended December 31, 2005. The increase in
      net
      interest expense was the result of the draws on the lease line of credit during
      the year ended December 31, 2005 and the first, second and third quarters of
      2006.




Net
      interest expense for the year ended December 31, 2005 increased to $342,299,
      as
      compared to $138,414 for the year ended December 31, 2004. The increase in
      net
      interest expense was the result of the draws on the lease line of credit during
      the second, third and fourth quarters of 2004 and the second and third quarters
      of 2005.




***Net
      Loss***




The
      aforementioned factors resulted in a net loss of $7,492,397 during the year
      ended December 31, 2006, as compared to a net loss of $3,936,044 for the year
      ended December 31, 2005, an increase of 90.4%. The increase was primarily due
      to:




·
            The
                result of the other income for the year ended December 31, 2005 of
                $1,302,537;




53


·
            The
                increase in cost of sales and resulting decrease in gross margin,
                due to
                stock option expense of $1,437,170 following the adoption of SFAS
                No.
                123R; and




·
                An
                    increase of $982,110 of depreciation and amortization over the
                    comparable
                    period of the prior year.




The
      following table illustrates the impact of the three components between the
      periods:




For
                the Year ended December 31,2006
            
            
            2005
            
            
            ChangeNet
                loss
            
            $
            7,492,398
            
            $
            3,936,044
            
            $
            3,556,354Components
                included in net loss:Other
                income
            
            
            -
            
            
            1,302,537
            
            
            (1,302,537
            )Depreciation
                and amortization expense
            
            
            (4,199,047
            )
            
            (3,216,937
            )
            
            (982,110
            )Stock-based
                compensation expense
            
            
            (1,437,170
            )
            
            -
            
            
            (1,437,170
            )($5,636,217
            )
            
            ($1,914,400
            )
            
            ($3,721,817
            )




The
      aforementioned factors resulted in a net loss of $3,936,044 during the year
      ended December 31, 2005, as compared to a net loss of $4,984,196 for the year
      ended December 31, 2004, a decrease of 21.0%. This decrease was primarily the
      result of the other income for the year ended December 31, 2005.




Income
      taxes were immaterial, given our current period losses and operating loss
      carryforwards.




**Liquidity
      and Capital Resources**




We
      have
      historically financed our operations with cash provided by equity financing
      and
      from lines of credit and, more recently, from positive cash flow generated
      from
      operations.




On
      March
      18, 2005, we acquired ProCyte. The skincare products and royalties provided
      by
      ProCyte increased revenues for the year ended December 31, 2006. We realized
      cost savings from the consolidation of the administrative and marketing
      infrastructure of the combined company. Additionally, now that the consolidated
      infrastructure is in place, we expect our revenues to grow without
      proportionately increasing the rate of growth in our fixed costs.




At
      December 31, 2006, our current ratio was 2.66 compared to 2.42 at December
      31,
      2005. As of December 31, 2006, we had $16,069,615 of working capital compared
      to
      $11,120,992 as of December 31, 2005. Cash and cash equivalents were $12,885,742
      as of December 31, 2006, as compared to $5,609,967 as of December 31, 2005.
      We
      had $156,000 of cash that was classified as restricted as of December 31, 2006
      compared to $206,931 as of December 31, 2005.




We
      believe that our existing cash balance together with our other existing
      financial resources, including access to lease financing for capital
      expenditures, and revenues from sales, distribution, licensing and manufacturing
      relationships, will be sufficient to meet our operating and capital requirements
      beyond the first quarter of 2008. The 2007 operating plan reflects continuing
      cost savings from the integration of ProCyte as well as increases in
      per-treatment fee revenues for use of the XTRAC system based on increased
      utilization of the XTRAC by physicians and on wider insurance coverage in the
      United States. In addition, the 2007 operating plan calls for increased revenues
      and profits from our newly acquired Skin Care business. In light of our recent
      private placement of approximately $11.4 million worth of our common stock
      in
      November 2006, we believe that we shall have the necessary financing to meet
      our
      operating and capital requirements, at a minimum, into 2008.




54




On
      June
      25, 2004, we entered into a leasing credit facility from GE Capital Corporation
      (“GE”). 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, with equitable ownership in the lasers remaining with us.
      GE
      retains title as a form of security over the lasers. Each draw against the
      credit facility has a repayment period of three years and is secured by specific
      lasers, which we have sold to GE and leased back for deployment in the field.
      A
      summary of the activity under the GE leasing credit facility is presented in
      Note 9, “ *Long-term
      Debt* .”




Net
      cash
      provided by operating activities was $60,984 for the year ended December 31,
      2006, compared to cash used of $1,729,842 for the same period in 2005. The
      change was primarily due to a decrease in inventory. In the prior year,
      significant inventory purchases were made of copper peptide in the skincare
      products segment and in launching the diode program in the surgical products
      segment. Increases in sales in these segments in 2006 reduced the inventory
      levels.




Net
      cash
      used in operating activities was $1,729,842 for the year ended December 31,
      2005, compared to $2,765,221 for the same period in 2004. The decrease was
      mostly due to the payment of various previously recorded costs associated with
      the acquisition and increases in inventory.




Net
      cash
      used in investing activities was $5,026,811 for the year ended December 31,
      2006
      compared to cash provided by investing activities of $1,993,412 for the year
      ended December 31, 2005. This change was mostly the result of receiving cash
      of
      $5,578,416, net of costs, in the acquisition of ProCyte in 2005. Of this
      increase in cash from the acquisition, we used $3,461,803 for production of
      our
      lasers-in-service compared to $4,931,835 in 2006.




Net
      cash
      provided by investing activities was $1,993,412 for the year ended December
      31,
      2005 compared to cash used of $2,677,670 for the year ended December 31, 2004.
      During the year ended December 31, 2005, we received cash of $5,578,416, net
      of
      acquisition costs, in the ProCyte acquisition and used $3,461,803 for production
      of our lasers-in-service compared to $1,683,528 for the same period in 2004.




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 $12,292,533 for the year ended December
      31,
      2006 compared to $1,254,649 for the year ended December 31, 2005. In the year
      ended December 31, 2006 we received $10,449,402, net from the issuance of common
      stock, $2,511,437 from the advances under the lease line of credit, net of
      payments, $361,469 from the exercise of common stock options and warrants and
      a
      decrease in restricted cash of $50,931. These cash receipts were offset by
      $1,080,706 for the payment of certain notes payable and capital lease
      obligations.




Net
      cash
      provided by financing activities was $1,254,649 for the year ended December
      31,
      2005 compared to $2,694,240 for the year ended December 31, 2004. In the year
      ended December 31, 2005 we made payments of $1,145,474 on certain notes payable
      and capital lease obligations and incurred $169,524 in registration costs.
      These
      payments were offset, in part, by the advances under the lease line of credit,
      net of payments, of $1,889,487 and by receipts of $774,891 from the exercise
      of
      common stock options and warrants. In the year ended December 31, 2004, we
      received $3,296,751 from the exercise of common stock options and warrants
      and a
      net increase of $527,548 from the lapse of the bank line of credit and the
      initiation of the leasing line of credit from GE. These cash receipts were
      offset by $879,001 for the payment of certain notes payable and capital lease
      obligations.




Set
      forth
      below is a summary of current obligations as of December 31, 2006 to make future
      payments due by the period indicated below, 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.




55




Payments
                due by periodContractual
                Obligations
            
            
            Total
            
            
            Less
                than 1 year
            
            
            1
                - 3 years
            
            
            4
                - 5 yearsCredit
                facility obligations
            
            $
            6,490,077
            
            $
            2,936,215
            
            $
            3,553,862
            
            $
            -Other
                capital lease obligations
            
            
            122,716
            
            
            82,658
            
            
            40,058
            
            
            -Operating
                lease obligations
            
            
            50,345
            
            
            32,523
            
            
            17,822
            
            
            -Rental
                lease obligations
            
            
            1,795,189
            
            
            470,663
            
            
            1,018,524
            
            
            306,002Notes
                payable
            
            
            328,756
            
            
            195,249
            
            
            87,030
            
            
            46,477Total
            
            $
            8,787,895
            
            $
            3,717,308
            
            $
            4,718,108
            
            $
            352,479




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 in this Report and
      beginning on page F-1.




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




None.




**Item
      9A.**  **Controls
      and Procedures**




**Controls
      and Procedures**




As
      of
      December 31, 2006, 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.




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.




56




There
      were no changes in our internal controls over financial reporting during the
      quarter ended December 31, 2006 that materially affected, or were
      reasonably likely to materially affect, our internal controls over financial
      reporting. As a prophylactic measure and support for our compliance with the
      Sarbanes Oxley Act, we adopted an Anti-Fraud Program in January
      2007.




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, 2006. 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**




None.




57


**PART
      III**




**Item
      10.** **Directors,
      ExecutiveOfficers and Corporate Governance**




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 Board of
      Directors held eight meetings and three unanimous written consents in lieu
      of
      meetings in 2006.




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
            
            65Jeffrey
                F. O'Donnell
            
            Director,
                President and Chief Executive Officer
            
            47Dennis
                M. McGrath
            
            Chief
                Financial Officer and Vice President - Finance and
                Administration
            
            50Michael
                R. Stewart
            
            Executive
                Vice President and Chief Operating Officer
            
            49Alan
                R. Novak
            
            Director
            
            72Warwick
                Alex Charlton
            
            Director
            
            47Anthony
                J. Dimun
            
            Director
            
            63David
                W. Anderson
            
            Director
            
            54Wayne
                M. Withrow
            
            Director
            
            51




**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 in 1999. Mr. McGrath is currently an outside Board
      member of RICOMM Systems, Inc. and Noninvasive Medical Technologies, Inc. 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.




58




***Michael
      R. Stewart*** was
      appointed as our Executive Vice President of Corporate Operations on December
      27, 2002, immediately following the acquisition of SLT and on July 19, 2005,
      he
      was appointed our Chief Operating Officer. 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.




***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 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. 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 September 28, 2004. Mr. Anderson has
      been
      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.




***Wayne
      M. Withrow*** was
      appointed to our Board of Directors on August 16, 2006. Mr. Withrow is currently
      Executive Vice President for SEI Investments Company, a leading global provider
      of outsourced asset management, investment processing and investment operation
      solutions. He is also the head of SEI’s Investment Advisors Segment, and a
      member of its Executive Committee. Mr. Withrow’s broad background was gained
      from over 15 years in various senior management positions with SEI Investments.
      Formerly, he was with the law firm of Schnader, Harrison, Segal & Lewis,
      where he was significantly involved in corporate securities and acquisitions.
      His earlier experience also included a federal judicial clerkship with the
      Honorable William J. Ditter as well as public accounting experience with
      Deloitte & Touche.




59




**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. The table below sets
      forth non-employee directors’ compensation in 2006.




**DIRECTOR
      COMPENSATION TABLE**




**Name**
            
            
            **Fees
                Earned or**
              **Paid
                in Cash**
              **($**)****
            
            
            **Option
                Awards**
              **($)
                (1**)****
            
            
            **Total**
              **($)**Richard
                J. DePiano
            
            
            29,000
            
            
            43,190(2
            )
            
            72,190Alan
                R. Novak
            
            
            26,500
            
            
            43,190(2
            )
            
            69,690Warwick
                Alex Charlton
            
            
            27,500
            
            
            43,190(2
            )
            
            70,690Anthony
                J. Dimun
            
            
            30,000
            
            
            43,190(2
            )
            
            73,190David
                W. Anderson
            
            
            29,000
            
            
            43,190(2
            )
            
            72,190Wayne
                M. Withrow
            
            
            7,500
            
            
            17,045(3
            )
            
            24,545




(1)
      The
      amounts shown for option awards relate to shares granted under our 2000
      Non-Employee Director Plan. These amounts are equal to the dollar amounts
      recognized in 2006 with respect to the option awards for financial statement
      purposes, computed in accordance with SFAS 123(R), but without giving effect
      to
      estimated forfeitures. The assumptions used in determining the amounts in this
      column are set forth in note 1 to our consolidated financial
      statements.





(2)
      The
      grant date fair value computed in accordance with SFAS 123(R) was
      $1.23.





(3)
      The
      grant date fair value computed in accordance with SFAS 123(R) was
      $0.97.




**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 had in
      place. We have adopted a Code of Ethics on Interactions with Health Care
      Professionals and have adopted a related Comprehensive Compliance Program.
      To
      view the charters of the Audit, Compensation and Nominations and Corporate
      Governance Committees, the Code of Ethics and Comprehensive Compliance Program,
      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 Report). The
      Board
      determined in 2006 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** .
      Our
      Compensation Committee discharges the Board’s responsibilities relating to
      compensation of our Chief Executive Officer, other executive officers and
      directors, produces an annual report on executive compensation for inclusion
      in
      our annual proxy statement and in this Report, and provides general oversight
      of
      compensation structure. Other specific duties and responsibilities of the
      Compensation Committee include:




·
            reviewing
                and approving objectives relevant to executive officer
                compensation;




·
            evaluating
                performance and determining the compensation of our Chief Executive
                Officer and other executive officers in accordance with those
                objectives;




·
            reviewing
                employment agreements for executive
                officers;




·
            recommending
                to the Board the compensation for our
                directors;




·
            administering
                our stock option plans (except the 2000 Non-Employee Director Stock
                Option
                Plan); and




·
            evaluating
                human resources and compensation
                strategies.




Our
      Board
      of Directors has adopted a written charter for the Compensation Committee.
      The
      Compensation Committee is composed of Messrs. Novak, Charlton, DePiano, Dimun
      and Withrow. Mr. Dimun serves as the Chairman of the Compensation Committee;
      Mr.
      Withrow joined the Committee in August 2006. The Board determined in 2006 that
      each member of the Compensation Committee satisfies the independence
      requirements of the Commission and Nasdaq. The Compensation Committee held
      three
      meetings during 2006.




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), provides oversight
      for
      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 2006 is presented
      below.




**Nominations
      and Corporate Governance**  **Committee** .
      Our
      Board has established a Nominations and Corporate Governance Committee for
      the
      purpose of reviewing all Board-recommended and stockholder-recommended nominees,
      determining each nominee’s qualifications and making a recommendation to the
      full Board as to which persons should be our Board’s nominees. Our Board has
      adopted a written charter for the Nominations and Corporate Governance
      Committee. The Nominations and Corporate Governance Committee is composed of
      Messrs. Novak, DePiano and Anderson. Mr. Anderson serves as the Chairman of
      the
      Nominations and Corporate Governance Committee. The Board of Directors
      determined in 2006 that each member of the Nominations and Corporate Governance
      Committee satisfies the independence requirements of the Commission and Nasdaq.
      The Nominations and Corporate Governance Committee held two meetings during
      2006.




The
      duties and responsibilities of the Nominations and Corporate Governance
      Committee include:




·
            identifying
                and recommending to our Board individuals qualified to become members
                of
                our Board and to fill vacant Board
                positions;




·
            overseeing
                the compensation of non-employee directors, including administering
                the
                2000 Non-Employee Director Stock Option
                Plan;




·
            recommending
                to our Board the director nominees for the next annual meeting of
                stockholders;




·
            recommending
                to our Board director committee
                assignments;




·
            reviewing
                and evaluating succession planning for our Chief Executive Officer
                and
                other executive officers;




·
            monitoring
                the independence of our board
                members;




61




·
            developing
                and overseeing the corporate governance principles applicable to
                our Board
                members, officers and employees;




·
            monitoring
                the continuing education program for our directors;
                and




·
            evaluating
                annually the Nominations and Corporate Governance Committee
                charter.




Our
      Board
      of Directors believes that it is necessary that the majority of our Board of
      Directors be comprised of independent directors and that it is desirable to
      have
      at least one audit committee financial expert serving on the Audit Committee.
      The Nominations and Corporate Governance Committee considers these requirements
      when recommending Board nominees. Our Nominations and Corporate Governance
      Committee utilizes a variety of methods for identifying and evaluating nominees
      for director. Our Nominations and Corporate Governance Committee will regularly
      assess the appropriate size of the Board, and whether any vacancies on the
      Board
      are expected due to retirement or other circumstances. When considering
      potential director candidates, the Nominations and Corporate Governance
      Committee also considers the candidate’s character, judgment, diversity, age,
      skills, including financial literacy, and experience in the context of our
      needs, the needs of PhotoMedex and of the existing directors. The Committee
      recommended to the Board that Mr. Wayne M. Withrow be invited to join the Board.
      The Board accepted the recommendation, and Mr. Withrow accepted the invitation
      in August 2006.




**Audit
      Committee** .
      Our
      Board of Directors has established an Audit Committee to assist the Board in
      fulfilling its responsibilities for general oversight of the integrity of our
      consolidated financial statements, compliance with legal and regulatory
      requirements, the independent auditors’ qualifications and independence, the
      performance of our independent auditors and our internal audit function, and
      risk assessment and risk management. The duties of the Audit Committee
      include:




·
            appointing,
                evaluating and determining the compensation of our independent
                auditors;




·
            reviewing
                and approving the scope of the annual audit, the audit fee and the
                financial statements;




·
            reviewing
                disclosure controls and procedures, internal control over financial
                reporting, any internal audit function and corporate policies with
                respect
                to financial information;




·
            reviewing
                other risks that may have a significant impact on our financial
                statements;




·
            preparing
                the Audit Committee report for inclusion in the annual proxy
                statement;




·
            establishing
                procedures for the receipt, retention and treatment of complaints
                regarding accounting and auditing matters;
                and




·
            evaluating
                annually the Audit Committee
                charter.




The
      Audit
      Committee works closely with management as well as our independent auditors.
      The
      Audit Committee has the authority to obtain advice and assistance from, and
      receive appropriate funding from us for, outside legal, accounting or other
      advisors as the Audit Committee deems necessary to carry out its
      duties.




Our
      Board
      of Directors has adopted a written charter for the Audit Committee meeting
      applicable standards of the Commission and Nasdaq. The members of the Audit
      Committee in 2006 were Messrs. DePiano, Dimun and Anderson; Mr. Withrow joined
      the Committee in January 2007. Mr. DePiano serves as Chairman of the Audit
      Committee. The Audit Committee meets regularly and held eight meetings during
      2006.




The
      Board
      of Directors determined in 2006 that each member of the Audit Committee
      satisfies the independence and other composition requirements of the Commission
      and Nasdaq. Our Board has determined that each member of the Audit Committee
      qualifies as an “audit committee financial expert” under Item 401(h) of
      Regulation S-K under the Exchange Act, and has the requisite accounting or
      related financial expertise required by applicable Nasdaq rules.




62




**Compensation
      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.




**Stockholder
      Communications with the Board of Directors**




Our
      Board
      of Directors has established a process for stockholders to communicate with
      the
      Board of Directors or with individual directors. Stockholders who wish to
      communicate with our Board of Directors or with individual directors should
      direct written correspondence to Davis Woodward, Corporate Counsel at
      dwoodward@photomedex.com or to the following address (our principal executive
      offices): Board of Directors, c/o Corporate Secretary, 147 Keystone Drive,
      Montgomeryville, Pennsylvania 18936. Any such communication must
      contain:




·
            a
                representation that the stockholder is a holder of record of our
                capital
                stock;




·
            the
                name and address, as they appear on our books, of the stockholder
                sending
                such communication; and




·
            the
                class and number of shares of our capital stock that are beneficially
                owned by such stockholder.




Mr.
      Woodward or the Corporate Secretary, as the case may be, will forward such
      communications to our Board of Directors or the specified individual director
      to
      whom the communication is directed unless such communication is unduly hostile,
      threatening, illegal or similarly inappropriate, in which case Mr. Woodward
      or
      the Corporate Secretary, as the case may be, has the authority to discard the
      communication or to take appropriate legal action regarding such
      communication.




**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, 2007, we believe, based solely on a review of the copies of such
      reports furnished to us and representations of these persons that no other
      reports were filed, that all reports needed to be filed have been filed for
      the
      year ended December 31, 2006.




**Item
      11.**  **Executive
      Compensation**




**COMPENSATION
      DISCUSSION AND ANALYSIS**




**Introduction**




The
      Compensation Committee is responsible for reviewing and approving the annual
      compensation of our executive officers, of whom we presently have three, the
      fourth having departed from our employ on June 30, 2006. These four current
      and
      former executive officers are our named executive officers. The Nominations
      and
      Corporate Governance Committee is responsible for reviewing and approving the
      compensation of our non-employee directors.




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 provides
      oversight for all of our other compensation and benefit programs.




63




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 and now, under
      the 2005 Equity Compensation Plan, in the form of restricted shares of our
      common stock. 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.




**Objectives
      of Compensation Program**




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.




We
      have
      no retirement plans or deferred compensation programs in effect for our
      non-employee directors and our executive officers, except for our 401(k) plan
      in
      which the executive officers are eligible to participate. Compensation is
      generally paid as earned. We do not have an exact formula for allocating between
      cash and non-cash compensation, which has been in the form of stock options
      and
      awards of stock. We do not have a Non-Equity Incentive Plan, as that term is
      used in SFAS No. 123R, “Share-Based Payment.”




In
      order
      to assess whether the compensation program we had been providing to our
      executive officers was competitive and effective, the Compensation Committee
      engaged in 2005 a third-party consulting firm specializing in executive
      compensation. The consulting firm advised that our program was within the range
      of compensation programs that appeared to be offered by a group of our peer
      companies. The consulting firm also counseled the Compensation Committee on
      modifications to the compensation program which were under consideration. The
      primary consideration was the use of performance-based restricted stock. As
      an
      ongoing matter, the Committee does not engage a third-party consultant to advise
      on our compensation policies. Nor does the Committee delegate its
      responsibilities for reviewing and approving executive compensation, except
      in
      the case of the 2005 Investment Plan, where the Plan has pre-approved the grant
      of matching options to an executive who purchases shares of our common stock
      in
      the open market in accordance with the provisions of the Plan.




To
      the
      extent consistent with the foregoing objectives, the Compensation Committee
      also
      intends to maximize the deductibility of compensation for tax purposes. The
      Committee may, however, 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.




**What
      Our Compensation Program is Designed to Reward**




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 and now, under
      the 2005 Equity Compensation Plan, in the form of restricted shares of our
      common stock. 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.




Stock
      price performance has not been a factor in determining annual compensation
      insofar as the price of the Company’s common stock is subject to a number of
      factors outside our control. We have endeavored through the grants of stock
      options to the executive officers to incentivize individual and team
      performance, providing a meaningful stake in the Company and linking them to
      a
      stake in the Company’s overall success. Through the awards of restricted stock,
      we have striven to forge a closer link by tying the vesting of the restricted
      stock to certain milestone prices of our common stock.




**Elements
      of Company’s Compensation Plan and How Each Element Relates to
      Objectives**




There
      are
      three primary elements in the compensation package of our executive officers:
      base salary, bonus and long-term incentives. Compensation payable in the event
      of an executive’s termination from the Company is a secondary, material element
      in the package.




64




***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. For 2006, there were three factors of generally
      equal weight: Company revenues, the Company’s net loss or profit and a
      discretionary component.




***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.




Prior
      to
      2006, stock options granted under the various stock option plans generally
      have
      had a four-year vesting schedule depending upon the size of the grant, and
      generally have been set to expire five years from the date of grant. In 2006,
      the Committee determined that such grants would be for ten years and vest over
      five years. The exercise price of options granted under the stock option plans
      is at no less than 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. The options granted
      to
      executives as a rule have provisions by which vesting and exercisability are
      accelerated in the event of a change of control or a termination of employment
      initiated by the Company other than for cause.




Similar
      criteria are applied in making awards of restricted shares of our common stock
      under the 2005 Equity Compensation Plan, but in the case of restricted stock,
      we
      have made direct linkage between the price performance of our stock with the
      vesting schedule of the restricted stock.




To
      encourage our executive officers to have a greater stake in the equity of the
      Company, the Committee recommended, and the Board of Directors and the Company
      stockholders approved at the 2005 Annual Stockholders’ Meeting, the 2005
      Investment Plan.




***Compensation
      on Termination of Employment or Change of Control.*** 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 had an employment agreement
      with
      Mr. Clifford, but we mutually agreed to a separation agreement that superseded
      his employment agreement, effective June 30, 2006.




In
      the
      event of a involuntary termination not in connection with a change in control
      of
      the Company, an executive will be vested in those options that were unvested
      as
      of the termination but that would have vested in the 12 months following
      termination. In the event of a change of control, all of an executive’s unvested
      options will vest. As to unvested shares of restricted stock, they will vest
      upon a change of control to the extent that the acquisition price exceeds a
      milestone price or if the acquirer elects not to continue to employ the services
      of the executive.




65




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 $1,677,000 at December 31, 2006 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 $2,146,000 at December 31,
      2006.




**How
      Amounts Were Selected for Each Element of an Executive’s Compensation**




Each
      executive’s current and prior compensation is considered in setting future
      compensation. In addition, we review from time to time the compensation
      practices of other companies, particularly peer companies. To some extent,
      our
      compensation plan is based on the market and the companies we compete against
      for executives. Base salary and the long-term incentives are not set with
      reference to a formula.




An
      executive ’ s
      target
      bonus amount is set by an executive ’ s
      employment agreement, which was negotiated at arm ’ s
      length.
      A target bonus, or portion thereof, is earned, based on fulfillment of
      conditions, which are set by the Committee at the outset of a fiscal
      year.




As
      a
      general rule, options and/or restricted stock awards are made in the first
      or
      second quarter of a year and after the financial results for the prior year
      have
      been audited and reported to the Board of Directors. Grants and/or awards are
      valued, and exercise prices are set, as of the date the grant or award is made.
      Exceptions to the general rule may arise for grants made to recognize a
      promotion or to address the effect of expiring options. The Committee may elect
      to defer a grant until after the Company has made public disclosure of its
      financial results, typically in a conference call on earnings; in such a case,
      the exercise price is set at the higher of the closing prices on the approval
      date or the fixed grant date. In these deliberations, the Compensation Committee
      does not delegate any related function, unless to the Board of Directors as
      a
      whole, and the grants or awards made to executives are valued under the same
      measurement standards as for grants made to other grantees.




**Accounting
      and Tax Considerations**




On
      January 1, 2006, we adopted SFAS No. 123R. Under this accounting standard,
      we
      are required to value stock options granted, and restricted stock awarded,
      in
      2006 and beyond under the fair value method and expense those amounts in the
      income statement over the vesting period of the stock option or restricted
      stock. We were also required to value unvested stock options granted prior
      to
      our adoption of SFAS 123R under the fair value method and amortize such expense
      in the income statement over the stock option’s remaining vesting period. A
      material portion of such amortizing expense relates to option grants made to
      our
      executive officers, and future option grants and stock awards made in 2006
      and
      beyond to our executive officers will also have a material impact on such
      expense.




Our
      compensation program has been structured to comply with Internal Revenue Code
      Sections 409A and 162(m). If an executive is entitled to nonqualified deferred
      compensation benefits that are subject to Section 409A, and such benefits do
      not
      comply with Section 409A, then the benefits are taxable in the first year they
      are not subject to a substantial risk of forfeiture. In such case, the executive
      service-provider is subject to regular federal income tax, interest and an
      additional federal income tax of 20% of the benefit includible in income.




Under
      Section 162(m) of the Internal Revenue Code, a limitation was placed on tax
      deductions of any publicly-held corporation for individual compensation to
      certain executives of such corporation exceeding $1,000,000 in any taxable
      year,
      unless the compensation is performance-based. 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 each
      executive in 2004, 2005 and 2006 did not exceed the limits under Section 162(m)
      for tax deductibility; no executive exercised any options in 2004, 2005 or
      2006.




66




**Overview
      of Executive Employment Agreements and 2006 Equity-Based
      Awards**




***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, 2007 and will expire then if due notice is given by December 1, 2007. 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.




On
      January 15, 2006, Mr. O’Donnell was granted 200,000 incentive stock options
      (having an exercise price of $2.50 and a life of 10 years, vesting ratably
      over
      the first 5 years from the 2005 Equity Compensation Plan. In the event of a
      sale
      of the Company, the options will become fully vested and exercisable). He was
      also awarded from the 2005 Equity Compensation Plan and as of the same date
      525,000 restricted shares of our common stock, setting their purchase price
      at
      $0.01 per share. Shares that are purchased will be held in escrow by us for
      as
      long as they are subject to our right of repurchase. Our right of repurchase
      will continue for such shares for so long as the shares remain subject to
      performance restrictions and time restrictions.




As
      to the
      performance restrictions, our repurchase right will lapse if the trading price
      of our common stock attains certain targets above the 2005 Average Price, which
      by contract was set at $2.50, being higher than the average fair market value
      (generally the closing price of our common stock) for each of the trading days
      in the 90-day period ending on December 28, 2005. For the years 2006 through
      2010, the Average Price will mean the average fair market value of our common
      stock for each of the trading days in the last three months of the calendar
      year. Our right of repurchase shall lapse with respect to 20% of the purchased
      shares if the 2006 Average Price equals or exceeds the 2006 Target Price, where
      the term “2006 Target Price” will equal 125% of the 2005 Average Price, or
      $3.13, and where the lapsing shall be effective as of December 31, 2006. The
      restrictions did not lapse in 2006 inasmuch as the 2006 Target Price was not
      attained.




Likewise,
      our right of repurchase will lapse with respect to 20% of the purchased shares
      if the 2007 Average Price equals or exceeds the 2007 Target Price, where the
      term “2007 Target Price” will equal 125% of the 2006 Target Price, or $3.91, and
      so on. For 2010, if the 2010 Average Price equals or exceeds the 2010 Target
      Price of $7.64, then our right of repurchase will lapse with respect to all
      of
      the purchased shares for which our repurchase right has not previously lapsed,
      and such lapsing will be effective as of December 31, 2010. As to time
      restrictions, to the extent that any of the purchased shares remain subject
      to
      our right of repurchase and therefore are unvested, they will vest ratably
      (i.e.
      one-third) on the fifth, sixth and seventh anniversaries of the award of the
      restricted shares.




However,
      in the event of a transaction that constitutes a change in control of the
      Company, our right of repurchase will lapse with respect to the performance
      restrictions on the restricted shares that are unvested immediately prior to
      the
      consummation of such transaction as follows. Where the per-share purchase price
      paid or deemed paid in connection with such change in control is equal to or
      greater than a Target Price described above, then it shall be deemed that the
      Target Price has been attained as of the change in control, and our repurchase
      rights applicable to such Target Price will lapse. Shares that have not vested
      on a change of control will remain subject to such repurchase restriction.
      Such
      shares still subject to repurchase shall vest ratably and monthly over the
      period of time (but not greater than 36 months) that the acquirer in the change
      in control event contracts for Mr. O’Donnell’s services. If the acquirer opts
      not to contract for such services, then the unvested balance of shares will
      vest
      as of the change in control event.




On
      May
      25, 2006, Mr. O’Donnell was granted 2,000 stock options under the 2005
      Investment Plan. The exercise price of the options was set at the price paid
      by
      Mr. O’Donnell for 2,000 shares of our common stock purchased by Mr. O’Donnell in
      the open market.




67






On
      November 20, 2006, Mr. O’Donnell was granted stock options on 125,000 shares of
      our common stock out of the 2005 Equity Compensation Plan and the exercise
      price
      was set at the closing price of our stock on the date of grant. This grant
      offset the expiry in December 2006 of 125,000 options which had been made to
      Mr.
      O’Donnell in December 2001 from the now-frozen 2000 Stock Option Plan.




On
        March
        6, 2007, Mr. O’Donnell was granted 2,000 stock options under the 2005 Investment
        Plan to match his purchase on the same date of an equal number of shares
        of our
        common stock on the open market.


***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, 2007 and will expire then if
      due
      notice is given by December 1, 2007. 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.




On
      January 15, 2006, Mr. McGrath was awarded from the 2005 Equity Compensation
      Plan
      335,000 restricted shares of our common stock, having a purchase price at $0.01
      per share. The terms and conditions applicable to Mr. McGrath’s award of
      restricted stock are the same as the terms and conditions applicable to the
      award to Mr. O’Donnell, which are discussed above.




On
      March
      10, 2006, Mr. McGrath was granted 140,000 stock options from the 2005 Equity
      Compensation Plan after the audited financial results of the Company had been
      reported to the Board of Directors and disclosed in our conference call on
      earnings.




On
      May
      24, 2006 and May 25, 2006, Mr. McGrath was granted 5,000 and 2,000 non-qualified
      stock options, respectively, under the 2005 Investment Plan. In accordance
      with
      the terms of the Investment Plan, the exercise price of each option was set
      at
      the price paid by Mr. McGrath for each of his discrete purchases of shares
      of
      our common stock in the open market.




On
      November 20, 2006, Mr. McGrath was granted stock options on 110,000 shares
      of
      our common stock out of the 2005 Equity Compensation Plan; the exercise price
      was set at the closing price of our stock on the date of grant. This grant
      offset the expiry in December 2006 of 110,000 options which had been granted
      to
      Mr. McGrath in December 2001 from the now-frozen 2000 Stock Option Plan.




***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 became our Chief Operating Officer on July 19, 2005, at which time
      he
      was granted 40,000 options. Mr. Stewart’s current base salary is $250,000 per
      year. This agreement has renewed through December 31, 2007  and
      will
      expire then if due notice is given by December 1, 2007. 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 his base pay, 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.




On
      March
      10, 2006, Mr. Stewart was granted 100,000 stock options from the 2005 Equity
      Compensation Plan, after the audited financial results of the Company had been
      reported to the Board of Directors and disclosed in our conference of earnings.




68




**SUMMARY
      COMPENSATION TABLE**




The
      following table includes information for the year ended December 31, 2006
      concerning compensation for our three incumbent executive officers and our
      one executive
      officer who separated from us on June 30, 2006. All of our other officers are
      not executive officers, within the meaning ascribed by the Securities and
      Exchange Act of 1934.





**Name
                and Principal Position**
            
            **Year**
            
            **Salary**
              **($)**
            
            **Bonus ($)(1)**
            
            **Option**
              **Awards**
              **($)(3)**
            
            **Equity**
              **Incentive
                Plan**
              **Compensation**
              **($)(2)(3)**
            
            **All
                Other**
              **Compensation**
              **($)(4)**
            
            **Total**
              **($)**Jeffrey
                F. O’Donnell, President and Chief Executive Officer
            
            
            2006
            
            
            350,000
            
            
            157,500
            
            
            420,213
            
            
            943,005
            
            
            17,395
            
            
            1,888,113Dennis
                M. McGrath, Chief Financial Officer & Vice President -
                Finance/Administration
            
            
            2006
            
            
            285,000
            
            
            102,600
            
            
            377,054
            
            
            601,727
            
            
            15,105
            
            
            1,381,486Michael
                R. Stewart, Chief Operating Officer and Executive Vice
                President
            
            
            2006
            
            
            250,000
            
            
            75,000
            
            
            190,200
            
            
            0
            
            
            18,366
            
            
            533,566John
                F. Clifford, former Executive Vice President, Dermatology
            
            
            2006
            
            
            150,000
            
            
            0
            
            
            0
            
            
            0
            
            
            156,000
            
            
            306,000




(1)
      “ Bonus”
in
      the foregoing table is the bonus earned in 2006, even though it will have been
      paid in a subsequent period.




(2)
      The
      Company does not have a Non-Equity Incentive Plan. The Equity Incentive Plan
      is
      comprised of our awards of restricted common stock.




(3)
      The
      amounts shown for option awards and restricted stock awards relate to
      shares granted under our 2005 Equity Compensation Plan and 2005 Investment
      Plan.
      These amounts are equal to the aggregate grant-date fair value with respect
      to
      the awards made in 2006, computed in accordance with SFAS 123(R), before
      amortization and without giving effect to estimated forfeitures. The assumptions
      used in determining the amounts in this column are set forth in Note 1 to our
      consolidated financial statements. For information regarding the number of
      shares subject to 2006 awards, other features of those awards, and the
      grant-date fair value of the awards, see the Grants of Plan-Based Awards Table
      on p. 71.




(4)
“All
      Other Compensation” includes car allowance ($12,000), premiums for supplementary
      life insurance and matching 401(k) plan contributions for Messrs. O’Donnell,
      McGrath and Stewart. In Mr. Clifford’s case, it includes severance payment and
      allied benefits of $150,000 and car allowance of $6,000.




**Non-Qualified
      Deferred Compensation**




The
      Company has no plan or program of non-qualified deferred compensation.




**Potential
      Payments on Termination of Employment or Change of Control**




Potential
      payments to our three incumbent executives on termination of employment or
      upon
      a change of control of the Company are governed by their respective employment
      agreements and by the terms of their option agreements and restricted stock
      agreements. Mr. Clifford is currently receiving payments by virtue of the
      Separation Agreement we entered with him on April 30, 2006.




If
      any of
      the events set forth in the table had occurred by December 31, 2006, then we
      estimate the value of the benefits that would have been triggered and thus
      accrued to the three incumbent executives as set forth below. Also set forth
      below are the benefits that Mr. Clifford will receive after December 31, 2006.




69




**POTENTIAL
      PAYMENTS UPON TERMINATION OR CHANGE IN CONTROL TABLE**




**Name**
            
            **Benefit**
            
            **Before Change**
              **in
                Control Termination**
              **w/o Cause
                or for**
              **Good
                Reason**
            
            **After Change in
                Control Termination**
              **w/o Cause
                or**
              **for Good**
              **Reason**
            
            **Voluntary**
              **Termination**
            
            **Death
                (4)**
            
            **Disability
                (4)**
            
            **Change in**
              **Control**Jeffrey
                F. O’Donnell(1)(2)
            
            
            Severance
            
            
            350,000
            
            
            700,000
            
            
            0
            
            
            0
            
            
            0
            
            
            N/AHealth
                continuation
            
            
            15,378
            
            
            30,756
            
            
            0
            
            
            0
            
            
            0
            
            
            N/AAD&D
                insurance
            
            
            780
            
            
            1,560
            
            
            0
            
            
            0
            
            
            0
            
            
            N/AExecutive
                life ins.
            
            
            5,355
            
            
            10,711
            
            
            0
            
            
            0
            
            
            0
            
            
            N/AAccelerated
                vesting
            
            
            0
            
            
            577,500
            
            
            0
            
            
            0
            
            
            0
            
            
            0Dennis
                McGrath(1)(2)
            
            
            Severance
            
            
            285,000
            
            
            570,000
            
            
            0
            
            
            0
            
            
            0
            
            
            N/AHealth
                continuation
            
            
            15,378
            
            
            30,756
            
            
            0
            
            
            0
            
            
            0
            
            
            N/AAD&D
                insurance
            
            
            780
            
            
            1,560
            
            
            0
            
            
            0
            
            
            0
            
            
            N/AExecutive
                life ins.
            
            
            1,680
            
            
            10,152
            
            
            0
            
            
            0
            
            
            0
            
            
            N/AAccelerated
                vesting
            
            
            0
            
            
            368,500
            
            
            0
            
            
            0
            
            
            0
            
            
            0Michael
                Stewart(2)
            
            
            Severance
            
            
            250,000
            
            
            500,000
            
            
            0
            
            
            0
            
            
            0
            
            
            N/AHealth
                continuation
            
            
            15,378
            
            
            30,756
            
            
            0
            
            
            0
            
            
            0
            
            
            N/AAD&D
                insurance
            
            
            780
            
            
            1,560
            
            
            0
            
            
            0
            
            
            0
            
            
            N/AExecutive
                life ins.
            
            
            5,076
            
            
            10,152
            
            
            0
            
            
            0
            
            
            0
            
            
            N/AAccelerated
                vesting
            
            
            0
            
            
            0
            
            
            0
            
            
            0
            
            
            0
            
            
            0John
                Clifford(3)
            
            
            Severance,
                consulting
            
            
            N/A
            
            
            N/A
            
            
            202,500
            
            
            N/A
            
            
            N/A
            
            
            N/AHealth
                continuation
            
            
            N/A
            
            
            N/A
            
            
            9,430
            
            
            N/A
            
            
            N/A
            
            
            N/AAD&D
                insurance
            
            
            N/A
            
            
            N/A
            
            
            0
            
            
            N/A
            
            
            N/A
            
            
            N/AExecutive
                life ins.
            
            
            N/A
            
            
            N/A
            
            
            0
            
            
            N/A
            
            
            N/A
            
            
            N/A







(1)
            If
                upon a change of control, the acquirer does not desire the services
                of the
                executive, then any unvested restricted stock will vest. The closing
                price
                of our stock on December 29, 2006 (the last trading day of the year)
                was
                $1.11. All shares were unvested at that date and were purchased for
                the
                par value of the stock, i.e. $0.01, assuming a change of control
                as of
                December 31, 2006, each share would return a gain of $1.10.




(2)
            All
                unvested options become exercisable by reason of a change of control.
                However, none of the executives’ unvested options as of December 31, 2006
                were in the money, and therefore there would have been no benefit
                as of
                December 31, 2006. Similarly, in the event of an involuntary termination
                without cause, the executive optionee becomes vested in those options
                that
                would otherwise have vested in twelve months following the date of
                termination. As in the hypothetical change of control, so in this
                case of
                hypothetical involuntary termination, there would have been no benefit
                to
                the optionee inasmuch as no option was in the money at December 31,
                2006.




(3)
            Mr.
                Clifford resigned on June 30, 2006. After December 31, 2006 and until
                June
                30, 2007, he will receive severance of $150,000, and he will receive
                health continuation benefits until September 30, 2007. For the period
                July
                1, 2007 to June 30, 2008, Mr. Clifford will continue to act as consultant
                for us for $52,500. After June 30, 2008, he may discontinue such
                services.




(4)
            We
                pay an executive’s salary and benefits through the end of the month of
                termination due to death or disability, except that we will pay the
                disability premiums during the period of disability.




**STOCK
      OPTIONS**




The
      2005
      Equity Compensation Plan is currently the primary vehicle by which stock awards
      and option grants are made to the executives and other service-providers. The
      Plan has been authorized by the stockholders for 3,160,000 shares of our common
      stock. Participation in the 2005 Investment Plan is limited to the executives;
      this Plan has been authorized by the stockholders for 400,000 shares of our
      common stock.




70




**Grants
      of Plan-Based Awards Table**




The
      following table sets forth certain information with respect to the options
      granted and
      stock
      awarded during or for the year ended December 31, 2006 to each of our executive
      officers listed in the Summary Compensation Table as shown under the caption
      “Executive Compensation.” **** Stock
      awards and option grants made in 2006 were primarily from the 2005 Equity
      Compensation Plan. Matching options grants were made out of the 2005 Investment
      Plan to Messrs. O ’ Donnell
      and McGrath for 2,000 and 7,000 options, respectively. There were no grants
      or
      awards to Mr. Clifford in 2006.





**GRANTS
      OF PLAN-BASED AWARDS TABLE**




**Estimated Future Payouts Under**
              **Equity
                Incentive Plan Awards(2)**
            
            **All
                Other**
              **Option Awards:**
              **Number
                of**
              **Securities**
              **Underlying**
            
            **Exercise or**
              **Base
                Price**
              **of
                Option**
            
            **Closing**
              **Price on**
              **Grant** **Date**
            
            **Grant
                Date**
              **Fair**
              **Value
                of Stock**
              **and
                Option****Name**
            
            **Grant**
              **Date**
            
            **Approval**
              **Date
                (1)**
            
            **Threshold**
              **(#)**
            
            **Target**
              **(#)**
            
            **Maximum**
              **(#)**
            
            **Options**
              **(#)**
            
            **Awards**
              **($ / Sh)**
            
            **($ / Sh)(3)**
            
            **Awards
                ($)(4)**Jeffrey
                O’Donnell
            
            
            1/15/06
            
            
            12/28/05
            
            
            -
            
            
            525,000
            
            
            -
            
            
            200,000
            
            
            2.50
            
            
            1.83
            
            
            1,245,8055/24/06
            
            
            5/24/06
            
            
            
            
            
            
            
            
            
            
            
            2,000
            
            
            1.59
            
            
            N/A
            
            
            2,78811/20/06
            
            
            11/20/06
            
            
            
            
            
            
            
            
            
            
            
            125,000
            
            
            1.11
            
            
            1.11
            
            
            114,625Dennis
                McGrath
            
            
            1/15/06
            
            
            12/28/05
            
            
            -
            
            
            335,000
            
            
            -
            
            
            N/A
            
            
            N/A
            
            
            1.83
            
            
            601,7273/10/06
            
            
            2/28/06
            
            
            
            
            
            
            
            
            
            
            
            140,000
            
            
            2.23
            
            
            1.97
            
            
            266,2805/24/06
            
            
            5/24/06
            
            
            
            
            
            
            
            
            
            
            
            5,000
            
            
            1.58
            
            
            N/A
            
            
            6,9725/25/06
            
            
            5/25/06
            
            
            
            
            
            
            
            
            
            
            
            2,000
            
            
            1.63
            
            
            N/A
            
            
            2,93211/20/06
            
            
            11/13/06
            
            
            
            
            
            
            
            
            
            
            
            110,000
            
            
            1.11
            
            
            1.11
            
            
            100,870Michael
                Stewart
            
            
            3/10/06
            
            
            2/28/06
            
            
            
            
            
            
            
            
            
            
            
            100,000
            
            
            2.23
            
            
            1.97
            
            
            223,000





(1)
            On
                December 28, 2005, the stockholders approved that the awards to Messrs.
                O’Donnell and McGrath should be made on January 15, 2006. The exercise
                prices of options granted under the 2005 Investment Plan were set
                equal to
                the optionee’s purchase price of shares of common stock on the date of the
                grant. The grant of options on March 10, 2006 was delayed at the
                decision
                of the Board on February 28, 2006, until after the conference call
                of
                earnings had taken place. The exercise price was to be the higher
                of the
                closing prices on February 28, 2006 (i.e. $2.23) and March 10, 2006
                (i.e.
                $1.97).




(2)
            The
                Company does not have a Non-Equity Incentive Plan. The Equity Incentive
                Plan is comprised of the restricted shares of common stock issued
                to
                Messrs. O’Donnell and McGrath under the 2005 Equity Compensation
                Plan.




(3)
            The
                exercise price of options granted on 5/24/06, 5/25/06 and 5/26/06
                were set
                equal to the optionee’s purchase price of shares of common stock on the
                date of the grant.




(4)
            Computed
                in accordance with FSAS 123 (R).




**Outstanding
      Equity Awards Value at Fiscal Year-End Table**




The
      following table includes certain information with respect to the value of all
      unexercised options previously awarded to the executive officers named above
      at
      the fiscal year end, December 31, 2006.




71




**OUTSTANDING
      EQUITY AWARDS AT FISCAL YEAR-END TABLE**




**Option
                Awards**
            
            **Stock
                Awards****Number
                of**
              **Securities**
              **Underlying**
              **Unexercised**
              **Options**
              **(#)**
            
            **Number
                of**
              **Securities**
              **Underlying**
              **Unexercised**
              **Options**
              **(#)**
            
            **Equity**
              **Incentive**
              **Plan Awards:**
              **Number
                of**
              **Securities**
              **Underlying**
              **Unexercised**
              **Unearned**
              **Options**
            
            **Option**
              **Exercise**
              **Price**
            
            **Option**
              **Expiration**
            
            **Number of**
              **Shares
                or**
              **Units
                of**
              **Stock That**
              **Have
                Not**
              **Vested**
            
            **Market**
              **Value of**
              **Shares or**
              **Units
                of**
              **Stock That**
              **Have
                Not**
              **Vested**
            
            **Equity Incentive**
              **Plan
                Awards:**
              **Number
                of**
              **Unearned**
              **Shares,
                Units**
              **or
                Other**
              **Rights
                That**
              **Have
                Not**
              **Vested**
            
            **Equity**
              **Incentive**
              **Plan Awards:**
              **Market
                or**
              **Payout
                Value**
              **of
                Unearned**
              **Shares,
                Units**
              **or
                Other**
              **Rights
                That**
              **Have
                Not**
              **Vested****Name**
            
            **Exercisable**
            
            **Unexercisable**
            
            **(#)**
            
            **($)**
            
            **Date**
            
            **(#)**
            
            **($)(1)**
            
            **(#)**
            
            **($)
                (1)**Jeffrey
                O’Donnell
            
            
            93,750
            
            
            31,250
            
            
            0
            
            
            1.66
            
            
            1/16/08
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A75,000
            
            
            75,000
            
            
            0
            
            
            2.14
            
            
            1/22/09
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A112,500
            
            
            37,500
            
            
            0
            
            
            2.45
            
            
            3/1/10
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A0
            
            
            200,000
            
            
            0
            
            
            2.50
            
            
            N/A
            
            
            0
            
            
            0
            
            
            525,000
            
            
            582,7500
            
            
            2,000
            
            
            0
            
            
            1.59
            
            
            5/24/16
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A0
            
            
            125,000
            
            
            0
            
            
            1.11
            
            
            11/20/16
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/ADennis
                McGrath
            
            
            82,500
            
            
            27,500
            
            
            0
            
            
            1.66
            
            
            1/16/08
            
            
            
            
            
            
            
            
            N/A
            
            
            N/A62,500
            
            
            62,500
            
            
            0
            
            
            2.14
            
            
            1/22/09
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A105,000
            
            
            35,000
            
            
            0
            
            
            2.45
            
            
            3/1/10
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A0
            
            
            N/A
            
            
            0
            
            
            N/A
            
            
            N/A
            
            
            0
            
            
            0
            
            
            335,000
            
            
            371,8500
            
            
            140,000
            
            
            0
            
            
            2.23
            
            
            3/10/16
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A0
            
            
            5,000
            
            
            0
            
            
            1.58
            
            
            5/24/16
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A0
            
            
            2,000
            
            
            0
            
            
            1.63
            
            
            5/25/16
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A0
            
            
            110,000
            
            
            0
            
            
            1.11
            
            
            11/20/16
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/AMichael
                Stewart
            
            
            150,000
            
            
            0
            
            
            0
            
            
            1.85
            
            
            12/27/07
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A75,000
            
            
            0
            
            
            0
            
            
            1.83
            
            
            1/2/08
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A75,000
            
            
            37,500
            
            
            0
            
            
            2.14
            
            
            1/22/09
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A100,000
            
            
            75,000
            
            
            0
            
            
            2.45
            
            
            3/1/10
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A40,000
            
            
            20,000
            
            
            0
            
            
            2.63
            
            
            7/19/10
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A0
            
            
            100,000
            
            
            0
            
            
            2.23
            
            
            3/10/16
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/AJohn
                Clifford
            
            
            33,110
            
            
            0
            
            
            0
            
            
            2.17
            
            
            9/30/08
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A99,330
            
            
            0
            
            
            0
            
            
            1.16
            
            
            9/30/08
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A66,220
            
            
            0
            
            
            0
            
            
            1.07
            
            
            9/30/08
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A66,220
            
            
            0
            
            
            0
            
            
            1.96
            
            
            9/30/08
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A99,330
            
            
            0
            
            
            0
            
            
            2.76
            
            
            9/30/08
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A27,591
            
            
            5,519
            
            
            0
            
            
            1.65
            
            
            9/30/08
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A167,500
            
            
            82,500
            
            
            0
            
            
            2.78
            
            
            9/30/08
            
            
            0
            
            
            0
            
            
            N/A
            
            
            N/A




(1)
      The
      market value of unvested shares of restricted stock is based on $1.11 per share,
      which was the closing price of our stock on December 29, 2006, the last trading
      day of 2006.




**Option
      Exercises and Stock Vested Table**




None.




72




**Compensation
      Committee Report on Executive Compensation**




We
      have
      reviewed and discussed with management certain Compensation Discussion and
      Analysis provisions to be included in the Company’s 2006 Form 10-K Annual. Based
      on the reviews and discussions referred to above, we recommend to the Board
      of
      Directors that the Compensation Discussion and Analysis referred to above be
      included in the Company’s Form 10-K. Having joined the Committee in August 2006,
      Mr. Withrow has abstained from joining in this report.




**Compensation
      Committee**





Anthony
      J. Dimun  Richard
      DePiano  Warwick
      Alex Charlton  Alan
      R.
      Novak




**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.




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.




**Directors'
      and Officers' Liability Insurance**




We
      have
      obtained directors' and officers' liability insurance which expires on February
      24, 2008.




73


**Item
                12.**
            **Security
                Ownership of Certain Beneficial Owners and Management and Related
                Stockholder Matters**




The
      following table reflects, as of March 15, 2007, 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)
            
            
            244,300
            
            
            *Jeffrey
                F. O’Donnell(3)
            
            
            884,500
            
            
            1.41Dennis
                M. McGrath(4)
            
            
            647,750
            
            
            1.03Michael
                R. Stewart(5)
            
            
            372,690
            
            
            *Alan
                R. Novak(6)
            
            
            226,101
            
            
            *David
                W. Anderson(7)
            
            
            105,000
            
            
            *Warwick
                Alex Charlton(8)
            
            
            367,500
            
            
            *Anthony
                J. Dimun(9)
            
            
            276,250
            
            
            *Wayne
                M. Withrow(10)
            
            
            65,004
            
            
            *Corsair
                Reporting Persons(11)
            
            
            4,417,323
            
            
            7.03Wellington
                Management Co., L.P.(12)
            
            
            8,528,259
            
            
            13.57LB
                I Group, Inc.(13)
            
            
            5,271,154
            
            
            8.31Prides
                Capital Partners, L.L.C.(14)
            
            
            3,569,821
            
            
            5.71All
                directors and officers as a group (9 persons)(15)
            
            
            3,189,095
            
            
            4.95




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, 2007, 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 62,536,054 shares of
                common
                stock outstanding as of March 15, 2007.




(2)
            Includes
                31,800 shares and options to purchase up to 212,500 shares of common
                stock. Does not include options to purchase up to 17,500 shares of
                common
                stock, which may vest more than 60 days after March 15, 2007. Mr.
                DePiano's address is Escalon Medical Corporation, 565 East Swedesford
                Road, Suite 200, Wayne, PA 19087.




(3)
            Includes
                7,000 shares, 525,000 additional shares subject to restriction agreements
                with us and options to purchase up to 352,500 shares of common stock.
                Does
                not include options to purchase up to 401,500 shares of common stock,
                which may vest more than 60 days after March 15, 2007.




(4)
            Includes
                11,000 shares, 335,000 additional shares subject to restriction agreements
                with us and options to purchase up to 301,750 shares of common stock.
                Does
                not include options to purchase up to 330,250 shares of common stock,
                which may vest more than 60 days after March 15,
                2007.




(5)
            Includes
                1,440 shares, and options to purchase 371,250 shares of common stock.
                Does
                not include options to purchase up to 168,750 shares of common stock,
                which may vest more than 60 days after March 15,
                2007.




74




(6)
            Includes
                28,601 shares of common stock and options to purchase up to 197,500
                shares
                of common stock. Does not include options to purchase up to 17,500
                shares
                of common stock, which may vest more than 60 days after March 15,
                2007.
                Mr. Novak's address is 3050 K Street, NW, Suite 105, Washington, D.C.
                20007.




(7)
            Includes
                options to purchase up to 105,000 shares of common stock. Does not
                include
                options to purchase up to 17,500 shares of common stock, which may
                vest
                more than 60 days after March 15, 2007. Mr. Anderson's address is
                147
                Keystone Drive, Montgomeryville, PA
                18936.




(8)
            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 197,500 shares of common stock. Does not include options
                to
                purchase up to 17,500 shares of common stock, which may vest more
                than 60
                days after March 15, 2007. Mr. Charlton's address is 444 Madison
                Avenue, Suite 605, New York, New York
                10022.




(9)
            Includes
                145,000 shares of common stock owned by Mr. Dimun and his wife and
                options
                to purchase up to 131,250 shares of common stock. Does not include
                options
                to purchase up to 17,500 shares of common stock, which may vest more
                than
                60 days after March 15, 2007. Mr. Dimun’s address is 46 Parsonage Hill
                Road, Short Hills, New Jersey
                07078.




(10)
            Includes
                30,004 shares of common stock owned by Mr. Withrow and his wife and
                options to purchase up to 35,000 shares of common stock. Does not
                include
                options to purchase up to 17,500 shares of common stock, which may
                vest
                more than 60 days after March 15, 2007. Mr. Withrow’s address is 23 Craig
                Lane, Malvern, PA 19355.




(11)
            Includes
                4,157,029shares 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.
                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 21,100 additional shares
                of common
                stock, and Mr. Petschek beneficially owns 60,000 additional shares
                of
                common stock. Accordingly, the Corsair Reporting Persons may collectively
                be deemed to be the beneficial owners of 4,417,323 shares of common
                stock,
                including 4,157,029 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 14, 2007.




(12)
            Wellington
                Management Company, LLP is an investment adviser which has shared
                voting
                powers with respect to 8,198,859 shares of common stock owned of
                record by
                its clients and warrants becoming exercisable by May 15, 2007 and
                owned of
                record by its clients to purchase up to 329,400 shares of common
                stock.
                The foregoing information has been derived from a Schedule 13G filed
                on
                behalf of Wellington Management on February 14, 2007 and by a prospectus
                filed by us on December 11, 2006.




(13)
            LB
                I Group Inc. is a wholly-owned subsidiary of Lehman Brothers Inc,
                which is
                a wholly-owned subsidiary of Lehman Brothers Holdings Inc. LB I Group
                Inc.
                owns 4,376,923 shares of common stock and warrants becoming exercisable
                by
                May 15, 2007 to purchase up to 894,231 shares of common stock. The
                foregoing information has been derived from a Schedule 13G filed
                on behalf
                of LBI Group, Inc. on February 8,
                2007.




(14)
            Prides
                Capital Partners, L.L.C. is the owner of 3,569,821 shares of common
                stock.
                The foregoing information has been derived from a Schedule 13D filed
                on
                behalf of Prides Capital on December 20, 2006.




75




(15)
            Includes
                424,845 unrestricted shares, 860,000 restricted shares and options
                to
                purchase 1,904,250 shares of common stock. Does not include options
                to
                purchase up to 1,005,500 shares of common stock, which may vest more
                than
                60 days after March 15, 2007.




**Item
      13.**  **Certain
      Relationships and Related Transactions, Director
      Independence**




As
      of
      March 15, 2007, 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.




Our
      Board
      determined in 2006 that all members of our Board are independent under the
      applicable Nasdaq listing standards, except for Mr. O'Donnell, who is also
      our
      Chief Executive Officer.




**Item
      14.**  **Principal
      Accountant Fees and Services**




Our
      Audit
      Committee has appointed Amper, Politziner & Mattia, P.C. as our independent
      auditors for the fiscal year ending December 31, 2006 and 2005.




The
      following table shows the fees paid or accrued by us for the audit and other
      services provided by Amper, Politziner & Mattia for 2006 and
      2005:




2006
            
            2005Audit
                Fees
            
            
            343,000
            
            $
            343,000Audit-Related
                Fees
            
            
            35,000
            
            
            20,000Tax
                Fees
            
            
            -
            
            
            -All
                Other Fees
            
            
            1,250
            
            
            23,000Total
            
            $
            379,250
            
            $
            386,000




As
      defined by the Commission, (i) “audit fees” are fees for professional services
      rendered by our principal accountant for the audit of our annual financial
      statements and review of financial statements included in our Form 10-Q, or
      for
      services that are normally provided by the accountant in connection with
      statutory and regulatory filings or engagements for those fiscal years; (ii)
      “audit-related fees” are fees for assurance and related services by our
      principal accountant that are reasonably related to the performance of the
      audit
      or review of our financial statements and are not reported under “audit fees”;
      (iii) “tax fees” are fees for professional services rendered by our principal
      accountant for tax compliance, tax advice, and tax planning; and (iv) “all other
      fees” are fees for products and services provided by our principal accountant,
      other than the services reported under audit fees,” “audit-related fees,” and
“tax fees.”




***Audit
      Fees*** *.* The
      aggregate fees billed to us in 2006 by the independent auditors, Amper,
      Politziner & Mattia, P.C., for professional services rendered in connection
      with our Quarterly Reports on Form 10-Q and for the audits of our financial
      statements and internal controls included in this Annual Report on Form 10-K
      for
      2006, totaled approximately $343,000.




The
      aggregate fees billed to us in 2005 by the independent auditors, Amper,
      Politziner & Mattia, P.C., for professional services rendered in connection
      with our Quarterly Reports on Form 10-Q and for the audits of our financial
      statements and internal controls included in this Annual Report on Form 10-K
      for
      2005, totaled approximately $343,000.




76




***Audit-Related
      Fees.*** ** The
      aggregate fees billed to us by Amper, Politziner & Mattia, P.C. 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 $35,000 for 2006 and
      $20,000 for 2005.




***All
      Other Fees.*** ** The
      aggregate fees billed to us by Amper, Politziner & Mattia, P.C. for products
      and services rendered by Amper, Politziner & Mattia for tax consulting and
      other services were for $1,250 for 2006 and $23,000 for 2005.




***Engagement
      of the Independent Auditor*** *.* The
      Audit Committee is responsible for approving every engagement of Amper,
      Politziner & Mattia, P.C. to perform audit or non-audit services for us
      before Amper, Politziner & Mattia, P.C. is engaged to provide those
      services. Under applicable Commission rules, the Audit Committee is required
      to
      pre-approve the audit and non-audit services performed by the independent
      auditors in order to ensure that they do not impair the auditors’ independence.
      The Commission’s rules specify the types of non-audit services that an
      independent auditor may not provide to its audit client and establish the Audit
      Committee’s responsibility for administration of the engagement of the
      independent auditors.




Consistent
      with the Commission’s rules, the Audit Committee Charter requires that the Audit
      Committee review and pre-approve all audit services and permitted non-audit
      services provided by the independent auditors to us or any of our subsidiaries.
      The Audit Committee may delegate pre-approval authority to a member of the
      Audit
      Committee and if it does, the decisions of that member must be presented to
      the
      full Audit Committee at its next scheduled meeting.




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.




***Auditor
      Selection for Fiscal 2007*** Amper,
      Politziner & Mattia, P.C. **** has
      been
      selected to serve as our independent auditors for the year ending December
      31,
      2007, subject to conclusion of an engagement letter and ratification by our
      stockholders at the next Annual Meeting.




**PART
      IV**


**Item
      15**   **Exhibits**




(a)(1)
            Financial
                Statements




Consolidated
      balance sheet of PhotoMedex, Inc. and subsidiaries as of December 31, 2006
      and
      2005, 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, 2006.




(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.




77


(b)  Exhibits




Following
        the footnote reference is the number of the exhibit in the original filing
        (e.g.
“Exh 10.3”) in which it was submitted to the SEC.
  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)2.3
              
              Securities
                  Purchase Agreement, dated October 31, 2006, by and between PhotoMedex,
                  Inc. and each purchaser a party thereto (3)3.1(a)
              
              Restated
                  Certificate of Incorporation, filed on August 8, 2000 (4)(Exh
                  3.1)3.1(b)
              
              Amendment
                  to Restated Certificate of Incorporation, filed on January 6, 2004.
                  (5)(Exh 3.2)3.2
              
              Amended
                  and Restated Bylaws (5)(Exh 3.1E)10.1
              
              Lease
                  Agreement dated May 29, 1996, between Surgical Laser Technologies,
                  Inc.
                  and Nappen & Associates (Montgomeryville, Pennsylvania) (5)(Exh
                  10.31)10.2
              
              Lease
                  Renewal Agreement, dated January 18, 2001, between Surgical Laser
                  Technologies, Inc. and Nappen & Associates (5)(Exh
                  10.32)10.3
              
              Lease
                  Agreement, dated July 10, 2006, PhotoMedex, Inc. and Nappen &
                  Associates (6)(Exh 10.3)10.4
              
              Lease
                  Agreement (Carlsbad, California) dated August 4, 1998
                  (7)10.5
              
              Standard
                  Industrial/Commercial Multi-Tenant Lease - Net, dated March 17,
                  2005
                  (Carlsbad, California)(8)(Exh 10.52)10.6
              
              Industrial
                  Real Estate Lease, dated August 30, 1993, as amended five times
                  (Redmond,
                  Washington) (8) (Exh 10.53)10.7
              
              License
                  and Development Agreement, dated May 22, 2002, between Surgical
                  Laser
                  Technologies, Inc. and Reliant Technologies, Inc. (5)(Exh
                  10.7)10.8
              
              Secured
                  Promissory Note, dated May 22, 2002, between Surgical Laser Technologies,
                  Inc. and Reliant Technologies, Inc. (5)(Exh 10.8)10.9
              
              Security
                  Agreement, dated May 22, 2002, between Surgical Laser Technologies,
                  Inc.
                  and Reliant Technologies, Inc. (5)(Exh 10.9)10.10
              
              Agreement
                  as to Collateral, dated May 22, 2002, among Surgical Laser Technologies,
                  Inc., Reliant Technologies, Inc. and AmSouth Bank (5)(Exh
                  10.10)10.11
              
              Master
                  Purchase Agreement, dated September 7, 2004, between PhotoMedex,
                  Inc. and
                  Stern Laser, srl (9)10.12
              
              Master
                  Lease Agreement, dated June 25, 2004, between PhotoMedex, Inc.
                  and GE
                  Capital Corporation. (10)10.13
              
              Investment
                  Agreement, dated March 30, 2006, between AzurTec, Inc. and PhotoMedex,
                  Inc. (11)(Exh 10.56)10.14
              
              License
                  Agreement, dated March 30, 3006, between AzurTec, Inc. and PhotoMedex,
                  Inc. (11)(Exh 10.57)10.15
              
              License
                  Agreement, dated March 31, 2006, and effective April 1, 1006, between
                  Mount Sinai School of Medicine and PhotoMedex, Inc.
                  (12)10.16
              
              2005
                  Equity Compensation Plan, approved December 28, 2005
                  (13)10.17
              
              2005
                  Investment Plan, approved December 28, 2005 (13)10.18
              
              Amended
                  and Restated 2000 Non-Employee Director Stock Option Plan
                  (1)10.19
              
              Amended
                  and Restated 2000 Stock Option Plan
                  (1)




78




10.20
              
              2004
                  Stock Option Plan, assumed from ProCyte (14)10.21
              
              1996
                  Stock Option Plan, assumed from ProCyte (14)10.22
              
              1991
                  Restated Stock Option Plan for Non-Employee Directors, assumed
                  from
                  ProCyte (14)10.23
              
              1989
                  Restated Stock Option Plan, assumed from ProCyte (14)10.24
              
              Amended
                  and Restated Employment Agreement with Jeffrey F. O'Donnell, dated
                  August
                  1, 2002 (1)10.25
              
              Amended
                  and Restated Employment Agreement with Dennis M. McGrath, dated
                  August 1,
                  2002 (1)10.26
              
              Employment
                  Agreement of Michael R. Stewart, dated December 27, 2002 (5)(Exh
                  10.37)10.27
              
              Employment
                  Agreement of John F. Clifford, dated March 18, 2005 (2)10.28
              
              Employment
                  Agreement of Robin L. Carmichael, dated March 18, 2005
                  (2)10.29
              
              Separation
                  Agreement, effective June 30, 2006, between PhotoMedex, Inc. and
                  John F.
                  Clifford. (15)10.30
              
              Restricted
                  Stock Purchase Agreement of Jeffrey F. O’Donnell, dated January 15, 2006
                  (8)(Exh 10.44)10.31
              
              Restricted
                  Stock Purchase Agreement of Dennis M. McGrath, dated January 15,
                  2006
                  (8)(Exh 10.45)10.32
              
              Consulting
                  Agreement dated January 21, 1998 between the Company and R. Rox
                  Anderson, M.D. (7)(Exh
                  10.4)10.33
              
              Letter
                  Agreement dated October 28, 2003 between PhotoMedex and True North
                  Capital
                  Ltd. (16)(Exh 10.41)22.1
              
              List
                  of subsidiaries of the Company23.1
              
              Consent
                  of Amper, Politziner & Mattia P.C.31.1
              
              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




79







(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 Registration Statement on Form S-4/A filed with
                  the
                  Commission on January 21, 2005, and as
                  amended.
  (3)
              Filed
                  as part of our Current Report on Form 8-K, dated November 6,
                  2006.
  (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 Annual Report on Form 10-K for the year ended December
                  31,
                  2002.
  (6)
              Filed
                  as part of our Annual Report on Form 10-K for the year ended December
                  31,
                  2006.
  (7)
              Filed
                  as part of our Registration Statement on Form S-1, as filed with
                  the
                  Commission on January 28, 1998, as
                  amended.
  (8)
              Filed
                  as part of our Annual Report on Form 10-K for the year ended December
                  31,
                  2005.
  (9)
              Filed
                  as part of our Current Report on Form 8-K, dated September 10,
                  2004.
  (10)
              Filed
                  as part of our Quarterly Report on Form 10-Q for the quarter ended
                  June
                  30, 2004.
  (11)
              Filed
                  as part of our Current Report on Form 8-K, filed on April 6,
                  2006.
  (12)
              Filed
                  as part of our Current Report on Form 8-K, filed on April 10,
                  2006.
  (13)
              Filed
                  as part of our Definitive Proxy Statement on Schedule 14A, as filed
                  with
                  the Commission on November 15,
                  2005.
  (14)
              Filed
                  as part of our Registration Statement on Form S-8, as filed with
                  the
                  Commission on April 13, 2005.
  (15)
              Filed
                  as part of our Quarterly Report on Form 10-Q for the quarter ended
                  March
                  31, 2006.
  (16)
              Filed
                  as part of our Quarterly Report on Form 10-Q for the quarter ended
                  September 30, 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.




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. The information on the website listed above is not and
      should not be considered part of this Annual Report on Form 10-K and is intended
      to be an inactive textual reference only.




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 16, 2007
            By:
            /s/
              Jeffrey F. O’DonnellJeffrey
                F. O’Donnell
              President,
                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
                16, 2007Richard
                J. DePiano/s/
                Jeffrey F. O’Donnell
            
            President,
                Chief Executive Officer and Director
            
            March
                16, 2007Jeffrey
                F. O'Donnell/s/
                Dennis M. McGrath
            
            Chief
                Financial Officer
            
            March
                16, 2007Dennis
                M. McGrath/s/
                Alan R. Novak
            
            Director
            
            March
                16, 2007Alan R. Novak/s/
                David W. Anderson
            
            Director
            
            March
                16, 2007David
                W. Anderson/s/
                Warwick Alex Charlton
            
            Director
            
            March
                16, 2007Warwick
                Alex Charlton/s/
                Anthony J. Dimun
            
            Director
            
            March
                16, 2007Anthony
                J. Dimun/s/
                Wayne M. Withrow
            
            Director
            
            March
                16, 2007Wayne
                M. Withrow





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-3Consolidated
                Balance Sheets, December 31, 2006 and 2005
            
            
            F-4Consolidated
                Statements of Operations, Years ended December 31, 2006, 2005 and
                2004
            
            
            F-5Consolidated
                  Statements of Stockholders’ Equity, Years ended December 31,
                  2006, 2005 and 2004
            
            
            F-6Consolidated
                Statements of Cash Flows, Years ended December 31, 2006, 2005 and
                2004
            
            
            F-7Notes
                to Consolidated Financial Statements
            
            
            F-8





REPORT
        OF
        INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM




Board
      of
      Directors and shareholders


PhotoMedex,
      Inc. and Subsidiaries





We
      have
      audited the accompanying consolidated balance sheets of PhotoMedex, Inc. and
      Subsidiaries as of December 31, 2006 and 2005, and the related consolidated
      statements of operations, stockholders’ equity, and cash flows for the years
      ended December 31, 2006 and 2005. 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 audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board of United States of America. Those standards require
      that we plan and perform the audit to obtain reasonable assurance about whether
      the financial statements are free of material misstatement. An audit includes
      examining, on a test basis, evidence supporting the amounts and disclosures
      in
      the financial statements. An audit also includes assessing the accounting
      principles used and significant estimates made by management, as well as
      evaluating the overall financial statement presentation. We believe that our
      audits provide a reasonable basis for our opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the financial position of PhotoMedex, Inc. and
      Subsidiaries as of December 31, 2006 and 2005, and the results of its operations
      and its cash flows for the years ended December 31, 2006 and 2005, in conformity
      with accounting principles generally accepted in the United States of
      America.





As
      discussed in Note 1 to the consolidated financial statements, the Company
      changed its method of accounting for stock-based compensation upon the adoption
      of Statement of Financial Accounting Standard No. 123 (R), “Share-Based
      Payment”.





We
      also
      have audited, in accordance with the standards of the Public Company Accounting
      Oversight Board of the United States of America, the effectiveness of
      PhotoMedex, Inc. and Subsidiary’s internal control over financial reporting as
      of December 31, 2006, 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 8, 2007 expressed an
      unqualified opinion thereon.






/s/
      Amper, Politziner & Mattia, P. C.





March
      8,
      2007


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 2006
      Annual Report on Internal Controls, that PhotoMedex, Inc. and Subsidiaries
      (the
      Company) maintained effective internal control over financial reporting as
      of
      December 31, 2006, 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 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 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 audits provide 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, 2006, 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, 2006, 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, 2006 and the related consolidated
      statements of operations, stockholders’ equity and cash flows for the years
      ended December 31, 2006 in our report dated March 8, 2007, expressed an
      unqualified opinion.






/s/
      Amper, Politziner & Mattia, P. C.





March
      8,
      2007


Edison,
      New Jersey


F-3


PHOTOMEDEX,
      INC. AND SUBSIDIARIES




CONSOLIDATED
      BALANCE SHEETS




December
                31,2006
            
            2005ASSETSCurrent
                assets:Cash
                and cash equivalents
            
            $
            12,729,742
            
            $
            5,403,036Restricted
                cash
            
            
            156,000
            
            
            206,931Accounts
                receivable, net of allowance for doubtful accounts of $508,438 and
                $765,440
            
            
            4,999,224
            
            
            4,651,080Inventories
            
            
            7,301,695
            
            
            8,047,444Prepaid
                expenses and other current assets
            
            
            534,135
            
            
            621,372Total
                current assets
            
            
            25,720,796
            
            
            18,929,863Property
                and equipment, net
            
            
            9,054,098
            
            
            7,044,713Patents
                and licensed technologies, net
            
            
            1,695,727
            
            
            1,577,554Goodwill,
                net
            
            
            16,917,808
            
            
            16,375,384Other
                intangible assets, net
            
            
            3,537,625
            
            
            4,467,625Other
                assets
            
            
            555,467
            
            
            280,467Total
                assets
            
            $
            57,481,521
            
            $
            48,675,606LIABILITIES
                AND STOCKHOLDERS' EQUITYCurrent
                liabilities:Current
                portion of notes payable
            
            $
            195,250
            
            $
            228,398Current
                portion of long-term debt
            
            
            3,018,874
            
            
            1,749,969Accounts
                payable
            
            
            3,617,726
            
            
            3,572,077Accrued
                compensation and related expenses
            
            
            1,529,862
            
            
            867,427Other
                accrued liabilities
            
            
            657,293
            
            
            924,968Deferred
                revenues
            
            
            632,175
            
            
            466,032Total
                current liabilities
            
            
            9,651,180
            
            
            7,808,871Notes
                payable, net of current maturities
            
            
            133,507
            
            
            159,213Long-term
                debt, net of current maturities
            
            
            3,593,920
            
            
            2,278,871Other
                liabilities
            
            
            -
            
            
            11,623Total
                liabilities
            
            
            13,378,607
            
            
            10,258,578Commitment
                and contingenciesStockholders'
                Equity:Common
                Stock, $.01 par value, 75,000,000 shares authorized; 62,536,054 and
                51,414,294 shares issued and outstanding at December 31, 2006 and
                2005,
                respectively
            
            
            625,360
            
            
            514,143Additional
                paid-in capital
            
            
            131,152,557
            
            
            118,140,838Accumulated
                deficit
            
            
            (87,675,003
            )
            
            (80,182,606
            )Deferred
                compensation
            
            
            -
            
            
            (55,347
            )Total
                stockholders' equity
            
            
            44,102,914
            
            
            38,417,028Total
                liabilities and stockholders’ equity
            
            $
            57,481,521
            
            $
            48,675,606




The
      accompanying notes are an integral part of these consolidated financial
      statements.




F-4


PHOTOMEDEX,
      INC. AND SUBSIDIARIES




CONSOLIDATED
      STATEMENTS OF OPERATIONS





For
                the Year Ended December 31,2006
            
            2005
            
            2004Revenues:Product
                sales
            
            $
            20,352,905
            
            $
            16,544,894
            
            $
            6,497,397Services
            
            
            12,836,972
            
            
            11,839,612
            
            
            11,247,78433,189,877
            
            
            28,384,506
            
            
            17,745,181Cost
                of revenues:Product
                cost of revenues
            
            
            8,628,651
            
            
            7,219,504
            
            
            3,324,564Services
                cost of revenues
            
            
            9,843,199
            
            
            8,456,001
            
            
            7,038,70518,471,850
            
            
            15,675,505
            
            
            10,363,269Gross
                profit
            
            
            14,718,027
            
            
            12,709,001
            
            
            7,381,912Operating
                expenses:Selling,
                general and administrative
            
            
            20,682,056
            
            
            16,477,322
            
            
            10,426,256Engineering
                and product development
            
            
            1,006,600
            
            
            1,127,961
            
            
            1,801,43821,688,656
            
            
            17,605,283
            
            
            12,227,694Loss
                from operations
            
            
            (6,970,629)
            
            
            (4,896,282
            )
            
            (4,845,782
            )Interest
                expense, net
            
            
            (521,768
            )
            
            (342,299
            )
            
            (138,414
            )Other
                income, net
            
            
            -
            
            
            1,302,537
            
            
            -Net
                loss
            
            
            ($
                7,492,397
            )
            
            ($
                3,936,044
            )
            
            ($
                4,984,196
            )Basic
                and diluted net loss per share
            
            
            ($0.14
            )
            
            ($0.08
            )
            
            ($0.13
            )Shares
                used in computing basic and diluted net loss per share
            
            
            54,188,914
            
            
            48,786,109
            
            
            38,835,356




The
      accompanying notes are an integral part of these consolidated financial
      statements


F-5


PHOTOMEDEX,
      INC. AND SUBSIDIARIES


CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ EQUITY





Common
                Stock
            
            Additional
                Paid-In
            
            Accumulated
            
            DeferredShares
            
            Amount
            
            Capital
            
            Deficit
            
            Compensation
            
            TotalBALANCE,
                JANUARY 1, 2004
            
            
            37,736,139
            
            $
            377,361
            
            $
            86,871,415
            
            
            ($71,262,366
            )
            
            ($8,335
            )
            $
            15,978,075Sale
                of stock, net of expenses
            
            
            -
            
            
            -
            
            
            11,199
            
            
            -
            
            
            -
            
            
            11,199Exercise
                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
            
            
            -Registration
                expense for acquisition
            
            
            -
            
            
            -
            
            
            (125,914
            )
            
            -
            
            
            -
            
            
            (125,914
            )Issuance
                of stock for Stern laser assets acquisition, net of
                expenses
            
            
            113,877
            
            
            1,139
            
            
            218,066
            
            
            -
            
            
            -
            
            
            219,205Issuance
                of warrants for draws under line of credit
            
            
            -
            
            
            -
            
            
            80,462
            
            
            -
            
            
            -
            
            
            80,462Amortization
                of deferred compensation
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            6,266
            
            
            6,266Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            (4,984,196
            )
            
            -
            
            
            (4,984,196
            )BALANCE,
                DECEMBER 31, 2004
            
            
            40,075,019
            
            
            400,750
            
            
            90,427,632
            
            
            (76,246,562
            )
            
            (1,537
            )
            
            14,580,283Exercise
                of warrants
            
            
            73,530
            
            
            735
            
            
            146,325
            
            
            -
            
            
            -
            
            
            147,060Exercise
                of stock options
            
            
            350,189
            
            
            3,502
            
            
            624,329
            
            
            -
            
            
            -
            
            
            627,831Issuance
                of stock for ProCyte merger, net of expense
            
            
            10,540,579
            
            
            105,406
            
            
            26,197,732
            
            
            -
            
            
            (132,081
            )
            
            26,171,057Stock
                options issued to consultants for services
            
            
            -
            
            
            -
            
            
            123,257
            
            
            -
            
            
            -
            
            
            123,257Reversal
                of unamortized portion of deferred compensation for terminated
                employee
            
            
            -
            
            
            -
            
            
            (1,534
            )
            
            -
            
            
            1,534
            
            
            -Amortization
                of deferred compensation
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            76,737
            
            
            76,737Issuance
                of stock for Stern laser assets acquisition, net of
                expenses
            
            
            374,977
            
            
            3,750
            
            
            723,300
            
            
            -
            
            
            -
            
            
            727,050Registration
                expense
            
            
            -
            
            
            -
            
            
            (161,739
            )
            
            -
            
            
            -
            
            
            (161,739
            )Issuance
                of warrants for draws under line of credit
            
            
            -
            
            
            -
            
            
            61,536
            
            
            -
            
            
            -
            
            
            61,536Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            (3,936,044
            )
            
            -
            
            
            (3,936,044
            )BALANCE,
                DECEMBER 31, 2005
            
            
            51,414,294
            
            
            514,143
            
            
            118,140,838
            
            
            (80,182,606
            )
            
            (55,347
            )
            
            38,417,028Reversal
                of deferred compensation upon adoption of SFAS 123R
            
            
            -
            
            
            -
            
            
            (55,347
            )
            
            -
            
            
            55,347
            
            
            -Exercise
                of warrants
            
            
            140,000
            
            
            1,400
            
            
            166,600
            
            
            -
            
            
            -
            
            
            168,000Exercise
                of stock options
            
            
            60,750
            
            
            607
            
            
            86,664
            
            
            -
            
            
            -
            
            
            87,271Sale
                of stock, net of expenses
            
            
            9,760,000
            
            
            97,600
            
            
            10,449,402
            
            
            -
            
            
            -
            
            
            10,547,002Amortization
                of deferred compensation
            
            
            -
            
            
            -
            
            
            55,347
            
            
            -
            
            
            -
            
            
            55,347Stock
                options issued to consultants for service
            
            
            -
            
            
            -
            
            
            132,624
            
            
            
            
            
            -
            
            
            132,624Stock-based
                compensation expense related to employee options
            
            
            -
            
            
            -
            
            
            990,372
            
            
            -
            
            
            -
            
            
            990,372Issuance
                of restricted stock
            
            
            860,000
            
            
            8,600
            
            
            314,174
            
            
            -
            
            
            -
            
            
            322,774Issuance
                of stock for Azurtec agreement
            
            
            200,000
            
            
            2,000
            
            
            381,273
            
            
            -
            
            
            -
            
            
            383,273Issuance
                of stock for Stern laser assets acquisition, net of
                expenses
            
            
            101,010
            
            
            1,010
            
            
            190,725
            
            
            -
            
            
            -
            
            
            191,735Stock-based
                compensation expense related to severance agreement
            
            
            -
            
            
            -
            
            
            195,497
            
            
            -
            
            
            -
            
            
            195,497Issuance
                of warrants for draws under line of credit
            
            
            -
            
            
            -
            
            
            104,388
            
            
            -
            
            
            -
            
            
            104,388Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            (7,492,397
            )
            
            -
            
            
            (7,492,397
            )BALANCE,
                DECEMBER 31, 2006
            
            
            62,536,054
            
            $
            625,360
            
            $
            131,152,557
            
            
            ($87,675,003
            )
            
            -
            
            $
            44,102,914




The
      accompanying notes are an integral part of these consolidated financial
      statements.


F-6


PHOTOMEDEX,
      INC. AND SUBSIDIARIES




CONSOLIDATED
      STATEMENTS OF CASH FLOWS




For
                the Year Ended December 31,2006
            
            2005
            
            2004**Cash
                Flows From Operating Activities:**Net
                loss
            
            
            ($7,492,397
            )
            
            ($3,936,044
            )
            
            ($4,984,196
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
                and amortization
            
            
            4,199,047
            
            
            3,217,200
            
            
            1,765,944Loss
                on disposal of property and equipment
            
            
            7,500
            
            
            101,009
            
            
            -Provision
                for doubtful accounts
            
            
            66,211
            
            
            373,964
            
            
            459,861Stock
                options and warrants issued toconsultants
                for services
            
            
            132,624
            
            
            123,257
            
            
            98,435Compensatory
                charge for stock options and restricted stock issued to employees
            
            
            1,304,546
            
            
            -
            
            
            -Non-monetary
                exchange
            
            
            -
            
            
            (88,667
            )
            
            -Amortization
                of deferred compensation
            
            
            55,347
            
            
            76,737
            
            
            6,266Changes
                in operating assets and liabilities, net of acquisition:Accounts
                receivable
            
            
            (414,355
            )
            
            229,768
            
            
            (1,094,230
            )Inventories
            
            
            815,766
            
            
            (782,880
            )
            
            (628,257
            )Prepaid
                expenses and other assets
            
            
            1,138,691
            
            
            1,011,340
            
            
            541,170Accounts
                payable
            
            
            45,648
            
            
            (518,289
            )
            
            1,273,300Accrued
                compensation and related expenses
            
            
            315,508
            
            
            (246,950
            )
            
            22,718Other
                accrued liabilities
            
            
            (279,295
            )
            
            (1,023,921
            )
            
            (51,482
            )Deferred
                revenues
            
            
            166,143
            
            
            (266,366
            )
            
            (174,750
            )Net
                cash provided by (used in) operating activities
            
            
            60,984
            
            
            (1,729,842
            )
            
            (2,765,221
            )**Cash
                Flows From Investing Activities:**Purchases
                of property and equipment
            
            
            (94,976
            )
            
            (123,201
            )
            
            (111,319
            )Lasers
                placed into service
            
            
            (4,931,835
            )
            
            (3,461,803
            )
            
            (1,683,528
            )Cash
                received from acquisition of ProCyte, net of acquisition
                costs
            
            
            -
            
            
            5,578,416
            
            
            (882,823
            )Net
                cash (used in) provided by investing activities
            
            
            (5,026,811
            )
            
            1,993,412
            
            
            (2,677,670
            )**Cash
                Flows From Financing Activities:**Proceeds
                from issuance of common stock, net
            
            
            10,547,002
            
            
            (169,524
            )
            
            (138,858
            )Proceeds
                from issuance of restricted common stock
            
            
            8,600
            
            
            -
            
            
            -Proceeds
                from exercise of options
            
            
            87,271
            
            
            627,831
            
            
            210,283Proceeds
                from exercise of warrants
            
            
            168,000
            
            
            147,060
            
            
            3,086,468Payments
                on long-term debt
            
            
            (179,993
            )
            
            (263,442
            )
            
            (291,840
            )Payments
                on notes payable
            
            
            (900,715
            )
            
            (882,032
            )
            
            (587,161
            )Net
                advances on line of credit
            
            
            2,511,437
            
            
            1,889,487
            
            
            527,548Decrease
                (increase) in restricted cash, cash equivalents and short-term
                investments
            
            
            50,931
            
            
            (94,731
            )
            
            (112,200
            )Net
                cash provided by financing activities
            
            
            12,292,533
            
            
            1,254,649
            
            
            2,694,240Net
                increase (decrease) in cash and cash equivalents
            
            
            7,326,706
            
            
            1,518,219
            
            
            (2,748,651
            )Cash
                and Cash Equivalents, Beginning of Year
            
            
            5,403,036
            
            
            3,884,817
            
            
            6,633,468Cash
                and Cash Equivalents, End of Year
            
            $
            12,729,742
            
            $
            5,403,036
            
            $
            3,884,817




The
      accompanying notes are an integral part of these consolidated financial
      statements.


F-7


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 its subsidiaries) (the “Company”) is a medical device and specialty
      pharmaceutical company focused on facilitating the cost-effective use of
      technologies for doctors, hospitals and surgery centers to enable their patients
      to achieve a higher quality of life. The Company operates in five distinct
      business units, or segments (as described in Note 11): three in Dermatology,
      -
      Domestic XTRAC®, International Dermatology Equipment, and Skin Care (ProCyte®);
      and two in Surgical, - Surgical Services (SISTM) and Surgical Products (SLT®).
      The segments are distinguished by our management structure, products and
      services offered, markets served or types of customers.




The
      Domestic XTRAC segment generally derives revenues from procedures performed
      by
      dermatologists in the United States. The Company’s XTRAC laser system is placed
      in a dermatologist’s office without any initial capital cost to the
      dermatologist, and then the Company charges a fee-per-use to treat skin disease.
      The International Dermatology Equipment segment was formerly called the
      International XTRAC segment, but the Company re-named this segment following
      the
      addition of the VTRACTM lamp-based system in 2006. In comparison to the Domestic
      XTRAC segment, the International Dermatology Equipment segment generates
      revenues from the sale of equipment to dermatologists outside the United States
      through a network of distributors. The Skin Care segment generates revenues
      by
      selling physician-dispensed skincare products worldwide and by earning royalties
      on licenses for our patented copper peptide compound.




The
      Company designed and manufactured the XTRAC laser system to treat psoriasis,
      vitiligo, atopic dermatitis and leukoderma phototherapeutically. In January
      2000, the Company received the first Food and Drug Administration (“FDA”)
      clearance to market an excimer laser system, the XTRAC® laser system, for the
      treatment of psoriasis. It was followed by FDA 510(k) clearance to treat
      vitiligo in March 2001, atopic dermatitis in August 2001, and leukoderma in
      May
      2002. The first XTRAC phototherapy treatment systems were commercially
      distributed in the United States in August 2000 before any of its procedures
      had
      been approved for medical insurance reimbursement. In the last several years,
      the Company has sought to obtain reimbursement for psoriasis and other
      inflammatory skin disorders. By the latter part of 2005, the Company had
      received many approvals for the reimbursement for use of the XTRAC system.
      In June 2006, the Company received approval from Blue Cross and Blue Shield
      of
      Florida. The manufacturing facility for the XTRAC laser system is located in
      Carlsbad, California.




The
      Surgical Services segment generates revenues by providing fee-based procedures
      typically 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 laser products and disposables
      to
      hospitals and surgery centers both domestically and internationally. The
      Surgical Products segment also sells other non-laser products .




The
      Skin
      Care business resulted from the acquisition of ProCyte Corporation (“ProCyte”)
      on March 18, 2005. ProCyte, located in Redmond, Washington, markets products
      for
      skin health, hair care and wound care. Many of these products incorporate
      patented copper peptide technologies. In addition to a diversified product
      line,
      ProCyte has provided a national sales force and increased the Company’s
      marketing capabilities. (see Note 2).




The
      Company also develops, manufactures and markets proprietary lasers and delivery
      systems for both contact and non-contact surgery and provides surgical services
      utilizing these and other manufacturers’ products. The Montgomeryville facility
      also serves as the Company’s corporate headquarters.




F-8




***Liquidity
      and Going Concern***




The
      Company has incurred significant losses and negative cash flows from operations.
      As of December 31, 2006, the Company had an accumulated deficit of $87,675,003.
      The Company has historically financed its activities from operations, the
      private placement of equity securities and borrowings under lines of credit.
      To
      date, the Company has dedicated most of its financial resources to research
      and
      development, marketing and general and administrative expenses.




Cash
      and
      cash equivalents as of December 31, 2006 were $12,885,742, including restricted
      cash of $156,000. Management believes that the existing cash balance together
      with its other existing financial resources, including its leasing credit line
      facility with a remaining availability of $1,289,946 (see Note 9), and any
      revenues from sales, distribution, licensing and manufacturing relationships,
      will be sufficient to meet the Company’s operating and capital requirements
      through the end of the first quarter of 2008. The 2007 operating plan reflects
      anticipated growth from an increase in per-treatment fee revenues for use of
      the
      XTRAC laser system based on increased utilization and wider insurance coverage
      in the United States and continuing cost savings from the integration of
      business operations acquired from ProCyte and the growth of the Company’s
      skincare products. In light of the Company’s recent private placement (see Note
      12,) of approximately $11.4 million, the Company now believes that it will
      have
      the necessary financing to meet its operating and capital requirements through
      2007 and into 2008, at a minimum.




Since
      2002, the Company has made significant progress in obtaining more extensive
      reimbursement approval including the Centers for Medicare and Medicaid Services
      and various private health plans for the treatment of skin disorders using
      the
      XTRAC laser system. The Company plans to continue to attempt securing
      reimbursement from more private insurers and to concentrate sales and marketing
      efforts where such reimbursement has become available. As additional approvals
      for reimbursements are obtained, the Company will increase spending on the
      marketing and selling of its psoriasis, vitiligo, atopic dermatitis and
      leukoderma treatment products and, if necessary, expansion of its manufacturing
      facilities. Even with the approval for reimbursement by Centers for Medicare
      and
      Medicaid Services and recent approvals by certain private insurers, the Company
      may continue to face resistance from remaining private healthcare insurers
      to
      adopt the excimer-laser-based therapy as an approved procedure or to provide
      adequate levels of reimbursement.




The
      Company’s future success also depends in part upon increased patient acceptance
      of its excimer-laser-based systems for the treatment of a variety of skin
      disorders. The Company’s ability to introduce successful new products may be
      adversely affected by a number of factors, such as unforeseen costs and
      expenses, technological change, economic downturns, increased competition,
      other
      factors beyond the Company’s control or excessive costs in order to market the
      product and thus win patient acceptance. The Company is continuing to implement
      its rollout strategy for the XTRAC laser system in the United States in selected
      areas of the country where reimbursement is widely available. The success of
      the
      rollout depends on increasing physician and patient demand for the treatment.




Management
      cannot provide assurance that the Company will market the XTRAC product
      successfully or operate profitably in the future, or that it will not require
      significant additional financing in order to accomplish or exceed the objectives
      of its business plan. Consequently, the Company’s historical operating results
      cannot be relied on to be an indicator 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




**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 Nos. 101 and 104 and SFAS No.
      48.




***Cash
      and Cash Equivalents and Restricted Cash***




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, 2006
      and
      2005. 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
      customer’s 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'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 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. In
      reflection of their improved reliability, XTRAC lasers placed in service after
      December 31, 2005 are depreciated on a straight-line basis over the estimated
      useful life of five-years; other XTRAC lasers-in-service continue to be
      depreciated over the original 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 or both.




F-10




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, 2006, 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.
      Developed technology was also recorded in connection with the acquisition of
      ProCyte in March 2005 and is being amortized on a straight-line basis over
      seven
      years. Other licenses, for example, the AzurTec, Stern and Mount Sinai licenses,
      are capitalized and amortized over the estimated useful lives of 10
      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, 2006, no such write-down was required (see ***Impairment
      of Long-Lived Assets*** below).




***Other
      Intangible Assets***




Other
      intangible assets were recorded in connection with the acquisition of ProCyte
      in
      March 2005. The assets are being amortized on a straight-line basis over 5
      to 10
      years.




Management
      evaluates the recoverability of such other 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
      the
      net book value of the asset, the asset is written down to fair value. As of
      December 31, 2006, no such write-down was required. ******





***Goodwill***




Goodwill
      was recorded in connection with the acquisition of ProCyte in March 2005 and
      the
      acquisition of Acculase in August 2000.




Management
      evaluates the recoverability of such goodwill 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 fair value. As of December 31, 2006,
      no
      such write-down was required.




***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 years
      ended December 31, 2006 and 2005 is summarized as follows:




December
                31,2006
            
            2005Accrual
                at beginning of year
            
            $
            204,708
            
            $
            196,890Additions
                charged to warranty expense
            
            
            105,000
            
            
            105,000Expiring
                warranties
            
            
            (87,426
            )
            
            (15,308
            )Claims
                satisfied
            
            
            (98,544
            )
            
            (81,874
            )Accrual
                at end of year
            
            $
            123,738
            
            $
            204,708




F-11




***Revenue
      Recognition***




The
      Company has two distribution channels for its phototherapy treatment equipment.
      The Company either (i) sells the laser through a distributor or directly to
      a
      physician or (ii) places the lasers in physician’s offices (at no charge to the
      physician) and charges 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 foreign or domestic physician, revenue is recognized when the following
      four criteria under Staff Accounting Bulletin No. 104 have been met: (i) the
      product has been shipped and the Company has no significant remaining
      obligations; (ii) persuasive evidence of an arrangement exists; (iii) the price
      to the buyer is fixed or determinable; and (iv) collection is probable (the
“SAB
      104 Criteria”). At times, units are shipped, but revenue is not recognized until
      all of the SAB 104 criteria have been 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 upon 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 distributors or physicians
      that do not fully satisfy the collection criteria are recognized when invoiced
      amounts are fully paid




Under
      the
      terms of the Company’s distributor agreements, distributors do not have a
      unilateral right to return any unit that they have purchased. However, the
      Company does allow products to be returned by its distributors for product
      defects or other claims.




When
      the
      Company places a laser in a physician’s office, it recognizes service revenue
      based on the number of patient treatments performed by the physician. Treatments
      in the form of random 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. Unused treatments are deemed to remain an obligation
      of
      the Company because the treatments can only be performed on Company-owned
      equipment. Once the treatments are delivered to a patient, this obligation
      has
      been satisfied.




The
      Company excludes all sales of treatment codes made within the last two weeks
      of
      the period in determining the amount of procedures performed by its
      physician-customers. Management believes this approach closely approximates
      the
      actual amount of unused treatments that existed at the end of a period. For
      the
      year ended December 31, 2006 and 2005, the Company deferred $506,440 and
      $311,571, respectively, under this approach.




In
      the
      first quarter of 2003, the Company implemented a program to support certain
      physicians in addressing treatments with the XTRAC laser system that may be
      denied reimbursement by private insurance carriers. The Company recognizes
      service revenue 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. For the year ended December 31, 2006, the Company deferred an
      additional $124,427, under this program, as all the SAB 104 Criteria for revenue
      recognition had not been met. At December 31, 2006, the Company had net deferred
      revenues of $80,697 under this program.




Under
      this program, the Company may reimburse qualifying doctors for the cost of
      the
      Company’s fee but 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 be in an identified location where there
                is an
                insufficiency of insurance companies reimbursing the procedure or
                where a
                particular practice faces similar insurance
                obstacles;




·
            The
                program only covers medically necessary treatments of psoriasis as
                determined by the treating
                physician;




F-12




·
            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
                a
                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 to
                9
                months;




·
            After
                all appeals have been exhausted by the Company and the claim remains
                unpaid, the physician is entitled to receive credit for the fee for
                the
                treatment he or she purchased from the Company 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 sales
                of
                treatments to a physician can be denied if timely payments are not
                made,
                even if a patient’s appeal is still in process.




The
      Company estimates a contingent liability for potential refunds under this
      program by reviewing the history of denied insurance claims and appeals
      processed. The Company estimates that approximately 4% of the revenues under
      this program for the quarter ended December 31, 2006 are subject to being
      credited or refunded to the physician. The Company estimated that 11% of the
      revenues under this program for the quarter ended December 31, 2005 were subject
      to being credited or refunded to the physician.




The
      Company generates revenues from its Skin Care business primarily through three
      channels. The first is through product sales for skin health, hair care and
      wound care; the second is through sales of the copper peptide compound,
      primarily to Neutrogena Corporation, a Johnson & Johnson company; and the
      third is through royalties generated by our licenses, principally to Neutrogena.
      The Company recognizes revenues on the products and copper peptide compound
      when
      they are shipped, net of returns and allowances. The Company ships the products
      FOB shipping point. Royalty revenues are based upon sales generated by our
      licensees. The Company recognizes royalty revenue at the applicable royalty
      rate
      applied to shipments reported by our licensee.




The
      Company generates revenues from its Surgical businesses primarily from two
      channels. The first is through product sales of laser systems, related
      maintenance service agreements, recurring laser delivery systems and laser
      accessories, and the second is through per-procedure surgical services. The
      Company recognizes revenues from surgical laser and other product sales,
      including sales to distributors and other customers, when the SAB 104 Criteria
      have been met.




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 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.




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. Consistent with the rules of purchase accounting, the
      historical deferred tax asset of ProCyte was valued at zero when the Company
      acquired ProCyte. If and when components of that asset are realized in future,
      the goodwill recognized in the acquisition of ProCyte will be reduced.




***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.




F-13




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 10,840,382, 7,177,955 and 6,464,140 as of December 31, 2006, 2005
      and 2004, respectively, were thus excluded from the calculation of fully diluted
      earnings per share.




***Exchanges
      of Nonmonetary Assets***




Exchanges
      under SFAS No. 153, “Exchanges of Nonmonetary Assets,” are measured based on the
      fair value of the assets exchanged. Further, SFAS No. 153 eliminates the
      previous 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.” The Company elected to adopt this
      Statement in fiscal year 2005. For the year ended December 31, 2006, the Company
      has not recognized any income or expense in accordance with this Statement.
      For
      the year ended December 31, 2005, the Company has recognized $88,667 recorded
      as
      Other Income in accordance with this Statement.





***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 estimated to be equal to their 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 in 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 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, 2006, no such impairment
      exists.




***Share-Based
      Compensation***




On
      January 1, 2006, The Company adopted SFAS No. 123R, “Share-Based Payment,” which
      requires all companies to measure and recognize compensation expense at fair
      value for all stock-based payments to employees and directors. SFAS No. 123R
      is
      being applied on the modified prospective basis. Prior to the adoption of SFAS
      No. 123R, the Company accounted for its stock-based compensation plans for
      employees and directors under the recognition and measurement principles of
      Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued
      to Employees”, and related interpretations, and accordingly, the Company
      recognized no compensation expense related to the stock-based plans for grants
      to employees or directors. Grants to consultants under the plans were recorded
      under SFAS No. 123.




Under
      the
      modified prospective approach, SFAS No. 123R applies to new grants of options
      and awards of stock as well as to grants of options that were outstanding on
      January 1, 2006 and that may subsequently be repurchased, cancelled or
      materially modified. Under the modified prospective approach, compensation
      cost
      recognized for the year ended December 31, 2006 includes compensation cost
      for
      all share-based payments granted prior to, but not yet vested on, January 1,
      2006, based on fair value as of the prior grant-date and estimated in accordance
      with the provisions of SFAS No. 123R. Prior periods were not required to be
      restated to reflect the impact of adopting the new standard.




F-14




SFAS
      No.
      123R also requires companies to calculate an initial "pool" of excess tax
      benefits available at the adoption date to absorb any tax deficiencies that
      may
      be recognized under SFAS No. 123R. The pool includes the net excess tax benefits
      that would have been recognized if the Company had adopted SFAS No. 123 for
      recognition purposes on its effective date. The Company has elected to calculate
      the pool of excess tax benefits under the alternative transition method
      described in FASB Staff Position ("FSP") No. FAS 123(R)-3, "Transition Election
      Related to Accounting for Tax Effects of Share-Based Payment Awards," which
      also
      specifies the method to calculate excess tax benefits reported on the statement
      of cash flows. The Company is in a net operating loss position; therefore,
      no
      excess tax benefits from share-based payment arrangements have been recognized
      for the year ended December 31, 2006.




The
      pro-forma information presented in the following table illustrates the effect
      on
      net income and net income per share if the Company had applied the fair value
      recognition provisions of SFAS No. 123, “Accounting for Stock-Based
      Compensation,” as amended SFAS No. 148, “Accounting for Stock-Based Compensation
      - Transition and Disclosure,” to stock-based employee compensation for the years
      ended December 31, 2005 and 2004:





Year
                Ended December 31,2005
            
            2004Net
                loss:As
                reported
            
            
            ($3,936,044
            )
            
            ($4,984,196
            )Less:
                stock-based employee compensation expense included in reported net
                loss
            
            
            76,737
            
            
            6,266Impact
                of total stock-based compensation expense determined under
                fair-value-based method for all grants and awards
            
            
            (1,718,296
            )
            
            (1,540,636
            )Pro-forma
            
            
            ($5,577,603
            )
            
            ($6,518,566
            )Net
                loss per share:As
                reported
            
            
            ($0.08
            )
            
            ($0.13
            )Pro-forma
            
            
            ($0.11
            )
            
            ($0.17
            )




The
      Company uses the Black-Scholes option-pricing model to estimate fair value
      of
      grants of stock options with the following weighted average
      assumptions:




Year
                Ended December 31,Assumptions
                for Option Grants
            
            2006
            
            2005
            
            2004Risk-free
                interest rate
            
            
            4.62
            %
            
            4.04
            %
            
            3.20
            %Volatility
            
            
            92.48
            %
            
            97.81
            %
            
            99.3
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %
            
            0
            %Expected
                life
            
            
            7.50
                years
            
            
            5
                years
            
            
            5
                yearsEstimated
                forfeiture rate
            
            
            16
            %
            
            N/A
            
            
            N/A




The
      Company calculates expected volatility for a share-based grant based on historic
      daily stock price observations of our common stock during the period immediately
      preceding the grant that is equal in length to the expected term of the grant.
      For estimating the expected term of share-based grants made in the year ended
      December 31, 2006, the Company has adopted the simplified method authorized
      in
      Staff Accounting Bulletin No. 107. SFAS No. 123R also requires that estimated
      forfeitures be included as a part of the estimate of expense as of the grant
      date. The Company has used historical data to estimate expected employee
      behaviors related to option exercises and forfeitures. Prior to our adoption
      of
      SFAS No. 123R, the Company reduced pro-forma share-based compensation expense,
      presented in the notes to its financial statements, for actual forfeitures
      as
      they occurred.




With
      respect to both grants of options and awards of restricted stock, the risk
      free
      rate of interest is based on the U.S. Treasury rates appropriate for the
      expected term of the grant or award.




With
      respect to awards of restricted stock, the Company uses the Monte-Carlo pricing
      model to estimate fair value of restricted stock awards made in the first
      quarter 2006 with the following weighted average assumptions:




Assumptions
                for Stock Awards
            
            Year
                Ended December 31, 2006Risk-free
                interest rate
            
            
            4.32
            %Volatility
            
            
            70
            %Expected
                dividend yield
            
            
            0
            %Expected
                Life
            
            
            4.92
                years




F-15








The
      Company calculated expected volatility for restricted stock based on historic
      daily stock price observations of our common stock during the three-year period
      immediately preceding the award.




Options
      that were assumed from ProCyte and that were unvested as of March 18, 2005
      were
      re-measured as of March 18, 2005 under intrinsic-value-based accounting.
      Unearned or deferred compensation of $132,084 was recorded and is being
      amortized over the remaining vesting period, which is an average of two years.
      The Company recognized $55,347 and $76,737 of such expense in the years ended
      December 31, 2006 and 2005, respectively.




There
      was
      $990,372 and $314,174 of compensation expense related to stock options granted
      and restricted stock awarded, respectively, in the year ended December 31,
      2006.
      This expense is recognized in the operating results in selling, general and
      administrative expenses. For stock options granted to consultants, an additional
      selling, general, and administrative expense in the amount of $132,624, $123,257
      and $98,435 was recognized during the years ended December 31, 2006, 2005 and
      2004, respectively.




***Supplemental
      Cash Flow Information***




During
      the year ended December 31, 2006, the Company financed insurance policies
      through notes payable for $763,982, financed certain credit facility costs
      for
      $160,279, financed a license agreement with a note payable of $77,876 and issued
      warrants to a leasing credit facility which are valued at $104,388, and which
      offset the carrying value of debt. In March 2006, the Company issued 101,010
      shares of its restricted common stock to Stern Laser srl (“Stern”) due upon
      achievement of a milestone under the Master Purchase Agreement with Stern.
      The
      cost associated with this issuance is included in the license from Stern, which
      is found in patents and licensed technologies. In March 2006, the Company also
      issued 200,000 shares of its restricted common stock to AzurTec, Inc.
      (“AzurTec”) as part of an investment in the capital stock of AzurTec as well as
      for a license agreement on AzurTec technology, both existing and to be developed
      in the future.




In
      connection with the purchase of ProCyte in March 2005, the Company issued
      10,540,579 shares of common stock and assumed options to purchase 1,354,973
      shares of its own common stock (see Note 2).




During
      the year ended December 31, 2005, the Company financed insurance policies
      through notes payable for $978,252. During the year ended December 31, 2005,
      the
      Company issued 345,477 shares of its restricted common stock to Stern upon
      attainment of certain milestones, which is included in patents and licensed
      technologies.




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.




For
      the
      years ended December 31, 2006, 2005 and 2004, the Company paid interest of
      $670,839, $403,376 and $181,115, respectively. Income taxes paid in the years
      ended December 31, 2006, 2005 and 2004 were immaterial.




***Recent
      Accounting Pronouncements***




In
      February 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
      159, "The Fair Value Option for Financial Assets and Financial Liabilities."
      This Statement permits entities to choose to measure many financial instruments
      and certain other items at fair value that are not currently required to be
      measured at fair value. The objective is to improve financial reporting by
      providing entities with the opportunity to mitigate volatility in reported
      earnings caused by measuring related assets and liabilities differently without
      having to apply complex hedge accounting provisions. This statement also
      establishes presentation and disclosure requirements designed to facilitate
      comparisons between entities that choose different measurement attributes for
      similar types of assets and liabilities. This Statement is effective for
      financial statements issued for fiscal years beginning after November 15, 2007
      and will become effective for us beginning with the first quarter of 2008.
      We
      have not yet determined the impact of the adoption of SFAS No. 159 on our
      financial statements and footnote disclosures.




F-16




In
      September 2006, the
      FASB issued
      SFAS No. 157, “Fair Value Measurements,” which is effective for the Company on
      January 1, 2008. The Statement defines fair value, establishes a framework
      for
      measuring fair value in accordance with generally accepted accounting
      principles, and expands disclosures about fair value measurements. The Statement
      codifies the definition of fair value as the price that would be received to
      sell an asset or paid to transfer a liability in an orderly transaction between
      market participants at the measurement date. The standard clarifies the
      principle that fair value should be based on the assumptions market participants
      would use when pricing the asset or liability and establishes a fair value
      hierarchy that prioritizes the information used to develop those assumptions. The
      adoption of this Statement is not expected to have a material effect on the
      Company’s consolidated financial statements.




In
      September 2006, the SEC staff issued Staff Accounting Bulletin (SAB) Topic
      1N
      (SAB No. 108), “Financial Statements — Considering the Effects of Prior Year
      Misstatements when Quantifying Misstatements in Current Year Financial
      Statements,” which is effective for calendar year companies as of December 31,
      2006. SAB No. 108 provides guidance on how prior-year misstatements should
      be
      taken into consideration when quantifying misstatements in current-year
      financial statements for purposes of determining whether the financial
      statements are materially misstated. Under this guidance, companies should take
      into account both the effect of a misstatement on the current-year balance
      sheet
      as well as the impact upon the current-year income statement in assessing the
      materiality of a current-year misstatement. Once a current-year misstatement
      has
      been quantified, the guidance in SAB Topic 1M, “Financial Statements —
Materiality,” (SAB No. 99) will be applied to determine whether the misstatement
      is material. The
      adoption of this Statement has not had a material effect on the Company’s
      consolidated financial statements.




In
      July
      2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in
      Income Taxes - an Interpretation of FASB Statement No. 109”. This Interpretation
      prescribes a recognition threshold and measurement attribute for the financial
      statement recognition and measurement of a tax position taken or expected to
      be
      taken in a tax return. This Interpretation also provides guidance on
      derecognition, classification, interest and penalties, accounting in interim
      periods, disclosure, and transition. The Interpretation is effective for fiscal
      years beginning after December 15, 2006. The
      Company does not believe that its historical or expected tax reporting
      positions, which considered before application of the valuation allowance,
      will
      have a material impact on its consolidated financial statements .
      See
      Note 13, Income Taxes.




*Note
      2*




**Acquisitions:**




***ProCyte
      Transaction***




On
      March
      18, 2005, the Company completed the acquisition of ProCyte Corporation, which
      was organized in 1986. ProCyte 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.




The
      aggregate purchase price of $28,086,208 consisted of the issuance of 10,540,579
      shares of the Company’s common stock valued at $2.29 per share, the assumption
      of 1,354,973 common stock options valued at $2,033,132 net of deferred
      compensation of $132,084, and the incurrence of $1,915,150 of transaction costs.
      The merger consideration was based on a fixed exchange ratio of 0.6622 shares
      of
      PhotoMedex common stock for each share of ProCyte common stock. As the exchange
      ratio was fixed, the fair value of PhotoMedex’s common stock for accounting
      purposes was based on a stock price of $2.29 per share, which was the average
      of
      the closing prices on the date of the announcement of the planned merger and
      the
      two days prior and afterwards.




F-17


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
            
            $
            6,272,540Accounts
                receivable
            
            
            1,137,413Inventories
            
            
            2,845,698Prepaid
                expenses and other current assets
            
            
            134,574Property
                and equipment
            
            
            340,531Patents
                and licensed technologies
            
            
            200,000Other
                intangible assets
            
            
            5,200,000Other
                assets
            
            
            38,277Total
                assets acquired
            
            
            16,169,033Accounts
                payable
            
            
            (605,520
            )Accrued
                compensation and related expenses
            
            
            (158,610
            )Other
                accrued liabilities
            
            
            (1,143,761
            )Deferred
                revenues
            
            
            (95,436
            )Other
                liabilities
            
            
            (52,883
            )Total
                liabilities assumed
            
            
            (2,056,210
            )Net
                assets acquired
            
            $
            14,112,823




The
      purchase price exceeded the fair value of the net assets acquired by
      $13,973,385, which was recorded as goodwill. The increase in goodwill recognized
      in the year ended December 31, 2006 reflects management’s best estimate of
      pre-acquisition contingencies based upon plans entered into prior to March
      18,
      2006.




The
      accompanying consolidated financial statements do not include any revenues
      or
      expenses related to the acquisition on or prior to March 18, 2005, the closing
      date. Following are the Company’s unaudited pro-forma results for the years
      ended December 31, 2006 and 2005, assuming the acquisition had occurred on
      January 1, 2005:




Year
                Ended December 31,2006
            
            2005Net
                revenues
            
            $
            33,189,877
            
            $
            31,354,068Net
                loss
            
            
            ($7,492,397
            )
            
            ($4,038,193
            )Basic
                and diluted loss per share
            
            
            ($0.14
            )
            
            ($0.08
            )Shares
                used in calculating basic and diluted loss per share
            
            
            54,188,914
            
            
            50,932,410




These
      unaudited pro-forma 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, 2005, nor to be
      indicative of future results of operations.




The
      Company has realized on some, but not all of these goals. The Company has
      recently engaged a new senior officer to direct the operations of the Skin
      Care
      business. For the time being, the Company will concentrate less on the
      cross-integration of the ProCyte sales personnel into sales of the XTRAC system
      and more on focusing the ProCyte sales personnel on growth of the skincare
      sales.




***Stern
      Laser Transaction***




On
      September 7, 2004, the Company closed the transactions provided for in the
      Master Asset Purchase Agreement (the “Master Agreement”) with Stern. In March
      2006, the Company issued an additional 101,010 shares of its restricted common
      stock to Stern based on a milestone set forth in the Master Agreement. As of
      December 31, 2006, the Company has issued an aggregate of 589,854 shares of
      its
      restricted common stock to Stern in connection with the Master Agreement. The
      Company also agreed to pay Stern up to an additional $250,000 based on the
      achievement of two remaining milestones. The Company retains the right to pay
      these conditional sums in cash or in shares of its common stock, at its sole
      discretion. To provide for the issuance of shares, the Company has reserved
      for
      issuance, and placed into escrow, 110,136 shares of its unregistered stock.
      The
      per-share price of any shares issued in the future will be the average closing
      price of the Company’s common stock during the 10 trading days ending on the
      date of achievement of a particular milestone. Stern also has served as the
      distributor of the Company’s XTRAC laser system in South Africa and Italy since
      2000. The primary asset acquired from Stern in the transaction is a license
      for
      Stern’s lamp-based technology, which was carried on the Company’s books at
      $1,013,009, net, as of December 31, 2006. Amortization of this intangible is
      on
      a straight-line basis over 10 years and began in January 2005. In the year
      ended
      December 31, 2006, Stern purchased $35,333 of products from the
      Company.




F-18




***AzurTec
      Transaction***




On
      March
      30, 2006, the Company closed the transaction provided for in the Investment
      Agreement with AzurTec. The Company issued 200,000 shares of its restricted
      common stock in exchange for 6,855,141 shares of AzurTec common stock and
      181,512 shares of AzurTec Class A preferred stock, which represents a 14%
      interest in AzurTec, on a fully diluted basis. In accordance with APB No. 18,
      and related interpretations, the Company accounts for its investment in AzurTec
      on the cost basis.




The
      Company also received a license from AzurTec with respect to its existing and
      future technology for the MetaSpex Laboratory System. The license gives the
      Company rights to manufacture and market the ex vivo versions of the MetaSpex
      product in exchange for certain royalty obligations. The license also provides
      the Company certain rights on a potential in situ version of the MetaSpex
      product. AzurTec remains responsible for the development and clinical trial
      costs of the MetaSpex products, for which AzurTec is committed to raise
      additional equity capital. AzurTec has contracted with the Company to resume
      development work of the ex vivo versions of the MetaSpex product. The Company
      will resume, and be paid for, such work once AzurTec has raised additional
      equity capital and has settled its prior indebtedness owed to the Company for
      development work. The Company has extended by 12 months the time in which
      AzurTex may raise such additional capital.




The
      Company assigned $268,291 as the fair value of the investment in AzurTec. It
      also assigned $114,982 as the fair value of the license it acquired from
      AzurTec, which is carried on the Company’s books at $106,358, net at December
      31, 2006. Amortization of this intangible is on a straight-line basis over
      10
      years, which began in April 2006.




***Mount
      Sinai License***




On
      March
      31, 2006, the Mount Sinai School of Medicine of New York University granted
      the
      Company an exclusive license, effective April 1, 2006, to use Mount Sinai's
      patented methodology for utilization of ultraviolet laser light for the
      treatment of vitiligo. The licensed patent is US Patent No. 6,979,327, Treatment
      of Vitiligo. It was issued December 27, 2005, and the inventor is James M.
      Spencer, MD, a member of the Company’s Scientific Advisory Board. The license is
      carried on the Company’s books at $72,035, net at December 31, 2006.
      Amortization of this intangible is on a straight-line basis over 10 years,
      which
      began in April 2006.




*Note
      3*




**Inventories:**




Set
      forth
      below is a detailed listing of inventories.




December
                31,2006
            
            2005Raw
                materials and work-in-process
            
            $
            4,433,917
            
            $
            4,998,847Finished
                goods
            
            
            2,867,778
            
            
            3,048,597Total
                inventories
            
            $
            7,301,695
            
            $
            8,047,444




Work-in-process
      is immaterial given the typically short manufacturing cycle, and therefore
      is
      disclosed in conjunction with raw materials. Finished goods includes $0 and
      $69,963 as of December 31, 2006 and 2005, 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. As of December 31, 2006 and 2005, the Company carried reserves
      against its inventories of $1,354,444 and $931,719, respectively.




F-19




*Note
      4*




**Property
      and Equipment:**




Set
      forth
      below is a detailed listing of property and equipment.




December
                31,2006
            
            2005Lasers
                in service
            
            $
            16,234,834
            
            $
            12,657,701Computer
                hardware and software
            
            
            334,490
            
            
            334,490Furniture
                and fixtures
            
            
            331,379
            
            
            338,089Machinery
                and equipment
            
            
            738,636
            
            
            755,565Autos
                and trucks
            
            
            382,690
            
            
            382,690Leasehold
                improvements
            
            
            247,368
            
            
            238,27618,269,397
            
            
            14,706,811Accumulated
                depreciation and amortization
            
            
            (9,215,299
            )
            
            (7,662,098
            )Property
                and equipment, net
            
            $
            9,054,098
            
            $
            7,044,713




Depreciation
      expense was $2,939,909 in 2006, $2,226,933 in 2005 and $1,596,154 in 2004.
      At
      December 31, 2006 and 2005, net property and equipment included $380,875 and
      $530,191, respectively, of assets recorded under capitalized lease arrangements,
      of which $122,717 and $302,710, respectively, of the capital lease obligation
      was included in long-term debt at December 31, 2006 and 2005 (see *Note
      9* ).




*Note
      5*




**Patents
      and Licensed Technologies:**




Set
      forth
      below is a detailed listing of patents and licensed technologies.




December
                31,2006
            
            2005Patents,
                owned and licensed, at gross costs of $501,657 and $438,939 net of
                accumulated amortization of $231,599 and $194,659,
                respectively
            
            $
            270,058
            
            $
            244,280Other
                licensed and developed technologies, at gross costs of $2,432,258
                and
                $2,047,665, net of accumulated amortization of $1,006,589 and $714,391,
                respectively
            
            
            1,425,669
            
            
            1,333,274Total
                patents and licensed technologies, net
            
            $
            1,695,727
            
            $
            1,577,554




Related
      amortization expense was $329,138, $257,894 and $169,790 for the years ended
      December 31, 2006, 2005 and 2004, respectively. Included in other licensed
      and developed technologies is $200,000 in developed technologies acquired from
      ProCyte and $114,982 for the license with AzurTec (see Note 2). On March 31,
      2006, the Company closed the transaction provided for in the License Agreement
      with Mount Sinai School of Medicine of New York University (“Mount Sinai”).
      Pursuant to the license agreement, the Company must reimburse $77,876 to Mount
      Sinai, over the first 18 months of the license term and at no interest, for
      patent prosecution costs incurred. The Company is also obligated to pay Mount
      Sinai a royalty on a combined base of domestic sales of XTRAC treatment codes
      used for psoriasis as well as for vitiligo. In the first four years of the
      license, however, Mount Sinai may elect to be paid royalties on an alternate
      base, comprised simply of treatments for vitiligo, but at a higher royalty
      rate
      than the rate applicable to the combined base. This technology is for the laser
      treatment of vitiligo and is included in other licensed and developed
      technologies.




Estimated
      amortization expense for amortizable intangible assets for the next five years
      is $275,000 in 2007, $190,000 in 2008, $190,000 in 2009, $190,000 in 2010,
      $190,000 in 2011 and $663,000 thereafter.




F-20




*Note
      6*




**Other
      Intangible Assets:**




Set
      forth
      below is a detailed listing of other intangible assets, all of which were
      acquired from ProCyte and which have been recorded at their appraised fair
      market values:




December
                31,2006
            
            2005Neutrogena
                Agreement, at gross cost of $2,400,000 net of accumulated amortization
                of
                $858,000 and $378,000, respectively.
            
            $
            1,542,000
            
            $
            2,022,000Customer
                Relationships, at gross cost of $1,700,000 net of accumulated amortization
                of $607,743 and $267,747, respectively.
            
            
            1,092,257
            
            
            1,432,253Tradename,
                at gross cost of $1,100,000 net of accumulated amortization of $196,632
                and $86,628, respectively.
            
            
            903,368
            
            
            1,013,372$
            3,537,625
            
            $
            4,467,625




Related
      amortization expense was $930,000 and $732,375 for 2006 and 2005, respectively.
      Estimated amortization expense for amortizable intangible assets for the next
      five years is $930,000 in 2007, $930,000 in 2008, $930,000 in 2009, $284,000
      in
      2010, $110,000 in 2011 and $353,000 thereafter. Under the Neutrogena Agreement,
      the Company has licensed to Neutrogena rights to its copper peptide technology
      and for which the Company receives royalties. Customer Relationships embody
      the
      value to the Company of relationships that ProCyte had formed with its
      customers. Tradename includes the name of “ProCyte” and various other trademarks
      associated with ProCyte’s products.




*Note
      7*




**Other
      Accrued Liabilities:**




Set
      forth
      below is a detailed listing of other accrued liabilities.




December
                31,2006
            
            2005Accrued
                professional and consulting fees
            
            $
            320,331
            
            $
            437,396Accrued
                warranty
            
            
            123,738
            
            
            204,708Accrued
                sales taxes and other expenses
            
            
            213,224
            
            
            282,864Total
                other accrued liabilities
            
            $
            657,293
            
            $
            924,968


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
                31,2006
            
            2005Note
                payable - secured creditor, interest at 16.47%, payable in monthly
                principal and interest installments of $2,618 through December
                2006.
            
            $
            -
            
            $
            26,736Note
                payable - unsecured creditor, interest at 7.42%, payable in monthly
                principal and interest installments of $61,493 through February
                2007.
            
            
            126,279
            
            
            177,450Note
                payable - unsecured creditor, interest at 6%, payable in monthly
                principal
                and interest installments of $2,880 through June 2012.
            
            
            159,213
            
            
            183,425Note
                payable - unsecured creditor, interest at 0%, payable in monthly
                principal
                installments of $4,326 through October 2007
            
            
            43,265
            
            
            -328,757
            
            
            387,611Less:
                current maturities
            
            
            (195,250
            )
            
            (228,398
            )Notes
                payable, net of current maturities
            
            $
            133,507
            
            $
            159,213




Aggregate
      maturities of the notes payable as of December 31, 2006 are $195,250 in 2007,
      $27,292 in 2008, $28,975 in 2009, $30,762 in 2010 and $46,477
      thereafter.




F-22


*Note
      9*




**Long-term
      Debt:**




Set
      forth
      below is a detailed listing of the Company’s long-term debt:




December
                31, 2006
            
            December
                31, 2005Borrowings
                on credit facility:Draw
                1 - effective interest at 17.79%, payable in monthly principal and
                interest installments of $48,156 through June 2007.
            
            $
            279,396
            
            $
            792,362Draw
                2 - effective interest at 17.14%, payable in monthly principal and
                interest installments of $9,957 through September 2007.
            
            
            85,646
            
            
            189,543Draw
                3 - effective interest at 17.61%, payable in monthly principal and
                interest installments of $4,797 through December 2007.
            
            
            54,150
            
            
            102,541Draw
                4 - effective interest at 12.62%, payable in monthly principal and
                interest installments of $34,859 through June 2008.
            
            
            580,501
            
            
            922,350Draw
                5 - effective interest at 12.94%, payable in monthly principal and
                interest installments of $28,757 through September 2008.
            
            
            550,546
            
            
            823,810Draw
                6 - effective interest at 13.36%, payable in monthly principal and
                interest installments of $28,923 through December 2008.
            
            
            622,508
            
            
            895,524Draw
                7 - effective interest at 13.74%, payable in monthly principal and
                interest installments of $40,887 through March 2009.
            
            
            973,474
            
            
            -Draw
                8 - effective interest at 13.45%, payable in monthly principal and
                interest installments of $40,155 through June 2009.
            
            
            1,052,037
            
            
            -Draw
                9 - effective interest at 13.10%, payable in monthlyprincipal
                and interest installments of $40,193 throughSeptember
                2009.
            
            
            1,148,960
            
            
            -Draw
                10 - effective interest at 12.69%, payable in monthlyprincipal
                and interest installments of $36,580 throughDecember
                2009.
            
            
            1,142,859
            
            
            -Total
                borrowings on credit facility
            
            $
            6,490,077
            
            $
            3,726,130Capital
                lease obligations (see Note 4)
            
            
            122,717
            
            
            302,710Less:
                current portion
            
            
            (3,018,874
            )
            
            (1,749,969
            )Total
                long-term debt
            
            $
            3,593,920
            
            $
            2,278,871




***Leasing
      Credit Facility***




The
      Company entered into a leasing credit facility with GE Capital Corporation
      (“GE”) on June 25, 2004. The credit facility has a commitment term of three
      years, expiring on June 25, 2007. For each year of the term, called a “tranche,”
various parameters are set or re-set. 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 security for
      the
      borrowings. The Company depreciates the lasers generally 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.




Under
      the
      first tranche, GE made available $2,500,000 under the line. A draw under that
      tranche is set at an interest rate based on 522 basis points above the
      three-year Treasury note rate. Each such draw is discounted by 7.75%; the first
      monthly payment is applied directly to principal. With each draw, the Company
      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 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 of the Company’s common stock for the ten days preceding the date of the
      draw.




F-23




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 accounted for these warrants as equity instruments in accordance
      with EITF 00-19, "Accounting for Derivative Financial Instruments Indexed to,
      and Potentially Settled in, a Company's Own Stock" since there is no option
      for
      cash or net-cash settlement when the warrants are exercised.




The
      Company obtained a second tranche under the leasing credit facility for
      $5,000,000 on June 28, 2005. The Company accounts for draws under this second
      tranche in the same manner as under the first tranche except that: (i) the
      stated interest rate is set at 477 basis points above the three-year Treasury
      note rate; (ii) each draw is discounted by 3.50%; and (iii) with each draw,
      the
      Company has agreed to issue warrants to purchase shares of the Company’s common
      stock equal to 3% of the draw. The number of warrants is determined by dividing
      3% of the draw by the average closing price of the Company’s common stock for
      the ten trading days preceding the date of the draw.




The
      Company obtained a third tranche under the leasing credit facility for
      $5,000,000 on June 30, 2006. The Company accounts for draws under the third
      tranche in the same manner as under the second tranche except that the stated
      interest rate is set at 400 basis points above the three-year Treasury note
      rate. Draws 8, 9 and 10 were taken against the third tranche.




The
      Company made the following draws against the line for 2006, as follows:




Draw
                7
            
            Draw
                8
            
            Draw
                9
            
            Draw
                10Date
                of draw
            
            
            3/29/06
            
            
            6/30/06
            
            
            9/29/06
            
            
            12/29/06Amount
                of draw
            
            $
            1,287,487
            
            $
            1,268,362
            
            $
            1,276,949
            
            $
            1,164,743Stated
                interest rate
            
            
            9.45
            %
            
            9.22
            %
            
            8.80
            %
            
            8.64
            %Effective
                interest rate
            
            
            13.74
            %
            
            13.45
            %
            
            13.10
            %
            
            12.69
            %Number
                of warrants issued
            
            
            20,545
            
            
            24,708
            
            
            25,038
            
            
            32,057Exercise
                price of warrants per share
            
            $
            2.06
            
            $
            1.69
            
            $
            1.68
            
            $
            1.20Fair
                value of warrants
            
            $
            27,853
            
            $
            26,548
            
            $
            28,103
            
            $
            21,884




The
      fair
      value of the warrants granted under the draws is estimated using the
      Black-Scholes option-pricing model with the following weighted average
      assumptions applicable to the warrants granted:




Warrants
                granted under Draw 7
            
            Warrants
                granted under Draw 8
            
            Warrants
                granted under Draw 9
            
            Warrants
                granted under Draw 10Risk-free
                interest rate
            
            
            4.79
            %
            
            5.18
            %
            
            4.59
            %
            
            4.69
            %Volatility
            
            
            87.16
            %
            
            84.17
            %
            
            84.52
            %
            
            72.53
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %
            
            0
            %
            
            0
            %Expected
                warrant life
            
            
            5
                years
            
            
            5
                years
            
            
            5
                years
            
            
            5
                years




As
      of
      December 31, 2006, the Company had available $1,289,946 from the third tranche
      of the line of credit from which to draw on in the future.




Future
      minimum payments for draws under the lease credit facility are as
      follows:




Year
                Ending December 31,2007
            
            $
            3,390,0082008
            
            
            2,653,8382009
            
            
            1,156,660Total
                minimum lease obligation
            
            
            7,200,506Less:
                interest
            
            
            (710,429
            )Present
                value of total minimum lease obligation
            
            $
            6,490,077




F-24




GE
      Capital Corporation has proposed a fourth tranche under the leasing credit
      facility for 2007. The tranche would be for $6,000,000, would bear interest
      at
      375 basis points above the three-year Treasury rate, and would reduce warrants
      to 2% of a draw. The Company has accepted the proposal. Consummation of the
      transaction is expected to close during the first quarter of 2007.




***Capital
      Leases***




The
      obligations under capital leases are at fixed interest rates of 7.06% to 10.68%
      and are collateralized by the related property and equipment (see Note
      4).




Future
      minimum payments for property under capital leases are as follows:




Year
                Ending December 31,2007
            
            $
            89,7422008
            
            
            40,952Total
                minimum lease obligation
            
            
            130,694Less:
                interest
            
            
            (7,977
            )Present
                value of total minimum lease obligation
            
            $
            122,717




*Note
      10*




**Warrant
      Exercises:**




In
      the
      year ended December 31, 2006, the Company received $168,000 from the exercise
      of
      140,000 warrants. The warrants were issued in connection with a private
      placement of securities in June 2002 and bore an exercise price of
      $2.00.




In
      the
      year ended December 31, 2005, the Company received $147,060 from the exercise
      of
      73,530 warrants. The warrants were issued in connection with a private placement
      of securities in June 2002 and bore an exercise price of $2.00.




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* .




F-25


*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 2011. Rent expense was $601,062,
      $558,683 and $456,077 for the years ended December 31, 2006, 2005 and 2004,
      respectively. The future annual minimum payments under these non-cancelable
      operating leases are as follows:




Year
                Ending December 31,2007
            
            $
            503,1862008
            
            
            373,7882009
            
            
            337,1782010
            
            
            325,380Thereafter
            
            
            306,002Total
            
            $
            1,845,534




***Litigation***




In
      the
      matter brought by the Company against RA Medical Systems, Inc. (“RA Medical”)
      and Dean Irwin in the United States District Court for the Southern District
      of
      California, the trial judge declined to issue to defendants summary judgment
      based on their theory of res judicata. On the other hand, the trial judge
      declined to issue to the Company partial summary judgment for unfair
      competition, which had been based on the fact that RA Medical did not have
      the
      requisite permission from the State of California to market its medical device.
      The declination of the Company’s claim for relief was based on reasons that the
      Company believes will not bar this claim for relief in the other pending
      Federal action, discussed in the paragraph below. The trial judge further
      declined to consolidate this Federal action brought by the Company with the
      Federal action brought by RA Medical and Mr. Irwin, discussed below. Pretrial
      is
      scheduled for the Spring of 2007, but no trial date has been set. In this
      action, there are no counterclaims that the Company must defend against.




In
      the
      matter brought in California Superior Court by RA Medical and Mr. Irwin against
      the Company for unfair competition, the Company removed the State action to
      Federal court. Plaintiffs’ claim is that the Company did not have the requisite
      permission to market its excimer medical device from its new facility in
      Carlsbad The Company has counterclaimed for, among other things, contractual
      interference, misappropriation of our technology and unfair competition under
      Federal and State statutes. The plaintiffs brought a motion to dismiss the
      latter two counterclaims, based in part on an alleged bar under the applicable
      statutes of limitations. The trial judge has not ruled on the motion. Discovery
      has been stayed, pending the judge’s ruling. Among the Company’s claims of
      unfair competition is a claim based on RA Medical’s lack of requisite permission
      from the State of California to market its medical device.




In
      the
      matter brought for malicious prosecution in California Superior Court by RA
      Medical Systems and Mr. Irwin against the Company, Jenkens & Gilchrist, LLP
      (the Company’s then outside counsel) and Michael R. Matthias, Esq. (the
      litigation partner at Jenkens & Gilchrist), trial is set for May 2007. The
      parties are conducting discovery. Morgan, Lewis & Bockius has been engaged
      to defend the Company.




In
      June
      2006, the insurance carrier that had undertaken to indemnify the Company in
      the
      malicious prosecution action, discussed in the paragraph above, and that had
      for
      18 months been defending the Company, recanted its undertaking to indemnify
      the
      Company. It recanted on two grounds: first, that malicious prosecution is an
      intentional tort and therefore is non-indemnifiable, and then later on a second
      ground that the alleged tort occurred after the period of coverage of its
      underlying policy had expired. The Company notified the subsequent insurance
      carrier in whose coverage period the alleged tort occurred. That carrier has
      undertaken to defend the Company, but has denied its duty to indemnify the
      Company, based on the same ground that malicious tort is a non-indemnifiable
      tort. The Company has rejected this ground and brought, through Morgan, Lewis
      & Bockius, an action in the U.S. District Court for the Eastern District of
      Pennsylvania for breach of contract and for declaratory judgment on the issue
      whether malicious prosecution is indemnifiable under our insurance policy.
      Counsel for the carrier has agreed with the Company’s counsel at Morgan, Lewis
      that the issue for declaratory judgment is a question of law.




F-26




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
      that
      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
      $1,676,843 as of December 31, 2006. 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, 2006 was approximately
      $2,146,482.




***Restricted
      Securities and Warrants***




If
      Stern
      Laser fulfills the either or both of the two remaining milestones under the
      Master Asset Purchase Agreement, then the Company will be obliged to issue
      to
      Stern Laser restricted shares of its common stock. Against this contingency,
      an
      escrow agent holds 110,136 shares of the Company’s common stock. The Company
      deems it to be remote that Stern Laser will fulfill one milestone valued in
      the
      Master Agreement at $150,000, and deems it to be reasonably possible that the
      other milestone, valued in the Agreement at $100,000, will be attained.




If
      AzurTec succeeds in raising the additional equity capital called for in the
      Investment Agreement, then the Company will be obliged to issue to AzurTec
      warrants on 100,000 shares of the Company’s common stock. Such warrants will
      have a five-year
      life and be exercisable in full but the first six months of the life; the
      warrants will have an exercise price equal to 90% of the mean of the closing
      prices of PhotoMedex common stock on Nasdaq for the 30 trading days preceding
      the issuance of the warrants.




If
      an
      investor participating in the November 2006 private placement exercises a
      warrant received in the placement, then Cowen & Company is entitled to a
      6.5% commission on the gross proceeds to the Company from such exercise. If
      all
      such warrants are exercised, then the Company will receive $3,904,000 and will
      owe Cowen & Company $253,760 in commissions.




The
      Company is obliged to use reasonable efforts to register the shares underlying
      the warrants issued to GE Capital Corporation under Draws 8, 9 and
      10.




*Note
      12*




**Stockholders’
      Equity:**




***Common
      Stock***




As
      of
      December 31, 2006, the Company had issued 589,864 shares of its restricted
      common stock in connection with the Asset Purchase agreement with Stern Laser
      Srl, or Stern, of which 113,877 shares had been issued in September 2004 and
      248,395 in June 2005, 126,582 in December 2005 and 101,010 in March
      2006.




On
      November 3, 2006, the Company closed on a private placement for 9,760,000 shares
      of common stock at $1.17 per share resulting in gross proceeds of $11,419,200.
      The closing price of the Company’s common stock on November 1, 2006 was $1.27
      per share. In connection with this private placement, the Company paid
      commissions and other expenses of $864,308, resulting in net proceeds of
      $10,554,892. In addition, the investors received warrants to purchase 2,440,000
      shares of common stock at an exercise price of $1.60 per share, and Cowen &
Company, the placement agent, received warrants to purchase 244,000 shares
      of
      common stock, under the same terms and conditions as the warrants issued to
      the
      investors. As such the warrants have a five-year term and will become
      exercisable on May 1, 2007 (see ***Common
      Stock Warrants*** below).
      Cowen & Company is entitled to a **** 6.5%
      commission on any proceeds to the Company from future exercises by the investors
      of their warrants. The warrants issued to Cowen & Company were in
      consideration of its services as the placement agent and have a value under
      the
      Black Scholes method of approximately $200,000. The Company has used 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.




On
      March
      18, 2005, the Company completed the acquisition of ProCyte Corporation, paid
      through the issuance of 10,540,579 shares of common stock valued at $2.29 per
      share. The merger consideration resulted in the equivalent of a fixed ratio
      of
      0.6622 shares of PhotoMedex common stock for each share of ProCyte common
      stock.




***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.




F-27




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, 2006, the
      plan had 15,000 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 became inactive on December 28, 2005, and had 2,316,730 options outstanding
      at December 31, 2006.




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 and on December 28, 2005,
      they voted to increase the number of reserved shares to 1,400,000. The plan
      is
      active and had 903,750 options outstanding at December 31, 2006.




In
      March
      2005, the Company assumed four option plans from ProCyte: the 2004 Stock Option
      Plan, the 1996 Stock Option Plan, the 1991 Restated Stock Option Plan for
      Non-Employee Directors and the 1989 Restated Stock Option Plan.




On
      December 28, 2005, the stockholders approved the 2005 Equity Compensation Plan,
      authorizing 3,160,000 shares thereto. The plan is active and had 2,300,000
      options outstanding at December 31, 2006.




On
      December 28, 2005, the stockholders approved the 2005 Investment Plan,
      authorizing 400,000 shares thereto. The plan is active and had 9,000 options
      outstanding at December 31, 2006.




In
      January 2006 and August 2006, the Company issued 175,000 and 17,500 options,
      respectively, to purchase common stock to non-employee directors, in accordance
      with the terms of the Non-Employee Director Plan.




On
      January 15, 2006, the Company awarded 860,000 restricted shares of our common
      stock to two of the Company’s executive officers, and 200,000 stock options to
      one of the two executive officers.




Also,
      during the course of 2006, the Company granted an aggregate of 1,238,500 options
      to purchase common stock to a number of employees and consultants at the market
      value at the date of grant. The options vest over five years and expire ten
      years from the date of grant.




In
      January 2006, the Company granted 42,000 options to purchase common stock to
      the
      various members of the Company’s Scientific Advisory Board for services rendered
      at the market value at the date of grant. The options have an exercise price
      of
      $1.72 per share. The options vest upon issuance and will expire ten years from
      the date of the grant.




F-28


In
      May
      2006, the Company granted 9,000 options to purchase common stock to executives
      in accordance with the terms of the 2005 Investment Plan.




In
      January 2005, 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.




Also,
      during the course of 2005, the Company granted an aggregate of 1,182,000 options
      to purchase common stock to a number of employees at the market value at the
      date of grant. The options vest over four years and expire five years from
      the
      date of grant.




In
      February 2005, the Company granted 18,000 options to purchase common stock
      to
      the various members of the Company’s Scientific Advisory Board for services
      rendered at the market value at the date of grant. The options have an exercise
      price of $2.35 per share. The options vest over three years and will expire
      five
      years from the date of the grant. The Company recorded $31,859 of expense
      relating to these options for the year ended December 31, 2005.




On
      March
      18, 2005, the Company agreed to assume up to 2,063,000 common stock options
      associated with the acquisition of ProCyte Corporation valued at $2,033,132.
      These ProCyte common stock options were converted into 1,366,131 common stock
      options for PhotoMedex common stock.




In
      July
      and October 2005, the Company granted 25,000 options, each, to purchase common
      stock to consultants for services rendered. The options have an exercise price
      of $2.66 and $2.30 per share, respectively. The options vest over four years
      and
      will expire five years from the date of the grant. The Company recorded $49,120
      and $42,278, respectively, of expense relating to these options for the year
      ended December 31, 2005.




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.
      The
      options lapsed in 2005.




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 pursuant
      to
      the 2000 Plan at the market value at the date of grant. The options vest over
      four years and expire five years from the date of grant. Also in 2004, the
      Company issued 66,666 options from the 2000 Stock Option Plan with an extended
      exercise period in replacement of options that had been granted outside of
      a
      plan in 1999, and those replacement options expired unexercised in
      2004.




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
      pursuant to the 2000 Plan at the market value at the date of grant. 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 pursuant to the 2000 Plan at the market value at the
      date
      of grant. 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.




F-29


A
        summary
        of option transactions for all of the Company’s options during the years ended
        December 31, 2006, 2005 and 2004 is as follows:


Number
                of Shares
            
            Weighted
                Average Exercise PriceOutstanding
                at January 1, 2004
            
            
            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
            
            
            3.48Granted
            
            
            1,460,000
            
            
            2.57Assumed
                from acquisition
            
            
            1,366,131
            
            
            1.73Exercised
            
            
            (350,189
            )
            
            1.80Expired/cancelled
            
            
            (1,608,836
            )
            
            5.83Outstanding
                at December 31, 2005
            
            
            5,077,646
            
            
            2.11Granted
            
            
            1,682,000
            
            
            1.92Exercised
            
            
            (60,750
            )
            
            1.44Expired/cancelled
            
            
            (605,171
            )
            
            1.92Outstanding
                at December 31, 2006
            
            
            6,093,725
            
            $
            2.09




As
      of
      December 31, 2006, 3,670,083 options to purchase common stock were vested and
      exercisable at prices ranging from $0.74 to $9.50 per share. As of December
      31,
      2005, 3,108,379 options to purchase common stock were vested and exercisable
      at
      prices ranging from $0.74 to $9.50 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
      aggregate intrinsic value for options outstanding and exercisable at December
      31, 2006 was approximately $6,460.




The weighted
      average grant date fair value of options was $1.52 and $2.09 for options granted
      during the years ended December 31, 2006 and 2005, respectively. The total
      intrinsic value of options exercised during the years ended December 31, 2006
      and 2005 was $31,494 and $292,577, respectively.




At
      December 31, 2006, there was $4,174,105 of total unrecognized compensation
      cost
      related to non-vested option grants and stock awards that is expected to be
      recognized over a weighted-average period of 2.70 years.




The
      outstanding options, including options exercisable at December 31, 2006, have
      a
      range of exercise prices and associated weighted remaining contractual life
      and
      weighted average exercise price as follows:




Options
                Range of Exercise Prices
            
            Outstanding
                Number of Shares
            
            Weighted
                Average Remaining Contractual Life (years)
            
            Weighted
                Average Exercise Price
            
            Exercisable
                Number of Shares
            
            Exercisable
                Weighted Avg. Exercise Price$0
                - $2.50
            
            
            5,445,725
            
            
            5.10
            
            $
            1.95
            
            
            3,143,333
            
            $
            1.86$2.51
                - $5.00
            
            
            553,000
            
            
            3.64
            
            $
            2.74
            
            
            431,750
            
            $
            2.75$5.01
                - $7.50
            
            
            80,000
            
            
            4.01
            
            $
            5.63
            
            
            80,000
            
            $
            5.63$7.51
                - up
            
            
            15,000
            
            
            3.34
            
            $
            9.50
            
            
            15,000
            
            $
            9.50Total
            
            
            6,093,725
            
            
            4.95
            
            $
            2.09
            
            
            3,670,083
            
            $
            2.08




The
      outstanding options will expire as follows:




Year
                Ending
            
            Number
                of Shares
            
            Weighted
                Average Exercise Price
            
            Exercise
                Price2007
            
            
            379,530
            
            $
            1.72
            
            $
            1.26
                - $1.892008
            
            
            604,382
            
            
            1.72
            
            $
            0.74
                - $2.172009
            
            
            1,000,473
            
            
            1.97
            
            $
            1.41
                - $2.702010
            
            
            1,151,662
            
            
            2.47
            
            $
            1.07
                - $9.502011
                and later
            
            
            2,957,678
            
            
            2.10
            
            $
            1.06
                - $5.636,093,725
            
            $
            2.09
            
            $
            0.74
                - $5.63




F-30




***Common
      Stock Warrants***




In
      November 2006, in addition to receiving common stock in the Company’s private
      placement, the investors and placement agent received warrants to purchase
      2,684,000 shares of common stock at an exercise price of $1.60 per share. The
      warrants have a five-year term, expiring in November 2011.




In
      2006,
      the Company issued warrants to purchase common stock to GE Capital Corporation
      related to the leasing credit facility in the following manner: on March 29,
      2006, 20,545 shares at an exercise price of $2.06; on June 30, 2006, 24,708
      shares at an exercise price of $1.69 per share; on September 29, 2006, 25,038
      shares at an exercise price of $1.53 per share; and on December 28, 2006, 32,057
      at an exercise price of $1.20 per share. The warrants have a five-year
      term.




In
      2005,
      the Company issued warrants to purchase common stock to GE Capital Corporation
      related to the leasing credit facility in the following manner: on June 28,
      2005, 14,714 shares at an exercise price of $2.50 per share; on September 26,
      2005, 13,921 shares at an exercise price of $2.29 per share; and on December
      27,
      2005, 15,830 at an exercise price of $1.90 per share. The warrants have a
      five-year term.




In
      2004,
      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.




A
      summary
      of warrant transactions for the years ended December 31, 2006, 2005 and 2004
      is
      as follows:




Number
                of Warrants
            
            Weighted
                Average
              Exercise
                PriceOutstanding
                at January 1, 2004
            
            
            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
            
            
            2.34Issued
            
            
            43,765
            
            
            2.22Exercised
            
            
            (73,530
            )
            
            2.00Expired/cancelled
            
            
            (38,525
            )
            
            13.43Outstanding
                at December 31, 2005
            
            
            2,100,309
            
            
            1.98Issued
            
            
            2,786,348
            
            
            1.60Exercised
            
            
            (140,000
            )
            
            2.00Expired/cancelled
            
            
            -
            
            
            -Outstanding
                at December 31, 2006
            
            
            4,746,657
            
            $
            1.75




At
      December 31, 2006, all outstanding warrants were exercisable at prices ranging
      from $1.20 to $3.54 per share.




If
      not
      previously exercised, the outstanding warrants will expire as
      follows:




Year
                Ending December 31,
            
            Number
                of Warrants
            
            Weighted
                Average
              Exercise
                Price2007
            
            
            888,350
            
            $
            1.892008
            
            
            994,533
            
            
            2.002009
            
            
            33,661
            
            
            3.292010
            
            
            43,765
            
            
            2.222011
            
            
            2,786,348
            
            
            1.604,746,657
            
            $
            1.75




F-31




*Note
      13*




**Income
      Taxes:**




The
      Company accounts for income taxes pursuant to Statement of Financial Accounting
      Standards 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.




The
      Company recorded no provisions in 2006, 2005 and 2004 due to losses incurred.
      Any other provisions, including accrual adjustments for prior periods, were
      completely offset by changes in the deferred tax valuation
      allowance.




Income
      tax expense (benefit) consists of the following. Because the Company acquired
      ProCyte Corporation on March 18, 2005, the effect of ProCyte’s deferred tax
      asset is included for 2006 and only a part of 2005 and not at all in 2004.




Year
                Ended December 31,2006
            
            2005
            
            2004Federal,
                including AMT tax:Current
            
            $
            -
            
            $
            -
            
            $
            -Deferred
            
            
            (1,805,000
            )
            
            8,887,000
            
            
            (2,114,000
            )State:Current
            
            
            -
            
            
            -
            
            
            -Deferred
            
            
            (2,131,000
            )
            
            68,000
            
            
            (174,000
            )(3,936,000
            )
            
            8,955,000
            
            
            (2,288,000
            )Change
                in valuation allowance
            
            
            3,936,000
            
            
            8,955,000
            
            
            (2,288,000
            )Income
                tax expense
            
            $
            -
            
            $
            -
            
            $
            -




A
      reconciliation of the effective tax rate with the Federal statutory tax rate
      of
      34% follows:




Year
                Ended December 31,2006
            
            2005
            
            2004Expected
                Federal tax benefit at statutory rate
            
            $
            2,547,000
            
            $
            1,338,000
            
            $
            1,701,000Gross
                change in valuation allowance
            
            
            3,936,000
            
            
            (8,955,000
            )
            
            2,288,000Adjustments
                of temporary differences and net operating loss expirations and
                limitations
            
            
            (4,460,000
            )
            
            7,652,000
            
            
            (3,792,000
            )State
                income taxes
            
            
            278,000
            
            
            68,000
            
            
            (174,000
            )Other,
                including adjustment due to State loss carryforwards
            
            
            (2,301,000
            )
            
            (103,000
            )
            
            (23,000
            )Income
                tax expense
            
            $
            -
            
            $
            -
            
            $
            -




In
      2006,
      the deferred benefit from net operating loss carryforwards was reduced to
      rationalize expirations with cumulative Federal limitations as well as to
      harmonize the lesser State loss carryforwards with the Federal carryforwards.




As
      of
      December 31, 2006, the Company had approximately $176 million of federal net
      operating loss carryforwards. Included in the aggregate net operating loss
      carryforward are approximately $23 million of losses sustained by SLT prior
      to
      the tax-free acquisition on December 27, 2002 and approximately $62 million
      of
      losses sustained by ProCyte prior to the tax-free acquisition on March 18,
      2005.
      As of December 31, 2006, the Company has estimated that only $4 million of
      the
      net operating loss from SLT and $13 million of the loss from ProCyte can be
      realized upon, based on Federal limitations on the useabililty of such expiring
      losses. There have been no other changes of ownership identified by management
      that materially constrain the Company’s utilization of loss carryforwards. If
      the Company undergoes a change or ownership in the future, the utilization
      of
      the Company’s loss carryforwards may be materially constrained.




F-32




In
      addition, the Company had approximately $2.7 million of Federal tax credit
      carryforwards as of December 31, 2006. The credit carryforwards have begun,
      and
      continue, to expire over the ensuing 20 years. Under Federal rules applicable
      to
      the acquisition of SLT and ProCyte, the research credit carryforwards from
      these
      companies which are from years prior to their respective acquisitions and which
      approximate $2.0 million, are subject to severe utilization constraints and
      accordingly have been ascribed no value in the deferred tax asset.




Net
      deductible, or favorable, temporary differences were approximately $20,814,000
      at December 31, 2006.




The
      changes in the deferred tax asset are as follows.




December
                31,2006
            
            2005Beginning
                balance, gross
            
            $
            50,051,000
            
            $
            41,095,000Net
                changes due to:Operating
                loss carryforwards
            
            
            (6,687,000
            )
            
            9,688,000Temporary
                differences
            
            
            2,643,000
            
            
            (630,000
            )Carryforward
                and AMT credits
            
            
            108,000
            
            
            (102,000
            )Ending
                balance, gross
            
            
            46,115,000
            
            
            50,051,000Less:
                valuation allowance
            
            
            (46,115,000
            )
            
            (50,051,000
            )Ending
                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.




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,
      but
      only in 2006 and in part of 2005 for ProCyte.




December
                31,2006
            
            2005Loss
                carryforwards
            
            $
            37,456,000
            
            $
            44,143,000Carryforward
                and AMT credits
            
            
            750,000
            
            
            642,000Accrued
                employment expenses
            
            
            557,000
            
            
            176,000Amortization
                and write-offs
            
            
            1,336,000
            
            
            (107,000
            )Bad
                debts
            
            
            292,000
            
            
            390,000Deferred
                R&D costs
            
            
            3,049,000
            
            
            2,607,000Deferred
                revenues
            
            
            240,000
            
            
            177,000Depreciation
            
            
            1,533,000
            
            
            1,152,000Inventoriable
                costs
            
            
            81,000
            
            
            140,000Inventory
                reserves
            
            
            567,000
            
            
            395,000Other
                accruals and reserves
            
            
            254,000
            
            
            335,000Gross
                deferred tax asset
            
            
            46,115,000
            
            
            50,051,000Less:
                valuation allowance
            
            
            (46,115,000
            )
            
            (50,051,000
            )Net
                deferred tax asset
            
            $
            -
            
            $
            -




F-33




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 and that approximate $3.1 million in benefit, or that
      were contributed by ProCyte from periods prior to the acquisition in March
      2005
      and that approximate $6.5 million in benefit will first be taken to reduce
      the
      carrying value of goodwill and other intangibles that were recorded in the
      respective transactions. Only after such values have been fully reduced will
      any
      remaining benefit be reflected in the Company’s Statement of Operations. It is
      not expected that any material tax benefit from the Acculase and ProCyte
      acquisitions will be reflected in the Statement of Operations. Within the net
      operating loss carryforward as of December 31, 2006 are approximately $17.5
      million of tax deductions from the exercise of Company stock options. The
      preponderance of these options were to employees and therefore no book expense
      was recognized on their grant under APB No. 25.




*Note
      14*




**Significant
      Alliances/Agreements:**




On
      March
      31, 2005, the Company entered into a Sales and Marketing Agreement with
      GlobalMed (Asia) Technologies Co., Inc. (“GlobalMed”). Under this agreement,
      GlobalMed acts as master distributor in the Pacific Rim for the Company’s XTRAC
      excimer laser and for the Company’s LaserPro® diode surgical laser system. The
      Company’s diode laser will be marketed for, among other things, use in a
      gynecological procedure pioneered by David Matlock, MD. The
      Company has engaged Dr. Matlock as a consultant to explore further business
      opportunities for the Company. In connection with this engagement, Dr. Matlock
      received options to purchase up to 25,000 shares of the Company’s common stock
      at an exercise price which was the market value of the Company’s common stock on
      the date of the grant. In July 2006, the Company broadened the territory covered
      by the Sales and Marketing Agreement to include the United States and added
      Innogyn, Inc., a related party of GlobalMed, as co-distributor under the
      agreement.




On
      July
      27, 2005, the Company entered into a Marketing Agreement with KDS Marketing,
      Inc. (“KDS”). Using money invested by each party, KDS has researched market
      opportunities for the Company’s diode laser and related delivery systems, and
      KDS is now marketing the diode laser primarily through a website that physicians
      may access for information about purchasing the lasers. KDS began marketing
      the
      laser in the first quarter 2006 but has faced difficult market conditions and
      therefore has yet to achieve meaningful results. In light of this, the Company
      has written down its investment in the program.




On
      March
      30, 2006, the Company entered a strategic relationship with AzurTec to resume
      development, and to undertake the manufacture and distribution, of AzurTec's
      MetaSpex Laboratory System, a light-based system designed to detect certain
      cancers of the skin. The Company issued 200,000 shares of its restricted common
      stock in exchange for 6,855,141 shares of AzurTec common stock and 181,512
      shares of AzurTec Class A preferred stock, which represent a 14% interest in
      AzurTec on a fully diluted basis. The Company will assist
      in
      the development of FDA-compliant prototypes for AzurTec’s product. Continuing
      development of this project requires additional investment by AzurTec, which
      AzurTec has undertaken to raise. The Company will resume development once the
      additional investment has been raised, and AzurTec has settled its prior
      indebtedness to the Company for development work. The Company has granted
      AzurTec an additional 12 months in which to raise the additional
      investment.




On
      March
      31, 2006, the Mount Sinai School of Medicine of New York University granted
      the
      Company an exclusive license, effective April 1, 2006, to use Mount Sinai's
      patented methodology for utilization of ultraviolet laser light for the
      treatment of vitiligo. The licensed patent is US Patent No. 6,979,327, Treatment
      of Vitiligo. It was issued December 27, 2005, and the inventor is James M.
      Spencer, MD, a member of the Company’s Scientific Advisory Board.




On
      April
      14, 2006, the Company entered into a Clinical Trial Agreement protocol with
      the
      University of California at San Francisco. The
      agreement covers a protocol for a phase 4, randomized, double-blinded study
      to
      evaluate the safety and efficacy of the XTRAC laser system in the treatment
      of
      moderate to severe psoriasis. John Koo, MD, a member of our Scientific Advisory
      Board, is guiding the study using our high-powered UltraTM excimer
      laser.





***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, for the treatment of cardiovascular
      and vascular disease using the surgical procedure known as transmyocardial
      revascularization, or TMR.




F-34




The
      Company’s strategic relationship with Edwards was terminated in early 2001. The
      termination was the subject of certain disputes and litigation between Edwards
      and the Company. All disputes and litigation have been resolved in December
      2005.




*Note
      15*




**Significant
      Customer Concentration:**




No
      one
      customer represented 10% or more of total revenues for the year ended December
      31, 2006, 2005 and 2004.




*Note
      16*




**Business
      Segment and Geographic Data:**




Segments
      are distinguished by the Company’s management structure, products and services
      offered, markets served and types of customers. The Domestic XTRAC business
      derives its primary revenues from procedures performed by dermatologists in
      the
      United States. The International Dermatology Equipment segment, in comparison,
      generates revenues from the sale of equipment to dermatologists outside the
      United States through a network of distributors. The Skin Care (ProCyte) segment
      generates revenues by selling skincare products and by earning royalties on
      licenses for the Company’s patented copper peptide compound. The Surgical
      Services segment generates revenues by providing fee-based procedures typically
      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. For
      the years ended December 31, 2006, 2005 and 2004, the Company did not have
      material revenues from any individual customer.




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 that was carried at $2,944,423 at December 31, 2006
      and 2005 has been allocated to the domestic and international XTRAC segments
      based upon its fair value as of the date of the Acculase buy-out in the amounts
      of $2,061,096 and $883,327, respectively. Goodwill of $13,973,385 at December
      31, 2006 from the ProCyte acquisition has been entirely allocated to the Skin
      Care segment. The following tables reflect results of operations from our
      business segments for the periods indicated below:




F-35





Year
                Ended December 31, 2006DOMESTIC
              XTRAC
            
            INTERN’L
              DERM.
                EQUIPMENT
            
            SKIN
              CARE
            
            SURGICAL
                SERVICES
            
            SURGICAL
                PRODUCTS
              AND
                OTHER
            
            TOTALRevenues
            
            $
            5,611,387
            
            
            2,186,424
            
            $
            12,646,910
            
            $
            6,944,292
            
            $
            5,800,864
            
            $
            33,189,877Costs
                of revenues
            
            
            4,166,199
            
            
            1,268,080
            
            
            3,858,944
            
            
            5,703,925
            
            
            3,474,702
            
            
            18,471,850Gross
                profit
            
            
            1,445,188
            
            
            918,344
            
            
            8,787,966
            
            
            1,240,367
            
            
            2,326,162
            
            
            14,718,027Allocated
                operating expenses:Selling,
                general and administrative
            
            
            4,408,753
            
            
            77,639
            
            
            5,580,985
            
            
            959,848
            
            
            552,824
            
            
            11,580,049Engineering
                and product development
            
            
            -
            
            
            -
            
            
            498,602
            
            
            -
            
            
            507,998
            
            
            1,006,600Unallocated
                operating expenses
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            9,102,0074,408,753
            
            
            77,639
            
            
            6,079,587
            
            
            959,848
            
            
            1,060,822
            
            
            21,688,656Loss
                from operations
            
            
            (2,963,565
            )
            
            840,705
            
            
            2,708,379
            
            
            280,519
            
            
            1,265,340
            
            
            (6,970,629
            )Interest
                expense, net
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (521,768
            )Net
                loss
            
            
            ($2,963,565
            )
            $
            840,705
            
            $
            2,708,379
            
            $
            280,519
            
            $
            1,265,340
            
            
            ($7,492,397
            )Segment
                assets
            
            $
            11,143,750
            
            $
            1,838,558
            
            $
            21,750,716
            
            $
            4,450,302
            
            $
            4,772,302
            
            $
            43,955,628Capital
                expenditures
            
            $
            2,933,680
            
            $
            885
            
            $
            -
            
            $
            998,541
            
            $
            70,215
            
            $
            4,003,321




Year
                Ended December 31, 2005DOMESTIC
              XTRAC
            
            INTERN’L
              DERM.
                EQUIPMENT
            
            SKIN
              CARE
            
            SURGICAL
                SERVICES
            
            SURGICAL
                PRODUCTS
              AND
                OTHER
            
            TOTALRevenues
            
            $
            3,498,235
            
            $
            1,404,096
            
            $
            10,042,133
            
            $
            7,719,529
            
            $
            5,720,513
            
            $
            28,384,506Costs
                of revenues
            
            
            2,691,506
            
            
            930,574
            
            
            3,132,532
            
            
            5,675,787
            
            
            3,245,106
            
            
            15,675,505Gross
                profit
            
            
            806,729
            
            
            473,522
            
            
            6,909,601
            
            
            2,043,742
            
            
            2,475,407
            
            
            12,709,001Allocated
                operating expenses:Selling,
                general and administrative
            
            
            2,692,388
            
            
            313,713
            
            
            5,331,764
            
            
            1,192,911
            
            
            582,366
            
            
            10,113,142Engineering
                and product development
            
            
            -
            
            
            -
            
            
            442,367
            
            
            -
            
            
            685,594
            
            
            1,127,961Unallocated
                operating expenses
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            6,364,1802,692,388
            
            
            313,713
            
            
            5,774,131
            
            
            1,192,911
            
            
            1,267,960
            
            
            17,605,283Loss
                from operations
            
            
            (1,885,659
            )
            
            159,809
            
            
            1,135,470
            
            
            850,831
            
            
            1,207,447
            
            
            (4,896,282
            )Other
                Income
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            1,302,537Interest
                expense, net
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (342,299
            )Net
                loss
            
            
            ($1,885,659
            )
            $
            159,809
            
            $
            1,135,470
            
            $
            850,831
            
            $
            1,207,447
            
            
            ($3,936,044
            )Segment
                assets
            
            $
            8,936,793
            
            $
            2,523,953
            
            $
            22,585,592
            
            $
            4,118,909
            
            $
            4,176,741
            
            $
            42,341,988Capital
                expenditures
            
            $
            3,391,376
            
            $
            14,327
            
            $
            -
            
            $
            216,633
            
            $
            80,552
            
            $
            3,702,888




F-36




Year
                Ended December 31, 2004DOMESTIC
              XTRAC
            
            INTERN’L
              DERM.
                EQUIPMENT
            
            SKIN
              CARE
            
            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
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (138,414
            )Net
                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




December
                31,Assets:
            
            
            2006
            
            
            2005Total
                assets for reportable segments
            
            $
            43,955,628
            
            $
            42,341,988Other
                unallocated assets
            
            
            13,525,893
            
            
            6,333,618Consolidated
                total
            
            $
            57,481,521
            
            $
            48,675,606




For
      the
      years ended December 31, 2005, 2004 and 2003, there were no material net
      revenues attributed to an individual foreign country. Net revenues by geographic
      area were as follows:




Year
                Ended December 31,2006
            
            2005
            
            2004Domestic
            
            $
            27,691,157
            
            $
            24,667,314
            
            $
            15,460,793Foreign
            
            
            5,498,720
            
            
            3,717,192
            
            
            2,284,388$
            33,189,877
            
            $
            28,384,506
            
            $
            17,745,181




F-37




*Note
      17*




**Quarterly
      Financial Data (Unaudited):**




*For
                the Quarter Ended***2006**
            
            Mar.
                31
            
            Jun.
                30
            
            Sep.
                30
            
            Dec.
                31Revenues
            
            $
            8,081,000
            
            $
            8,224,000
            
            $
            8,292,000
            
            $
            8,593,000Gross
                profit
            
            
            3,373,000
            
            
            4,000,000
            
            
            3,633,000
            
            
            3,712,000Net
                loss
            
            
            (2,350,000
            )
            
            (1,340,000
            )
            
            (1,693,000
            )
            
            (2,109,000
            )Basic
                and diluted net loss per share
            
            
            ($0.05
            )
            
            ($0.03
            )
            
            ($0.03
            )
            
            ($0.03
            )Shares
                used in computing basic and diluted net loss per share
            
            
            52,173,618
            
            
            52,622,189
            
            
            52,659,132
            
            
            59,239,878**2005**
            
            
            Mar.
                31
            
            
            Jun.
                30
            
            
            Sep.
                30
            
            
            Dec.
                31Revenues
            
            $
            4,983,000
            
            $
            8,055,000
            
            $
            7,624,000
            
            $
            7,722,000Gross
                profit
            
            
            2,351,000
            
            
            3,833,000
            
            
            3,320,000
            
            
            3,205,000Net
                loss
            
            
            (1,128,000
            )
            
            (661,000
            )
            
            (1,350,000
            )
            
            (797,000
            )Basic
                and diluted net loss per share
            
            
            ($0.03
            )
            
            ($0.01
            )
            
            ($0.03
            )
            
            ($0.01
            )Shares
                used in computing basic and diluted net loss per share
            
            
            41,755,950
            
            
            50,859,562
            
            
            51,198,095
            
            
            51,322,000**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




*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, 2006:Reserve
                for Doubtful Accounts
            
            $
            765,440
            
            $
            66,211
            
            $
            -
            
            $
            323,213
            
            
            508,438For
                The Year Ended December 31, 2005:Reserve
                for Doubtful Accounts
            
            $
            736,505
            
            $
            373,964
            
            $
            121,633
            
            $
            466,662
            
            $
            765,440For
                The Year Ended December 31, 2004:Reserve
                for Doubtful Accounts
            
            $
            698,044
            
            $
            459,861
            
            $
            -
            
            $
            421,400
            
            $
            736,505





(1)
            Represents
                allowance for doubtful accounts related to the acquisition of
                ProCyte.


(2)
            Represents
                write-offs of specific accounts
                receivable.




F-38